Clearance and Settlement Reform: The Stock, Options, and Futures Markets Are Still at Risk

Published by the Government Accountability Office on 1990-04-11.

Below is a raw (and likely hideous) rendition of the original report. (PDF)

       Report to Cc-mgressional Cornmi ttees

       The Stock, Options, and
       Futures Markets Are Still
       at Risk

      United States
GAO   General Accounting Office
      Waahiugton, D.C. 20548

      General Government Division


      April   11,lQQO
      The Honorable John D. Dingell
      Chairman, Committee on Energy
        and Commerce
      House of Representatives
      The Honorable E (Kika) de la Garza
      Chairman, Committee on Agriculture
      Houseof Representatives
      The Honorable Henry B. Gonzalez
      Chairman, Committee on Banking, Finance,
        and Urban Affairs
      House of Representatives
      The Honorable Patrick J. Leahy
      Chairman, Committee on Agriculture, Nutrition,
        and Forestry
      United States Senate
      The Honorable Donald W. Riegle, Jr.
      Chairman, Committee on Banking, Housing,
        and Urban Affairs
      United States Senate
      This report evaluates the sufficiency of industry and federal regulator actions in responseto
      clearance and settlement recommendationsmade by the President’s Working Group on
      Financial Markets after the October 1987 stock market crash. It is a follow-up to the work we
      did immediately following the crash.

      This report was prepared under the direction of Craig Simmons,Director, Financial
      Institutions and Markets Issues,who may be reached on 275-8678 if you or your staff have
      any questions. Other contributors are listed in appendix VIII.

      Richard L. Fogel
      Assistant Comptroller General

             After the stock market crash of October 1987, the President created the
Pyrpose      Working Group on Financial Markets (Working Group) to identify
             issues,make recommendations,and seek resolution of the complex prob-
             lems raised by the crash. The Working Group is chaired by the Secretary
             of the Treasury and its members are the Chairmen of the Securities and
             Exchange Commission(SEC),the Commodity Futures Trading Commis-
             sion (CFTC), and the Federal ReserveSystem (FRS).Among the areas they
             examined were the clearance and settlement systems for stock, options,
             and futures markets.
             The clearance processensuresthat both buyers and sellers agree on
             trade quantity and price. The settlement processis used to transfer pay-
             ments and stock among buyers and sellers for hundreds of thousands of
             daily trades that are worth billions of dollars. The Group of Thirty, an
             international private sector group, also made recommendationsto
             improve securities clearance and settlement systems.As a follow-up to
             its initial observations on the October‘1987 stock ‘market crash, GAO
             evaluated the merits of, and assessedthe progress made in implement-
             ing, the two groups’ recommendationsfor clearance and settlement
             reforms in three areas:

             the processingof information about trades,
             procedures used by clearing organizations to managefinancial risks, and
             payments to and from clearing organizations.

             Specializedorganizations handle clearance and settlement processesfor
Background   the different markets. These functions are done primarily by the
             National Securities Clearing Corporation (NSCC)for the stock market; the
             Options Clearing Corporation (KC) for the stock options market; and
             nine clearing organizations for futures markets, depending upon the
             exchangesat which the futures contracts are traded. Clearing members
             of these organizations include stock, options, and futures firms.
             Clearing organizations not only administer trade matching and payment,
             but they guarantee both sides of a trade once the details are reconciled.
             Such guarantees boost the integrity of the markets but represent a
             financial risk to the clearing organization, which must be carefully
             The Working Group reported in May 1988 that unprecedented trading
             volumes and price declines during the market crash causedthe

             Page 2                                  GAO/GGD-90-33 Clearance and Settlement
                         Esecntlve hunmary

                     . Clearing organizations and exchangesexperiencedtrade processing
                       problems. The stock market had problems with data entry and promptly
                       resolving trades, and the Options Clearing Corporation could not quickly
                       obtain prices.
                     l Someclearing organizations were unable to routinely determine their
                       clearing members’ financial risk and exposure in other markets.
                     l Someclearing members did not have the funding necessaryto meet their
                       obligations, and many had to increasetheir borrowing from banks.
                     l Somebanks, clearing organizations, and their membersdid not make
                       necessarypayments to each other within normal time frames.
                         The Group of Thirty recommendedchangesthat would match trades by
                         the day after the trade and settle stock trades within 3 businessdays
                         after a trade is completed.

