St~ptcwllwr l!M) U.S. GOVERNMENT SECURITIES More Transaction Information and Investor Protection Measures Are Needed w I 142213 ---l_~-“- -- -- t;Ao./‘(;(;I)-!Mbl 14 li ,b ;; .--_ _._ _ ..-_- ___- _....-_-.- --.-. ---.-l----- -.--.---- I :, . (gQ() ~~~~~in~go¶c , I@ General Government Division B-236437 September 14,199O The Honorable Donald W. Riegle Chairman, Committee on Banking, Housing, and Urban Affairs United States Senate The Honorable John D. Dingell Chairman, Committee on Energy and Commerce Houseof Representatives The Honorable Henry B. Gonzalez Chairman, Committee on Banking, Finance and Urban Affairs Houseof Representatives This report discussesimplementation of the Government Securities Act of 1986.The report was undertaken in responseto the requirement included in that act. The report includes a discussion of the availability of brokers’ servicesin the secondary market for government securities, a discussionthat follows up our December1987 report on the subject that was also mandated by the act. We are also sending copies of this report to the Chairman of the Board of Governors of the Federal ReserveSystem; Chairman, Securities and ExchangeCommission;the Secretary of the Treasury; Chairman, Securities Investor Protection Corporation; other interested congressionalcommittees and subcommittees;and to other interested parties. This report was prepared under the direction of Craig A. Simmons,Director, Financial Institutions and Markets Issues,who may be reached on 2768678 if you or your staffs have any questions, Other major contributors are listed in appendix VII. Richard L. Fogel Assistant Comptroller General Y -RxecutiveSummary Public confidence in the integrity of the,government securities market is Purpose essential for the federal government to sell its securities at the lowest cost. This confidence was shaken during the first half of the 1980swhen several unregulated government securities dealers failed and investors lost money. As a result, to protect investors and to insure fair, honest, and liquid markets in government securities, Congresspassedthe Gov- ernment Securities Act of 1986. The act and implementing rules set by the Treasury Department created a limited regulatory structure appli- cable to all banks and securities firms active in the government securi- ties market. This report respondsto the legislative requirement that GAO evaluate the act’s effectiveness and recommendwhether or not Treasury’s authority should be continued. The report also follows up on a 1987 GAO study that concluded government securities brokers should make timely information about transactions available to the public. The government securities market refers to the buying and selling Background (trading) of Treasury and federal agency and government-sponsored enterprise debt securities, government-supported mortgage-backedsecu- rities, and related contracts basedon these securities. Trading activity in the full range of U.S. Treasury securities and non-mortgage-backed federal agency securities is dominated by 42 banks and securities firms designated as primary dealers by the Federal Reserve.These dealers agreeto meet Federal Reservestandards for capital, creditworthiness, and market participation. Primary dealers reported daily Treasury security trading activity in 1989 of about $113 billion. The act specified that the areas of registration, recordkeeping, capital adequacy, financial reporting, and audit were to be regulated. The act also regulates custody of securities used in financing transactions known as repurchase agreementsthat had beenthe source of investor losses.Although the act applies to all government securities brokers and dealers, the burden of complying was the greatest for the relatively few nonbank firms (specialist firms) that had not previously been regulated becausethey specialized in securities that were generally exempt from securities market regulation. The act established Treasury as rulemaker with authority to write rules until October 1,199l. The act placed rule enforcement authority with the Securities and ExchangeCommission(SEC),working through industry self-regulatory organizations, such as the National Association Page 2 GAO/GGIMO=114Government Securilieo Executive Summary of Securities Dealers and the New York Stock Exchange,and with appropriate bank regulators. A majority of primary dealer trading is conducted through sevenspe- cialized brokers that operate computerized screen-trading systems.Six of these brokers, known as interdealer brokers, allow only primary dealers (and a few dealers that aspire to be primary dealers) to trade on their systems. These interdealer brokers do not make information avail- able to the public. The other broker servesmore customers and dissemi- nates much of its information to the public. In December1987, SEC,the Treasury, and the Federal Reserveagreed with GAO'S conclusion that interdealer brokers should make transaction information publicly available becausesuch information would make financial markets more efficient without any increase in risk to market safety. GAO also concluded that in keeping with the act’s philosophy of limited regulation, brokers and their primary and aspiring primary dealer customers should be allowed time to work out expanded access arrangements on their own before a regulatory requirement is imposed. GAO said it would examine progress made in expanding accessto infor- mation as part of this current study. Results in Brief The act appears to have improved investor safety in the government securities market. GAO believes,however, that gaps remain in the protec- tion afforded to someindividual and small institutional investors. These gaps could result in investor lossesdue to abusive practices by dealers. Someinvestors could also experience lossesbecausespecialist firms lack insurance coveragerequired of other securities firms registered with sE!c. Voluntary efforts by msrket participants have not resulted in public accessto transaction information. GAO, therefore, believes legislation is neededto assurethe timely public dissemination of transaction informa- tion by interdealer brokers. GAO also believesthat Treasury’s role as rulemaker should be extended for a sunset period. New rules are neededin the areas of salespractices and information disclosure. Treasury has done a goodjob of developing rules to this point and, as Congressinitially reasoned,appears to be best positioned to assurethat new rules do not inadvertently damagethe market or impair the government’s ability to sell its securities at the lowest cost. These rules, when developed,will complete the initial rule Page8 GAO/GGD9@114Gover~nentsecurities Jikecutive Summary structure under the act and the decision can be revisited regarding who should be rulemaker beyond that point. GAO’s Analysis Implementation of the Act It is difficult to quantify the act’s effectiveness becausethere is no way and Areas Needing to identify problem situations that have been avoided. Thus, GAO focused on assessingthe coverageof Treasury’s rules, the implementa- Attention tion and enforcement of those rules, and the views of market participants. As of July 1989, the registration processhad identified 1,841 govern- ment securities brokers and dealers comprised of 63 specialist firms, 1,496 diversified securities firms, 281 bank dealers, and 1 thrift. GAO found a few areas in ‘rule implementation and enforcement where improvements could be made, including better tracking of dealer regis- tration status and narrowing differences in the frequencies with which bank and security dealers are examined. By and large, however, GAO found that the general view held by market participants was that the act has been implemented properly and has made the market safer. (See pp. 34-36.) Sales Practices and There are disparities between different securities markets regarding Investor Protection investor protection against abusive salespractices. In the markets for registered corporate and municipal securities, self-regulatory organiza- tions enforce SEC-approvedrules of fair dealing that supplement SEC’S anti-fraud rules. These rules cover the reasonablenessof price mark-ups and the suitability of the match between the risk characteristics of a security and the needsof a purchaser. This element of investor protec- tion is missing in the government securities market. The biggest gap is that National Association of Securities Dealers,the securities regulatory organization with the most explicit rules on price mark-ups and investor suitability, is not permitted under the act to apply such rules to the government securities transactions of the nearly 1,400 dealers and brokers it examines. (Seep. 49.) Another concern is that while New York Stock Exchange and bank regulators say they look for abusive practices in the government securities activities of the firms they examine, the act doesnot require them to do this. Page 4 GAO/GGD-90-114Govemment Securities Executive Summary GAO believes that the absenceof fair dealing rules (and related specific enforcement authority) makes transactions in government securities by someindividuals and smaller institutional investors potentially vulner- able to abusive dealer practices. This is particularly true becausein recent years securities have been developed in the government securi- ties markets that have risk characteristics similar to those in registered markets. Examples of such securities are zero coupon bonds (whose prices are extremely sensitive to interest rate changes)and mortgage- backed securities (which are subject to cash flow variations). (Seepp. 47-49.) Actual abuse is hard to document, but there is someevidencethat problems have occurred and that investors have lost millions of dollars. For example, according to information collected by the Government Finance Officers Association, one state lost over $200 million and a city lost over $60 million in questionable transactions with dealers. The Association also documentedevidenceof inappropriate transactions of zero coupon and mortgage-backedsecurities. Although there is no way to be certain, someor all of such lossesmight have been prevented by appropriate salespractice rules. The Government Finance Officers Asso- ciation and other investors of public funds believe such rules are needed to ensure the safety of public investors. (Seep. 56.) As with salespractices, there are also disparities within the government securities market regarding insurance coverageon customer accounts. Of the 1,669 registered government securities firms, only the 63 spe- cialist firms do not have somedegreeof insurance protection against lossesin customer accountsdue to fraud or failure of the dealer. Cus- tomer accounts at the remaining 1,496 firms have insurance coverage provided by the Securities Investor Protection Corporation. (Seepp, 60-61.) GAO believes that to attain better consistencyof investor protection within the government securities market, the Securities Investor Protec- tion Corporation coverageshould be extended to customer accountsof specialist firms. (Seepp. 62-63.) This would enhanceinvestor protection while adding relatively little to the cost of operations of these firms and making little difference in the Securities Investor Protection Corpora- tion’s total exposure to losses. Page6 GAO/GGMO-114 Government !ikcuritiee Executive Summary Accessto Broker In the 2 years since GAO concluded that transaction information should Information Should Be be made public, interdealer brokers have made several efforts to arrange for greater public accessto the information. However, these Expanded arrangements have faltered, in part becauseof brokers’ concernsabout possible adverse reactions on the part of the primary dealers. (Seepp. 81-86.) To avoid further delay, GAO believesCongressshould mandate public access. Extension of Treasury’s When the act was adopted, CongresschoseTreasury as the rulemaker. Rulemaking Authority Congressreasonedthat becauseof Treasury’s knowledge of the market and responsibility for managing the public debt, Treasury was in the best position to assurethat implementation of the act did not inadver- tently damagethe market. Such damagecould make it harder for the government to sell its securities at the lowest possible cost. For similar reasons,GAO believes that Treasury should continue its role as rulemaker for a sunset period. New rules are neededregarding sales practices and disclosure of information on brokered trades. It is impor- tant that these rules not inadvertently damagethe market or make it unduly difficult for the government to sell its securities. Treasury has done a goodjob in developing the rules the market is presently operating under and appears to be in the best position to assurethat the new rules will be appropriate for the situation. GAO expects that in setting the rules, Treasury would continue to coordi- nate closely with SECso that the rules would also be appropriately sim- ilar to those applicable in other regulated securities markets. (Seepp. 90-92.) As at present, the rules set by Treasury would continue to be enforced by the SEC, self-regulatory organizations, and the bank regulators. The salespractice and information accessrules, once in place, should complete the initial development of an overall rule structure for the market. Thus, at the end of the sunset period, the decision regarding who serves as the market rulemaker can be revisited. The decision at that time should be basedon consideration of several factors, including market conditions, whether gaps exist in regulatory coverage,and any developments that have occurred affecting the way banking organiza- tions or securities firms are regulated or supervised. Page 6 GAO/GGD-90-114Government Securities Congressshould amend the Exchange Act to Recommendations l extend Treasury’s rulemaking authority over the government securities market, subject to a sunset provision (seep, 92); . give Treasury authority to adopt rules as neededover the salesprac- tices of government securities brokers and dealers (seepp. 63-64); and l require all government securities screenbrokers to make transaction information available to market participants on a real time basis (see pp. 86-U). Congressshould also extend Securities Investor Protection Corporation insurance coverageto customer accountsin specialized government securities dealers (seep. 64). GAO also recommendsseveral measuresto improve and simplify the administration of the Government Securities Act. (Seep. 44.) The Department of the Treasury and the Securities Investor Protection Agency Comments Corporation provided written commentson a draft of this report. The Treasury agreedwith GAO’S recommendationsregarding expanding accessto broker screeninformation and extending Treasury’s role as rulemaker under the act. The Securities Investor Protection Corporation did not take a position on GAO’S recommendation to extend insurance coverageto customer accountsin specialist firms, but it expressedcon- cern about the risks involved in extending coverageto a group of firms subject to rulemaking by Treasury rather than SEC. GAO believesthe risks are not great and are outweighed by the benefits of providing con- sistent protection to customers.(Seepp. 64-66.) The Board of Governors of the Federal Reserve,SEC,and the National Association of Securities Dealers declined to provide written comments on the report. However, the Federal ReserveBoard and SEC (under Trea- sury’s leadership) are preparing their own required joint study on the rules’ effectiveness that is due by October 1, 1990. Page7 GAO/QGlM@114ihvernment &curlties Contents I Executive Summary 2 Chapter 1 12 Introduction The Nature of the Government Securities Market The Government Securities Act of 1986 12 19 Objectives,Scope,and Methodology 21 Agency Comments 24 Chapter 2 25 Implementation of the Implementation of the Act 25 Benefits and Costsof the Act 34 Government Securities Areas in Need of Attention 37 Act Conclusions 43 Recommendations 44 Agency Comments 45 Chapter 3 46 Additional Investor The Need for SalesPractice Rules in the U.S. Government Securities Market 46 Protection Measures NASD Should Have Authority to Enforce SalesPractice 49 Are Needed Rules in the Government Securities Market SalesPractice Rules Should Be Promulgated at the 57 Federal Level Protecting Government Securities Investors Against 60 Broker/Dealer Failure Conclusions 63 Recommendationsto Congress 63 Agency Commentsand Our Evaluation 64 Chapter 4 66 Trading Access to The Nature of the Issue Trading Accessto Systemsin the U.S. Government 66 70 ScreenBroker Systems Securities Market Will Be a Continuing Matter for Should Not Be CongressionalOversight Regulated at This Conclusions 74 Time Page 8 GAO/GGD-99-114Government Securities Contents Chapter 5 76 Action Is Needed to Information AccessRemainsLimited Why Information AccessIs Important 75 77 Expand Access to Why a Legislative Solution Is Needed 81 Brokers’ Information Key Elements of an Information AccessRequirement 85 Conclusions 86 Recommendationsto Congress 86 Agency Comments 87 Chapter 6 88 Treasury’s Why an Extension Is Appropriate 88 91 Rulemaking Authority $~~~~~~ssunset Provision 92 Should Be Extended Recommendationsto Congress 92 Agency Comments 92 Appendixes Appendix I: Government Securities Market Components 94 and Activity Appendix II: Primary Dealers and Examining Authority 96 as of June 28,199O Appendix III: How Broker Trading SystemsOperate 97 Appendix IV: Regulatory Agencies and Market 101 Participants Contacted During This Study Appendix V: CommentsFrom the Department of the 104 Treasury Appendix VI: CommentsFrom the Securities Investor 106 Protection Corporation Appendix VII: Major Contributors to This Report 109 Related GAO Products 112 Tables Table 2.1: RegisteredGovernment Securities Brokers and 28 Dealers:Data on Types of Firm/Institutions, Regulators, Number of Primary Dealers, and Regulators’ Total Workload, (July 1989) Table 2.2: Problems DisclosedDuring Regulatory 31 Examinations of Specialist Firms July 1987 - April 1989 Table 4.1: Primary Dealers Average Daily Trading 67 Volume in Treasury Securities: 1986-1989 Page 9 GAO/GGD9@114Government Securities Cantant Figure Figure III. 1: Sample Broker Screenfor Treasury 98 Securities, 2-Coh.unnFormat Abbreviations CATS Certificate of Accrual on Treasury Securities CBOE Chicago Board of Options Exchange CFrC Commodities Futures Trading Commission CM0 Collateralized Mortgage Obligations FDIC Federal Deposit Insurance Corporation FHLMC Federal Home Loan Mortgage Corporation FNMA Federal National Mortgage Association Nxus Financial and Operational Combined Uniform Single (Report) FOGS Financial and Operational Government Securities (Report) FRBNY Federal ReserveBank of New York a.3 Federal ReserveSystem FRB Federal ReserveBank GAO General Accounting Office GFOA Government Finance Officers Association GNMA Government National Mortgage Association GSE government-sponsoredenterprise GSBA Government Securities Brokers Association GSCC Government Securities Clearing Corporation HIC hold-in-custody HA Information Industry Association NASD National Association of Securities Dealers NASDAQ National Association of Securities DealersAutomated Quotations NX.3E New York Stock Exchange cm Office of the Comptroller of the Currency CYrs Office of Thrift Supervision PSA Public Securities Association SEC Securities and Exchange Commission SIPC Securities Investor Protection Corporation SRO self-regulatory organization STRIPS Separate Trading of RegisteredInterest and Principal of Securities TIGRS Treasury Investment Growth Receipts Page10 GAO/GGDBO-114Government Securities J Page 11 GAO/GGD-90-114Government Securities : ” , Chapter 1 htroduction Public confidence in the integrity of the U.S. government securities market is essential for the federal government to sell its securities at the lowest possible interest cost. To help preserve that confidence,Congress enacted the Government Securities Act of 1986 (P.L. 99-671, signed October 28, 1986). This law (the act) regulated, for the first time, bro- kers and dealers who did businessexclusively in government securities or in government securities and other securities exempt from SECregis- tration In 1984 and 1986, someunregulated dealers had failed and cre- ated lossesfor various institutional investors, thereby damaging confidence in the safety of the government securities market. The act required us to report on whether the act’s purposes have been achieved and to recommendany changesneededto protect investors or assurethat the market was fair, open, and honest. We also were to rec- ommend whether or not Treasury’s rulemaking authority should be extended. This chapter describesthe nature of the government securi- ties market, the purpose of the act, and how we pursued our study. The Nature of the A number of features distinguish the government securities market from other securities markets and contribute to its reputation as one of the Government Securities most efficient,’ largest, and most liquid2 securities markets in the world. Market As background, this section describesthese key features of the market: the securities themselves,the volume and importance of secondary market trading, the role played by primary dealers, and the trading sys- tems operated by screenbrokers. US. Government In the broadest sense,the U.S. government securities market consistsof Securities all initial sale (primary market) and subsequentresale (secondary market) transactions of securities issued or guaranteed by either the federal government, individual government agencies,or a government- sponsoredenterprise, as well as contractual obligations, such as repur- chaseagreements,futures, forwards, and options contracts, which give people the right or obligation to buy or sell these securities in the future. Appendix I describes,in chart form, the various securities and contracts and provides activity information. The three basic categoriesof these securities are: Treasury, agency, and mortgage-backed. ‘Markets are efficient if buyers and sellers can complete their transactions quickly and with low transactions costs, and if information is rapidly reflected in the price of the security. 2Marketa are considered liquid when those who want to sell government securities can usually do so at, or close to, the last sale price in the market. Page 12 GAO/GGIMO-114Government !Securities . chapter1 Introduction Treasury Securities Treasury issuesmarketable debt securities in the form of bills, notes, and bonds;3these are used to refinance debt, to help raise new funds neededto finance deficits, and to managethe government’s cash flow. Treasury also provides a mechanism for the issuanceof zero-coupon instruments, which represent the principal and interest coupon pay- ments from selectedTreasury notes and bonds of 10 or more years to maturity. The resulting securities, known as STRIPS (Separate Trading of RegisteredInterest and Principal of Securities), may be separately owned and are traded at a deep discount from face value becausethey pay zero interest until maturity.4 Treasury auctions its securities to the public using the Federal Reserve Banks as its fiscal agent. All marketable Treasury securities, including STRIPS, are issued in book-entry form with ownership recorded in an account established by a Federal ReserveBank or at Treasury, and investors receive only a receipt as evidenceof purchase. Treasury secu- rities comprise about 69 percent of the nearly $3.3 trillion marketable U.S. Government securities outstanding as of December3 1, 1989. Mortgage-BackedSecurities Mortgage-backedgovernment securities represent an interest in a group (pool) of mortgages.In connection with the activities of the Government National Mortgage Association (GNMA), the Federal National Mortgage Association (FNMA),or the Federal Home Loan Mortgage Corporation (FHLMC), lending institutions pool mortgagesto create securities collater- alized by the individual mortgages.Each month, holders of the securities receive a pro rata share of the monthly payment of interest and prin- cipal received on the underlying mortgages.GNMA doesnot issue these securities but guaranteesthe timely payment of scheduledinterest and principal. FHLMC issuessecurities that carry a guarantee for the timely “Treasury bills are short-term obligations that mature in a year or less. T-Bills do not pay interest during their term; the interest earned ls the difference between the price paid by the investor and the par value paid by the government at maturity. Treasury notes and bonds are both debt securities that pay interest every 6 months and the par value at maturity. Notes have initial maturities of more than 1 year up to 10 years, and bonds have longer maturities, usually 30 years. Treasury also issues nonmarketable securities to government trust funds and other accounts, such as the Social Security trust fund and the Federal Deposit Insurance Corporation (FDIC). 4Before Treasury made STRIPS available, certain government securities dealers began issuing zero coupon instruments, called generically Treasury receipts, which represent a claim against the prln- cipal or specific interest payments on a group of Treasury notes and bonds owned by the dealers. These securities, issued in definitive (i.e., not book-entry form), are marketed under trade names, such as CATS (Certificates of Accrual on Treasury Securities) or TIGRS (Treasury Investment Growth Receipts). These instrumenta have not been designated as government securities, but in its capital adequacy rules Treasury regards them as having comparable risks to STRIPS. With the development of the STRIPS program, Treasury receipts are no longer being issued, but outstanding securities are traded in the secondary market. Page 13 GAO/GGD-30-114Government Securities Chapter 1 Introduction payment of scheduledinterest and the ultimate repayment of principal. FNMAissuessimilar securities but guaranteestimely repayment of prin- cipal as well. There is greater uncertainty regarding the duration of a mortgage-backedsecurity than with a Treasury bond becauseany unscheduled prepayments of principal on the underlying mortgagesare passedthrough to the holders of the security, thereby creating prepay- ment risk. Mortgage-backedsecurities are sold directly by issuers to securities dealers. Mortgage-backedsecurities account for about 28 percent of the government securities outstanding as of December3 1,1989.‘j Agency Securities Although someagency securities are direct debt obligations of certain federal agencies,most are obligations of government-sponsoredenter- prises (GSE). GSES sell debt obligations in the financial markets and channel the proceedsto agricultural, student loan, small business,and mortgage lending institutions either through direct loans or through the purchase of loans originated by these institutions. Although all agency securities are exempt from SECregistration, the nature of the govern- ment’s backing varies, A few are backed by the full faith and credit of the United States, others are supported by the issuing agency’sright to borrow from the Treasury, but somelack any formal governmental backing. The major categoriesof agency securities actively traded in the govern- ment market are those issued by FNMA,FHLMC, Federal Home Loan Banks, the Student Loan Marketing Association, and the Farm Credit System. These agenciestypically issue the securities through groups of dealers, known as selling groups, who locate purchasers. Agency securi- ties account for about 13 percent of the government securities out- standing as of December31,1989. “The previous discussion described the common mortgage-backed pass-through security. Because of the uncertainty of the principal payments, other mortgage-backed securities have been developed, such as collateralized mortgage obligations (CMOS),which are designed to give the investor greater certainty about the timing of the repayment of principal. Under a CMO, the investor buys the right to receive the interest or principal payments during various periods of time. Also, there are interest only and principsl only mortgage-backed securities which allow investors to deal separately with the b expected return from the interest and principal portions of a pool of mortgages. These types of secu- rities can be considered government securities if they are issued by FHLMC or FNMA, but many are issued by private institutions as SEC-registered securities. Page 14 GAO/GGBgO-114Government Securiciea Chapter 1 Introduction RepurchaseAgreements A principal focus of the act was regulation of repurchase agreements Contracts contracts (repos). Reposare two-part transactions that involve the ini- tial sale of securities at a specified price with a simultaneous commit- ment to repurchase the sameor equivalent securities at a specified price. The term of the repo transaction is determined by the parties to the repo. They can agreeto terminate the transaction at a specified future date or on demand. According to a representative of the Public Securities Association (PSA),most repos are entered into on an overnight or short-term basis, but long-term repos are not uncommon,The repur- chaseprice is usually higher, providing the equivalent of an interest return to the initial purchaser of securities. Repurchaseagreementsare important in that they serve as a principal meansby which dealers obtain money to finance their securities inven- tories; the Federal Reserveimplements monetary policy; and public bodies, financial institutions, and other corporate investors invest cash balances.Dealers use repos aggressively,becausethey can obtain funds inexpensively and offer government securities to investors as security for the transaction. Dealers also initiate what are termed reverse repo transactions, in which the dealer is the initial purchaser of securities, to obtain securities that are neededeither to meet delivery requirements or to engagein other repo transactions. For many dealers, repo and reverse repo transactions have becomea major line of business.Primary dealer activity in this market averaged over $776 billion per day in 1989, which is more than double the 1986 level and about 6 times greater than the averagedaily volume of regular trading in Treasury securities reported by these dealers. While repurchase agreementsare important, they also involve potential credit risk if the parties involved fail to meet their respective commit- ments to repurchase or sell the securities on the future date. Credit risk is even larger if customers allow a dealer to retain custody of securities that have beenpurchased. Such repos, called hold-in-custody (HIC) repos, can be a problem if dealers use those customer-owned securities for other transactions, while telling the investors that the securities were set aside in safekeeping. Customersof ESMGovernment Securities, Inc., and Bevill Bresler and Schulman Asset ManagementCorp. lost mil- lions of dollars when these dealers failed in 1986, and there were not enough securities to satisfy customers’ claims. Page 16 GAO/GGD-90-114Government Securities Chapter 1 Introduction Derivative Products Treasury securities are also the basis for derivative products that are an integral part of the government securities market. Theseproducts include both forward and when-issuedtrading agreementsand stan- dardized futures, options, and options on futures contracts bought and sold on organized exchanges.Most of these products, which are described in appendix I, are actively traded. For example, averagedaily volume of trading in futures contracts was over $38 billion during the year ending September30, 1989. The exchangetraded instruments were not included within the scopeof regulation under the act becausesuch instruments are already regulated by the Commodity Futures Trading Commission(CFTC)or, in the caseof exchangetraded options on securi- ties, by SEC. The Secondary Market Except for futures and someoptions contracts that are bought and sold on registered exchanges,trading in government securities and related contracts occurs in a worldwide, 24-hour, resale (secondary) market in which investors, dealers, and brokers agreeon trades over the tele- phone. Dealers and investors negotiate trades directly or conduct them through brokers-firms that do not buy or sell securities but specialize in arranging trades for others. Settlement, the exchangeof securities for cash to accomplish trades, typically occurs on the next US. businessday through depository institutions, located primarily in New York City, that offer clearing bank services6 Secondarymarket trading performs two important functions. First, it distributes the debt to the private investors who end up holding most of the government’s marketable debt. These investors include commercial banks, state and local governments, insurance companies,pension funds, other domestic and foreign financial institutions, and individuals. Second,the secondary market makes it easier for investors to resell the securities they own whenever they want to. An efficient and liquid sec- ondary market for government securities is important becausethe market affects the structure of interest rates throughout the economy.7 “Mortgage-backed securities are the exception. Unless otherwise specified by the parties to a trade, mortgage-backed securities settle by class once each month on designated settlement dates. 