oversight

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)

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                                      U.S. GOVERNMENT
                                      SECURITIES
                                      More Transaction
                                      Information and
                                      Investor Protection
                                      Measures Are Needed



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      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
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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
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              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
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                      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&regulated
                                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.



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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.



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                             Chapter 3
                             Additional Investor Protection Measures
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                             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
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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.



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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.




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                      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



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                            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.



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                            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
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                          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
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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.



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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.



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                    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


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                      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
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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
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                       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.



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                        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
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                      A&on Is Neededto Expand Acceoato
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                      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.


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                         Action b Neededto Expand Acceeeto
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                         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


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                          Action Ie Neededto Expand Access to
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                          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


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    ActionIs Neededto Expand Accessto
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    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
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                             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
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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
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                      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
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                     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



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