                         Someof the weaknessesin clearance and settlement systems revealed by
Rest ts in Brief         the 1987 stock market crash still exist, making clearance and settlement
                         systems vulnerable to instability in the event of another large and sud-
                         den market adjustment. Much progress is being made in increasing
                         exchangeand clearing organization capabilities of handling large
                         volumes of trades and processingtrade information. However, more
                         needsto be done to improve procedures used to managefinancial risk
                         and to ensure that payments are made within time frames established
                         by stock, options, and futures markets.
                         Many of the neededchangesinvolve coordination and cooperation
                         among competing exchangesand acrossstock, options, and futures mar-
                         kets. The Working Group needsto take the lead role to identify responsi-
                         bilities, assigntasks, and set a timetable for accomplishing the
                         remaining recommendedchangeson information sharing and ensuring
                         prompt payment.

Prinbipal Findings       Certain clearance and settlement problems that occurred during the
                         October 1987 crash have been solved, but others remain uncorrected.
                         The greatest progress has been made in upgrading trade processingsys-
                         tems. Somesystems are now capable of handling larger volumes of
                         trades and clearing them more quickly than was possible in October
                         1987. These capabilities should facilitate efforts of the Working Group
                         and the Group of Thirty to shorten the stock settlement cycle. (Seepp.

                         Page 3                                 GAO/GGD!W33 Clearance and Settlement
                      JCxecntive Snmnuuy

                      Less progress has been made in the areas of managing the financial risk
                      to clearing organizations. While improvements have been made in capi-
                      tal and liquidity requirements, clearing organizations continue to have
                      difficulty monitoring the financial position of firms trading in more than
                      one market, becauseclearing organizations operate only in single mar-
                      kets while 20 percent of their member firms trade in more than one mar-
                      ket. To obtain an expanded view of a firm’s exposure, clearing
                      organizations would need to share information among their counterparts
                      in other markets, but progress in this area has been slow. (Seepp.
                      Someprogress has been made to reduce cash flows and ensure prompt
                      payment. cm and the Chicago Mercantile Exchange (CME) have worked
                      to revise payment agreementswith banks and make routine intraday
                      payments to and from the clearing organization. Although somepro-
                      grams have been developed to lessencash flows between stock, options,
                      and futures markets, studies of cash flow netting and simplifying
                      intermarket clearing have not been completed. The adequacy of availa-
                      ble clearing member credit to support payments in times of high volume
                      and major price swings is unclear. (Seepp. 40-61.)

                      Most actions that require intermarket cooperation, such as a shared
                      information system to evaluate inter-market risk, have not been com-
                      pleted. No joint effort to study methods of reducing cash demands
                      between markets or integrating clearing has been made.

                      GAOendorsesthe Working     Group and Group of Thirty recommendations
Rfxommendations       to resolve clearance and settlement problems. GAOrecommendsthat the
                      Secretary of the Treasury, as Chairman of the Working Group, ensure
                      that recommendationsto reduce clearanceand settlement system risks
                      and improve cash flows are completed. The Secretary, working with
                      other members of the Working Group as well as the exchangesand their
                      clearing organizations, should identify responsibilities, assign tasks, and
                      set time frames for accomplishing clearanceand settlement recommen-
                      dations that have not been implemented. These efforts should ensure

                  l   a routine, inter-market, information sharing system is developed and
                      used to assessthe inter-market risks posed by joint members(Seep. 38);

                      Page 4                                   GAO/GGD-90-33   Clearanceand Settlement
                      Executive Summary

                  l   studies exploring ways to lessenintermarket cash flow pressuresand to
                      simplify intermarket clearing without diminishing safeguards against
                      financial risk are completed and acted on appropriately. (Seep. SO.)
                      Market-specific recommendationsare included at the end of chapters 3
                      and 4.

                      The Department of the Treasury, SEC,CFTC,NSCC,occ, and CMEprovided
Agepcy Comments       written comments on a draft of this report. The Department of the Trea-
                      sury said that the Working Group, chaired by the Secretary of the Trea-
                      sury, ranks progress on clearance and settlement issuesamong its
                      highest priorities and will do its part to advancethe GAO
                      SECand CETCsupported the general recommendations contained in        the
                      report. CFTCsupports the recommendation that it assessthe adequacy of
                      clearing organization’s use of letters of credit in guarantee funds.