7Certain changes in government policy, events, or new information of any type lead to expectations of changes in interest rates. Actions by dealers and other secondary market participants transmit these expectations into changes in interest rates on Treasury securities. Then, through arbitrage between the market in Treasury securities and the debt and equity markets, other interest rates are affected. Page 16 GAO/GGD-90-114Government Securities Chapter 1 Iutroduction Importanceof the Secondary The safety, efficiency, and liquidity of secondary market trading sys- Market to Treasury and the terns have a direct impact on the rate of interest that must be paid on FederalReserve newly issued government debt. Easier resale opportunities lower invest- ment risk, which in turn lowers the rate of interest that must be paid to sell the public debt. This fact is important considering the large amounts of money-$12 trillion in 1989-that Treasury must raise each year to finance current budget deficits and to refinance existing debt. The liquidity of the secondary market also contributes to the Federal ReserveSystem’s ability to conduct monetary policy. A central feature of monetary policy is the frequent purchase or sale of securities in the secondary market by the Federal ReserveBank of New York (FRBNY).* In 1989, open market operation transactions averaged about $6 billion per businessday. The more liquid the secondary market is, the easier and cheaper it is for the FRBNY to conduct these transactions. Primary Dealers Dealers are firms that buy and sell securities for their own accountsto both meet the needsof their customers and to profit from changesin the price of securities. An especially important category of dealers is the primary dealers, a group of securities dealers and commercial banks with whom FRBNY conducts its open market transactions. Dealers apply to becomeprimary dealers, agreeing to meet certain standards and to provide the information FRBNY needsto monitor compliance with these standards. FRBNY expects primary dealers to be creditworthy, to partici- pate actively in Treasury auctions, and to contribute to market liquidity by entering into a high volume of transactions on a continuing basis with other dealers and investors. The Federal Reservealso expects pri- mary dealers to stand ready to buy Treasury securities from FRBNY or to sell securities to FRBNY even during adversemarket conditions. FRBNY can designate as many primary dealers as it believes to be appro- priate. The number of primary dealers has grown over the years, although there has been a slight drop during the past year. There were 'FRBNY buys securities in the market when the Federal Reserve System wants to inject money into the banldng system, and it sells securities when it wants to reduce the banking system’s money supply. These transactions, conducted by the open market desk of the Federal Reserve Bank of New York for the System Open Market Account, are nearly all in the form of repurchase agreements and matched transactions. When the Federal Resellre makes a repurchase agreement with a government securities dealer, the Federal Reserve buys a security for immediate delivery with an agreement to sell the security back at the same price by a specific date (usually within 16 days) and receives interest from the dealer at a specified rate. This arrangement allows the Federal Reserve to tempora- rily inject cash into the economy to meet a temporary need and to withdraw these reserves as soon as that need has passed. Matched transactions are the reverse of repurchase agreements and are used to temporarily withdraw cash from the economy. Page 17 GAO/GGD-90-114Government Securities Chapter 1 Introduction 20 primary dealers in 1970, around 36 from 1981 through 1986, and 40 in 1987. The number increasedto 46 in September 1988 and dropped to 42 in July 1989. There were 42 on June 28, 1990. Appendix II is the list of primary dealers as of June 28,199O. Firms attempting to demonstrate their creditworthiness and other quali- fications to FRBNY in order to becomeprimary dealers are called aspiring primary dealers. According to FRBNY officials, the qualification process typically takes at least 1 year from the time the dealer notifies FRBNY that it is aspiring and begins providing information to FRBNY. During this time, aspiring primary dealers are subject to limited and differing degreesof FRBNY surveillance.QFRBNY doesnot publicly identify or other- wise formally recognizeaspiring dealers. The marketplace learns from the dealers themselvesthat they are aspiring. In February 1987, the market recognized 13 aspiring primary dealers; about 6 were recognized as of December31, 1989. Screen Brokers Brokers are firms that are in businessto arrange transactions for others. The most important brokers in the government market are the screen brokers, which operate the systems through which most trading by pri- mary and aspiring primary dealers takes place. These brokers enhance liquidity by enabling these dealers and, in one case,certain investors to trade large quantities of securities quickly and anonymously. This anon- ymous trading, often referred to as “blind” trading, meansthat brokers arrange trades without revealing the identities of the buyers and sellers to one another.10 Dealers provide quotation and trade execution instructions by telephone to the brokers. This quotation information and the trading activity that results are subsequently displayed on a network of video display screensthat brokers have installed in the dealers’ trading rooms. Each “FRBNY does not inform market participants of the identity of aspiring primary dealers, whether they are reporting their trading activity on a daily or monthly basis, or if FRBNY has visited them for on-site review. Those dealers in the initial application stage report their trading activity monthly, while those who are closer to an approval decision file daily activity reports. Unlike primary dealer reports, which are verified for accuracy at least once a year, aspiring primary dealer reports are not verified for accuracy until an on-site review is conducted by FRBNY just prior to formal designation of the dealer as a primary dealer. “‘Treasury and agency securities are brokered and settled on an anonymous basis. Brokered transac- tions for mortgage-backed securities are not completely anonymous; names are not revealed when trades are arranged, but names are divulged after about 3 days as part of the transaction’s clearing and settlement process. For repurchase agreements, which are considered credit transactions, names are divulged and must be acceptable before the trade is finalized. Page 18 GAO/GGDfJO-114 Government Securities chapter 1 Introduction government securities broker’s screendisplays the best bid and offer quotation available from its customers for each issue shown. Thesequo- tations are binding commitments for the quantities and prices specified and, as such, constitute a market for each issue displayed. Appendix III describesin more detail how trades are executed through brokers and shows a representative broker video display screen. This report mentions two categoriesof screenbrokers: interdealer bro- kers, which only service primary and aspiring primary dealers; and retail brokers, which also serve such dealers but also allow large institu- tional investors and other dealers to trade on their systems.In addition to the difference in trading access,retail brokers have permitted noncus- tomers to view the screensfor information purposes through arrange- ments with information vendors. Interdealer brokers thus far restrict such information access. The act’s primary purpose was to assurepublic confidence in the gov- The Government ernment securities market by regulating previously unregulated dealers Securities Act of 1986 and brokers and improving the safety of repurchase agreementtransac- tions, The act required dealers and brokers that were previously unregu- lated to register with the SECand join either an exchangeor a registered securities association, i.e., the National Association of Securities Dealers (NASD). The Secretary of the Treasury was directed to issue rules for financial responsibility, possessionand control of customer securities and funds, recordkeeping, financial reporting and audit for government securities brokers and dealers, and to issue rules governing the custody of government securities held by all depository institutions. Also, the act included a provision to prevent false advertising for government securi- ties, particularly mortgage-backedsecurities, and gave SECregulatory authority over clearing agenciesfor government securities transactions. In developing its rules, Treasury was directed by Congressto consider the adequacy of the existing requirements on firms before imposing additional regulation. Consequently, the act imposed few new require- ments on government securities brokers and dealers that were already registered with SECas diversified securities firms, or on dealer opera- tions that were part of regulated banks. But SEC-regulatedfirms had to update their registration to indicate that they were government securi- ties brokers or dealers. Also, banks were required to file notice of their status as government securities dealers with their regulators, who then were to furnish a copy to SEC. Page 19 GAO/GGLMO-114Government Securities Chapter 1 Introduct.ion The registration and most regulatory provisions of the act went into effect by July 25, 1987, as stipulated in the act. SEC and NASD are respon- sible for enforcement of rules for the newly registered government secu- rities specialist brokers and dealers, while the appropriate regulatory agency enforces the requirements on the other firms.*’ Limitations on Treasury’s Treasury’s rulemaking authority for government securities broker/ Authority dealers was made subject to a sunset provision. Treasury’s power to issue orders and to propose and adopt rules applicable to government securities brokers and dealers (Section 101 of the act) will terminate unless renewed on October 1, 1991. Should Congressnot renew Trea- sury’s authority or assign it elsewhere, rules in effect on the sunset date will continue in effect and, according to the legislative history, Treasury will still be able to make technical adjustments. Treasury’s authority to prescribe securities custodial requirements for depository institutions (Title II of the act) is not subject to the sunset provision. The act’s legislative history makes it clear that it was designedto addressidentified weaknessesin the market without creating duplica- tive requirements, impairing the operation of a market that appeared to be working efficiently, increasing the costs of financing the federal debt, or compromising the execution of monetary policy. Government securi- ties continue to be exempt from SEC registration requirements. The act also limited regulators from applying requirements common in other markets, such as sales practice and trading systems rules. Salespractice rules govern the broker/dealers’ trading relationships with their customersto ensure that transactions are priced fairly and that dealers properly carry out their responsibility for fair dealings with their customers.The act did not give Treasury authority to write rules governing the salespractice of brokers and dealers and restricted NASD from applying any such rules to the government securities activities of its members. In addition, NASD cannot require specialist broker/dealers ’ ‘The appropriate regulator for non-bank securities firms, including separate securities subsidiaries of bank holding companies, is SEC. Examinations for these firms are performed by the designated self-regulatory organization (SRO), usually either NASD or the New York Stock Exchange. Regulators for depository institutions are: Office of the Comptroller of the Currency (OCC) for national banks, the Federal Reserve System (FRS) for bank holding companies and state-chartered banks that are members of the Federal Reserve System, the Federal Deposit Insurance Corporation (FDIC) for state- chartered nonmember banks and some insolvent thrifts, and the Office of Thrift Supervision (CKS) for thrifts. UK3 assumed this responsibility from the Federal Home Loan Bank Board ln 1989. We will use OTS as the name for the thrift regulator in this report. Futures commission merchants, which do enough transactions in government securities to register with SEC as brokers or dealers, continue to be regulated by the Commodity Futures Trading Commission (CFTC) through appropriate SROs. Page 20 GAO/GGD@O-114 Government !Tkcuritiea , Chapter 1 hmoduction to have their employeespass a securities industry qualification exam, nor can the Securities Investor Protection Corporation (SW) provide coveragefor the customers’ accountsof such dealers. The act also did not give Treasury authority to write rules governing accessto government securities trading systems-including those oper- ated by the screenbrokers. Accesspolicies include the eligibility criteria for trading on the system and the availability of information on trading activity to participants and the general public. Such areas were left unregulated as the individual businessdecisionsof firms. Outside the government market, the SROS can promulgate such rules under CFTCand SECapproval when they are considerednecessaryto ensure that markets are fair, open, and honest. The act did, however, require GAOto study whether broker accessdecisionswere unnecessarily restrictive. GAO’s 1987 Study of In December1987, we completed our study of broker accessarrange- Accessto Broker Systems ments and reached conclusions,concurred in by FRB,SEC,and Treasury, regarding limitations in both trading accessand information availa- bility.12We concluded that trading accesslimitations were not unreason- able at that time, but that different arrangements could reasonably evolve if regulation of brokers and dealers and improved transaction clearing arrangements reduced the risks of anonymous trading. We also concluded that brokers and dealers should develop arrangements to make transaction information available becausesuch information would enhanceinvestor protection and contribute to the public interest through greater efficiency and equity in the government securities and related markets. We concluded that market participants should be given the opportunity to develop such arrangements before pursuing regulatory interventions. We also said we would review the status of information accessand trading accessarrangements in this report. Section 103(b) of the act directed us to evaluate whether the amend- Objectives, Scope,and ments made by the act have been effective in protecting investors and Methodology the integrity, liquidity, and efficiency of the market. Also, we were to assesswhether implementation of the act has permitted unfair discrimi- Y nation between market participants or has imposed any unnecessary ,I” ‘U S GOVERNMENT SECURITIES: An Examination of Views Expressed About Access to Broker Services, (GAO/GGD-888,Dec. 18,1987). Page 21 GAO/GGD-90-114Government Securities chapter 1 , Introduction burden on competition. We were to make.any recommendationswe believe were necessaryto further the objectives of the act, including, at a minimum, a recommendation regarding whether Treasury’s rulemaking authority should be extended. Accordingly, within the broad mandate of the act, we organized our work around four issues: 1) Did Treasury, SEC,and the bank regulators effectively carry out their responsibilities under the act, and are any changesneeded? 2) Are changesin the act’s regulatory coverageneededto deal with developments in the government securities market that affect investor protection? 3) Are limitations in the act’s regulatory coveragestill appropriate with respect to whether screenbrokers should be required to expand either trading or information accessto their trading systems? 4) Should Treasury’s authority to promulgate rules be extended consid- ering its performance thus far and any additional areas that we believe warrant regulatory attention? We discussedthese issuesand our approach to addressingthem with the committees that had written the act: the SenateCommittee on Banking, Housing and Urban Affairs; the HouseCommittee on Energy and Com- merce; and the HouseCommittee on Banking, Finance and Urban Affairs. Cur analysis of these issuesinvolved extensive interviews with repre- sentatives from various entities affected by the act. The organizations contacted are listed in appendix IV. The federal agenciesand SROSwe contacted were directly involved in the market or in regulating partici- pants. Trade associationsfor market participants and government secu- rities dealers were selectedon a judgment basis, in part becauseof their interest and involvement in our previous study. We also sought to obtain views of a cross section of market participants that could have been affected in various ways by the act. We also contacted all screenbrokers and major financial information servicesthat provided coverageof the market. In these discussions,we obtained viewpoints and supporting data regarding how well the act was implemented; how the act affected their operations and the market; areas where more or less regulation is Page 22 GAO/GGD9@114Government Securities Chapter 1 Introduction needed;and technological, legal, and regulatory developments affecting market operations and regulation. In addition to analyzing the information obtained from these discus- sions, we . analyzed comment letters Treasury received in developing the regula- tions and Treasury’s responsesto subsequentinquiries and exemption requests; l compared registration lists maintained by SECand various agenciesto test for potential unregistered firms and to determine the quality of SEC records; l compared the capital adequacy and other regulatory provisions applied to specialist dealers by Treasury with SEC’Srequirements for diversified firms; l analyzed investor protection rules used in other markets; l reviewed regulator examination procedures and selectedexamination reports and summary statistics for government securities brokers and dealers; and l developed market activity statistics from the Federal ReserveBulletin and other published sources. We mention somefirms by name in the report becausetheir activities are a matter of public record. However, in developing our findings and conclusions,we also consideredcertain proprietary data developed through our discussionsthat we could not describeexplicitly in the report. We worked in accordancewith generally acceptedgovernment auditing standards. We did our fieldwork in Washington, D.C., New York, N.Y., and Chicago,Ill., from December1988 to April 1990. ScopeLimitations During this study, we did not attempt to render a judgment on the overall safety and soundnessof the market or of any market partici- pants. Moreover, we did not try to evaluate the quality of the regulatory oversight and examinations provided by various regulators or the effec- tiveness of their various rules. Also, our meetings with primary dealers and screenbrokers were done while these parties were subject to an open Justice Department order for these parties to maintain records relating to discussionspertinent to the issue of accessto screenbroker services.The Justice Department has had an antitrust investigation of broker accesslimitations in processfor several years. Page 23 GAO/GGD-90-114Government Securities Chapter 1 Introduction Agency Comments Federal ReserveSystem, and occ throughout our review and provided these agenciesthe opportunity to comment formally on the report. Sec- tion 103(a) of the act requires Treasury, SEC,and FRB to conduct their own study to evaluate the effectiveness of the rules and to report their findings by October 1, 1990.13We also sent the report for comment to NASD and the Securities Investor Protection Corporation (SIPC).” The Department of the Treasury and SIPCprovided written comments. Relevant portions of their comments are presented and, where appro- priate, evaluated at the end of chapters 2,3,6, and 6. The comments are reprinted in their entirety as appendicesV and VI, respectively. We also received technical comments on the draft from the Department of Treasury, SEC,and the Board of Governors of the Federal Reserve System. These commentswere incorporated as appropriate. We did not provide the GSES, GNMA, or Commodity Futures Trading Com- mission a draft for official comment becauseour discussionswith offi- cials from these agenciesrevealed no significant concernswith current market operations. ‘%ection 103(a) states: “Task Force Recommendation - The Secretary of the Treasury, together with the Securities and Exchange Commission and the Board of Governors of the Federal Reserve System, shah evaluate the effectiveness of the rules promulgated pursuant to section 16C of the Securities Exchange Act of 1334 in effecting the purposes of such Act, and shall submit to the Congress, not later than October 1, 1990, their recommendation with respect to the extension of the Secretary’s authority under such section, and such other recommendations as they may consider appropriate.” Page 24 GAO/GGD-O-114Government Securities . Chapter 2 lknplementationof the Goveuunent SecuritiesAct Although it is not possible to comeup with hard evidence about the impact the act has had on the market, for the most part we have found that market participants are generally satisfied with the way the act has been implemented. They believe the act has made the market safer without serious adverse effects. However, we have someconcernsabout the effectiveness of someaspectsof the act’s implementation, and we believe Treasury should consider simplifying its rules on capital adequacy. This section highlights actions taken by Treasury and the other regula- Implementation of the tors to implement key provisions of the act. These provisions concern Act registration, regulation and examination of specialist firms, repurchase agreements,advertising, and clearing agencies. Registration Three types of government securities brokers and dealers were initially brought under regulation by having to register or file notice of their gov- ernment securities businessby July 25, 1987. The first type, repre- senting a major reason the act was enacted,was previously unregulated brokers and dealers engagedexclusively in the businessof buying and selling government and certain other exempt securities. These firms, called specialist firms, had to register with SECand obtain membership in an SRO as a condition for continuing to operate in the market.* The secondtype was brokers and dealers already registered with SEC. These firms simply had to update their registration with SECon a revised form that better described the firms’ government securities activities.2 The third type was banks and thrifts, which, using criteria stipulated in the act and the regulations, must decide whether they qualify as brokers ‘SEC has the authority to register or deny registration to brokers and dealers required to register with the Commission. It prescribes the form and information required for registration or withdrawal from registration. SEC uses Form BD, the Uniform Application for Broker-Dealer Registration. Included as part of the application on Form BD is a statement of financial condition and other data on financial resources, such as the applicant’s assets, liabilities, net worth, and capital adequacy. Addi- tionally, a Form U-4 must be filed, which discloses information on persons associated with govern- ment securities brokers and dealers. A firm must amend its registration if its business changes or if it withdraws from the market. To obtain NASD membership, firms had to pay NASD assessmentsand have their associated persons fingerprinted. ‘Previously, SEC-registered firms indicated if their government business represented 10 percent or more of their operations. The new form required this same information and also required firms to designate if they did broker or dealer activity or both, and whether they did their government busi. ness in a specialized firm or as part of a diversified operation. The form also could be used to give notice that the firm was ceasing its government securities business. Page 25 GAO/GGD-90-114Government Securities chapter 2 Implementation of the Government Secnrities Act and dealers.3If they met the criteria, they were required to file notice with their regulatory agency on a form prescribed by the Federal Reserve,with a copy sent to SEC.~ Regulators took varying degreesof initiative to encouragefirms to reg- ister. NASD worked with SEC,Treasury, the Public Securities Association, and somestate regulators to develop a list of potential specialist dealer registrants that were contacted by mail to inform them of the require- ments. For diversified dealers, NASD and NYSE sent out notices to mem- bers informing them of the need to amend their registration if they were government securities brokers or dealers. Similarly, FFtB and FJXCsent out notices to their banks along with copies of appropriate filing forms. In contrast, both occ and CYErelied upon the banks’ and thrifts’ aware- nessand good faith efforts to file timely notices. Status of Registration According to the regulators, as of July 26, 1987, a total of about 1,740 Process firms had registered or filed notice. By July 1989,2 years later, there were 1,841 registrants-63 non-bank specialists, 1,496 diversified firms, and 281 bank dealers. The initial notice of one thrift broker/dealer was still on file as of the July 1989 date although, according to Treasury officials, it appears not to have been active.” The 1,559 non-bank firms “Many banks provide a number of dealer-like services for their customers in trust departments and by redeeming and safekeeping customer securities. Moreover, banks are typically active market par- ticipants, buying and selling government securities for their own portfolios. Treasury did not require banks and thrifts to register as brokers and dealers if their government securities activities were limited to l handling savings bond transactions; l submitting tenders for the account of customers at Treasury auctions; l doing limited brokering of government securities, which means either effecting fewer than 600 bro- kerage transactions annually or effecting all brokerage transactions on a fully disclosed network basis through a registered government securities broker-dealer; l purchases or sales in a fiduciary capacity and/or purchases and sales of repurchase or reverse repur- chase agreements. 