                      NSCC,occ, and CMEneither   endorsednor disagreed with GAO'Srecommen-
                      dations. Each of these three organizations took exception with certain
                      data and phrases in the draft report. Specific comments are addressedat
                      the end of report chapters and in appendixes III through VII.

                      Page 5                                 GAO/GGD-90-33 Clewwuce and Settlement
  ecutive Summary                                                                                2

Chapter 1
Introduction        Clearanceand Settlement Take Place After a Trade Is
                    Various Organizations Are Involved in the Clearanceand                   10
                        Settlement Process
                    Clearing Organizations Extend Trade Guarantees                           14
                    The Importance of Routine Clearanceand Settlement                        16
                    Federal Regulation of Clearanceand Settlement Systems                    16
                    The SECRegulatesStock and Stock Options Clearance                        16
                        and Settlement
                    CFTC RegulatesFutures Clearanceand Settlement                            16
                    The Federal ReserveRegulatesthe Payment and Credit                       16
                    Clearanceand Settlement Practices Are Different in the                   17
                        Three Markets
                    Clearanceand Settlement SystemsAre Linked                                17
                    The Presidential Working Group Identified Problems                       18
                    The Group of Thirty RecommendedClearanceand                              20
                        Settlement Changes
                    Objectives,Scope,and Methodology                                        20
                    Commentsand Our Evaluation                                              21

Chapter 2                                                                                   23
Tr@deProcessing     Efficient Trade ProcessingSystemsAre Crucial to                         23
                         Financial Markets
Systems Are Being   The Stock Markets Experienced Problems in Their Trade                   26
Improved                 ProcessingSystems
                    Stock Trade ProcessingSystemsAre Being Improved                         26
                    Options Information ProcessingSystemsAre Being                          27
                    Conclusions                                                             28
                    Commentsand Our Evaluation                                              28

                    Page 6                               GAO/GGIMO-33 Clearance and Settlement
Chabter 3
Prog’ ess Made in      Capital Requirements Help Ensure Clearing Member
Cha: ging Clearing     Liquidity and Capital Problems Occurred During the                      30
Org ‘nization Risk-        Crash
                       NSCCHas Maintained Current Capital Requirements                         31
Man“agement Systems    OCCHas Increased Its Capital Requirements                               32
Has hen Slow           CME Has Increased Its Capital Requirements                              32
    I                  Guarantee Funds Help Provide Market Integrity                           32
                       Clearing Organizations Reviewed Their Guarantee Funds                   33
                       Clearing Organizations Cannot Routinely Monitor the                     34
                           Financial Exposure That Clearing Members Have in
                           All Other Markets
                       NSCCDoesNot Participate in the Futures Inter-market                     35
                           Information Sharing System
                       The Securities Clearing Group Is Improving Information                  37
                       Conclusions                                                             37
                       Recommendations                                                         38
                       Comments and Our Evaluation                                             38

Chapter 4
Credit and Late        Credit and Late Payment Problems During the Crash
                       Stock, Options, and Futures Markets Rely on Banks for
Payment Problems in        Timely Payment and Credit
the Stock, Options,    SomeClearing Members Were Late Paying Their Clearing                    41
and !Futures Markets       Organizations During the Crash
                       RevisedSettlement Agreements and Routine Intraday                       42
Havh Not &en Fully         Pays and Collects Will Help ResolveLate Payment
Resolved                   Problems
                       The Adequacy of Available Clearing Member Credit Is                     43
                           Not Clear
                       The OCCWas Late in Paying Its Clearing Members                          43
                       CME Made Late Payments to Two Clearing Members                          44
                       SomeProposals to ReduceCash Demandson Clearing                          45
                           Members With Inter-market Positions Have Not Led
                           to Reform
                       Conclusions                                                             60
                       Recommendations                                                         60
                       Comments and Our Evaluation                                             61

                       Page 7                               GAO/GGD90-33 Clearance and Settlement
A$pendixes             Appendix I: Status of Reform Recommendationson                           62
                          Clearanceand Settlement of President’s Working
                          Group on Financial Markets
                       Appendix II: CommentsFrom the Department of the                          60
                       Appendix III: CommentsFrom the Securities and                            61
                          Exchange Commission
                       Appendix IV: CommentsFrom the Commodity Futures                          76
                          Trading Commission
                       Appendix V: CommentsFrom the National Securities                         86
                          Clearing Corporation
                       Appendix VI: CommentsFrom the Options Clearing                          100
                       Appendix VII: CommentsFrom the Chicago Mercantile                       107
                       Appendix VIII: Major Contributors to This Report                        121

Related GAO Products                                                                           122

Table                  Table 1: Inter-market Membership in Clearing                             18
                           Organizations (August 1989)

Figures                Figure 1: The Primary Linkages in Stock Clearanceand                     12
                       Figure 2: The Structure of Options Clearanceand                          13
                       Figure 3: The Structure of Futures Clearanceand                          14

                       Page 8                                GAO/GGIMO-33 Clearance and Settlement

ABA   American Bar Association
AMEX  American Stock Exchange
ACT   Automated Confirmation Transaction
mcc   Board of Trade Clearing Corporation
COMEX Commodity Exchange Incorporated
CFTC  Commodity Futures Trading Commission
CBOE  Chicago Board Options Exchange
GET   Chicago Board of Trade
CME   Chicago Mercantile Exchange
FE3   Federal ReserveSystem
ICC   Inter-market Clearing Corporation
NASD  National Association of Securities Dealers
NSCC  National Securities Clearing Corporation
NkSE  New York Stock Exchange
occ   Options Clearing Corporation
SCG   Securities Clearing Group
SEC   Securities and Exchange Commission
SRO   Self-Regulatory Organization
TARS  Trade Acceptance and Reconciliation Service

Page 9                             GAO/GGD-9033 Clearance and Settlement
Chapter 1                                                                                            0

                                This study follows up a report issued in January 1988 on the October
                                1987 market crash.’ That report described the linked nature of stock,
                                options, and futures markets and the actions taken by industry and fed-
                                eral regulators during the crash to stabilize markets. This report is a
                                status report on clearance and settlement actions that have been taken
                                in responseto federal recommendations.2

                      On an average day, hundreds of millions of individual shares and con-
Cl$arance and         tracts are traded in US. stock, options,3and futures markets. These
Settlement Take Place transactions result from hundreds of thousands of trades that are worth
Afker a Trade Is Made billions of dollars. Clearanceand settlement take place after a trade is
                      made. Clearanceis the processof capturing the trade data, comparing
                                the buyer’s and seller’s version of the data, and guaranteeing that the
                                trade will settle once the data match. Settlement is the final stage of the
                                processwhen funds and/or financial instruments are exchanged
                                between the parties through the clearing organization. Those who owe
                                money and/or financial instruments make payments or deliveries. Those
                                who are owed money and/or securities receive the funds or securities.

                                Exchanges,clearing organizations,4clearing members, and banks are
Vairious Organizations          participants in clearance and settlement systems. Data concerning the
Are Involved in the             specific features of a trade, such as the identity of the buyer and seller
Clearance and                   and the price, in somecases,are captured at the exchangeand sent to a
                                clearing organization. For other trades, the buyer and seller submit
Settlement Process              trade information to the clearing organization for comparison. The infor-
                                mation should be identical. Trades that do not initially match are recon-
                                ciled by the buyers and sellers to allow the trade to be cleared and
                                Oncea trade is matched, the clearing organization becomesresponsible
                                for completing the clearance and settlement process.To managethis
                                risk, clearing organizations operate risk-management systems, which
                                include margin requirements, minimum capital standards for members,
                                ‘Financial Markets: Preliminary Observations On The October 1987 Crash (GAO/GGD88-38, Jan.
                                2Seeapp. I for a list of federal recommendations and their status.
                                3The term “option” is used in this report to mean stock options, not options on a futures contract.

                                4We use the generic term “clearing organization” here to cover what are called “clearing agencies” in
                                the stock market, and “clearing corporations” ln the options market. 17 CFR 8 1.3(d) (1989) calls
                                them “clearing organizations” in futures markets.