4Like SEC’s registration form, the G-FIN form requests identification information on the bank and its associated persons. However, the form does not require a description of the percentage involvement in government securities financial information on the bank. “In interpreting the statistics in table 2.1 it is important to recognize that the number of dealers in any one category reflects the way firms choose to organize their government securities activities within their total operation. For example, banks both within and outside of the holding company structure can organize their securities activities among affiliate firms in a number of ways. The bank itself can be dealer, it can have separate affiliates or subsidiaries registered aa diversified dealers or govern- ment securities specialists, or it can do both. Non-bank securities firms can split or combine their operations in much the same way. Page 26 GAO/GGD-90-114Govemment Securities chapter2 Implement&on of the Gov-nt l3emritles Act that registered under the act represented about one-fourth of all non- bank securities firms registered with SC. The 281 bank dealers were about 2 percent of all banks. NASDis the predominant examining authority for smregulated non-bank brokers and dealers, although NISE examines a majority of the non-bank primary dealers. For banks, occ regulates about 70 percent of the 281 dealers, including the 3 banks that are primary dealers.6Table 2.1 presents data on the number of government securities brokers and dealers and their regulators. (jAn additional 10 firms conduct their primary dealership through !Section20 subsidiaries of bank holding companies. Page 27 GAO/QGD-BSll4 Government Securltiee Chapter 2 Implementation of the Government flmxritles Act Table 2.1: Regirtered Qovernment Securitiecl Broker6 and Dealers Data on Regulator8 Type8 of Firm/inrtltutione, Regulators, Type of firm/institution and Qovernment securltier Prima7 total Number of Primary Dealers, and regulator broker/dealer’ dealer8 workiosdC Regulators’ Total Workload (July 1989) Securities firms regulated by SEC NASD 1,376 18 5,712 Specialist 63 9 Diversified 1,315d 9 NYSE diversified 168 20 392 Other” 13 0 I Subtotal 1,559 38 Banking and thrift institutions occ- 191 4 4,280 FDIC 43 0 7,622 FRB 47 0 1,037 Subtotal banks 281 4 Office of Thrift Supervision 1 0 2,934 Grand Total 1,841 42 %cludes primary dealers shown in next column. bExcludes two primary dealers named by FRBNY on December 8, 1989. Both firms are NASD-diversified firms, CFigures represent the number of firms or institutions subject to examination by each regulator. Work- load figures are shown to provide a perspective on the significance of the number of government securi- ties brokers and dealers relative to the total number of firms/institutions to be examined by each regulator. dFigure does not include 88 memberships that were pending. %cludes firms examined by the Chicago Board of Options Exchange (CBOE), the American Stock Exchange, the Midwest Stock Exchange, and the Philadelphia Stock Exchange, as reported by SEC ‘Figure not available. Source: Data on the number of government securities dealers and brokers and classification of primary dealers were developed by reconciling various listings of firms provided to us by regulators and Trea- sury from various internal reports. All figures should be considered close approximations, because the same monthly dates were not available from all sources. When the act was being written, an estimated 200 to 300 unregulated firms were in the market, although in December1986 NASD,in coopera- tion with other regulators, had identified only 117 potential registrants. As it turned out, even fewer firms than expected registered as special- ists, On August 31, 1987, 1 month after the effective date of the regis- tration requirement, 67 firms had registered, of which 36 were among Page 28 GAO/GGLMO-114Govemment Securities Chapter 2 Implementation of the Government Securities Act the 11’7identifiedP Of the initial 67 registrants, 46 were among the 63 specialists still operating in July 1989 (although somehad changed names). The 63 specialist firms operating in July 1989 consistedof 16 brokers (9 screenbrokers, 4 screenbroker subsidiaries or affiliates, and 3 non- screenbrokers), and 47 dealers, of which 9 were primary dealers. About a third of the 47 specialist dealers were affiliated with diversified secu- rities firms or bank holding companies. Regulation and Treasury’s regulations for specialist firms took effect on July 26, 1987; Examination of Specialist and NASD, in conjunction with Treasury and SEC,held three seminars to inform firms of the requirements. The rules for recordkeeping, Firms reporting, and audit were essentially the sameas those employed by SEC through the SROS for registered securities firms. With respect to capital adequacy, Treasury’s requirements for interdealer brokers were based on the requirements applied by SEC to similar screenbrokers in the municipal securities market, but with a higher minimum capital level.s For dealers, Treasury made several modifications to the SEC approach sufficient to require specialist dealers to report their capital level on a special set of forms.H 7When a previously unregulated dealer was faced with the requirement to register as a specialist firm, the dealer had several options. On the basis of a review of registration data and discussions with NASD, we determined that the 117 expected registrants behaved as follows: 36 registered as specialists; 18 registered as diversified firms, or eliminated their separate government securities oper- ations and merged them into an already registered diversified dealer or newly registered bank dealer; 8 remained in the securities business, but discontinued their government securities transactions; and 66 left the securities business or reorganized under a new name. “Treasury allowed such brokers to obtain permission to maintain a minimum capital level of $1 mil- lion (municipal brokers need $160,000), in lieu of applying the more complicated calculation required of dealers. To qualify, brokers had to meet certain conditions, including having only registered dealers as customers. The interdealer screen brokers all initially opted for the $1 million minimum capital level. However, only two use it now, in part because certain customers that are foreign affili- ates of U.S. primary dealers could not be treated as registered dealers. %@ecialist dealers that calculate capital using Treasury’s approach file quarterly and annual reports with NASD on the Financial and Operational Government Securities (FOGS)report form instead of the Financial and Operational Combined Uniform Single (FOCUS) report form used by all other broker dealers. The forms essentially provide much of the same basic income and balance sheet infor- mation but are arranged differently to correspond to the different methods for computing minimum liquid capital. Treasury’s modifications for determining dealer capital adequacy were based on the capital adequacy guidelines that FRBNY was already applying to the specialist primary dealers and that FRBNY had published prior to the act as voluntary capital adequacy guidelines for other spe- cialist firms. Treasury believed that its capital adequacy approach was better suited to measuring specialist dealer risk and would be easier for specialist primary dealers to implement. Page 29 GAO/GGD-90-114Government Securities chapter 2 Implementation of the Government Secorltlee Act NASDdetermined specialist firm compliance with requirements through its examination process.Its goal has been to examine these newly regis- tered firms annually, Data we received from NASDshowed that from July 1987 to November 30, 1989, NASDhad conducted 219 on-site exami- nations of 78 different specialist firms, with 73 of the 219 exams being premembership exams. We also noted NASD'Sgoal is to annually examine firms that maintain accountswith customer securities and funds and to examine other firms every 2 years. NASDappears to have met its goal for specialist firms. We did not evaluate the quality of NASD'Sexams. However, SEChad inde- pendently examined 10 of these specialist firms to ensure that NASDwas doing a goodjob, and it was generally satisfied with NASD'Sperformance. We obtained information on the results of the examinations done by NASDand SECduring the period July 1987 through April 1989. This information showed that the examinations detected problems in a number of areas (seeTable 2.2). However, NASDand SECofficials agreed that the findings were not unusual for firms newly regulated and that, overall, specialist firms were making a legitimate effort to comply with the rules. For example, the financial responsibility (primarily capital adequacy) findings typically involved incorrect computations of min- imum liquid capital that resulted in capital being under- or overstated, but not so understated as to result in capital being less than the min- imum requirement. Page 30 GAO/GGD-90-114Government Securities -~ -- ~---. - chapter 2 Implementation of the Government Securities Act Table 2.2: Problems Diaclored During Regulatory Ewaminatlona of Specialist NASD SEC Firms July 1987 - April 1989 Number of examination9 65 10 Category and number of deficiencies Recordkeepingb 46 9 ReDortina & AuditinaC 32 2 Financial Responsibilitvd 33 9 Customer Protectior? 22 2 Reaistration/EmDlovee Qualification/SuDervision’ 34 2 aNASD’s 65 exams were of 55 institutions; SEC’s 10 exams covered 10 institutions. blncludes deficiencies in recordkeeping ledgers, such as stock records and customer ledgers, cash receipts and disbursements blotter not maintained, etc. ‘Covers inaccurate FOCUS and FOGS reports and failure to meet audit requirements (Le., changed annual audit but did not notify regulator), etc. dConsists primarily of capital computation errors but also includes capital deficiencies, etc elncludes failure to maintain separate customer accounts, improper confirmations on repurchase trans- actions, etc. ‘Problems pertain to inaccurate filing of forms for associated persons, Form ED not current, employee not fingerprinted, supervisory procedures inadequate, etc. RepurchaseAgreements As noted in chapter 1, a principal focus of the act was regulation of repurchase agreements(repos). Treasury’s efforts to promulgate rules under the act coincided with a number of efforts to better control securi- ties recordkeeping practices associatedwith hold-in-custody (HIC) repos. These include SEC efforts to improve its repo rules for registered securi- ties firms, bank regulator efforts to increasethe safety of bank repo practices, the FSA’Sefforts to standardize dealer repo practices, and ini- tiatives by investor groups such as the Government Finance Officers Association (GFOA) to increase awarenessof HIC repo risks. Treasury’s rules that took effect on July 26, 1987, were essentially the same as those developedby SEC, except for two minor differences.‘” In fact, when Treasury amendedits rules in August 1988, it replaced the text of the rule it had previously adopted with a citation that incorporated the SEC rules by reference. (The SECrules becameeffective January 31,1988.) Although Treasury was successfulin getting rules promulgated, the task was not without controversy. Repurchaseagreementswere the subject of the most written comments and informal inquiries Treasury received during the rulemaking process.Specifically, of the inquiries Treasury “‘Treasury required that the written agreements had to specify that HIC repos were not protected by SIPC coverage and that foreign customers could waive a right to daily confirmations. Page 31 GAO/GGD-90-114Government Securities . Chapter 2 Implementation of the Government Securities Act received between June 2,1987, and April 28, 1989, about 40 percent related to these areas. The principal points of controversy concernedcosts.The rules imposed costs on dealer operations by requiring dealers to (1) have signed repo agreementswith all HIC repo counterparties, and (2) issue confirmations to the customersof the securities held in custody whenever a new trans- action occurred or the identity of the securities changed.Treasury insisted that these costs were necessaryto provide customerswith the information they need in situations where there are potential risks becausea dealer is acting both as counter-party and custodial agent for the customers’ securities. Many dealers said these costs resulted in excessivepaperwork and provided investors with more protection than they needed.Furthermore, these requirements tended to affect bank and non-bank dealers differently depending on their product lines, customer base,and ability to modify their recordkeeping systems.Treasury, not dissuadedby these concerns,amendedits rules on August 1,1988, to eliminate an exemption to repo agreementsand daily confirmations that it had originally provided for certain banks.” Treasury basedits action on the view that broker-dealers that are not financial institutions were already complying with confirmations and control requirements and because“some cost increaseis a necessaryand expected outcome of leg- islative requirements to establish regulations for government securities transactions and, in particular, for repurchase transactions.012 Advertising The act gave NASD authority to regulate the government securities advertising activities of its members,primarily becauseof problems ’ ‘Initially, Treasury had exempted banks from the daily confirmation requirement if they met certain conditions but rescinded this exemption over the protests of several banks in an August 1,1988 amendment (effective December 1,1988). Banks were particularly upset by the daily confirmation requirement because they had developed products such as overnight “sweep” repurchase transac- tions, which would become much more costly with daily confirmations. In a sweep repurchase trans- action, excess funds are swept from a customer’s deposit account for overnight investment in instruments that include repurchase transactions. Since sweep repurchase transactions are recurring transactions, generally giving rise to a new repurchase transaction daily, a new confirmation has to be issued daily. On the other hand, certain securities firms also offer a similar service to their cus- tomers by sweeping the uninvested balances in customers’ investment accounts and investing them in various instruments, including repurchase agreements. These securities firms’ repo transactions were subject to daily confirmations under the rules passed by Treasury on July 26, 1987. ‘“Text of Treasury August 1,1988, amendments to its July 24,1987, Government Securities Act rules, Federal Register vol. 63, No. 147, page 28962. Page 32 GAO/GGD-90-114 Government Securities chapter 2 Implementation of the Government kkcurities Act with mortgage-backedsecurities advertising.13NASD rules governing advertising requirements for government securities becameeffective on January 1, 1989. The new rules require NASD membersto send to NASD, for review, all advertising in government securities within 10 days of first useel During 1989,98 firms submitted 242 ads for review. NASD told us that 47 percent were acceptableas submitted, 62 percent required revisions, and 1 percent were rejected. In addition, NASD received 20 complaints, usually from a broker/dealer’s competitor. Most complaints involved GNMAS and zero coupon government securities. According to NASD officials, after NASD review, the advertising material was revised.lF, SECRegulation of Clearing agenciesprocessthe paperwork confirming securities trades to Registered Clearing arrive at a net amount due between buyers and sellers. Typically, a clearing agency steps in to bear the risk of a transaction failure by Agencies becomingthe buyer to every seller and the seller to every buyer. The act expanded SEC’S authority over the activities of clearing agenciesin regis- tered securities to include clearing agents operating in the government market. This authority includes approving the accesscriteria and oper- ating plan of any such systems as it doesfor clearing agenciesoperating in other markets. SEC has approved four systems involving government securities: the Mortgage-BackedSecurities Clearing Corporation (MBSCC),Participants Trust Company (PTC), Government Securities ‘“Beginning in 1979, NASD’s Advertising Department received complaints regarding GNhL4 adver- tisements that raised concerns, primarily because the yields quoted were based on a calculation using an accelerated rate of prepayment rather than the traditional 12 year average life, resulting in an inflated yield figure. This distinction was not being disclosed in the ads. Compounding the situation was the lack of disclosure that such a prepayment rate was not guaranteed over the life of the pool, and that the advertised yield would be subject to fluctuations. Although the Department recognized that the ads appeared deficient, it could not take an active role in the regulation of advertising because NASD rules could not be applied to exempt securities. Concern for government securities advertising arose again in 1986 when interest rates started to fall dramatically and the advertising problems appeared more abusive. In making a letter appeal to Con- gress on the need to regulate government securities advertising, the president of GNMA stated that “This provision is necessary because many investors continue to be misled by advertising appeals and prospectus reports which fail to adequately address yield calculation, price fluctuations, investment risk factors, extent of the government guarantee, and other characteristics unique to the GNMA security which will assist the average investor in making an informed decision.” 141ngeneral, advertisements subject to filing requirements include material published or designed for public use through newspapers, magazines, radio, television, etc., but would not include material referring to government securities solely as part of a listing of products and/or services offered. ‘“NASD officials told us they review advertising as part of the examination process and also have a separate system to periodically spot-check members’ advertising. Statistics on findings from these two areas were not available. Page 33 GAO/GGD-fJO-114 Government Securities Chapter 2 Implementation of the Government Securltles Act Clearing Corporation (GSCC), and Delta Options Clearing Corporation (Delta&l6 Benefits and Costs of The legislative history of the act as set forth in committee reports and floor debatesshows that Congresssought to improve the safety of the the Act market by ensuring that all broker/dealer participants were subject to a basic regulatory schemeand assurethat the repurchase agreement market not be a source of loss to investors. Congresshoped that one consequenceof the act would be to stop investor incentives to deal only with primary dealers at the expenseof responsible, financially sound nonprimary dealers. Congressalso wanted to be sure that Treasury’s rules would not impose excessivecosts on participants and, thereby, affect Treasury’s cost of selling the debt. Congresswas also concerned that Treasury’s rules not favor dealers in Treasury securities at the expenseof dealers in other government securities. Dealers and brokers told us that they believe that the market is safer for investors now that the act has been implemented, although regulation such as that provided under the act will not prevent fraud from occur- ring. Greater safety results from the fact that all securities brokers and dealers are now clearly subject to capital requirements, prudential rules, and regulatory inspection. Therefore, NASD and SEXnow clearly have the authority to enter a firm and inspect the firm’s books and records to determine whether or not fraud has occurred.17In the caseof repurchase agreements,our discussionswith regulators and market participants found no support for additional repo-related rules in this area. However, given the inherent risks involved in HIC repos, these officials also point out that the safety of repo transactions dependsupon the honesty of the person doing the transaction, investor awareness,and examiner dili- gencein enforcing the act’s requirements. We were not able to identify any major positive or negative effects on market liquidity or efficiency resulting from implementation of the act, although our efforts were limited becauseof the absenceof marketwide activity data. We observed sometemporary reduction in primary dealer “‘MEBCC and PTC combine to provide clearing and settlement services for mortgage-backed securi- ties. GSCC,approved by SEC in 1988, is centralizing the processing of transactions in Treasury and agency securities by primary and aspiring primary dealers, screen brokers, and clearing banks. Delta is part of an SEC approved proprietary trading system for over-the-counter options on Treasury securities. The trading system part of the Delta system is an affiliate of an interdealer screen broker. 17Prior to the act, only SEC could enter the speck&t firms’ premises. To do so, SEC had to obtain a court order based on evidence of suspected fraud. Page 34 GAO/GGDBO-114Govenunent Securities Chap&r 2 Implementation of the Government Seaultles Act trading and repo activity in late 1987, when the act’s major provisions went into effect. However, the timing of the act’s implementation coin- cided with the problems in the stock market in October 1987. None of the market participants or regulators we spoke to attributed any changesin repo market activity to the implementation of the act. Moreover, neither Treasury nor FRB officials said that the act had any adverse effect on Treasury’s cost of selling the debt or FRBNY’S ability to conduct monetary policy. We also found no adverse effect on the market for government-sponsoredenterprise securities causedby implementa- tion of the act or Treasury’s rules. Increasing the Investors reacted to the problems with the unregulated dealers E.&M. Acceptability of Government Securities, Inc., and Bevill Bresler and Schulman Asset ManagementCorp. by limiting trading to primary dealers only. Specifi- Nonprimary Dealers cally, after the E.S.M.failure, ors guidance to thrifts and Gm policy guidance to its members encouragedinstitutions to do businesswith pri- mary dealers. The absenceof information on the volume of nonprimary dealers’ trans- actions prevented us from determining quantitatively whether the role and activity of nonprimary dealers have changedin the marketplace since the act was adopted.18The qualitative evidencewe found was mixed. One nonprimary bank dealer told us municipalities were more willing to do businesswith his firm since passageof the act. However, New York State’s investment policy recommendationsfor local govern- ments, which calls for limiting repurchase agreement activity to regis- tered primary dealers or to banks and trust companiesauthorized to do businessin New York State, is still in effect. A GmA official told us its guidance emphasizesthat thrifts and public investors should deal with registered firms (i.e., not just primary dealers), taking the steps neces- sary to investigate the reputation and capability of any dealers with whom they chooseto do business. l*Statistical information from SEX did not enable us to determine the number of diversified dealers before and after the act, and no data are collected on transaction volume. In addition, data reported by FRB on primary dealer activity can change because the number of primary dealers changes. Page 36 GAO/GGD-90-114Government Securities chapter 2 Implementation of the Govemment Secarltlea Act Costs on Market The act did impose somecosts;regulation always does.We did not Participants and attempt to gather systematic verifiable information on costs from those affected by the act. While no one suggestedto us that the act raised Regulators costs by an amount that adversely affected the market as whole, it is clear that implementing the act was expensive for somefirms. The results of our discussionswith market participants follow: l The major cost paid by all specialist brokers and dealers was the NASD annual assessment.In obtaining SECapproval for its assessmentcharges, NASDsaid its 1988 cost for implementing the act was about $2.4 million, and it expected to recover about $1.6 million from its assessmentof spe- cialists in 1989 (based on a net rate of 0.126 percent of specialist firms’ annual gross income (revenue) derived from their government securities business).Screenbrokers challenged the assessmentas excessive becausethey claimed it resulted in too high a charge relative to their need for and cost of examination. SEC agreedwith NASDthat the cost was appropriate. The NASDassessmentwill likely continue to be an issue. However, SECcan address any concernsthrough its processof approving NASDI'UkL . Non-bank diversified dealers said the act imposed few additional costs on them. Dealers most adversely affected were specialist firms whose recordkeeping systems were not automated or suited to keeping the cus- tomer account records required. One specialist primary dealer estimated its start-up costs at about $289,000 to adopt in-house systems,while a nonprimary specialist dealer provided an estimate of $60,000. While such costs are no doubt significant to the firms involved, we believe they should not be consideredas pure regulatory compliance costs becausesuch expenditures also helped to bring firms up to industry standards. . Bank dealers experienced recordkeeping system costs similar to non- bank broker/dealers and also seemedto be the most affected by changes in the repo business.As discussedpreviously, several banks had viewed the loss of their sweep repo businessas significant and had voiced their concern formally to Treasury prior to its August 1988 rule amendment. Also, an ABA official told us that annual coststo implement the new repo requirements averaged $76,000 per bank for five banks surveyed. While such costs are important, like Treasury we were not persuaded that they were too high a price to pay to ensure consistency in repo practices. . The act imposed additional costs on Treasury, SEC,and the bank regula- tors, but these agenciesdid not view them as substantial and some agen- cies could not estimate them. Treasury estimated its fiscal 1987 costs at $208,400 and subsequentannual costs at about $300,000. Most of the Page 26 GAO/GGD-90-114Government Securities Chapter2 I,mplement&ion of the Government securltlw Act initial costs of the agencieswere for promulgating rules and educating participants, while recurring costs involve examination, monitoring, and administration of the regulations. We have four concernsthat we believe warrant attention from Trea- Areas in Need of sury, SEC,and the regulators to ensure that the act’s provisions are Attention implemented effectively without imposing an unnecessaryregulatory burden. These concernsrelate to the accuracy of SEC’S data base and differences in both examination frequency and advertising regulation for bank dealers relative to non-bank securities firms. Also, an opportu- nity to simplify regulation results from the fact that only a few firms have registered as specialist firms and are using Treasury’s capital ade- quacy rules. Problems With SEC’sData Congressmandated the registration and notification requirements so Base that market participants could be identified and comeunder regulatory oversight. SECkeeps track of data on government securities brokers and dealers as part of its data baseof the registration filings of all brokers and dealers, which these firms must keep up-to-date. The information is used for developing program statistics on market participants and regu- lator workload, and it is also used as a checklist to ensure that all dealers operating in the market are being regulated. For example, NASD examiners in New York obtained listings of registered government secu- rities dealers from SECso they could check for unregistered firms. In addition, Treasury referred to SECseveral callers who were interested in learning whether or not particular firms were registered aa government securities brokers or dealers. We found SEC'Sdata basewas not completely reliable for determining the number and identity of active broker dealer participants in the gov- ernment securities market. According to Treasury and NASD,SEC'Squar- terly listing of specialist dealers typically contained 10 to 20 firms that no longer were active as specialist firms. Typically, it also omitted 2 to 6 firms that were active as specialists. SEC’S listing of diversified brokers and dealers was also incomplete when compared to NASDrecords. We obtained a list from SECof 96 firms that prior to July 26, 1987, had reported on the old BD registration that they were deriving 10 percent or more of their revenue from government securities activities. We found, and SECverified, that none of these firms had filed amendedBD forms giving notice of their continued businessactivities as government securities dealers. As of February 16, 1990,48 of the 96 firms were Page 87 GAO/GGDBMM Government Securitlea Chapter 2 Implement&ion of the Government SecnrItiea Act shown on a NASDlisting as being diversified government securities dealers, indicating that they were active in the market. In addition to firms that had not filed, we found that the information in the data basewas incomplete or inconsistent in 161 of 1,267 caseswhere firms filed the proper forms. Most of these were fairly obvious omis- sions. For example, firms indicated that they did 10 percent or more of their businessin government securities but did not indicate if they were a specialist or diversified firm. We believe such errors could have been detected and corrected before the data were input into the system. We realize the difficulty in maintaining an up-to-date data base of broker-dealer filings when the responsibility for accurate and timely submission is on the dealers and considering the frequency with which dealers enter or leave the market or adjust their lines of business.How- ever, we also believe that there are practical steps the SECcan take to improve its data base. At a minimum, SECneedsto improve its verification and checking of sub- missions that are obviously incorrect or incomplete so that erroneous information is not made part of the data base.Secondly,SECshould develop a processto reconcile its list of registrants with agency records. Such a processwould not only assist SEC,it would help the self-regula- tors to determine if broker dealers have corrected their registration if required by examination findings. SECofficials acknowledged that there are someproblems with the accu- racy of the data, and they said that they would give the issue some attention in the near future. Infrequent Examinations Periodic examination by regulators is the primary means of ensuring by SomeBank Regulators compliance with all of the act’s provisions-both those that apply to dealers and those that apply to depository institutions’ custody of cus- Raise Compliance tomer securities. The act did not prescribe how frequently regulators Concerns should examine registered brokers and dealers or nondealer depository institutions having custody of customer securities; instead it left the timing issue to the discretion of regulators. According to regulator records, occ, FDIC,and ors have examined their institutions less fre- quently than FRB,NASDand WE and were also slower to issue guidance on the act to examiners. Statistics also indicate that when examinations were done, compliance violations were usually detected. Therefore, we Page 38 GAO/GGDBO-114Government Securitiee . Chapter 2 Implementation of the Qovemment secnrltlee Act have concernsabout the extent to which CKX,FDIC,and or®ulated institutions are meeting the act’s requirements. Examination F’requency Varied On page 30, we said that NASD did timely exams of newly registered spe- cialist firms. For diversified dealers, NASD officials said they were meeting their goal of examining firms with customer accounts annually and other firms every 2 years. NYSEofficials said they were examining all institutions annually. Similarly, F’RB reported that in 1988 it had met its goal of having each state member bank examined annually (1989 sta- tistics were not yet available).lQFRB did 876 of the 1,063 exams itself; the rest were done by state bank examiners. Also, NASD, NXSE, and FRB had amendedtheir guidance to examiners to reflect the act’s require- ments by May 1,1988. WC’Spolicy is to scheduleexams using criteria based on assetsize, random sampling, and identified need. Banks with assetsover $1 billion are to be examined every other year-this would include 146 govern- ment securities bank dealers. occ plans to examine one-sixth of all smaller banks-including 64 bank dealers-each year based on a random selection process.This criterion itself meansless frequent exams than for FRB-regulatedbanks. However, in addition, occ doesnot appear to be meeting its examination goals. The majority of CCCregulated bank dealers, both large and small, were not examined for compliance with the act during 1988 or 1989. occ reported to Treasury that in 1989, through November, it had examined 16 of the 199 bank dealers for compliance with the act’s rules and reviewed compliance with repurchase agreement and custodial require- ments for 24 other banks. WC did not report statistics for 1988, but on the basis of other information provided to Treasury, it appears few exams were done. occ says that someadditional exams were done in both 1988 and 1989 and not reported to the national office. occ said it did not issue its compliance procedures relating to custody of securities in repurchase agreementsuntil January 1, 1989, becauseof delays in finalizing the related sectionsof the regulations. occ did not view the hold-in-custody implementing regulations as finalized until August 1, 1988. lsFigures discussed in this section of the report represent those reported by the regulators in their response to a Treasury questionnaire on GSA implementation that was sent out in November 1989. The figures do not reflect those discussed on pages 41 and 46, which pertain to a different time period. Page 89 GAO/GGD9&114 Qovenunent Securitlem Chapter 2 ImplementNon of the Government Secnrltles Act Like occ, FDIChas examined few of its government securities bank dealers and did not update its examination guidance until February 1989. Although FDIC’Spolicy is that banks are to be examined at least once every 2 years, through November 30, 1989, FDIChad completed exams of 2 of 47 dealers and 6 were in process.FDICdid not provide us statistics regarding coverageby state bank examiners. FDICalso did not provide statistics as to how many nondealer banks were examined for compliance with the securities custody requirements under the act. However, FDICofficials acknowledged that compliance with the dealer requirements and the securities custody requirements were not the focus of FDICexaminations until after FDICissued its guidance to exam- iners in 1989. 