                                Page 10                                                  GAO/GGD-go-33 Clearance and Settlement
Chapter 1

and financial surveillance. Clearing organization memberships are com-
prised of securities broker-dealers, options market makers, or futures
commission merchants. Clearing membersoften take responsibility for
clearing the trades of smaller market participants. Banks are involved in
the clearance and settlement processin that they extend credit to clear-
ing members and serve as settlement banks for clearing membersby
making payments for members in the options and futures markets.
All stocks are cleared through three clearing organizations. The National
Securities Clearing Corporation (NSCC)clears 96 percent of stock bans-
actions. Two regional stock exchanges,the Midwest Stock Exchange and
the Philadelphia Stock Exchange,each have their own clearing organiza-
tions. Settlement takes place at one of three different depositories. (See
fig. 1) In addition to the primary linkages, the three stock clearing orga-
nizations also maintain interfaces with each of the other trading market-
places so that, for example, a trade made on the New York Stock
Exchange can be settled at the Midwest Clearing Corporation.

The Options Clearing Corporation (XX) clears all options contracts on
the six options exchanges.Each exchangeprovides WC trade data for
options trades executed on its exchange.Those exercising their options
do so through one of the three stock clearing organizations and their
associateddepositories. (Seefig. 2.)

Futures clearance and settlement involves 9 futures clearing organiza-
tions serving 14 exchanges.Most futures clearing organizations are affil-
iated with a single futures exchange.Despite the relatively large number
of futures clearing organizations, almost 80 percent of futures trading
volume is cleared by the two largest futures clearinghouses-the Board
of Trade Clearing Corporation (BCJKC)  and the Chicago Mercantile
Exchange Clearing House Division (CME). Over 90 percent of the volume
is handled by the four largest futures clearing organizations-Bc,
CME,Commodity Exchange Inc. (COMEX)Clearing Association, and the
New York Mercantile Exchange Clearing House.(Seefig. 3.)

Page 11                                 GAO/GGMO-33 Clearance and Settlement
                                           chapter 1


‘Figuw 1: The Primary Linkage8 In Stock Clearance and Settlement
            Exchange                                      Clearing Organization                        Depository
           New York
        Stock Exchange

    National Association of
      Securities Dealers

                                                                                                    Trust Company

                                                           National Securities    L/
                                                          Clearing Corporation

        Stock Exchange


I           Midwest
        Stock Exchange                                                                              Securities Trust

                                           Page 12                                     GAO/GGD9O-33 Clearance and Settlement
Figure 24The Structure of Options Clearance and Settlement
        i Exchange                              Clearing Organization   Clearing Organization and Dq?ository
        I                                                                   for Options Exercise AcWty

                                                                                 _ D?p_ositov
                                                                                 Trust Company

    National Association
    of ;Securities Dealers

                                          Page 13                         GAO/GGD-90-33 Clearance and Settlement
                                           Chapter 1

Figure 3: The Structure of Futures Clearance and Settlement
                                                                                                               Clearing Organization

*                        *                         m                               174 members                        Board of Trade
                                                                                4 settlement banks                 Clearing Corporation

m                            ’                       “- 86 members                                        ’ ’ Chicago Mercantile   *
                                                     6 settlement banks                                    Clearing House Division

                                                        70 members                                                 New York Mercantile
                                                     6 settlement banks                                              Clearing House             h

                                                        50 members                                                  Comex Clearing
                                                     8 settlement banks                                             Association, Inc.
    \   /
                                                      53 members                                                    CSC Clearing
                                                   10 settlement banks

                                                        61 members                                                     Commodity
                                                     6 settlement banks                                            Clearing Corporation

                                          m                ~~L!!$l$$*      e
                                                        39 members                                   , Kansas City Board of Trade
                                                     2 settlement banks                                   Clearing Corporation

                                                          18 membersa                                               Minneapolis Grain
                                                                                                                     Clearing House

                                         a The Minneapolis Grain Clearing House does not use a clearing   bank. Clearing     members      settle
                                         their accounts by corporate checks.

                                           They guarantee that clearing members who are owed money or stocks
Extend Trade                               will receive them and that clearing members who owe money or stocks
Guarantees y                               will make payment and delivery. The guarantee is advantageous
                                           becauseonce it becomeseffective, market participants who buy and sell

                                           Page 14                                             GAO/GGD8O-33Clearance and Settlement
I--       -i..
                          Chapter 1

                          financial instruments do not have to concern themselves with the sol-
                          vency of counter-partieswith whom they have traded. The clearing
                          organization and, indirectly through assessment,the clearing members
                          who make up the organization, accept the responsibility of making good
                          on any clearing member who fails to meet its obligations.