0~sdid not issue any guidance to the thrifts pertaining to the act until May 1989, and it did not prepare and disseminate an examination module for determining compliance with the act until October 1989. As a result, CYI%has conducted only a small number of exams to determine compliance with the act’s requirements. However, as noted below, the potential for noncompliance with the act resulting from lack of examina- tions is probably less for thrifts than for banks becausethrifts are less likely to be dealers or custodians of customer securities. Although a number of thrifts participate actively in the mortgage- backed securities market, a telephone survey of district thrift examiners by CKSofficials in December1989 did not identify any likely registrants. Also, thrifts are not major custodians of customer securities in repur- chaseagreements,except for certain “retail repurchase agreements” in which the thrift pools investor funds and invests them through a repo. Under these circumstances,the thrift may have to provide confirma- tions of securities ownership to the investors as required by the act. ors officials assert that it is likely that the examiners would have detected any serious deficiencies in the government securities activities of thrifts as part of the examiners’ routine review of internal control and audit. Notwithstanding this assertion, we believe the limited and delayed CYIS action creates someuncertainty as to whether thrifts have complied with the act’s requirements. ExaminationsDisclose We reviewed statistics and summary categorizations of exam findings Compliance Problems provided by NYSE,FDIC,and occ and two completed exam reports from Y FRB.This information shows that the majority of exams had noncompli- ance findings, particularly in the area of repurchase agreementrelated requirements. For example, occ provided statistics on 31 examinations Page 40 GAO/GGIMO-114Govemment Securities cllapt43r2 Implement&Ion of the Government securltlea Act completed in 1989 through September26, of which 22 found 1 or more violations: 18 examinations identified customer protection violations, most of which showed improper compliance with repo requirements; 7 cited failures to fully comply with securities custodial holding proce- dures; 6 found problems with registration or filing requirements, 1 of which pertained to a bank that should have registered as a dealer but had not done so. Implications of Examination Effective examination is neededin order to determine whether the act’s Results requirements are being implemented properly. However, the apparent lack of timely examination of bank dealers raises somecomplicated issues.We seeno reason why, in principle, bank dealers should be examined less frequently than non-bank dealers, notwithstanding the differences in capital requirements applicable to the two types of dealers. On the other hand, it is widely recognizedthat bank examina- tion resourcesare strained. Bank regulators could plausibly argue, in someinstances,that on safety and soundnessgrounds, certain situations were of higher priority than checking on compliance with the require- ments of the act. The fact that bank and non-bank dealers do not appear to be subject to the samefrequency of examination is a specific example of a larger problem-how to achieve a reasonabledegreeof comparability of treat- ment for dealers competing in the samemarket but examined by dif- ferent regulators. We have not tried to addressthis larger issue in this study. While it will take time to solve all aspectsof the broader issue, we think it would be reasonablefor Treasury, SEC,and the bank regula- tory agenciesto addressthe more limited matter of frequency of exami- nation in the near future. The study on implementation of the act that these agenciesare to prepare by October 1,1990, would be an appro- priate place for this topic to be discussedand recommendationsdevel- oped, becausethe study was to addressthe effectiveness of rules promulgated under the act. Broadening Authority While NASDmember firms are explicitly subject to NASDrules to prohibit Over Government abusesin government securities advertising, no comparable requirement applies to bank dealers. Bank regulatory officials acknowledge that the Securities Advertising absenceof a provision addressing advertising rules for bank dealers in ” government securities creates an unevennessin regulatory requirements between bank and non-bank dealers. However, the regulators did not see a need to provide additional regulatory authority in this area, primarily becausethey believe few banks advertise, and if complaints were Page 41 GAO/GGD!bO-114 Government Securities Chapter 2 implementation of the Government secnriuea Act received, they could be investigated under SEC’S anti-fraud rule (lob-S), which covers all securities. While investigating complaints is important, NASD’S experience demon- strates that other measurescan be valuable. As discussedpreviously, NASD receivesads for review within 10 days of first use. In doing so, NASD found that at least half of the ads neededsomechangeto make them acceptable.The relatively high revision rate in the ads that were submitted appears to demonstrate the value of such a review program as a supplement to complaint investigation. It is difficult to determine how serious a problem there might be with the government securities advertising practices of bank dealers because this issue has not been a focus of regulatory attention. Bank examiners are not required to specifically evaluate the ads during their examina- tions, and bank regulator complaint records did not separately identify advertising issues.Bank regulators told us that in their experience, few bank dealers advertise their government securities activities. NASD’S experience is also that relatively few dealers seemto advertise their government securities activities.20 The advertising authority given to NASD permitted officials to implement a program with somesuccess.The bank regulatory agencieshave no similar specific authority, although an occ official said that the agency had authority to look at advertising under general anti-fraud provisions that it enforces. While we were unable to assessthe effect of excluding bank dealers’ government securities advertisements from explicit regu- latory scrutiny, we seeno reason why they should be excluded if we want to provide a comparable level of protection to all investors. Potential for Simplify ,ing As discussedearlier, Treasury’s regulatory requirements for specialist Capital Requirements for firms, except for the dealer capital adequacy rule and related reporting requirements, are essentially the sameas the requirements SIX applies to Specialist Dealers diversified dealers. In basic design, Treasury’s capital rates are also sim- ilar to SE&. Capital can, however, be somewhat more complicated to calculate under Treasury’s rule, and Treasury believes its rule is better suited to measuring specialist dealer risk and is easier for specialist pri- mary dealers to implement. “As noted on page 60,98 NASD-regulated government securities brokers and dealers submitted ads for review in 1989. This represented about 7 percent of the 1,378 NASD-regulated govemment securi- ties firms. Page 42 GAO/GGDBO-114Government Securities chapter 2 Implementation of the Govermnent secnrltles Act NASDand many dealers view Treasury’s methodology as complex. They say that eliminating these rules would mean that duplicate financial forms could be eliminated, and regulator examination and CPA audit guidelines could be standardized for all securities firms. NASDofficials told us eliminating the specialist category would simplify their examina- tion scheduling and lower costs.The few specialist firms in districts outside of New York do not justify establishing permanent examiner expertise in all regions. Consequently, when exams need to be done in these regions, someof which are for large firms, examiners with govern- ment securities experience must be brought in from other regions or headquarters. NASDofficials said that if all firms had to comply with the SECcapital rules, such expertise would not be a problem. If the specialist rule were to be eliminated, somefirms might have to maintain higher capital levels. However, NASDofficials also say, and a FRBNYdealer surveillance official confirmed, that larger specialist dealers typically reported capital levels that were substantially in excessof required levels under both methods becausethe marketplace often wants to seesubstantial excesscapital as an indication of the dealers’ capacity to handle large transactions. Becauseof the excess capital reported, the NASDofficials note that changing the minimum cap- ital rules for these specialist firms would, therefore, not tend to affect the amount of capital actually held by the firms. We believe that efforts to simplify capital regulation by eliminating a separate capital rule for specialist firms have merit. However, we are not persuaded immediate action is needed.Forcing dealers to change capital rules would impose additional compliance costs on dealers who set up their systems to meet the Treasury’s requirements when the act was passed.We also observedthat Treasury and SECofficials are contin- uing to review areas of difference in their requirements, a processthat we expect would continue to refine both methods. Unless Treasury can demonstrate that a common capital rule is inappropriate for specialist firms, such efforts and the continued decline in the number of specialist dealers should make it possible to phase out a separate rule for special- ized dealers. Market participants indicate that implementation of the government Conclusions securities act has succeededin establishing a regulatory structure that Y applies to all dealers and improves the safety of the repurchase agree- ment market. Overall, Treasury has done a goodjob of getting reason- able rules in place on time without overburdening the market, and NASD Page 43 GAO/GGDW114 Government Securities II Chapter 2 Implementation of the Government Seenrltles Act seemsto be meeting its examination goals to ensure that newly regu- lated firms comeunder compliance. Our concern about the act’s implementation is that inaccuraciesin SEC’S data baseof registrants and the limited number of compliance examina- tions by occ, FDIC, and ors raise doubts as to whether the act’s registra- tion and repurchase agreementprovisions are being complied with to the degreepossible. Moreover, the result of NASD’S review of ads filed by its memberssuggeststhe need for a similar review of bank dealer ads. Improving the SECdata basecalls for relatively straightforward correc- tive action. Dealing with issuesof examination frequency and adver- tising regulation of bank dealers are more complex becausethey need to be approached within a context of bank dealers’ overall responsibilities and workload, as well as in the context of ensuring comparable over- sight of the act’s provisions. Now that all government securities brokers and dealers have been brought under regulation, we believe it is appropriate to review the need for the unique capital requirements Treasury imposed on specialist firms to ensure that the differences in requirements are necessaryand appropriate. To deal with these concernswe recommendthe following: Recommendations l SECshould develop a procedure for ensuring the accuracy of dealer reg- istration data by, at a minimum, reviewing broker/dealer submissions for obvious omissions and inconsistenciesand periodically (at least annually) having the self-regulatory agenciesand bank regulators review SEC’S lists of registrants to identify discrepanciesfor follow-up by either SECor the regulator. . The Secretary of the Treasury, SEC,and FRB,as part of their required study of the act’s effectiveness, should develop recommendationsto ensure that bank dealers’ government securities activities, including advertising, are provided oversight comparable to the activities of N.&SD- regulated firms. . Unless Treasury can demonstrate that a common approach results in capital requirements that are inappropriate for specialist firms, the Sec- retary of the Treasury and should work together in developing a SEC plan to phase out Treasury’s unique capital requirements for specialist dealers. Page 44 GAO/GGDW114 Government Securities Chapter 2 Implementation of the Government Sewrltles Act The Department of the Treasury commentedon our recommendation Agency Comments that the Secretary of the Treasury and SECshould work together in developing a plan to phase out Treasury’s unique capital requirements for specialist dealers. Treasury said that an informal staff level working group has been established, comprised of representatives from SEC,the Federal ReserveBank of New York, and Treasury. This working group is considering the issuesthat need to be resolved in order to develop a uniform capital rule that would apply to the government securities activities of both specialist firms and other securities brokers and dealers. Pending the outcome of this study, Treasury said that it and SEC will continue to take advantage of opportunities to minimize the differ- encesin the agencies’respective capital rules. Page 45 GAO/GGDVO-114Government Securltiw ChaDter3 Additional Investor Protection Measures Are Needed The act said that our study should include an examination of the effec- tiveness of the act in protecting investors. As noted in chapter 1, the act specifically limited Treasury’s rulemaking authority and prohibited NASD from enforcing its rules of fair practice on the government securi- ties activities of NASD members.In addition, newly registered specialist broker/dealers are not eligible for membership in the Securities Investor Protection Corporation and, therefore, cannot provide insurance cov- erage for customer accounts. We believe Congressshould reconsider the limitations on salespractice rules and SIPCcoveragethat now exist in the U.S. government securities market. Many of the reasonsthese investor protection measureswere adopted in sEc-regulatedsecurities markets also apply in the market for U.S. government securities. To ensure fair dealings and protect investors, the Securities Exchange The Need for Sales Act of 1934 required that all exchangesand registered securities Practice Rules in the associationspromulgate rules for their membersto supplement the U.S. Government requirements of the act and of SEC regulations. These rules, which we refer to as salespractice rules, apply to transactions in SE-registered Securities Market securities. The rules define and regulate the kind of fraudulent or manipulative acts and practices that the securities laws were enacted to prevent, and they sometimesserve as a substitute for SEC regulations. Salespractice rules for registered securities cover broker/dealer pricing practices (mark-up practices) and placement of customer funds in secu- rities with risk characteristics suitable for the customers’ investment objectives (suitability requirements). They also prohibit other practices, such as excessivetrading of customer accountsto generate commissions (churning). Salespractices rules have been developedby self-regulatory organizations, such as ~‘15~ and NASD, and approved by the SEC. Salespractice rules also apply to transactions in municipal securities. Using its broad rulemaking authority over the salespractices of munic- ipal securities dealers and brokers, the Municipal Securities Rulemaking Board (MSRB) has promulgated salespractice rules modelled after those Of NASD.’ ‘MSRB’a rulea are approved by SEC. MSRB has no enforcement authority. Like Treasury, under the act, MSRB relies on SEC-through the SROs-and the bank regulators to ensure compliance. Page 46 GAO/GGD-9W14Government Securities , .,( I Chapter 8 AddItional Investor Protection Measures Are Needed The Government Securities Act doesnot apply salespractice rules to transactions in government securities, and the act prevents NASD from applying salespractice rules to government securities transactions. Many investors are, nonetheless,covered in someway by existing regu- latory arrangements becausethe act doesnot prevent registered securi- ties exchanges,such as NYSE, from applying such rules. In a similar manner, bank regulators have adopted the practice of applying MSRB'S salespractice rules to transactions in U.S. government securities as well. We believe investors would be better served if Congressadopted legisla- tion to protect customersof all U.S. government securities dealers by requiring salespractice rules comparable to those that exist in the mar- kets for SEC-registeredand municipal securities. Sales Practice Rules All securities dealers are subject to federal anti-fraud statutes. The law Supplement Anti-Fraud is contained in Section 17(a) of the Securities Act and Section 10(b) of the ExchangeAct.” Taken together, these provisions administered by the Protection Available in All SECprohibit material misstatements or omissions and fraudulent or Markets manipulative acts and practices in the offer, purchase, and sale of securities. SECenforces the anti-fraud provision and takes the position that when individuals or firms put out their shingles as broker/dealers, they agree to operate honestly and in accordancewith generally acceptedindustry standards and practices. This so-called“shingle theory” meansthat at a minimum, any deviation from the norm must be disclosedto the customer. As pointed out in chapter 2, the act made it easier for SECto act against fraud in the government securities market becauseinformation that could be used to bring fraud chargescan be obtained much more easily from regulated firms. When a firm is regulated, officials from SECand ‘The SEC anti-fraud rule applicable to all securities dealers is rule lob-6, which essentially restates the provisions of the two laws. Rule lob-6 provides: “It shall be unlawful for any person, directly or indirectly, by the use of any means or instrumentality of interstate commerce, or of the mails, or of any facility of any national securities exchange, (1) to employ any device, scheme, or artifice to defraud, (2) to make any untrue statement of a material fact or to omit to state a material fact necessary in order to make the statements made, in the light of the circumstances under which they were made, not misleading, or, (3) to engage in any act, practice, or course of business which operates or would operate as a fraud or deceit upon any person, in connection with the purchase or sale of any security.” Page 47 GAO/GGDSO-114Govemment Securlti~ Chapter 3 Additional Investor Protection Measures Are Needed the SROScan have full accessto a firm’s books and records at any time. The act, therefore, makes the government market comparable to other securities markets with respect to the regulators’ ability to enforce the anti-fraud statutes. However, the act doesnot provide for the type of salespractice rules that help to protect customers against abusive prac- tices in other securities markets. Salespractice rules have several practical benefits. First of all, they set a standard for conduct for all brokers and dealers operating in the market. These rules also gain force becausethey can be used by cus- tomers as support for legal action, principally in arbitration proceed- ings, alleging wrongdoing by brokers and dealers. Finally, the existence of salespractice rules enablesregulators to cite a broker or dealer for violations without having to prove that the dealer had intended to defraud a customer. As with any regulation, there are costs associatedwith salespractice rules. The rules limit broker/dealer activities and involve administrative costs that firms can be expected to pass on to customers.Unfortunately, it is difficult to quantify either the benefits or the costsof salespractice rules. The quantitative information that would be most useful in assessingthe need for salespractice rules-evidence of investor losses that have occurred becauseof salespractice abuses-is hard to docu- ment. There is little incentive for individuals or those managing funds for others in a fiduciary capacity to admit to, and to publicize, instances where they have lost money. In preparing this report, we did not attempt to make an independent assessmentof the prevalence of sales practice abusesin the government securities market, nor did we attempt to evaluate the effectiveness of salespractice rules in preventing abuses in the registered and municipal securities salesmarkets. On the basis of information currently available, the casefor extending salespractice rules to the U.S. government securities market rests prin- cipally on the following line of reasoning. Salespractice rules that sup- plement the basic anti-fraud provisions of the securities laws have becomea fixture in securities markets in the United States. If these rules make sensefor other securities markets, then they also make sensefor the government market as well, becausethere are similar opportunities for abusein both types of markets. Page 48 GAO/GGD90-114Government Securities Chapter 3 Addltiond Investor Protection Measures Are Needed Characteristics of the The government securities secondary market has traditionally been Government Securities characterized as a wholesale market dominated by primary dealers and large institutional investors who are presumed to know what they are Market That Warrant Sales doing. While no comprehensivestatistics on secondary market trading Practice Rules to Protect are available,” our discussionswith market participants indicated that Investors although the market is still primarily a wholesale market, there is evi- denceof increased secondary market participation by retail investors- smaller institutions, corporations, and individuals. For example, GFOA has provided guidance to its membersregarding the development of suitable investment practices becausethese state and local government fiscal officers are more directly involved in the market due to increased pressure to narrow fiscal deficits through active managementof their cash balances.In addition, a number of new investment instruments have been developedto facilitate investor participation, such as Trea- sury STRIPS and collateralized mortgage obligations. According to an NASD official, many of these instruments are purchased by retail-level inves- tors. As noted below, the risk characteristics of many of these instru- ments are similar to the risk characteristics of registered securities. Retail-level participants are valuable becausethey provide additional depth and liquidity for the market and profit opportunity for the dealers. We believe these retail-level participants are, however, also more vulnerable to lossesrelative to large commercial banks, insurance companies,and other large institutional market participants. Retail par- ticipants tend to be more dependent on information and execution from the dealers and may be less aware of risks and market values4 NASD’S inability to enforce salespractice rules in the government securi- NASD Should Have ties market creates a major investor protection gap in this market. The Authority to Enforce act’s limitations on NASDmean that customersof NASD-examined dealers Sales Practice Rules in (approximately 63 government securities specialist broker/dealers and over 1,300 diversified broker/dealers) do not receive salespractice pro- the Government tection for their government securities transactions. As a result, cus- Securities Market tomers of NAsD-examineddiversified dealers receive less protection on government securities transactions than on other securities transactions “Reports of daily transaction activity that primary dealers provide FRBNY are the only data col- lected on market activity. These reports differentiate trades completed through brokers from direct trades between dealers and their customers (see table 4.1) but they do not differentiate the volume of trading with different categories of customers. “As will be discussed in chapter 4, some large institutional investors can execute transactions with dealers through a screen broker in the same anonymous way that msjor dealers execute trades with each other. Page 49 GAO/GGD90-114Government Securities Chapter 3 AddItional Investor Protection Measurea Are Needed with those samedealers. This situation has the potential to be especially confusing to investors becausecustomers,seeingthe NASDseal on the door of the securities firm, may not be fully knowledgeable about what transactions are and are not subject to all of NASD’Ssalespractice rules. Customersof NASD-examined firms also receive less protection than cus- tomers examined by NYSE or bank regulators. Contrast Between NASD- As a result of the act’s limitations, NASD can only review improper prac- Examined Firms and tices in the context of the anti-fraud provisions of the securities laws.” NAED summarized its views on the problems resulting from the limita- Those Examined by NYSE tions in NARD’S authority in a letter to Treasury in 1989. or I3ank Regulators “Because there are no sales practice regulations for government securities, NASD disciplinary actions involving abusive practices must rise to the level of fraud before anything can be done. While there are specific rules for equity securities or municipal securities addressing matters such as suitability, mark-ups, fairness of commissions, churning and other sales practices, there are no such rules for govern- ment sales practices, other than the SEC lob-6 fraud rule. To successfully prosecute a lob-6 case, the conduct must be so egregious as to rise to the level of fraud, and all the attendant evidentiary standards must be met including proof of scienter [intent]. Thus, many questionable sales practices falling somewhere between compliance and fraud go unaddressed in the absence of clear statutory or regulatory authority to do so.“‘i In contrast to the situation with NASD, if investors do their government securities transactions with any of the approximately 168 NYSE- examined government securities broker/dealers, their transactions would be covered by NYSE’S salespractice rules. SECand Treasury offi- cials told us NESE is not prevented from applying standards regarding “In its report on a provision of S. 1416 that carried over to the enacted legislation, the Senate Banking Committee report stated: “Since government securities would continue to be treated as exempted securities for purposes of the Exchange Act, a registered securities association would have no authority with respect to government securities brokers, government securities dealers, and government securities transactions except as specifically authorized in the bill or as already exists in current law.... Aside from the areas of regulation described in section 16A(f)(2), a registered securities association would not be authorized to regulate transactions in exempted securities by member brokers or dealers. For example, a registered securities association would be precluded from adopting, under section 16A(bX6), any rules of fair practice applicable to government securities brokers and govem- ment securities dealers or from establishing any standards of financial responsibility, operational capability or competence with respect to government securities brokers, government securities dealers or their associated persons.” “Letter from NASD dated March 3,1939, to Robert Glauber, Under Secretary for Finance, the Depart- ment of the Treasury. Page 50 GAO/GGDBO-114Government Securities chapter a Additional Investor Protection Measure Are Needed salespractices to government securities activities becausethe act pro- hibited only registered securities associations,not exchanges,from applying such rules. Similarly, if the transactions were with one of the approximately 280 bank dealers, they could be subject to bank regulator oversight, although the authority and mandate to evaluate government securities sales practices is indirect. NOSEApplies SalesPractice NISE officials told us that NYSE examines the government securities- Rulesto the Diversified related salespractices of its membersin the overall context of activities Government Securities Dealers It in and managementof customers’ accounts.7In other words, NYSE exam- Examines iners look to seethat a member handled customer transactions, including those in government securities, in accordancewith NYSE rules. NYSE officials said that salespractices in the government securities market are covered in the NYSE examination program, with the scopeof each examination depending upon whether problems are expected based on the existence of complaints or internal control weaknesses. NISErules covering salespractices essentially require every member organization to adhere to good businesspractices, properly supervise accounts,and report any suspectedrule violations or complaints from customersto the Exchange.NYSE also has a suitability rule that requires member firms to use due diligence to learn the essential facts relative to every customer, every order, and every account, Regarding mark-up practices, NYSE usesits rules requiring good businesspractice and proper supervision as a basis for examination and any necessaryaction. NYSE officialsbelieve their rules provide an adequate basis for regulating the government securities related salespractices of member firms. They believe their ability to enforce the rules, in combination with the member firms’ desire to maintain a good reputation, works to deter firms from knowingly engaging in improper conduct. They provided sta- tistics on examination findings and complaints showing that few problems have been found or complaints received.8However, during the July 26, 1987, to June 30, 1989, period, NYSE had applied its rules as the 7NYSE rule 401 states that every member, allied member, and member organization shall, at all times, adhere to the principles of good business practice in the conduct of its business affairs. “NOSE officials said that from July 26,1987 to June 30,1989, they conducted 330 examinations of government securities dealer members, and in 36 exams, there were 46 government securities related findings. They said none of the findings were sales practice related. NkSE officials also said that only 8 of the 340 sales practice complaints it received about its dealer members during the first 6 months of 1989 were government securities related. None of the government securities related complaints resulted in regulatory sanctions against any firm. Page 61 GAO/GOD-90-114Government SecurItiea Chapter 3 Additional Investor Protection Measures Are Needed criteria for sanctions against 10 individuals who were dismissed by their firms becauseof improper government securities dealings. Bank Dealers The primary focus of bank examinations is to ensure that the institution is operating in a safe and sound manner. Bank regulators told us that they do not have explicit authority to review the government securities salespractices of bank dealers, but they do so in the general context of ensuring that the bank is properly handling transactions involving cus- tomers’ securities and funds. Bank regulators said that they follow the guidelines promulgated by MSRBfor municipal securities salespractices becausethe typical bank dealer handles government and municipal securities as part of the sameoperation. An official of the American Bankers Association (ABA) told us that the salespractices of banks in government securities are conducted and operated in accordancewith the rules of SEC,NASD,(as applied to registered securities), and MSRB,and that the bank policies and procedures manuals are subject to bank examiner review. There is someevidencethat investors are benefiting from bank regu- lator enforcement of salespractice rules on government securities bank dealers. Regulators have investigated salespractice complaints received from customers of bank dealers, which have resulted in corrective actions.RAlthough no statistics on the number of salespractice findings generated by bank examinations were available, bank regulators told us that examinations have not revealed many government securities sales practice problems. In addition, regulatory officials have periodically advised bank examiners and the institutions being examined regarding the nature of the standards that are being applied and the types of problems found.1” “CCC told us they had received 60 complaints concerning sales practices in the government securities market between July 1987 and July 1989. The complaints were grouped into 6 categories: Unautho- rized transactions (16), customer not receiving purchased securities (12), pricing (lo), misrepresenta- tion (8), and customer disadvantaged (6). Nearly half of the settled claims resulted in some compensation to the investor. “‘For example, in 1984 CCC used exam findings to clarify guidance to its examiners about what are unfair or unsafe practices. Some of the specific problems noted were: l overtrading (churning) customer investment portfolio, l investing customer funds in speculative long-term securities or stripped securities unsuitable for the customer. and . improper pricing of securities. Page 52 GAO/GGD-90-114Government Securities chapter 3 AddltIonal Investor Pcotmtion Measures Are Needed Investor Protection The preceding discussionindicates there is evidencethat government Concerns securities investors derive somebenefit from NYSE and bank regulator application of salespractice rules. If NASD were to be given similar ability to enforce salespractice rules, the benefits to investors would likely fall in the areas of dealer mark-ups and investor suitability in the government securities markets. DealerMark-Ups Rules involving