                          Properly operating clearance and settlement systems are important to
The klmportanceof         the efficiency and integrity of financial markets. Their failure to con-
Rout’i:ne Clearance and   tinue to operate in volatile markets can further exacerbate market insta-
sett: ment                bility. The inability of a major clearing member to meet major
                          obligations could jeopardize the financial health of all the clearing orga-
                          nizations to which it belongs,becausethe trade guarantee makes the
                          clearing organization responsible for fulfilling the financial obligations
                          of its failed clearing members.
                          The failure of a clearing organization could have severeconsequences
                          for financial markets as a whole. For example, if a clearing organization
                          fails, healthy clearing membersmay not get paid promptly for stocks
                          they delivered or receive stocks for money they paid. To the extent that
                          solvent clearing members are unable to meet other payment obligations
                          without payments from clearing organizations, these clearing members
                          may also fail. Thus, a widespread inability of clearing organizations and
                          their membersto meet their obligations could result in a rippling effect
                          on parties and markets not directly involved with the failed member.
                          Becauseof the potential impact that a poorly operating system could
Federal Regulation of     have, clearance and settlement regulation is the responsibility of the
Clekrance and             Securities and Exchange Commission(SEC),the Commodity Futures
           Systems        Trading Commission(cm), and the Federal ReserveSystem (FRS).The
                          SECregulates stock and options clearance and settlement. The CFTCregu-
                          lates futures clearance and settlement. The FRSoverseesthe payment
                          and credit roles of banks in the clearanceand settlement process.

                          In the stock, options, and futures markets, the structure of regulation is
                          such that self-regulatory organizations (sRo)-the clearing organizations
                          and the exchanges-are the primary regulators and the federal regula-
                          tors overseethe actions of the SROS  to determine whether or not they are
                          functioning in accordancewith regulations and the law. Stock, options,
                          and futures clearing organizations and exchangesestablish rules gov-
                          erning activities in the markets that are subject to approval by their
                          respective regulators.

                          Page 15                                  GAO/GGD90-33 Clearance and Settlement
                        Chapter 1

                        through registration requirements, rule reviews, periodic evaluations of
St ck and Stock         clearing organization operations called “inspections,” and special stud-
0 tions Clearance and   ies. Registration requirements specify financial, administrative, and
                        operational guidelines for clearing organizations. Through rule reviews,
Se” tlement             the SECexamines proposed clearing agency rules for their consistency
                        with the Securities and ExchangeAct and regulations issued by the SEC.
                        SECinspections focus on rule compliance at clearing organizations. Its
                        inspections of depositories are done in conjunction with the FRS and
                        state banking authorities. SECoversight also occurs through special stud-
                        ies such as those done after the crash.

                        CFTCoverseesclearance and settlement in the futures markets through
C@C Regulates           contract designation, rule reviews, and regular assessmentsof the finan-
Futures Clearance and   cial operations of exchanges,including clearance and settlement ele-
Settlement              ments called “audit and financial rule enforcement reviews,” and special
                        studies. The first time an exchangeapplies to trade a futures contract,
                        called “contract market designation,” CFTCexamines and analyzes the
                        clearance and settlement facilities and the applicable clearing rules. In
                        rule reviews, CFTCexamines proposed exchangeand clearing organiza-
                        tion rules for consistency with CFTC regulations and the Commodity
                        ExchangeAct, Through periodic audit and financial rule enforcement
                        reviews, CFIY:examines systems established by clearing organizations
                        and exchangesto identify, monitor, and managefinancial risk to the
                        exchanges,clearing organizations, and their members.CFTC oversight
                        also occurs through special studies, such as those done after the Volume
                        Investors Default and the October 1987 market crash which identified
                        problems and suggestedsolutions.