dealer pricing practices (mark-ups) consider both the size of the mark-up and whether or not the customer was told what the mark-up was (disclosure). While the reasonablenessof a particular mark-up is a judgment call basedon a number of factors, somecriteria for fraud have evolved as SEChas taken legal action against dealers, and those actions have been supported or negated by the courts. Specifically, SEC has considered any undisclosedmark-up in excessof 10 percent of the price of any security to be fraudulent, becausesuch a mark-up is far in excessof industry norms. Mark-ups in excessof 6 percent are consid- ered questionable. For registered securities, NASD has administered a 6 percent mark-up guideline on its members. This guideline creates a somewhat stricter standard than that contained in the SECanti-fraud rules. It also allows NASD to bring an action without having to prove fraudulent intent. SEC’Sposition is that mark-ups smaller than 6 percent can also be consid- ered fraudulent if they are undisclosed and in excessof industry norms. SECarticulated this view in an April 1987 notice” in which it stated that mark-ups in the government securities market are typically lower than in equity markets, and that the industry norm was to charge a mark-up on Treasury securities of l/32 percent to 3-l/2 percent. However, SEC has not taken court action on mark-ups just exceedingthese norms, choosing instead to pursue caseswhere the mark-ups exceededthe lo- percent or S-percentthresholds. NASD believes it should have authority to enforce mark-up rules in the government securities market (1) becauseof the difficulty of proving intent and (2) becausecontemporary standards for maximum mark-ups are even farther below the thresholds for fraud than are the maximum markups for registered securities. In a 1988 poll of dealers, NASD was LISecurities and Exchange Commission Release No. 34-24368, Zero Coupon Securities, Federal Reg- ister Vol. 62, No. 82, April 29, 1987, pp. 16676-16677. Page 53 GAO/GGD-30-114Government !ikcurItiea i Chapter 3 Additional Investor Protection Measures Are Needed told that mark-ups typically ranged from 3 to 13 basis points (l/32 per- cent to 4/32 percent) for Treasury notes and bonds.12Thus, a mark-up of, say, 3 percent for such Treasury securities could easily be excessive but go unchallenged in the absenceof a rule, becausethe practical fraud thresholds are generally in the 6- to lo-percent range. In the absenceof specific NASD rules governing mark-ups, the Arkansas Securities Commissionerin April 1989 issued a mark-up schedule appli- cable to government securities transactions. This scheduleestablishes mark-up limits for various types of transactions ranging from l/4 per- cent to 2-l/2 percent (26 to 260 basis points). Dealers are required to provide justification for mark-ups that exceedthese guidelines. The Arkansas rule was adopted becauseof the activity of certain gov- ernment securities dealers in the state. These dealers have comeunder extensive regulatory and criminal investigations resulting in fines, sus- pensions,and prosecutions for certain firms and participants. Someof these firms engagedin excessiveunsuitable trading of customer accounts(usually small banks and thrifts and state and local govern- ments), which has resulted in sizable lossesfor the institutions but sub- stantial commission income for the bond salesmen.NASD and the Arkansas State Securities Commissioneventually moved against those institutions by applying the anti-fraud statutes. However, NASD officials believe that its inability to enforce salespractice rules inhibited NASD from moving against these firms more quickly. Arkansas’ responseof creating its own rule is understandable. However, the state’s action underscoresyet another reason to incorporate sales practice rules within the scopeof federal securities laws. If each state begins to take action on its own, the national character of the govern- ment securities market would be diminished somewhat. Becauseof the government’s interest in selling its debt at as low a cost as possible, we believe standards for protection should be promulgated at the federal level. Such standards can still allow someflexibility to deal with regional differences in markets. Investor Suitability Rules Investor suitability rules have been developed in the context of SEC’S requirements that broker/dealers must deal fairly with their customers. For example, NASD’S rule, which applies only to registered securities Y ’ “The results of NASD’s poll were consistent with guidelines set out in bank examination manuals. The manuals note that mark-ups on government securities ranging between l/32 and 4/32 of a point are typical, and that higher mark-ups should be evaluated to determine whether circumstances jti- fied them. For example, infrequently traded securities can have higher mark-ups. Page 54 GAO/GGDIx)-114Government !!iecwitlea Chnptm 3 Mdltlonal Investor Protection Measures Are Needed transactions and cannot be applied to government securities transac- tions, states that: “In recommending to a customer the purchase, sale or exchange of any security, a member shall have reasonable grounds for believing that the recommendation is suitable for such customer upon the basis of the facts, if any, disclosed by such customer as to his other security holdings and as to his financial situation and needs.“‘” This means, for example, that a dealer cannot excessivelytrade a cus- tomer’s account, recommenda purchase beyond the customer’s ability, or recommendspeculative securities inappropriate for the investor’s objectives. MSRB has a similar rule, which states that dealers are required to make reasonableinquiry as to the financial condition and investment objec- tives of the customer so that the dealer has reasonablegrounds to believe the investment is suitable for the customer and no reason to believe it is not. The MSRB rule still allows the dealer to execute the transactions at the direction of the customer once it has communicated its concernsto the customer. The importance of applying investor suitability rules to the U.S. govern- ment securities market is illustrated by the regulatory treatment of zero coupon instruments and mortgage-backedsecurities. These instruments are available both in the government securities market and the regis- tered securities market. The primary suitability problems associated with these securities arise from the nature of the instruments them- selves,not from the presenceor absenceof a government guarantee for the securities. Zero coupon instruments present suitability problems for someinves- tors. Becausethese instruments are priced at a deep discount, their price is very sensitive to interest rate changesand may fluctuate considerably prior to maturity. Such changescould result in significant lossesto an investor who could not hold them to maturity. NASD officials are con- cerned that investors are not adequately informed of this risk. Mortgage-backedsecurities also present suitability concernsfor the unknowledgeable investor or one that may have intermittent liquidity “‘NASD Rules of Fair Practice: Recommendations to Customers, Article III, Section 2, Paragraph 2162. Page 56 GAO/GGD-90-114Government !3ecurities Chapter 3 Additional Investor Protection Measures Are Needed needs.The cash flows associatedwith these securities are hard to deter- mine becausethey depend on how fast borrowers pay off the principal on the underlying mortgages(usually by sale of the mortgaged property or refinancing). Such behavior is very sensitive to movementsin interest rates and can leave a customer with funds to reinvest unexpectedly at the worst time-when interest rates have fallen. Also, different parts of the country and types of mortgageshave different prepayment charac- teristics, Thus, all 9-l/2 percent GNMAmortgage-backedsecurities are not alike in maintaining their value over time as interest rates change. The most systematic effort we know of to document investor lossesthat have occurred since passageof the act has been conducted by the Gov- ernment Finance Officer’s Association (GFOA).GFDAhas collected infor- mation on a number of instances in which state and local governmental entities have lost money- in somecases,millions of dollars-due to investments that appear to be unsuitable. According to this information, one state lost over $200 million, and a city lost over $60 million in inap- propriate speculative bond trading. In addition, onejurisdiction incurred lossesby trading zero coupon bonds, and another by inappropriate hedging of transactions in mortgage-backedsecurities. The lossesin the various situations documentedby Gm appear to result from poor practices by both investors and dealers in much the sameway as did lossesin the repurchase agreementmarket, which prompted pas- sageof the act. GFOAhas issued guidelines to its membersthat they review the use of long-term securities, including GNMASand zero coupon securities, to ensure that the risk characteristics are suitable to the investor’s objectives. GFOAhas been supportive of NASD'Sconcerns regarding the need for appropriate salespractice rules. We have not attempted to review the details of the casesidentified by GFOAto determine what parties were at fault and whether the losses would have been prevented by explicit salespractice rules. The cases do, however, show that the potential for loss in the government securi- ties market is similar to that in the markets for registered and municipal securities. We therefore think it reasonablethat less sophisticated indi- vidual and institutional investors in the government securities market should have the sameprotections against abusethat exist in the regis- tered and municipal securities markets. Page56 GAO/GGDDO-114Government Securities Chapter 3 AdditIonaI Investor Protection Measures Are Needed Lifting the limitations on NASD'Sauthority to enforce salespractice rules SalesPractice Rules is a necessarystep in providing adequate protection to investors in the Should Be government securities market. For the firms it examines, NASDwould Promulgated at the then be in a position, just like the NBE, to enforce its sEc-approvedsales practice rules in the government securities market. Federal Level We believe, however, that government securities dealer salespractices should also be subject to explicit rulemaking by a federal agency.This would highlight the importance of investor protection in this market. Explicit rulemaking would also make it more likely that similar protec- tions would be available to customers of both bank and non-bank dealers. Why Rulemaking by a Vesting rulemaking authority in a single federal agency represents the Federal Agency Is best way to develop consistency in a market in which both bank and non-bank dealers operate. The presenceof both banks and securities Appropriate firms in the government securities market createspotential regulatory problems, becauseeach type of firm comesunder the jurisdiction of a different type of federal regulatory arrangement. Securities firms are regulated and supervised by SECand must alsojoin a self-regulatory organization such as NASDor the NYSE.Banks, on the other hand, are reg- ulated and supervised by one of the federal banking agencies-occ, the Federal Reserve,or FDIC. At the present time, NYSEand the banking agenciesboth rely on exam- iners’ judgment to protect investors against salespractice abuses.NYSE does not have an explicit rule governing mark-ups, nor has it provided written guidance to its examiners as to what constitutes unreasonable mark-ups in government securities. NYSEofficials told us examiners are to use their own judgment as to whether a dealer’s mark-ups to a cus- tomer are excessive.They said criteria for this judgment is primarily derived from SECguidance and enforcement actions. Bank regulators include a discussionof reasonablegovernment securi- ties mark-ups in the examination manual. The examination procedures say that examiners are to test for unsafe and unsound practices, including comparing trade prices on selectedtransactions with indepen- dently established market prices as of the date of trade. Federal Reserve officials said that examiners have considerableroom for judgment in evaluating the reasonablenessof mark-ups and generally challenge only those that are clearly egregiousbecausethe individual examiners have Page 57 GAO/GGD-90-114Government Securities Chapter 9 Additional Investor Protection Meamres Am Needed no readily available industry standards for mark-ups in government securities. Given the division of responsibility among federal agencies,the best way to get as consistent an approach as possible to protection against salespractice abusesis to have the samegeneral rules apply to all types of firms. The principle of providing rulemaking authority that applies to bank and non-bank dealers is reflected in the Government Securities Act, particularly in regard to repurchase agreements. When faced with the issue of how to establish consistent investor pro- tection measuresamong all bank and non-bank dealers operating in the municipal securities market, Congresscreated MSRB.MSRB'Srules, which apply to all types of dealers, are also subject to approval by SEC.While we believe that a single focus for rulemaking is appropriate, this does not mean that an entirely new agency analogousto MSRBmust be estab- lished. The Government Securities Act already provides a framework for establishing rulemaking responsibility in the government securities market. The topic of the appropriate role of Treasury and SECin setting rules is discussedin chapter 6. Structuring Rules for the It was not our objective in this study to develop the specific salesprac- Market tice rules for government securities dealers. In keeping with the under- lying philosophy of the Government Securities Act, we believe every effort should be made to assurethat salespractice rules in the govern- ment securities market are as consistent as possible with the rules already developed for other securities markets by SEC,MSRB,and self- regulatory organizations. In keeping with current practice for registered securities, the rulemaking authority can be used to approve rules devel- oped by SROS(such as NA~D), and it can also be used to approve rules proposed by the agenciesthat regulate and supervise banks. Fair practice rules need to be flexible enough so that attempts to control abusesdo not inhibit the operation of a market that, for the most part, works well. Examiners need to be able to consider a number of factors that affect the trading relationship between the dealer and the customer and the terms of the particular trade. These factors include the size of the trade, the type of investor, the role of the dealer in executing the trade, the dealer’s role as a marketmaker, the extent to which the secu- rities are actively or inactively traded, and the information on current market prices available to the customer. Page68 GAO/GGD-90-114Government Securities Chapter 3 Additional Investor Protaction Measures Are Needed A flexible arrangement also allows the regulatory system to keep cur- rent with changing market conditions so that regulators and the firms being regulated can be held accountable for the protection afforded to investors. For example, certain “sophisticated” investors could be excluded from coveragebecausethey operate in wholesale segmentsof the market and can be presumed to be knowledgeable about risks, values, and prices. Such arrangements need to be flexible becausethe criteria for sophistication can change,particularly if (as will be dis- cussedin chs. 4 and 6) trading and information systems evolve that give someinvestors accessto, or knowledge of, the prevailing interdealer market prices for government securities. Qualifying Examination .S Brokers and dealers in SEC-registered securities are required to pass a for Dealers and Brokers qualification examination intended to safeguard the investing public by helping to ensure that registered representatives are competent to per- form their jobs. This exam, known as the Series7 exam, is a companion requirement to the investor suitability rules becauseit tries to measure whether or not a candidate has attained an entry level of competency necessaryto properly advise customers and processthe customer’s transactions. For example, registered representatives of NASDmember firms who are engagedin sales and trading activities are tested for knowledge about the trading and risk characteristics of products they recommend and sell to investors. Managersand supervisors are examined for knowledge of the securities laws and regulations for which they have compliance responsibility. Broker and dealer personnel who deal solely in government securities are not required to pass such an examination. However, it is difficult to assessthe amount of harm causedby the absenceof an examination requirement, becausethe effectiveness of the testing processhas not been evaluated and it was beyond the scopeof our work to do so. We found that regulators’ opinions about the need for an exam generally are favorable but the degreeof support varies. Officials from SECand FHB recognizethat while exams are useful, passing an exam doesnot ensure an individual’s competency or integrity. On the other hand, two NASD officials said that exams should be required of chief financial officers of government specialist firms. They pointed out that a financial officer of a diversified firm can get fired for failing to pass the required exam, but the officer would have no problem joining a specialist firm becausea test is not required. Page 59 GAO/GGDsO-114Government Securities chapter 3 Additional Inv&or Protection Measures Are Needed The uncertainty created by the lack of qualification exams is also a con- cern because,as noted earlier, government zero coupon and mortgage- backed securities have risk characteristics similar to nongovernment zero coupon and mortgage-backedsecurities. Consequently, if testing requirements for managers,salespersonnel, and traders in nongovern- ment securities were consideredimportant for ensuring enforcement of rules relating to investor suitability, it would seemreasonableto have them for personnel of firms involved in comparable government securities. SIPCis a nonprofit corporation that insures the securities and cash in the Protecting customer accountsof member broker/dealer firms against the failure of bvernment securities th ose f’urns. Except for government specialist dealers and certain other Investors Against specialists,14all brokers and dealers registered with SEC(who, therefore, also must be membersof a national stock exchangeand/or NASD) are Broker/Dealer Failure automatically membersof SIPC. When a brokerage firm fails, SIPCwill try to transfer accountsto another brokerage firm and then will liquidate the firm’s assetsto settle any remaining claims. SIPCprotects customers’ cash and securities up to a maximum of $600,000 per customer, with a limit of $100,000 on cash and cash equivalents. SIPC doesnot, however, protect investors against lossesdue to market fluctuations in security prices or due to repo transactions. In passing the act, Congressdid not make government securities spe- cialist dealers eligible for membership in SIPC. Therefore, if 1 of the 63 specialist broker/dealers fails and is maintaining customer accounts, these customers have no federal protection for their funds. We believe this gap in SIFC coverageis not appropriate. There is nothing in the operation of a government securities specialist dealer that uniquely insulates such firms from the types of risks that led Congress to authorize SIPC. We found that 20 specialist dealers could maintain cus- tomer funds and securities.*6Fraud in handling customer accounts could i4Non-bank broker/dealers do not have to join SIPC if their business is exclusively: (1) distribution of mutual fund shares, (2) sale of variable annuities, (3) insurance business, or (4) furnishing of invest- ment advice to investment companies or insurance company separate sccounts. ‘“Of the 63 specialist brokers and dealers in July 1989,16 were brokers and 47 were dealers. Infor- mation available on 43 of the 47 dealers showed that 23 of the 43 firms claimed an exemption from certain capital requirements because they did not maintain customer accounts. Of the other 20 dealers that did not claim the exemption, 12 had nondealer customers and could maintain accounts for those customers such that it would have to provide SIPC coverage if it were a registered firm. We did not attempt to determine how many of these firms were maintainlng customer accounts, but we are aware of one spz&list dealer that wss doing so. Page 60 GAO/GGIWO-114Government SeeMtIes chapter 3 Additional Investor Protection Measures Am Needed occur as easily in a government securities specialist firm as in any other securities firm. Similarly, specialist firms could go bankrupt from poor investment decisionsjust as easily as other firms. We believe the absenceof SIPC coveragefor specialist dealers can be con- fusing to investors in sorting out the protection provided when dealing with certain firms. Specifically, we found that 13 of 47 specialist dealers have affiliates that are diversified securities firms that provide SIPC cov- erage. We also found that someof these specialist dealers share the sameoffice spaceand personnel with their diversified affiliates. As we entered the premises of one such dealer, we observedthat the door listed the names of the firms and had a SIPC membership seal at the bottom of the door. We think such a shared arrangement can easily keep investors from appreciating that transactions with different affiliates may carry different protection. One way to reduce the potential for confusion would be to require spe- cialist dealers to clearly disclosethat they do not provide SIPC c0verage.l” However, we question whether customers of specialist dealers should be without SIPC protection if they would have such protection by dealing with a diversified firm. As was the casewith salespractices, we believe the protection for investors in the government market should be at least as great for comparable risks as it is in other securities markets. We also seeno reason why specialist firms should be able to avoid the responsi- bilities for supporting the integrity of the market that derives from SIPC insurance. Another way to reduce the potential for confusion would be to abolish the category of specialist firms and require all securities firms operating in the government securities market to register with SEC, in the same manner as firms dealing in registered securities. Becauseof the limited experience that exists under the government securities act, we feel there is not enough information available to determine whether the specialist firm category established by that act could be abolished. However, dif- ferencesbetween specialist and other securities firms should greatly diminish as similar capital requirements and salespractice rules are applied to all securities firms operating in the government securities market. “‘Such a disclosure currently exists for repurchase agreements involving SIPC-insured firms. Trea- sury rules require that all repo agreements include a notice that SIPC coverage does not protect a customer’s securities held ln custody by a SIPC-insured dealer. Page 61 GAO/GGD-90-114Government Securities Chapter 8 Additional Investor Protection Measures Are Needed Extending coverageto the relatively small number of specialist firms would not represent a major expansion of SIPC’S potential liability. Pay ment by specialist firms of a SIPC premium would, of course,represent an increased cost to those firms, although SIPCpremiums are not large relative to the total revenue of securities firms.17Becausethe activities of such firms could easily involve two areas-repos and transactions in Treasury bills-that are not subject to the regular SIPC assessment formula, a special assessmentformula for such firms would have to be developed. The fact that SIPC coverageis available only for non-bank securities firms also raises a question about the comparability of insurance protec- tion for customers of bank and non-bank dealers. Our understanding is that, although not obvious, there is a considerabledegreeof compara- bility in protection for bank dealers’ customersbecauseof the way deposit insurance works. According to FDIC officials, money (up to $100,000) received from a customer to buy securities would be consid- ered an insured deposit if the bank were to fail. Similarly, if a bank failed, securities held for a customer would be returned to that cus- tomer, Becausemost insured banks are merged into another institution rather than liquidated, amounts in excessof $100,000 would typically be transferred to the new institution and would be available to the cus- tomer there. Bank customers would appear, however, to have less pro- tection than under SIPC if a bank failed, a customer’s securities were missing, and the bank was liquidated rather than merged into another institution. We recognizethat whether the deposit insurance system should cover dealer activities is an issue that can reasonably be addressedin its own right. If the definition of insured deposits were changedso that funds given to a bank for the purchase of securities were not covered, arrange- ments should be made for providing coveragefor the securities activities of bank dealers similar to that now provided by SIPC. 17SIPCassessmentsare based on a firm’s gross revenue subject to a number of adjustments. How- ever, for several years prior to 1989, SIPC has had sufficient balances such that it assessedeach member a $100 administrative charge instead of the regular assessment.A SIPC official told us a regular premium of 3/16th of 1 percent of adjusted revenues (minimum $160) was collected starting in 1989. The official said adjustments related to repurchase agreements typically reduced the pre- mium assessment for many government securities dealers toward the minimum amount, Further- more, the Securities Investor Protection Act of 1970, the act that authorizes SIPC, limits the assessment on commissions earned from transactions in Treasury bills based on SIPC’s loss experl- ence on such instruments over the preceding 6 years. Page 62 GAO/GGD90-114Government Securities Chapter 8 AddltionaI Investor Protection Meaeuree Are Needed The comparability of bank dealer and non-bank dealer customer protec- tion is a relevant issue to addressas part of an overall assessmentof the regulatory requirements imposed on these two classesof dealers. How- ever, we believe equalizing the SIFCcoveragefor customersof specialist and diversified non-bank government securities dealers is possible without addressingthis larger issue. When the Securities and ExchangeActs were adopted, and for many Conclusions years subsequently, it could plausibly be argued that participants in the US. government securities markets did not need all of the salespractice protection designedfor investors in registered securities. The principal reasonsfor this were the wholesale nature of the market, the size and competitive nature of the market, and the underlying soundnessof the securities being traded. Subsequently, it has becomeharder to draw the line between sophisti- cated investors who do not need protection and other investors who do. The Government Securities Act was passedin 1986, after it became clear that the presenceof unregistered government securities firms could hurt investors and damagethe market. Congressdecided that it was in the national interest to be sure that investors in U.S. government securities would always be dealing with firms that were subject to cer- tain requirements common to all securities dealers. We think the samelogic inherent in the act should be extended to sales practices and SIPCinsurance. The current limitations on NASDand the differences in salespractice enforcement by NISE and bank regulators, together with the lack of SIPCcoveragefor specialist firms, have created a situation in which someinvestors in the government securities market can receive less protection from salespractice abusesand lossesthan can investors in SEC-registered securities. We seeno compelling justifica- tion for allowing such limitations in protection to continue. We recommendthat Congressamend Section 15 of the ExchangeAct Recommendationsto (and such other statutes as may be necessary)to authorize a federal Congress agency to adopt general rules of fair practice applicable to all govern- ment securities brokers and dealers. Self-regulatory organizations and bank regulators should also be authorized to develop and enforce spe- cific requirements within the context of general rules. The rules, at a minimum, should cover dealer pricing practices (mark-ups) and investor suitability requirement4 The question as to whether Treasury or SEC Page 68 GAO/GGD-90-114Government Securities Chapter 8 Additional Investor Protection Measures Are Needed should have rulemaking authority is addressedin chapter 6 in the con- text of extending Treasury’s authority beyond the sunset date. We also recommendthat Congressamend the ExchangeAct to require that all non-bank government securities specialist dealers provide SIPC coverageif their businesswith customersis similar to that for which SIPCcoveragenormally applies in SK-registered securities markets. Fur- thermore, SIPC’Sassessmentstructure should be modified so that spe- cialist firms covered by SIPCpay their fair share of the assessment burden. SIPCcommentedon two aspectsof the draft report, SIPC did not take a Agency Comments and position on our recommendation to extend SIPCJcoverageto customers of Our Evaluation specialist firms. SIPCexpressedconcern,however, that requiring spe- cialist firms that held customer accountsto becomeSIPCmemberswould represent a departure from past practice. To date, all SIPCmembers are subject to the full rulemaking authority of SEC.Under our recommenda- tion, the firms would be subject to Treasury rules. SIPCstated that becausedifferences in financial responsibility rules might affect SIPC’S exposure to risk, such a changeneededto be thoroughly thought through, explored, and discussed. We agreethat the changewe are proposing should be consideredcare- fully. However, we believe the changedoesnot represent as great a departure from current practice or as great a potential insurance risk as the SIPCcomment seemsto imply. Under the Government Securities Act, all securities firms doing businessin the government securities market are already subject to Treasury’s rules; and the Treasury rule that potentially makes the most difference to srpc-the capital adequacy rule applicable only to specialist firms- is similar in design to the SECrule. Our recommendation in chapter 2 that differences between the Treasury and SECrules be eliminated is basedon simplifying the regulatory struc- ture, not on a concernthat the Treasury rule would sanction situations that were inherently riskier than those permitted under the SECrules. As noted in chapter 2, Treasury says it is working with SECand Federal ReserveSystem officials to develop a common capital rule. The risks to SIPCfrom having Treasury as rulemaker are also minimal becausethe supervision of specialist dealers, including enforcement of the rules, would be conducted by an SRO(NASD)that already supervisesmany SIPC membersand that is subject to full SECoversight. If, over time, differ- encesbetween specialist and other firms are greatly diminished, it might Page 64 GAO/GGD-90-114Government Securities chaptm a AdditlonnI Inveatm Protaction Memum% Are Needed be appropriate to abolish the specialist category, at which time the con- cern raised by SIPC would no longer be an issue. SIPC also said that changesin the assessmentstructure were neededif membership in SIPC were extended to specialist firms and those firms were to pay their fair share of the SIPC burden. The issue arises because specialist firms are likely to conduct businessthat is concentrated in activities subject to little or no SIPC assessments.We agreedwith this comment and added a recommendation in this chapter concerning assessmentsto be sure that specialist firms would pay their share. Page 85 GAO/GGD-90-114Government Securities Chanter 4 Trading Accessto ScreenBroker Systems Should Not Be Regulatedat This Time Ensuring the fairness and opennessof key market systems has played an important part in the development of securities market regulation. To achieve these objectives, SEChas been provided authority to regulate the operating practices of exchangesand trading systems in registered secu- rities markets. However, when it passedthe Government Securities Act of 1986, Congressdid not seethe need to regulate the operating prac- tices of the over-the-counter market for government securities because the market, for the most part, worked well. This chapter discusseswhether rulemaking authority should be extended to include regulating the blind trading systems operated by screenbrokers, focusing specifically on accesscriteria. The issue arises becauseeven though a great deal of trading takes place directly between dealers and investors, these broker systems continue to be the principal way major dealers trade with each other. As noted in chapter 1, we examined the question of accessto broker servicesin our 1987 report. In that report, we separated the question of trading accessfrom the question of expanding accessto information contained on the broker screens.We will follow the sameseparation in this report. Most observers agreethe government securities market is an efficient, The Nature of the liquid market. It accomplishesan averagedaily trading volume that is Issue many times greater in dollar value than the combined volume that occurs on stock market exchangesand the over-the-counter National Association of Securities Dealers Automated Quotations (NASDAQ)system operated by NASD.As noted earlier, the market is dominated by 42 pri- mary dealers who have pledged to FRBNYthat they will keep the market liquid by bidding at Treasury auctions by standing ready to enter into transactions with FRBNY,and by continuously making markets in a broad spectrum of issuesand maturity ranges. A major feature of the government securities market is the existence of limited accessin the interdealer and retail screenbroker systems that figure so prominently in the trades conducted by primary dealers. Avail- able statistics show that these screenbrokers have becomean even more important part of the market since 1987. The volume of secondary market trading by primary dealers was not much higher in 1989 than in 1987, but the percentageof primary dealer trades conducted through brokers increased.In 1989, an averageof 58.9 percent of all primary Page 66 GAO/GGDW=114Government Securities . cllapt43r4 Tradln# Accam to ScreenBroker Systems Should Not Be Regulated at This Time dealer trades were conducted through screenbrokers. In 1987, the per- centagewas 66.9 percent. (Seetable 4.1.) Table 4.1: Primary Dealers Average Dally Trading Volume In Treasury 8ecurltler: Dollars in billions 1985-1989 1985 1986 1987 1988 1989 Average daily trading volume $75.3 $95.4 $110.1 $101.6 $112.7 Screen brokered trade9 $36.2 $49.6 $61.5 $59.8 $66.4 Percent of trades screen brokered 46.1 52.0 55.9 56.9 58.9 Ynterdealer and retail brokers. Source: Federal Reserve Bulletins (March 1988, May 1989, March 1990). Sincethe screenbroker systems constitute the main wholesale market for government securities, the question arises as to whether accessto these systems-and perhaps other features of these systems as well- should be subject to rules, approved by a federal agency, designedto keep markets fair and open. Such rules, however, would represent a dif- ferent type of regulation than contemplated in the act. In securities market regulation, a clear distinction exists between regula- tion of the activities of individual broker/dealers and the regulation of structured trading systems within which firms may operate. Broker/ dealer regulation includes the operation of the firm and its dealings with customers-the capital adequacy and recordkeeping requirements and salespractice rules discussedin chapters 2 and 3. Structured trading system regulation used to regulate exchangesconcernssuch things as who has accessto the system, rules of procedure, responsibility for con- trolling risks, and financial responsibility in the event of a failure. The legislative history of the act makes it clear that Congressdid not intend to apply trading system rules to the government securities market. The act only regulates certain aspectsof individual broker/ dealers. Furthermore, as the following discussionshows, the govern- ment securities market has many characteristics that make it inappro- priate to consider screenbroker systems to be like exchanges.If consideration is to be given to regulating accessto broker systems,Con- gress and the appropriate regulatory agencieswould need to develop measurestailored to the special circumstancesof the government securi- ties market. Page 67 GAO/GGD-90.114Government Securities Chapter 4 Tradhg Access to ScreenBroker Systems Should Not Be Regulated at TNa Time Differences Between The most highly regulated trading systems are found in the stock Exchanges and Screen market. These trading systems include the NYSEand other stock exchangestogether with NASDAQ.These structured trading systems bring Broker Systems buyers and sellers together in a single location or through a single elec- tronic system so that memberscan obtain the best price quotations available from all other members.On these systems, certain dealers- called “marketmakers” or “specialists’‘-take responsibility for main- taining continuous markets in the stocks for which they have responsi- bility. Membersof these systems are obligated to pass all transactions in listed securities through the exchangeor NASDAQso that the price of the transaction can be recorded. A continual flow of information on market transactions is available to investors through financial information services. The exchangesand NASDAQare owned by their members,but their rules of operation are subject to approval by the SEC.These rules cover such things as eligibility requirements and trading responsibility rules in the event that a problem arises. The organizations are self-regulatory orga- nizations under the securities laws. This means that they are responsible for enforcing securities regulations on their members and they are held accountable by the SECfor the diligence of their efforts. The structure of the government market varies considerably from the stock market. There is no centralized trading place or single electronic system. Rather, the market is essentially a decentralized dealer market in which dealers, brokers, and investors do businessover the telephone. The trading systems, independently operated by several screenbrokers, provide an efficient way to accomplish telephone trading while also pro- viding anonymity to the participants. Also, unlike exchanges,there are no designated marketmakers for the systems.Primary dealers, who are obligated to be marketmakers by virtue of their FRBNYdesignation, can chooseto use various screenbrokers for trading, but there is no require- ment that they do so. The rules for broker trading systems take the form of generally accepted practices rather than enforceable rules. Moreover, each screenbroker is free to make its own private businessdecisionswithout regulatory approval regarding: accesscriteria; market coverage;commission rates; trade execution processes,including how it assignstrade execution pri- ority; and the terms for accessto information on completed trades. Becausedealer participation is voluntary, brokers would be able to be responsiveto the interests and needsof their more active customers whose participation generatesrevenue for the broker. Also, unlike Page 08 GAO/GGMO-114 Government Securities cllnptm 4 lhdlng Am to ScreenBroker Syrtem Should Not Be lkegulbted at Thb Time exchanges,brokers are not required to enforce the securities laws on their customers. These basic differences in the trading system componentsof the govern- ment securities market and exchangemarkets have continued for some time. However, changesin the clearing and settlement component of the government securities market have recently occurred which are making a major part of the government market comparable to the clearing and settlement arrangements in registered securities. For exchange-tradedsecurities, the risks that trades will not be com- pleted as agreed are small becausethe vast majority of trades are set- tled and cleared through a single clearing corporation, the National Securities Clearing Corporation (NSCC) whose membershave pledged capital to, in effect, guarantee all the trades it clears. In contrast, trades in Treasury and agency securities are usually cleared and settled on the next day through banks that specialize in this activity. Although each clearing bank monitors the size of its risk exposure to each customer and can require customersto put up funds, these indi- vidual clearing arrangements do not provide any systemwide way of managing or sharing clearing and settlement risk. Becausedealers and investors can have clearing arrangements with several banks, the dealers’ or investors’ total exposure is unknown. Therefore, if the dealer or investor defaults on its obligations, the risks associatedwith that failure fall onto the clearing bank and the particular entities that had open trades with the firm. However, the recent start-up of the Govern- ment Securities Clearing Corporation (GSCC) is a development which promises to bring somecomparability to the way clearing and settlement risks are managedamong major market participants. (Seep. 7 1.) Page 09 GAO/GGDO-114 Government Secdtiea chapter 4 Tmdlng Accessto ScreenBroker Systems Should Not Be Regulated at This Time Trading Access to Our December1987 report addressedthe question of whether regula- tions should control who should be allowed to trade on the blind trading Systems in the U.S. systems in the U.S. government securities market. Given the importance Gove+nment Securities to the government and the general public of the smooth operation of the government securities market, we concluded in our previous report that Market Will Be a at that time the potential risks from forcing expansion outweighed Continuing Matter for potential benefits. We noted that blind trading systems only work if par- Congressional ticipants in those systems can be confident that the risks inherent in such systems are being properly monitored and controlled. Oversight Primary dealer status, to which any dealer can aspire, provides a basis for giving participants that confidence. If a firm meets the FRBNYpri- mary dealer standards, other firms have confidence that the firm is committed to actively making markets in the full maturity spectrum of Treasury securities, has the experience to know what it is doing, and has sufficient capital. In addition, FRBNY'Speriodic review of primary dealers’ activities provides assurancebeyond that supplied by annual audits and examinations that the firm is living up to its primary dealer commitment. Our earlier report also pointed out, however, that changescould occur in the market that would make expanded trading accessless risky and therefore more feasible. “Changes occurring in the secondary market may make it more feasible to develop alternative means for controlling risks in blind brokerage systems by identifying the nature and degree of risks more carefully, by fixing responsibilities more clearly on market participants for bearing them, and by designating appropriate monitoring systems. One development that could lead to expanded access is experience cur- rently being gained by implementation of a regulatory structure under the Govern- ment Securities Act of 1986. In time, confidence in this regulatory and supervisory structure could lessen the market’s reliance on certain aspects of FRBNY’s primary dealer designation. If a proposal can be developed which adequately controls risks, we see no inherent reason why primary or aspiring primary dealer status needs to be a necessary condition for trading on interdealer broker systems.“’ ChangesOver the Past 2 During the past 2 years, someof the changesthat would make expanded Years Are Not Sufficient to accessless risky have begun to occur. Under the Government Securities Act, all firms operating in the market, including brokers, are now regis- Warrant Action on Trading tered with SECor federal bank regulators and are subject to minimum Access at This Time capital requirements and to periodic examinations. Also, in 1988, GSCC Y 'U.S.GovernmentSecurities:An Examinationof Views ExpressedAbout Accessto Brokers’Services (GAO/GGD-88-8,Dec.18,1987),p. 66. Page 70 GAO/GGD-DO-114 Government Securities ckaptm 4 Trading Aeeeeato 8creemBroker Syrrtemrr Skoukl Not Be Regulated at Thb Time began operating under rules approved by SEC as a centralized clearing agency servicing primary and aspiring primary dealers, screenbrokers, and clearing banks. The basic concept is that brokers and dealers must submit their trade confirmation paperwork to GSCC, which comparesthe paperwork to confirm the trade and then nets out offsetting obligations between all participants. The result is that each participating dealer and broker transfers cash and securities through the clearing banks for only their net obligation to the system. GSCC, like clearing corporations in the registered securities market, becomesthe counterparty to each trade. BecauseGSCC is majority-owned by the participating dealers, brokers, and clearing banks, the risk of unsettled obligations is shared by all par- ticipants. GSCC requires all participating dealers that have begun to net their transactions to have a net worth of at least $60 million and excess net capital of at least $10 million. GSCC has also proposed that screen brokers maintain liquid capital of at least $4.2 million.2 During 1989, GSCC made substantial progress toward providing coverage of the major segmentsof the government securities market and in get- ting full participation from the major dealers and brokers. As of Feb- ruary 1990, G!m is comparing transactions for all Treasury and agency securities and is netting transactions for Treasury notes, bonds, and bills. GSCC has nearly all of the primary and aspiring primary dealers and screenbrokers submitting trades for comparison at the end of each trading day and over half of this group involved in netting. GSCC officials expect to expand market coverageand participation during this year and later hope to receive transaction information from participants as it occurs, rather than in batch form at the end of the day. While the presenceof capital adequacy requirements and the GSCC are important developments,neither measurewill necessarily prevent a firm from failing or fully eliminate the disruptive effect of a firm’s failure to fulfill its obligations. Such failures can be harmful becausethe samesecurity is often bought and sold several times during a trading day before it reachesthe dealer or investor that owns it at the end of the day. Thus, when a trade fails, it can causeseveral market participants either to, in turn, fail on their obligations or to engagein other trading to replace the undelivered securities or funds. Consequently, although the capital adequacy rules and GSCC will help to ensure that brokers and 2GSCCarrived at the $4.2 million for broken by adding the Treasury minimum capital level of $1 million to $3.2 million, which is twice the brokers’ $1.6 million contribution to the clearing fund. The gB$ion in net worth for dealers is the same as the amount required of primary dealers by Page 71 GAO/GGD-90-114Qwernment Securitlee , Chapter 4 Trading Accessto ScreenBroker Systema Should Not Be Regulated at This Time dealers ultimately do not experience large losseswhen a firm fails, they cannot fully prevent the disruption to liquidity causedby undelivered commitments. The absenceof measuresto limit such liquidity disruptions continues to be the major reason for our position that accessshould not be expanded by regulation. Limiting accessto primary and someaspiring primary dealers has thus far been a workable way to limit potential liquidity dis- ruptions. We believe such risks could be reduced if Gscc continues to develop successfully and if its system is proven to be workable.3 In the meantime, one other development relating to FRBNY’S oversight of primary dealers should be noted. Starting in the summer of 1990, FRBNY plans to cut back on its day-to-day monitoring of primary dealers. At that time, primary dealers generally will report their positions to FRBNY on a weekly rather than daily basis.4FRBNY will still maintain significant oversight responsibilities and retain the ability to act immediately in responseto any problems that may arise. Still, the cutback in monitoring underscoresthe importance of market participants themselves, including brokers, doing the monitoring necessaryto control their expo- sure to risks without relying implicitly on FRBNY’S oversight of primary dealers. Basis for Oversight in the Looking ahead, there are other issuesin addition to risk management Future that we believe need to be consideredby Congressand others in assessingthe need for regulation of accessto broker trading systems. For example, changesin technology can make it relatively easy for a system designedto disseminate information to be converted into a trading system. This possibility can already be seenin the foreign exchangemarket, where a major information vendor now operates a trading system. The customer baseof such systems could extend consid- erably beyond that now served by interdealer brokers. As a result, regu- lation might be neededto addressquestions of fairness regarding who is allowed to participate in such systems and how trade execution priori- ties are determined. 3GSCCcurrently processes transactions in batch form overnight to arrive at the amount of money and securities to be transferred on the following day. However, GSCC has the capability to receive transaction information directly from each participant as the transactions occur. Such an on-lime system would immediately identify unmatched trades and also allow for ongoing monitoring of the dealers’ exposure to the system. 4 FRBNY plans to collect d&y reports on securities included in Treasury financing during the when- issued tradiig period. Page 72 GAO/GGD-W-114Government Securities Chapter 4 Trading Accessto ScreenBroker Systime Should Not Be Regulated at This Time Developmentsin regulation of registered securities market trading sys- tems may be another factor that helps shed somelight on operations in the government securities market. Recently, a class of firms has arisen that performs many of the functions that traditionally have been associ- ated with exchanges,These firms, known as proprietary trading sys- tems, are privately owned businessesthat use new technology to create market trading systems that have much in commonwith screenbrokers in the government securities markets, In SEC’s view, proprietary trading systems lie somewherebetween the exchangesand dealer systems for servicing their own customers in terms of how they should be regulated. In April 1989, SECproposed rules for these trading systems.The rules would require the systems to obtain SEC approval of their operating plan, which would cover such areas as qualification criteria, terms of order execution, order routing standards, and the handling of and liability for system errors. The systems that gave rise to the proposed rules include several auto- mated execution systems for trading common stocks and trading and information systems for common stocks, limited partnership interests, and municipal bonds. Someof the systems are blind systems in the sense that those conducting the trades do not know who the counterparty is, One system, Delta Options Corporation, is of particular significance becauseit issues,trades, and clears transactions in government security options using the trading system of an interdealer broker. In SEC’S view, more than just broker/dealer regulation was neededfor these systems.Broker-dealer regulation provides someprotection to system participants becausethe firm must maintain adequate capital and properly protect customer securities and funds. However, SEC believes broker/dealer registration may limit oversight of the actual organizational nature of the systems, including regulation of entry cri- teria, terms of execution, routing of orders, and the handling of systems errors or failures. SECbelieves that as those systems grow in importance, the question of accessto those systems on terms that are fair and non- discriminatory may becomeincreasingly significant. Finally, in conducting oversight of trading systems in the future, there are other public interest considerations besidesfairness and openness. The market must continue to function in a way that allows the Treasury and the Federal Reserveto carry out their respective debt management and monetary policy roles in a reliable, efficient manner. Current Page 73 GAO/GGD-9t-k114 Government SecWtiee chapter 4 Tradhg Aceem to SemenBroker System Should Not Be Regulated at ‘II&J Time arrangements involving the primary dealer system have proven suc- cessful in these areas.Any changesshould be made cautiously so as not to damagethese important aspectsof the market. Although the risks involved in expanding accessappear to be reduced Conclusions from what they were in 1987, in our judgment the systems are not yet in place to give assurancethat expanded accesscan safely be forced by regulation. As the market continues to change,the questions associated with expanded accessshould be reassessedin light of market and regu- latory developments as well as the continued importance of the market for debt managementand monetary policy purposes. Page 74 GAO/GGDfM-114Government Securities Chapter 6 A&ion Is Neededto Expand Accessto Brokers’ Information Our December1987 report concluded that accessto transaction informa- tion from interdealer brokers’ screensshould be expanded. We also said that market participants should be given time to voluntarily expand accesson their own. Unfortunately, market participants have generally not done so. We therefore believe the point has been reached where leg- islative action is needed. Information Access Although changeshave occurred over the past 2 years in the ownership, management,and operations of someof the brokers, accessto informa- Remains Limited tion on broker screensremains as restricted as before. Thus, as in 1987, the only dealers with accessto comprehensiveinformation about trans- actions and quotations in the entire wholesale market for government securities are the primary and aspiring primary dealer customers of the interdealer brokers. In December1987, we reported that of the nine screenbrokers, seven interdealer brokers provided accessto their screeninformation to no more than 63 firms: the 40 primary dealers and 13 aspiring primary dealers. As of January 31, 1990, six interdealer brokers limited accessto no more than 49 dealers, consisting of 44 primary, and 5 aspiring pri- mary dealers, In 1987, we also reported that two of the nine screenbrokers were retail brokers that allowed information from their screensto be displayed by information vendors in literally thousands of locations around the world. Only the larger of the two, Cantor Fitzgerald Securities Corpora- tion, remained active as of January 31, 199O.l Cantor transmits its screenquotation pagesdirectly to primary and aspiring dealers and certain other large customers in the sameway that interdealer brokers do. However, unlike the interdealer brokers, Cantor ‘According to Government Securities Brokers Association officials, the other retail broker, Newcomb Government Securities, never was a significant market participant. Since our previous report, New- comb was sold and restarted as a31interdealer broker, Brokerage Corporation of America @CA). BCA began its operation in 1989 but became inactive in January 1990. The six interdealer brokers active in February 1990 were also active in 1987. These firms are Funda- mental Brokers, Inc.; RMJ Securities Corp.; Garvin Information Systems; Liberty Brokerage Inc.; Chapdelaine and Company, Government Securities, Inc.; and Hill&d Farber and Company, Inc. One former lnterdealer broker, MKI Government Securities, ceased its Treasury and agency security busi- ness and now operates only in the mortgage-backed securities portion of the government securities market under a new company’s name. A new lnterdealer broker, TGB Corp., started operations in early 1989 but became inactive in January 1990. Page 76 GAO/GGlMO-114Government Securities Chapter 6 Action Ia Neededto Expand Access to Brokers’ Information also provides a data feed to Telerate, a subsidiary of Dow JonesIncor- porated, which in turn transmits someof the screenpictures to its net- work of financial information subscribers. A number of market participants have told us that viewing the Cantor screenon Telerate provides important information on the market. How- ever, as we noted in our previous report, viewing only the Cantor screen is not the sameas seeingall of the interdealer broker screens.Although Cantor will broker all Treasury issueson demand, due to spacelimita- tions only the more active Treasury issuesappear regularly on the screen.2 Moreover, Cantor currently doesnot have screenpagesshowing live quotation and trading activity for agency securities or zero-coupon Treasury securities. Therefore, market participants who only seeCantor cannot seethe entire government and agency market, as do the primary and aspiring dealer customers of interdealer brokers.3 We also learned that in 1989 Cantor reformatted its data transmissions so that Telerate subscribers receive less information than do the dealers and investors that receive their information directly from Cantor. Cantor stopped showing Telerate customersthe screenquotations for short-term Treasury notes maturing in the l-1/2 to 3-year range and for a few selectedlonger term Treasury maturities. A Cantor official said this changewas made becausethese issueswere relatively inactive and it was in the best interest of its business.Cantor’s action is significant becausebefore the change,there were no differences in the content of information received by various types of Cantor customers. %terdealer brokers have several pages on which virtually every Treasury issue is listed. The addi- tional quotation pages allow customers of interdealer brokers to view the entire market and readily see quotation and transaction activity occurring at intermediate dates within the 30-year range of Treasury maturities. Although a broker estimates that about 80 percent of the screen-brokered trading takes place in 8 to 10 active issues, market information on other issues can be important for some investors seeking to sell off their securities holdings to meet liquidity needs or for investors seeking the “cheapest” securities to fulfill delivery commitments related to futures contracts or repurchase agreements. 3We found in February 1990, as we had in 1987, that at least three interdealer brokers provide screen coverage of all segments of the Treasury and agency securities markets. Page 76 GAO/GGD-O-114Government Securities Ckaptm 6 Action la Neededto Expand Accessto Bmkerd Information Other Information In our 1987 report we recognizedthat market participants lacking Available Through accessto the interdealer broker screenshad accessto other types of market information through news media and financial information ser- Financial Information vices other than Telerate. Although the identity, coverage,and format Services of these serviceshave changedsomewhat since our previous report, the type of data presented is essentially the same.These sourcesprovide periodically updated benchmark quotations from dealers plus summary analytical pagesbasedon these quotes. For example, somesystems allow the user to track changesin one or more dealers’ bid prices over the course of the trading day and for longer time periods, as well as to look at the high and low bid over various periods. The most important differences between the information available from financial informa- tion servicesand that available through interdealer broker screensare as follows: . The dealers providing benchmark quotations are not committed to actu- ally trading at the quoted prices. l The difference between the bid and offer prices are all stated at stan- dard differences of 2/32nd to 4/32nd of a point becausethe dealers’ quotations are meant to be an indication of the market and not necessa- rily the actual spread in the market. . The services do not provide real time information on completed transac- tions or allow users to observetransaction activity occurring. There is a strong basis in economictheory for believing that financial Why Information markets are most likely to operate in the public interest when as many Access Is Important market participants as possible have accurate, current information about market conditions. Information on Treasury securities is of partic- ular importance as noted in a recent Chicago Board of Options Exchange publication: “The most closely watched interest rates are the benchmark rates on short-term and long-term U.S. Treasury securities. They reflect changes in the economy, infla- tionary expectations and the value of the U.S. dollar. Other interest rates including bank prime lending rates, bond rates, and home mortgage rates, respond to trends in the Treasury market.‘14 At the present time, as noted above, complete information about the market is available only to a limited set of dealers. In our judgment, the differing proprietary interests of dealers and brokers must be given due 4Chicago Board of Options Exchange, Take Interest: Options on Interest Rates, (Chicago, Ill., 1989), p. 2. Page 77 GAO/GGMO-114 Govemment Securities Chapter 6 Action Is Neededto Expand Access to Brokers’ Information consideration becausethe trades are businesstransactions between pri- vately owned firms. However, as in all securities market regulation, the proprietary interests of these firms need to be weighed against the importance of market information to all market participants. Benefits of Expanded Although the government securities market is an efficient one, there is Access to Information no reason to assumeit is as efficient as it can be. Benefits from expanded information access,though not possible to quantify, fall in three areas-market efficiency, investor protection, and equity. Market Efficiency Expanding information accesswould tend to increasemarket efficiency by creating a more knowledgeable group of market participants and encouraging innovation. In this regard, changesin technology that are occurring in the market, in our judgment, make information accesseven more important today than it was in 1987. Then, broker systems typi- cally operated in what is known as a broadcast mode. That is, the data were transmitted from the brokers’ communication stations and dis- played on the customers’ display screensaccording to the format pre- scribed by the brokers. All the customersof any one broker viewed the same format. To obtain completed trade information, the customer had to watch the screen,although to a limited extent somebrokers trans- mitted a listing of recently completed transactions in particular securities. Since then most brokers, including Cantor, have used new developments in computer-to-computer communication technology to transmit infor- mation By using digital feed systems,the broker’s computer “talks” either to the customer’s computer or to an information vendor’s com- puter. Those computers, in turn, can processthe information received, combine it with any other digitally fed data from other markets, apply analytical software, and present the analyzed data in the best format for the customer. The availability of this technology makes accessto interdealer broker transaction information even more important becausethose with access can do more with the information they receive. Although Telerate cus- tomers can receive somedigital information basedon Cantor, primary and aspiring primary dealers are the major beneficiaries from the new technology becausethey alone can receive all interdealer broker trans- action data. For example, somedealers have systems which show j changesin transaction prices and quotations as they occur on several interdealer broker screens.A vendor who developed one such system Page 78 GAO/GGD-90-114Government 8ecuritiea chapt.er 5 A&on Is Neededto Expand Acceoato Brokem’ Information for a dealer is now marketing it directly to primary and aspiring pri- mary dealers as a feature of its information system. Other information vendors are providing similar data to primary dealers but are taking the information from only one interdealer broker. Investor Protection From an investor protection standpoint, the availability of transaction information from the interdealer screenswill make it easier for more investors to becomesophisticated in protecting their interest by being better able to evaluate the reasonablenessof the prices quoted by dealers. The availability of such information would, in our judgment, be an important consideration in making distinctions among wholesale and other investors in the formulation of salespractice rules as recom- mended in chapter 3. SECand NASDofficials agreedthat publicly available market information also makes it easier for examiners to protect investors. Currently, without good market transaction data, it is very time consuming for an examiner to determine if a dealer sold securities at a reasonablemark- up from the market price unless the dealer purchased the samesecurity on the sameday. This is particularly true of infrequently traded Trea- sury issuesand zero coupon and agency issueswhich are not routinely displayed on the Cantor screenson Telerate. Without such information, examiners have to solicit transaction or quote sheetsfrom a sample of dealers. This practice is obviously less efficient than having information on the brokered transactions of all major dealers in a data base available for review. Therefore, good transaction information will contribute to the regulators ability to enforce any mark-up rules developedin responseto our recommendationsin chapter 3. Equity Expanded information accesswould make trading in financial markets more equitable. Specifically, non-primary dealers whose principal busi- nessis trading or investing in markets closely linked to the government securities market could then obtain the information they feel is neces- sary to compete with primary and aspiring primary dealers in these other markets. For example, in 1989, CBOEintroduced short-term and long-term interest rate indexed options whose values, respectively, depend on the market price of the current 13-weekTreasury bill and a composite price of the two most recent issuesof the ‘I-year, lo-year, and 30-year Treasury notes. Current values for these instruments are com- puted by Telerate basedon activity on the Cantor retail screen.More- over, the cash market Cantor screenis what is displayed next to the interest rate option screenfor traders to seeon the floor of the exchange. Page 79 GAO/GGIMO-114Government Securities chapter 6 Action b Neededto Expand Acceeeto Brokers’ Information So long as the Cantor screenaccurately reflects the current cash market, the values of the interest rate option will be accurate. However, any one broker screen,including Cantor, can trail behind the market if the majority of trading in the relevant Treasury securities is occurring through other brokers. Or the acreenmay show a false direction, ifi for example, heavy buying on the one broker screenis offset by selling on others. We believe it reasonableto concludethat regardlessof the accu- racy of the Cantor prices, an interest rate options trader seeingonly Cantor is at somedisadvantage compared to a dealer that knows all cash market broker activity. Assessmentof Potential Given the key role that the government securities market prays in Harm From Expanded financing the government and in the economy as a whole, it is important that actions are not taken that could damagethe market. We considered Information Access three ways that expanded information accesscould possibly damagethe market: introduction of additional risk, reduction in market liquidity, and impairment of the ability to managethe debt or to conduct mone- tary policy. Turning to the first of these, we noted in the preceding chapter that risk considerations are of crucial importance in considering trading access matters. However, we have found no evidencethat wider dissemination of information would damagethe blind trading systems of interdealer brokers that are so important for maintaining the liquidity of the gov- ernment securities market. Information accessdoesnot introduce addi- tional risk into these systems and hencebrokers’ and dealers’ exposure to credit risk would remain unaffected. Dealers have argued that expanding information accesscould damage the liquidity of the secondary market. Over the past 2 years, the opera- tions of someprimary dealers are reported to have been unprofitable. Somedealers have suggestedthat expanded information accessmight remove a market advantage that primary dealers have and lead some dealers to give up their primary dealer status. We question whether the liquidity of the market would be significantly affected in an adverse way by expanded information access.Indeed, we think the situation could actually be the reverse of what the dealers con- tend. That is, a better informed investing public can make the markets more liquid-although perhaps more competitive for the dealer. Ulti- mately, it is the funds of investors beyond the primary dealers that end up buying most of the government securities that are offered for sale in Page 80 GAO/GGD-90-114Government Securities ckapt8r 6 Action Ie Neededto Expand Access to Brokers’ Information the market. Moreover, if liquidity were to be materially damaged,it would mean that the ability of primary dealers to make trades is somehow dependent on their ability to maintain an information advan- tage over their customers.Achieving a high volume of trading that dependsupon keeping a significant part of the investing public poorly informed seemsto us to be a questionable policy. We also found no evidencethat expanded information accesswould damagedebt managementor monetary policy activities of the govern- ment. Treasury and the Federal Reserve,the two agencieswith direct responsibilities for these functions, concurred with our 1987 conclusion that information accesswould serve the public interest. Officials of the SEX:also agreedthat expanded information accesswas desirable. Offi- cials of all three agenciesstill hold this view. Why a Legislative In our 1987 report, we concluded that market participants should be given the opportunity to expand accessbefore regulatory intervention Solution Is Needed was pursued. In the past, the Public Securities Association has often worked with the Federal Reserveand the Treasury to develop rules and procedures to deal with various problems. Moreover, we found that there was still uncertainty at that time about the costs,nature, and timing of information that would best serve market participants’ needs. Finally, we observedthat the consensusamong federal agenciesthat expanded information was desirable would likely help to encouragepri- vate market participants to broaden accesswithout the need for regulation. In its comments on our 1987 report, SECexpressedskepticism that interdealer brokers would achieve expanded accessvoluntarily. SECsaid that dealer resistanceto dissemination, coupled with potential issues regarding the proprietary nature of trade and quote information, could undermine the successof voluntary measures.At this point, it appears that the SEC'Sskepticism has been borne out and that a legislative man- date will be neededto ensure development of satisfactory information accessarrangements. Unsuccessful Efforts to We are aware of four efforts with the potential to expand information Expand Information accessthat were undertaken between the time our previous report was issued and April 1990 when we completed our review of the broker Access accessissue in preparing our draft report. One was linked to an interdealer broker’s decision to becomea retail broker, two were part of Page 81 GAO/GGD90-114Govemment Securities Chapter 6 ActionIs Neededto Expand Accessto Brokers’ Information new or modified brokering systems, and the other was a joint effort by three brokers developedexplicitly to provide accessto the transaction information from their screens.None of these efforts succeededin expanding information access.A brief description of each effort follows: l RMJ Broker’s plan to go retail. In March 1989, RMJ announcedthat it was going to act as principal in brokered trades (as Cantor Fitzgerald does) as part of a plan that would eventually allow RMJ to expand its customer base(becomea retail broker) and sell the information on its screensto an information vendor. In making the announcement,RMJ managementsaid such a move was necessaryfor continued survival becauseof competition from other brokers. While an adverse reaction did not occur immediately, according to RMJ officials, over the next month, someof the larger primary dealers stopped doing businesswith RMJ, which causedother dealers to turn to other brokers where the screenswere more active. When RMJ saw the resulting financial losses, it backed off its plans and reverted to its former status as an interdealer broker. An official of PSAsaid that one reason for the primary dealers’ lack of acceptanceof the RMJ arrangement was that the dealers had doubts about RMJ’s financial capacity to act as principal in the trades brokered by the firm. . Chapdelaine: CHATSsystem. In early 1989, Chapdelaine, an interdealer broker that emphasizedagency securities, established a separate affil- iate to develop an interactive electronic trading system for Treasury security trading. Chapdelaine officials have installed this system (called CHATS) at several primary dealers and after testing, expect to have the primary dealers trading on the system in 1990. Chapdelaine officials have discussedthe possibility of providing information accessto their system to nonparticipants but are not pursuing this effort at this time until their trading system effort gains acceptance.The officials do not want any potential dealer resistanceto expanded information accessto jeopardize their trading system effort. . TGB Corporation. TGB Corporation was an interdealer broker that began operating in May 1989 by offering a somewhat more automated trade processingsystem than current interdealer brokers. The system promised faster execution at lower cost and included plans to sell real time information accessto information-only subscribers at a proposed fee of $600 per month. From the beginning, TGB experienced somediffi- culty gaining the support of the dealer community becauseof concerns about how well the system would work. TGB made several modifications to the original system proposal in an effort to attract more primary dealer business.Oneof the modifications was to drop its plan to have information-only subscribers.In January 1990, TGB becameinactive. Page 82 GAO/GGD-!JO-114 Government Securities Chapter 5 Action Is Neededto Expand Accessto Brokers’ InPormatlon . Newco. This information expansion effort was proposed in August 1987 by three brokers: RMJ, Garban, and Fundamental Brokers. The joint venture, known as “Newco,” would have purchased last trade price information from the three brokers and any other brokers or dealers who wanted to participate, and sold the information to a distributor of financial information, who in turn, would have made it available for sale on a non-exclusive basis to other information providers. On April 3, 1989, the Justice Department announcedthat it did not intend to chal- lenge the joint venture under the antitrust laws. The Newco plan did not move forward however, and the principals at this time do not appear to have plans to restart it. A number of factors appear to have causedthe project to lose momentum. After its own experience,RMJ management decided that it would not be prudent to pursue the joint venture unless Newco had the support of the largest dealers. Also, managementat Fun- damental Brokers changed and the principal spokesmanfor the proposal retired due to illness. The information accesselements of these efforts have not been imple- mented even though the principle of greater accesswas endorsedby the primary dealer community as a whole. On April 28, 1989, PSA’SPrimary Dealer Committee unanimously adopted a task force report which endorsedthe concept of expanded information access.sThe final report did not discussthe RMJ effort but argued that CHATS,TGB, and Newco should have a chanceto develop before a regulatory solution is imposed. However, a year has passed,TGB is out of business,and the information accessaspectsof the other efforts appear to be at a standstill. The Potential for Dealer During our meetings with all of the brokers and the major information ResistanceMay Continue vendors we learned of a number of other arrangements involving various combinations of brokers, information vendors, dealers, and to Inhibit Information financial analysis software corporations that were in varying stagesof Access Initiatives development. However, brokers were in agreementthat a broker’s effort to expand information accesswill only survive if the broker has the sup- port of a significant portion of the top 5 to 10 dealers. Brokers told us that these larger dealers generate a substantial portion of the broker’s commission revenue and by their participation make any broker’s screen sufficiently active to attract other dealers to trade on them. Brokers said “Public Securities Association, “Report and Recommendations of the Task Force on Government Secu- rities Price Information,” April 1989. Page 83 GAO/GGD-80-114Government Securities ckapter 6 Action Is Neededto JZxpandAccessto Brokers’ Infornwtlon that if dealers did not like one or more brokers’ plans to expand infor- mation access,the dealers could take their trading businessto a broker that was keeping accesslimited. We are not able to determine all the specific reasonsfor the lack of sup- port for brokers’ efforts to expand information accessarrangements. Someprimary dealers told us that the market neither needsnor wants additional information and that brokers and vendors do not want to commit themselvesto providing information that the market will not pay for.” A particularly important factor, however, appears to be dealers’ con- cerns about revenue. We noted previously that the profitability of a number of primary dealers declined over the last 2 years-a period during which trading volume has not increasedvery much. This has increasedthe importance of revenue considerations associatedwith expanded access,and as yet, satisfactory arrangements have yet to be worked out. When we were completing our draft report, we were aware that six of the larger primary dealers have invested several million dollars in devel- oping a joint effort to provide the marketplace information on their transactions in an effort to capture revenue from the sale of information apart from the brokers, In 1990, PSAalso established a task force repre- senting interdealer brokers and dealers to recommenda proposed struc- ture for an industrywide joint venture to disseminate price information. The task force issued a report regarding the minimum information to be disseminated, allocators of revenue, and corporate structure. A proposal to implement a joint venture was approved by the Primary Dealers Com- mittee at the end of April 1990. Sincethen, PSAformed an implementing sponsor group representing eight dealers and interdealer brokers. All firms currently transacting businessthrough brokers would be eligible to participate. While it is to be expected that dealers would try to obtain as much rev- enue as possible from information arrangements, in our judgment, the current revenue position of certain dealers should not inhibit implemen- tation of expanded information accessthat would benefit the market as a whole. Representativesof several brokers and information vendors “This sentiment was expressed by officials of one information vendor currently active in the market. However, all other information vendors and brokers we talked to welcomed the opportunity to com- pete and find out what the market would bear. Page 84 GAO/GGD90-114Government 8ecurities Action Is Neededto Jhpand Accessto Bmkem’ Information told us they are ready to provide expanded information accessonce it is clear that all brokers must expand information access.In their view, if brokers are required to make information available as a condition for doing business,primary dealers will not be able to take their businessto a broker that limits accessto its information. Brokers also told us they were confident that blind brokering is impor- tant enough that dealers will continue to use their serviceseven if the transaction information is publicly available. Moreover, they believe they can work out acceptablearrangements without detailed regulatory requirements. We would prefer this approach to a detailed regulatory solution becausewe believe competitive pressureson these privately owned brokers, dealers, and information vendors and the continuing improvements in information technology should allow a number of inno- vative approachesto develop. For the reasonsjust cited, we believe Congressshould act to require Key Elements of an information from government securities brokers to be made available on Information Access a real time basis to those willing to pay appropriate fees. At a minimum, Requirement Congressshould require brokers to make last sale (price and volume) information available to vendors on a real time basis as a condition for doing business.Although Congresscould specify the exact language con- cerning information disclosure in legislation, we believe it would be pref- erable for Congressto impose the requirement for information access but give necessaryauthority to a federal agency to write any rules neededto enforce the mandate. In that way, the agency could be respon- sive to market developments and ensure that information on transac- tions occurring on the market’s major trading systems is publicly available. We believe that in a world where technology and brokering arrange- ments can changequickly, the requirement needsto be drawn in such a way as to not impose a rigid structure on the market that would stifle innovation or give unwarranted benefits to certain dealers, brokers, or vendors. In this regard, the Justice Department’s acceptanceof Newco set forth certain principles that we believe should be consideredin eval- uating information accessarrangements: l Broker arrangements with vendors should not be exclusive. In other words, if one or more brokers contract to send data to an information vendor, other vendors should be able to purchase the sameinformation from either the vendor or the broker. Nonexclusive arrangements serve Page 86 GAO/GGD-So-114Government Securities Chapter 6 Action Is Neededto Expand Amens to Brokera’ Information to prevent dealers and brokers from creating special transaction execu- tion systems that are unavailable to other investors. It also allows for innovation to take place in the market and keeps the regulation from locking in place a particular set of institutional arrangements. . Any broker participating in a joint venture should be able to make other arrangements to still sell its own screeninformation even in competition with the joint venture. We also believe the accessrequirement should impose a near-term date for action. Dealers and brokers have already had a substantial amount of time to develop accessarrangements on their own and we are aware of a number of efforts that could be implemented fairly quickly. The intent of any accessrequirement should be to include all major trading systems operating in the market. The information access requirement we are recommending is most obviously directed at the screenbrokers becausethey currently operate the principal trading sys- tems in the market. However, arrangements among dealers, information vendors, or other brokers could conceivably create new automated trading systems that would diminish the importance of screenbrokers. An accessrequirement should be broad enough to be sure that such new trading systems could not operate outside a narrowly structured infor- mation requirement imposed on interdealer brokers. In adopting an information accessrequirement, Congressand the appropriate regula- tory agency may need to addresslegal issuesassociatedwith ownership of information utilized in trading systems. On the basis of brokers’ experience over the last 2 years, we believe Conclusions Congressneedsto give the industry a clear, enforceable mandate to expand information accessand thereby eliminate screenbrokers’ con- cerns about possible primary dealer reaction to the brokers’ information expansion efforts, The question of which federal agency should receive regulatory authority is discussedin chapter 6. To provide the public with the benefits of information accessto screen Recommendationsto brokers and similar trading systems for government securities, we rec- Congress ommend that Congressamend the ExchangeAct to require that govern- ment securities transaction information from screenbrokers and any Y trading systems that serve a similar function be made available on a real time basis to those willing to pay appropriate fees. Regulatory authority Page 86 GAO/GGD!W114Govemment Securities Action b Neededto Expand Accessto Brokend Information should be provided at the federal level to prescribe regulations as neededto ensure that transaction information is available. The Department of the Treasury concurred with our assessmentthat Agency Comments expanded accessto broker screeninformation would serve the public interest. The Department also supported our recommendation that Con- gress should mandate public accessand provide federal rulemaking authority to provide regulations, as needed,to ensure that information accessis expanded. Page 87 GAO/GGMJO-114Government Securities Chapter 6 Treasury’s RulemakingAuthority Should Ek Extended The mandate for our study included a requirement that we recommend whether or not Treasury’s rulemaking authority over government secu- rities brokers and dealers should be extended beyond its sunset date of October 1,199 1.* For the samereasonsTreasury was given rulemaking responsibility under the act, we believe Treasury’s authority should be continued for a limited period of time. Why an Extension Is When the act was adopted, CongresschoseTreasury as the rulemaker over several other possible alternatives-sxc, the Federal Reserve,or a Appropriate new entity patterned after MSRB.Treasury was selectedprimarily becauseof its role and expertise in a market that is so vital to the gov- ernment’s ability to finance the federal deficit. By choosingTreasury as the rulemaker, Congresssought to ensure that the new regulations would not inadvertently damagethe market and thereby increasethe government’s cost for selling the debt. Congressalso anticipated that Treasury would be able to promulgate regulations that applied in an even-handedmanner to both bank and non-bank securities dealers. We pointed out in chapter 2 that Treasury has done a goodjob in meeting the act’s rulemaking requirements. However, our principal reason for supporting a continuation of Treasury’s authority is not Treasury’s past performance. Rather, it is that concernsabout the impact of rulemaking on market safety and equity continue to be impor- tant considerations. To someextent, these concernsinvolve rulemaking under current authority. Thus, we noted in chapter 2 that dealers and depository insti- tutions have both raised concernsthat confirmation requirements for securities involved in repurchase agreementsmay be unnecessarily bur- densome,even though they may be imposed equally on dealers and nondealer depository institutions. We believe it is better for Treasury to be in a position to consider any changesthat might be neededthan to have separate regulators make rules that could potentially result in dif- ferent requirements for different types of firms. ‘Treasury’s power to issue orders and to propose and adopt rules applicable to government securities brokers and dealers (section 101 of the act) will terminate unless renewed on October 1,1991. Should Congress not renew Treasury’s authority or assign it elsewhere, rules in effect on the sunset date will continue in effect and, according to the legislative history, Treasury will still be able to make tech- nical adjustments. Treasury’s authority to prescribe securities custodial requirements on depository institutions (title II of the act) is not subject to the sunset provision. Page 88 GAO/GGDQO-114Govemment Securities . Chapter 6 ~aa~n;dadenMng Authority Should The most important considerations, however, involve areas where addi- tional rulemaking will be needed.In chapters 3 and 6, respectively, we recommendthat Congressprovide regulating salespractices in the gov- ernment securities market and the information accessarrangements of government securities screenbrokers. We believe it is appropriate to give lead rulemaking responsibility in these areas to Treasury, subject to a sunset provision, for the reasonsof market safety and equity that led Congressto select Treasury in the first place. Sales Practice Rules Concernsin the salespractice area described in chapter 3 relate prima- rily to potential abusesof individuals and smaller institutional inves- tors, such as small banks and thrifts and local governments.We are not aware of any concernswith respect to the wholesale transactions between dealers and larger institutional investors, such as large com- mercial banks, insurance companies,and major pension funds. Dealers told us many of these large investors are more like competitors than they are customersbecauseof their sophistication and the size of posi- tions traded. Salespractice rules in registered securities markets typically exempt dealer-to-dealer transactions in recognition of competitive concerns.In the government securities market, similar competitive concernsrelating to the participation of large institutional investors that are not dealers also need to be taken into consideration. It would, for example, be inap- propriate if salespractice rules placed dealers at a competitive disad- vantage relative to large institutional investors. It would also be inappropriate if the rules made dealers, particularly primary dealers, less willing to accept the risks associatedwith being market-makers in government securities. Becauseof its involvement and familiarity with the market and its participants, we believe Treasury should have the responsibility for ensuring that rules designedto ensure fair treatment of retail customersdo not inadvertently harm dealer participation in the wholesale market. As was the casewith repurchase agreements,rules promulgated in the salespractice area must also apply to both bank and non-bank dealers. Since Treasury routinely deals with both the banking industry and secu- rities firms, we believe Treasury is in a good position to balance the competing interests of these firms in setting salespractice rules. As was true of the rules for repurchase agreementsand for other areas covered Page 89 GAO/GGD-SO-114 Government f3ecurities chapter 6 Treamry’s Rulemakiug Authority Should Be Extended by the act, salespractice rulemaking should be consistent for both secu- rities dealers and depository institutions involved in the market. Differ- encesin the precise nature of the rules for each of these types of institutions could affect the size and distribution of compliance costs, placing one set of institutions at a competitive disadvantage with the other. Information Access Regarding information accessissues,we believe Treasury should also be given the authority to evaluate the arrangements developedby govern- ment securities brokers, dealers, and information vendors and to pro- mulgate rules, if necessary,to ensure that such arrangements are fair and beneficial to the operation of the secondary market. We expect that arrangements regarding cost, revenue, and the exclusivity of informa- tion distribution could affect the relative roles and profitability of bro- kers, dealers, and information vendors, and could, over time, affect the importance and concentration of brokered transactions within the sec- ondary market. In our judgment, Treasury’s involvement in the market puts it in the best position to evaluate the reasonablenessof these arrangements and their effect on competition and market safety. Importance of SEC As noted previously, we believe that in developing new rules Treasury Involvement should make every effort to make them conform to SIXrequirements whenever possible. For example, two types of government securities in need of salespractice attention-zero coupon and mortgage-backed securities-are similar to securities traded in the registered securities market, and protection in the government market should, therefore, be comparable. We believe Treasury should make every effort to ensure that salespractice rules for such securities differ from SEC-approved rules only when the risks associatedwith such securities are actually different.2 Treasury demonstrated its willingness and ability to coordi- nate with SECwhen it developedthe repurchase agreementrules under the act. %X took note of the similarities between certain government and nongovernment securities in an Amicus Curiae brief filed on December 8,1989, with a United States district court in New Jersey. The brief was filed in support of a civil action against a securities firm for fraudulent mark-ups in certain government and nongovernment mortgage-backed collateralized mortgage obligations (CMO) and mortgage-backed principal-only securities, which are similar to zero coupon securities. SEC asserted that it was reasonable to apply the same standards because the market treated the government secu- rities at issue as comparable to non-government securities to which the NASD mark-up standards applied. Page SO GAO/GGDBO-114Government Securities Chapter 8 Tx&egaeJ”making Authority Should Congress’decision to sunset Treasury’s rulemaking authority has pro- Applying a Sunset vided a useful opportunity to review the appropriateness of the rules Provision that Treasury developed and the continued need for a separate rulemaker. We believe Congressshould apply this logic again and place a sunset on the continuation of Treasury’s authority. One reason for including a sunset provision when extending Treasury’s rulemaking authority is that when the transition period associatedwith implementing the act’s rules has been successfully completed, the need for continuing Treasury as a separate rulemaker could diminish. For example, to simplify the regulatory structure it might, at some point, make senseto combine someor all of the rulemaking for the gov- ernment securities market with that for other registered securities mar- kets. Along these lines, we noted that most of the securities firms that operate in the market are diversified dealers already regulated by SEC. We also pointed out that Treasury’s regulatory requirements for spe- cialist firms, except for the dealer capital adequacy rule and related reporting requirements, are essentially the sameas the requirements SEC applies to other registered dealers. We recommendedthat Treasury develop a plan to phase out the separate rules for specialist brokers and dealers unless SEC’S capital rule is determined to be inadequate or inap- propriate. Similarly, once salespractice rules and information access arrangements are in place, there could be less of a need to treat rulemaking in these areas separately from that applicable to registered securities. Another reason for a sunset provision is that the concept of functional regulation could evolve over the next several years in a way that has implications for the continued need for Treasury as a rulemaker. Under functional regulation, a regulatory agency would regulate a particular type of activity no matter what type of firm engagedin it. Currently, however, it is not clear how to apply this concept to a situation like that in the government securities market in which both banks and securities firms can be dealers. We pointed out in chapter 2, for example, that many bank dealers are examined less frequently than are non-bank dealers. Achieving greater consistency in the frequency and quality of enforcement of securities laws among bank and non-bank dealers remains an unresolved issue in ongoing policy discussionsabout how best to regulate the financial servicesindustry. But should greater con- sistency be achieved, Treasury’s role as a rulemaker to reconcile sepa- rate practices in the Treasury securities market could become unnecessary. Page 91 GAO/GGD-99-114Government Securities Chapter 6 Treasury’s Rulemaking Authority Should Be Extended Finally, as the government securities market has grown in size and com- plexity and becomemore international in scope,we have becomecon- cerned about the ability of any regulator to monitor developments and anticipate problems in this market. An added benefit of the sunset pro- vision is that it increasesthe likelihood that, within several years, atten- tion will again be focused on identifying gaps in regulatory coverage that may have developed in the market. BecauseTreasury is responsible for selling the government’s debt, we Conclusions believe it is important as a policy matter that Treasury be heavily involved in rulemaking that affects the safety and efficiency of the gov- ernment securities market. Treasury also needsto participate actively in the rulemaking processto be sure that rules apply equitably to both bank and non-bank dealers. By working closely together, Treasury and SECcan ensure that government securities market rules, such as sales practice rules, are as similar as possible to comparable rules in other regulated securities markets. We believe Treasury’s rulemaking authority should be continued and extended to provide assurancesthat new rules concerning salesprac- tices and broker information accessdo not harm the market. However, Treasury’s authority should be subject to a sunset provision so that the need for a separate rulemaker can be reconsideredonce the issuesin need of attention have been addressed. We recommendthat Congress Recommendationsto Congress . continue Treasury’s current regulatory authority over the activities of government securities brokers and dealers, l assignTreasury new authority to adopt salespractice rules governing government securities brokers and dealers and to adopt any rules neededto ensure public accessto government securities screenbrokers’ information, and . provide for a sunset on Treasury’s authority so that the continued need for Treasury’s rulemaking role can be reevaluated. The Department of the Treasury supported our recommendation that Agency Comments Congressshould continue Treasury’s rulemaking authority over the gov- ernment securities market and the activities of government securities brokers and dealers. Page 92 GAO/GGD9@114Govemment Securities Page 93 GAO/GGIMJ@ll4 Govemment Securities Appendix I GovernmentSecuritiesMarket Components L and Activity Market component Description Activity I. lnltlal sale of securltles A. Treasury The Treasury, through the Federal Reserve System (principally the Federal Over $1.9 trillion out- Reserve Bank of New York) acting as Treasury’s fiscal agent, sells new securities standin as of December -.--.l-~_.-.-- to the public to raise new funds and refinance existing debt. 31,198 8 0. Agency Federz sponsored agencies issue securities to the public through dealer selling About $412 billion out- groups. standin as of December --- -_- -----___ 31,198 # C Mortgage-backed Lendin institutions pool mortgages and obtain, through GNMA, FNMA, or About $931 billion FHLM 2 , the securities collateralized by the mortgages. Government guarantees outstanding as of timely payment of interest and principal for GNMAs, and timely interest and December 31,1989. ultimate pavment of principal for securities issued bv FNMA and FHLMC. II. Secondary Markets tradlng _I~ .___- A. Outriaht purchase and Dealers buv and sell securities in an over-the-counter market, with transfers made About $131 billion averaae sale - ’ through clearing banks and the Fed-wire network. daily transactions by ” primary dealers in 1989. B. Repurchase agreement Dealers obtain financing and securities from and for customers in an over-the- About $776 billion average contracts counter market. Also used by the Federal Reserve Open Market Committee for outstanding agreements conduct of monetary policy. per day reported by primary dealers for 1989. About $6 billion average transactions per day in 1989 reported by Federal Reserve Open Market Account. Ill. Derlvative products .-____. KWhen-issued Over-the counter market used by dealers to lock in purchase and sale orders for WA commitments _-._-_-~___- ____- -- announced but not yet issued-used to take or hedge position risk. -_____ B. Forward commitments Over-the-counter market used by dealers to lock in purchase and sale orders at Total unknown. $11.6 billion least 5 days in advance of delivery-used to take or hedge position risk. average daily transactions in 1989 reported by orimarv dealers. C Over.thecounter Over-the-counter market used by dealers to purchase the right to buy or sell WA options securities at a iven price for a set period of time. Recently supplemented by a --___---.___ proprietary tra 2 rng system called Delta Options. D. Exchange-traded Traded on several exchanges including the Chicago Board of Trade (notes and Per CFTC, average daily futures bonds and some mortgage-backed securities); MidAmerica Commodity Exchange dollar value of contracts (bills, notes, and bonds); New York Cotton Exchange and Assoc. (notes); and traded was over $38 billion Chicago Mercantile Exchange (bills). Futures are used to lock in purchase and in fiscal year 1989 (ending -~- sale orders in advance of delivery and to take or hedge position risk. Sept. 30, 1989). E. Exchange-traded Traded on Chicago Board Options Exchange (bonds). Options are used to Average of 555 contracts options purchase the right to buy or sell securities at a given price for a set period of time.per day in calendar year 1988, per CBOE. F. Exchange-traded Traded on several exchanges: Chicago Board of Trade (notes and bonds); Average of 47,027 options on futures Chicago Mercantile Exchange (bills); New York Cotton Exchange Assoc. (notes). contracts per day in fiscal Dealers purchase the right to buy or sell futures contracts at a given price for a set year 1989, per CFTC. period of time. Page 94 GAO/GGD90-114Government Securities Appendix II Primary Dealersand Ekminin g Authority as of June Z&l990 Specialized Examiner Bank of New York Securities, Inc. NASD CRT, Gov’t Securities, Ltd. NASD Discount Corporation of New York NASD Harris Gov’t Securities, Inc. NASD Merrill Lynch Gov’t Securities, Inc. NASD Sanwa-BGK Securities Co., L.P.a NASD SBC Government Securities, Inc. NASD Shearson Lehman Gov’t Securites, Inc. NASD Diversified Barclavs De Zoete Wedd Sec. Inca NASD BT Securities Coroa NASD Carroll McEntee 81McGinley, Inc. NASD Chase Securities. Inca NASD Chemical Securities, Inca NASD Citicorp Securities Markets, Inca NASD First Chicago Capital Markets, Inca NASD Fuii Securities, Inc. NASD Greenwich Capital Markets, Inc.a NASD Aubrey G. Lanston & Co., Inc. NASD Bear, Stearns & Co., Inc. NYSE Daiwa Securities America. Inc. NYSE Dean Witter Revnolds, Inc. NYSE Dillon, Read & Co., Inc. NYSE Donaldson, Lufkin & Jenrette Securities Corp. NYSE The First Boston Corporation NYSE Goldman, Sachs & Co. NYSE Kidder, Peabody & Co., Inc. NYSE Manufacturers Hanover Securities Corp.a NYSE J.P. Moraan Securities, Inca NYSE Morgan Stanley & Co., Inc. NYSE The Nikko Securities Co. International, Inc. NYSE Nomura Securities Inter.. Inc. NYSE Paine Webber, Inc. NYSE Prudential-Bathe Secur., Inc. NYSE Salomon Brothers, Inc. NYSE Smith Barnev. Harris. Uoham & Co.. Inc. NYSE S.G. Warbura & Co. Inc. NYSE U.B.S. Securities, Inc. NYSE Wertheim Schroder & Co., Inc. NYSE Yamaichi International (America). Inc. NYSE (continued) Page 96 GAO/GGD-90-114Government Semrities Appendix II P&nary Dealers and Ekamhhg Authority aa of June 28,1999 Specialized Examiner Banks Bank of America NT&EGA occ Continental Bank, N.A. occ Security Pacific National Bank occ %ank holding company subsidiary authorized by the Federal Reserve Board pursuant to Section 20 of the Glass-Steagall Act. Page 96 GAO/GGD-90-114Govemment Securities Ppe biTBroker Trading SystemsOperate Government securities brokers arrange transactions between their cus- tomers, usually securities dealers, who are ,seekingto buy or sell securi- ties. Customersprovide quotation and trade execution instructions via telephone lines to the brokers. This information and the trading activity that results is then transmitted to a network of video display screens that brokers have installed in the customers’ trading rooms. Each gov- ernment securities broker’s screendisplays the best bid and offer quota- tion available from its customers for the issuesshown. These quotations are binding commitments for the quantities and prices specified and, as such, constitute a market for each issue displayed. Most brokers segmentthe government securities market as a whole into various trading centers, or “desks,” which function independently of each other. Each desk specializesin a market segment,such as Treasury bills, Treasury coupon securities of short or long maturity, zero coupon securities, agency securities, or mortgage-backedsecurities. Typically, brokers have separate screenpagesshowing the more actively traded issuesin each market segmentas well as derivative summary pages showing activity in key issuesacrossthe maturity spectrum. Brokers display similar information on each page but use various for- mats. Screenpagesthat customers seeshow securities’ maturity dates, coupon rates (when applicable), issuing agency (when applicable), the best bid and ask prices quoted by customers for each issue, and the quantities of securities each customer who provides a quote is com- mitted to sell or buy at the quoted price. As of January 31, 1990, the screensneither identified the customers whose quotations were dis- played nor did the screensreveal the depth of the market, i.e., the number and size of other orders waiting to be executed at the displayed price. Figure 111.1.shows a representative broker-screenpage. Page 97 GAO/GGD-SO-114 Government Securities Appendix IJl . How Broker Trading Syat.emrOperate Flgun 111.1:Sample Broker Screen for ‘Tnroury Securltlor, l-Column Format b 18 p&3 8ci! &&.&jj j# Jj $3&fJj 12 S/8 5/88 100.30-101.02 2X1 9 718 12/80 101.20-24 5 Xl 13 314 S/88 104.08- 3x 10 12/88 -101.30 x3 13 8188 104.08-12 10x5 9 314 1187 101.10-14 8 X8 14 718 8l88 9 2l87 100.10-14 1x7 12 518 7188 104.05 HIT 8 10 Y87 '101.21-25 2 x5 8 8180 99.29-01 3x5 10 718 2/87 102.29-01 12 X8 11 318 8185 103.00-04' 5X5 123/4 2J87 TAK102.07 7 12 318 8185 104.00-04 3X8 10 l/4 3187 102.03-07 7 Xl5 11 718 9188 -103.28+ X8 10314 3/87 102.27-31 1x5 12 3/4 9180 104.05-09+ 10X8 9 3/4 4187 101.09-11 20 x25 11 518 lOl88 103.19-19+ 30X50 9 118 5187 100.08-08 9 x5 8 118 11188 97.20-98.20 1x1 12 6187 10500.04 2x5 10 318 11188 102.08-lo++ 15X10 12 l/2 5187 105.20 HIT 10 11 11188 102.29-01 1x1 14 5187 -108.05 X8 13 718 11186 108.12+-18 7X10 8 l/2 8187 18 l/8 Ill88 -109.21 X10 10 112 8187 102.19-23 2 X3 Notes: A"+"lndloetesanaddltionel1/64leincludedintheprice. A “*I indicates that the flret bidder/seller still has the right to trade more before others can execute at that price. When a bld has been hit, the word “hit” appears on the screen; when the price asked has been taken, it appears aa “tak.” In each case the “hit” or “tak” flashes to draw the viewer’s attention to the trade. Source: Herrls Trust and Savings Bank, The U.S. Government Securitlee Market, 2nd edition, (New York lnetitute of Finance) 1986, p. 63. (Notes and column headings added by GAO.) Nearly all brokers execute trades in the sameway, observing an informal codeof market conventions that developed as screenbrokers beganto operate in the early 1980s.The key elements of the trading processstill followed by nearly all of the brokers are described below: . Customers have direct phone lines to the various desks at each of the broker firms. Each desk is a circular or horseshoeconfiguration of com- puter and phone consolesstaffed by 10 to 26 employees(brokers) han- dling one or more computer screenpagesthat show a certain segmentof the market. Each broker handles one to three customers depending on activity level. When customers wish to buy or sell a security, they call Page BS GAO/aODBO-114 Government Securltlea . Appendixm How Broksr Tmding Syatanu Operate their broker at one firm or, if they chooseto split their order, at more than one firm. The customer can either hit a bid or take an offer already shown on the screenor tell the broker to post a new bid or offer on the screen. l Brokers call out their bids and offers as received from customers when the new bid is higher (or offer lower) than one already shown or if it is an acceptanceof a posted price. (Otherwise, the brokers keep informal notes of customer quotations for later action should the market change.) Either the brokers or data entry staff at each desk enter this informa- tion so it is displayed on an internal computer screenor overhead pro- jector. Simultaneously, similar information is transmitted via computer for instant display on each customer’s video display screen.Codenum- bers or initials are used on the broker firms’ internal systems to identify the customers who are buying and selling the securities. These codesare not visible to the customers. . As a bid is hit or offer taken, brokers representing other customers shout their intention to be a buyer or seller at that price and are assigneda priority by the supervisor of the particular trading forum. The two customers who made the initial trade are given the right of first refusal for additional trades at that price. Generally, they are allowed about 20 secondsto decide (less time in very active markets) and will instruct their broker accordingly. If both customers continue to trade, their brokers will call out additional quantities, and the size of the trade will be worked up. Oncethe initial customers finish, other brokers may call out their customers’ orders joining either the buy or sell side of the transaction according to the established priority. Generally, this priority is basedon a first-come-first-served basis although we were told that somebroker firma at times give priority to their larger, more active cus- tomers. Brokers compete with one another becausetheir compensation dependsin part on the volume of businesseach generates. . When a bid is hit or an offer taken, “hit” or “tak” will be displayed on the screensand begins to flash. It will continue to flash and increase in size until all transactions at that price are completed. After a few secondsof inaction, this annotation will disappear.’ Brokers will then display the new best bid and ask prices provided by customers. l Usually, the customer who acted on the displayed quotation pays the price plus a commission,if buying, or receivesthe sale price less a com- mission, if selling. Commissionsare typically a percentageof the dollar size of the transaction, such as $39 per million for Treasury notes and bonds. ‘A completed transaction on a broker screen could, therefore, involve from one to several buyers or sellers. Page 99 GAO/WLWO-114Government Securities Appendix III How Broker lhdlng SystemsOperate . When a trade is completed, brokers verbally confirm the trade terms with their customers,and the broker firm prepares separate written confirmations to the buyers and sellers. The respective confirmations show the broker firm as the seller and purchaser of securities, thus maintaining customer anonymity. Before the development of the Government Securities Clearing Corpora- Clearing and Settling tion in 1988, broker firms often accumulated confirmations with partic- the Transaction ular customers during the trading day and offset purchasesand salesin the samesecurity so that only instructions for the net cash or securities transfer were sent to the clearing bank. This processby each broker firm was designedto reduce broker and customer clearing costs. With the development of Gscc, both brokers and dealers submit trade confirmations in batch form at the end of the day so that GX!C can com- pare the confirmations, validate the trade, and net transactions on a sys- temwide basis among all brokers and dealers involved. This processis expected to eventually replace the transaction pair-off processused by each broker. However, becausenot all broker customersbelong to GSCC, both processeswere operating at the time we completed our work. Page 100 GAO/GGD-O-114Government Securities Appendix IV &gulaOry Agenciesand Market Participants ContactedDuring This Study Department of the Treasury, Office of Domestic Finance and the Gov- Federal Agencies and ernment Securities Unit within the Bureau of the Public Debt Related Organizations Securities and ExchangeCommission,Division of Market Regulation Federal ReserveSystem, Division of Bank Supervision and Regulation, Division of Monetary Affairs, and Federal ReserveBank of New York, Dealer Surveillance Unit Federal Deposit Insurance Corporation, Division of Bank Supervision and Regulation Office of the Comptroller of the Currency, Investment Securities Division Office of Thrift Supervision, Office of Policy and Federal Home Loan Bank of Chicago,Examination Division Department of Housing and Urban Development, Government National Mortgage Association, Office of the Comptroller Federal National Mortgage Association Federal Home Loan Mortgage Corporation Commodities Futures Trading Commission,Division of Trading and Markets National Association of Securities Dealers,Inc., (Wash. and NY) Finan- Self Regulatory cial Responsibility Surveillance Organizations (SRO) New York Stock Exchange,Market Finance Regulation American Stock Exchange National Futures Association Chicago Board of Trade Chicago Board Options Exchange,New Products Planning Page 101 GAO/GGD-90-114Government Securities RegaIatery Agendea and Market Partidpanta Chtacted Durhg !l’hia Study American Bankers Association (ABA) Associations Credit Union National Association (CUNA) Representing Market Government Finance Officers Association (OFQA) Participants Government Securities Brokers Association (GSBA) Information Industry Association (IIA) Public Securities Association @A) National Association of Federal Credit Unions (NAFCU) Barclays De Zoete Wedd Government Securities, Inc. Governrnent Securities Carroll McEntee and McGinley, Inc. Dealers Chemical Bank Chemical Securities Inc. CRT Government Securities, Ltd. Discount Corporation of New York First Boston Corporation First TennesseeBank National Association G.X. Clarke Goldman, Sachsand Co. J.P. Morgan Securities Manufacturers Hanover Trust Co. Merrill Lynch Government Securities, Inc. Morgan Stanley & Co. Inc. O’Connor and Associates Salomon Brothers Inc. ShearsonLehman Hutton Inc. U.S. League,Government Securities, Inc. WestpacPollock, GSI Brokerage Corporation of America ScreenBrokers Cantor Fitzgerald Securities, Inc. Chapdelaine and Co. Government Securities, Inc. Fundamental Brokers, Inc. Garvin Information Systems,Garban Hilliard Farber and Co., Inc. Liberty Brokerage, Inc. RMJ Securities Corp. TGB Corporation Page 102 GAO/GGBB@l14 Government Securities ADP Brokerage Information ServicesGroup Information Vendors Bloomberg Financial Markets and Analytical Knight-Ridder Financial Information Services Quotron Systems,Inc. Reuters Information Service Inc. Telerate Inc. Government Securities Clearing Corporation Clearing Corporations The Options Clearing Corporation The Securities Investor Protection Corporation Other Page 103 GAO/GGIMh1l4 Government SecuritIem Appendix V CommentsFrom.the Department of the Treasury DEPARTMENT OF THE TREASURY WASHINSTON 86SISTANT SECRETARY July 3, 1990 Mr. Richard L. Fogel Assistant Comptroller General United States General Accounting Office Washington, D.C. 20548 Dear Mr. Fogel: Thank you for provid.ing us the opportunity to review and comment on your draft report on the effectiveness and implementation of the Government Securities Act of 1986. Since we have previously provided technical comments on the report to Stephen Swaim, our response will be limited to three items -- extension of Treasury's rulemaking authority over the government securities market, Treasury's capital rule for government securities brokers and dealers, and expanded access to broker screen information. We support your recommendation that Congress should continue Treasury's rulemaking authority over the government securities market and the activities of government securities brokers and dealers. We believe Treasury is best situated to regulate the government securities market due to our expertise and understanding of the market, our direct interest in ensuring that the market remains efficient, liquid and resilient so that Treasury securities can be sold at the lowest cost, and our ability to bring together the views of all interested parties so that regulations are promulgated in a uniform and consistent manner for all participants in the market. Treasury's continued role as rulemaker will guarantee that the interests of the regulatory community as well as the market participants are well represented. With regard to your recommendation that the separate Treasury capital rule applicable to government securities brokers and dealers should be phased out, an informal staff level working group has recently been established, comprised of representatives from the Securities and Exchange commission (SEC), the Federal Reserve Bank of New York and Treasury. This working group will identify, research and analyze the issues that need to be resolved in order to develop a uniform capital rule that would apply to the government securities activities of both registered Page104 GAO/GGD-I)O-114GovemmentSecurlties APP- v CemmemteFre~~~tl~eDepactmentof the Trearrnry 2 government rrecurities brokers and dealers and other registered brokers and dealers. Pending the outcome of this study, Treasury and the SEC will continue to take advantage of opportunities to minimize the differences between our respective capital rules. Treasury concur8 with your assessment that expanded access to broker screen information would serve the public interest. We support your recommendation that Congress should mandate public access and provide Federal rulemaking authority to prescribe regulations, as needed, to ensure that information access is expanded. As you know, Treasury, the SEC, and the Board of Governors of the Federal Reserve System are required to submit a joint report to Congress by October 1, 1990, evaluating the effectiveness of the Government Securities Act. We will offer our recommendations at that time. We trust that our comments prove useful. Sincerely, Michael E. Basham Acting Assistant Secretary (Domestic Finance) Page106 GAO/GGKMO-114GovernmentSecurities , Appendix VI CommentsFrom the SecuritiesInvestor Protection Corporation SECURITIES INVESTOR PROTEOTION OORPORKTION 806 FIFTEElYTH STREET, XV. W. SUITE 800 WASHINGTON, D. C. SOOO6--07 (sbOs3)371-8800 June 27,199O BY HAND Mr. Richard L. Fogel Assistunt Comptroller GeneraI General Government Division U.S. General Accounting Office Wsshington, D.C. 20548 Dear Mr. Fogel: This is in reply to your letter of May 26, 1990 in which you asked for SIPC’s comments on the General Accounting Office’s (“GAO”) draft report on the Government Securities Act of 1986 (“GSA”). The GAO draft report makes a number of recommendations, Including two of psrticulsr interest to SIPC, namely, the extension of SIPC protection to customer accounts at specialized government securities deaIers and the continuation of Treasury’s rulemsking authority for aII government securities dealers. while the GAO draft report does state that there Is no reason why these speciaIIzed government securities dealers should not support the integrity of the market that derives from SIPC protection, it, however, does not make a specific recommendation sbout whether the revenues from the securities activities of these government securities dealers should be subject to SIPC assessment, ss Is most securities revenue generated by other SIPC members. The draft report (at 160) notes that Congress, In passing the GSA, did not Now on p.60. require government securities specialI& desIers to become members of SIPC. See H.R. Rep. No. 99-258 at 25 (1985); &Rep. No. 99-426 at 20 (19861. The report (at 42 Now on pp. 29 and 60. and 100 n.18) notes that 89 of July, 1989 there sre 63 government securities speciaIIst firms (16 brokers and 47 dealers) who sre registered with the Securities and Exchange Commission and are not SIPC members. These firms sre registered under se&ion 15C Now on p. 64 of the Securtties ,Exchange Act of 1934 (“Exchange Act”), 16 U.S.C. f78~-5. The report (at 1051,recommends that “Congress amend the Exchange Act to require that aII nonbsnk government securities dealers provide SIPC coverage if they do business with customers for whom such coverage normaBy apples in SEC-registered securities msrkets.” Now on p 2. The report (at 3) further notes that the GSA established Treasury as t.he rulemaker with authority to write rules for government securities dealers until October I, 1991. The report (at 146) recommends that Treasury’s authority should be Now on p. 92 continued for a limited period of time. SIPC would like to make a few introductory comments about the Securities investor Protection Act of 1970 (“SIPA”), the membership of broker-deulers in SIPC, Page 106 GAO/GGD-DO-114 Government fbcurltien Appendix VI Commenta From the fkxxultiea Investor Pmt.4wtion Corporation Mr. Richard L. Fogel Jwle 27, 1990 Page 2 the registration of municipal securities dealers with the Securities snd Exchange Commission (‘SEC”) under the Securities Acts Amendments of 1975, and the reglstratlon of government securities broker-dealers with the SEC under the GSA. When Congress enacted SIPA ln 1970 and established SIPC to protect customers of SIPC member broker-dealers for the cash and securities which those members sre holdlng for customers, Congress mandated clear membership requirements for SIPC. Pursuant to SIPA section 3(a)(2)(A), 15 U.S.C. J78ccc(aIt2)(A), alI broker-dealers, with minor exceptions, registered with the SEC under section 15(b) of the Exchange Act, 15 U.S.C. 578pW, are automatics& members of SIPC. In 1975 when Congress mandated that municipal securities dealers register with the SEC and extended SIPC protection to these firms’ customers, these firms registered under section 15(b) of the Exchange Act and thus became SIPC members. Certain municipal securities dealers, not requlrlng membership In the SIPC protection program, registered under section 16B of the Exchange Act, 16 U.S.C. §78o-4, and dld not become SIPC members. As noted above, the GSA required the registration of government securities dealers with the SEC under either section 15(b) or section I5C of the Exchange Act. Many government securities dealers registered under section 15(b) and became SIPC members. Only 63 did not. They registered under section 15C. The GAO draft report is silent ss to whether the 63 government securities dealers, which the report recommends become SIPC members, would register with the SEC under section 16(b) of the Exchange Act as does every current SIPC member. One may surmise, however, that the draft report contemplates both the SlPC membership of these 63 government securities dealers and their continued registration under sectlou 1SC of the Exchange Act, because of the report’s recommendation that the Tressury continue to write the rules for these 63 entities. This would be the first time that Congress would consider making entities, which sre not registered under section 15(b) of the Exchange Act and which sre not subject to the fulI rulemsklng authority of the SEC, members of SIPC. SIPC believes that such a major departure from prior practice must be thoroughly thougbt through, explored, and discussed. Of special concern to SIPC ls the likelihood of having SIPC members subject to different finanpial responsibility rules. Up to now, the fhmnciaI responsiblllty rules governing the, more than 10,606 SIPC members have been uniform and have been written by the SEC. One final concern SIPC would Iike to raise ls the fairness of extending SIPC membership to these specialized government securities dealers without requhig them to pay their fair share of SIPC assessments. SIPA section 16(9)(K), 15 U.S.C. §78IIK9I(K), restricts the assessment on commissions earned from transactions in Treasury bills to only a percentage of such commissions bssed on SIPC’s loss experience with respect to such instruments over at least the precetig five years. No other basis for assessments is restricted in this msnner. SIPC believes that, if the specialized government securities dealers sre to be given SIPC membership, the restriction on assessments must be eliminated or substantialIy modified. In this Page 107 CAO/GGD90-114 Government SecnrItles ~-- Appendix VI Comments From the Securltles Investor Prokxtlon Ciwporatlon Mr. Richard L. Fogel June 27.1990 Page3 regard we note with approval the following comment ln the GAO drsft report (at 102) regarding the responslbllities of these speclaIlzed government securities dealers: “We abo see no resson why spe&Ust firms should be able to avoid the cesponslbllitlea for supporting the integrity of the market that derives from SIPC insurance.” SIPC belleves that such responsibllltles include shouldering a fair share of the assessment burden which supports a properly funded President and General Counsel THF:KHB:rm Page 108 GAO/GGD9@114 Government &curl&s I ADDendi; VII Maor Contributors to This Report General Government Stephen C. Swaim, Assistant Director Paul Zacharias, Assignment Manager Division, ‘Washington, Marion L. pitts, Evaluator DC. Katrina Richardson, Evaluator Carla Surratt, Evaluator Jaime Dominguez,Evaluator Leah B. Cates,Reports Analyst Ronda A. Ward, Secretary/Typist Page 109 GAO/GGD90-114Government Securltiea I Y Page 110 GAO/GGD-SO-114 Govemment &?curltiea b . . 4wendix W Cmunenta From the Securities Inveetor Protection Corporation Page 111 GAO/GGDM-114 Government Securities RelatedGAO Products Financial Markets: Tighter Computer Security Needed(GAO/IMTIX-90-16, Jan. 6,199O). Electronic Funds Transfer: Oversight of Critical Banking Systems Should Be Strengthened (GAO/IMTEC-90-14,Jan. 4, 1990). US. Government Securities: An Examination of Views ExpressedAbout Accessto Broker’s Services(GAo/GGD-~~-~,Dec. 18,1987). U.S. Government Securities: The Federal ReserveResponseRegarding Its Market-making Standard (GAO/GGDS~-66~s,Apr. 21,1987). U.S. Government Securities: Expanding Accessto Interdealer Broker’s Services(GAO/GGD-87-42).Transcript of a hearing held jointly by GAO,the Department of the Treasury, the Federal ReserveSystem, and the Secu- rities and Exchange Commission,Washington, D.C. (Feb. 4, 1987). U.S. Government Securities: QuestionsAbout the Federal Reserve’s Securities Transfer System (GAOpx~-87-EBR, Oct. 20,1986). U.S. Government Securities: Dealers’ View on Market Operations and Federal ReserveOversight (GAO/GGD-86-147FS,Sept. 29, 1986). US. Treasury Securities: The Market’s Structure, Risks, and Regulation Aug. (GAO/GGD-86-80BR, 20, 1986). (2&3206) Page 112 GAO/GGD-90-114Government Securities j I..,,. .I”. “llll..--.-. I-..“I... ..I _... -.._ -...... . ..- -..- . ..- --_- -.... ------ ~ _... .l.._ll..-“l”ll-- 1 / / I / 1 1 1 I ,/ I I / I / I ! I ” i ii
U.S. Government Securities: More Transaction Information and Investor Protection Measures Are Needed
Published by the Government Accountability Office on 1990-09-14.
Below is a raw (and likely hideous) rendition of the original report. (PDF)