                        The FRSalso plays a role in the clearance and settlement processthrough
The Federal Reserve     its regulation of banks, FedWire operations, and setting of monetary
Regulates the Payment   policy. As a regulator of banks, the FRSoverseesthe credit and payment
and Credit Role         role of banks in the clearanceand settlement process,primarily by issu-
                        ing regulations concerning credit and payment procedures that banks
                        must follow. The FRSoperates the FedWire funds transfer system.
                        FedWire is a communications and settlement system that links FXSbanks
                        with insured depository institutions and transfers money and certain
                        types of government securities. The FRS also influences credit through
                        monetary policy. Depository institutions are regularly examined to
                        determine, among other things, the soundnessof their assetsand sol-
                        vency. In its role as the lender of last resort to banks, the FXSseeksto (1)

                        Page 16                                  GAO/GGD40-33 Clearance and Settlement
                         chapter 1

                        ensure a sound banking system, (2) forestall liquidity crises and finan-
                        cial panics, and (3) ensure the health of the financial system.

                        Although clearing organizations in the three markets perform the same
Clea ante and           basic set of functions-trade comparison, risk management,and settle-
Settl ment Practices    ment-the details of how these functions are performed can vary
Are b ifferent in the   depending on whether the trade takes place in the stock, options, or
                        futures markets. For example, stock trades settle in 5 businessdays
Three Markets           after a trade occurs, while options and futures trades settle the day
    I                   after the trade. Also, options and futures are interests without certifi-
                        cates while those who own stocks can request certificates of ownership.
                        Depositories can hold these certificates and provide a simple means of
                        transferring ownership by book entry. The role of banks is also different
                        in the three markets becausein the stock market payment is made by
                        check, while in the options and futures markets payment is generally
                        made by banks who make wire transfers between clearing member and
                        clearing organization accounts.Options clearance and settlement is dif-
                        ferent from futures clearance and settlement in that payment and clear-
                        ing guarantee time frames are different.

                        Market participants who use trading strategies involving all three mar-
Cleabanceand            kets help connect or link markets that developed independently and are
Settlement Systems      regulated separately, The clearance and settlement systems developed
Are ‘Linked             in each market reflect the divergent histories and needsof each market.
                        The differences between clearance and settlement systems in the three
                        markets can sometimeshinder intermarket trading. Trading strategies
                        may develop settlement problems when gains in one market are needed
                        to cover lossesin another market.” For example, market participants
                        cannot use the proceedsfrom their stock market activity to cover daily
                        lossesin the futures market since payments are due in the futures mar-
                        kets the next businessday while funds available from stock settlement
                        take 6 businessdays. In such a situation, market participants sometimes
                        borrow funds against the stock value to cover losses.If capital to sup-
                        port intermarket strategies is limited, the margining arrangements, the
                        time it takes to settle, and other differences between markets can hinder
                        an intermarket strategy, especially in volatile markets.

                        “Typical intermarket strategies are: (1) using options or futures positions to hedge the risk of stock
                        purchases or sales or (2) trying to profit from price differences between a basket of stocks and a
                        stock index options or futures contract by buying one and selling the other.

                        Page 17                                                  GAO/GGD-90-33 Clearance and Settlement
                                       Chapter 1

                                       Clearing memberswho belong to clearing organizations in more than one
                                       market and actively employ intermarket investment strategies also link
                                       clearance and settlement systems.A number of the joint clearing mem-
                                       bers are very large firms, such as Prudential-Bathe Securities, Inc.;
                                       ShearsonLehman Hutton Inc.; and PaineWebberIncorporated.; who rep-
                                       resent a substantial number of investors and have substantial market
                                       Our analysis of firms listed as being clearing organization members in
                                       August 1989, indicates that 190 out of approximately 963 clearing mem-
                                       bers in the three markets, or 20 percent, were members of clearing orga-
                                       nizations in two or more markets. Of that number, 32 clearing members
                                       belong to clearing organizations in all three markets, 126 clearing mem-
                                       bers belong to both stock and options clearing organizations, 20 clearing
                                       members belong to both options and futures clearing organizations, and
                                       12 clearing members belong to both stock and futures clearing organiza-
                                       tions. Table 1 does not show the number of clearing firms, affiliations,
                                       and/or parent-subsidiary relationships among clearing firms. As a
                                       result, the number of intermarket clearing firms may be understated.
Table 1: Intermarket Membership In
Clea(lng Organizations (August 1989)                                                                                     Percent of All
                                       Markets                                                Number of members             members0
                                       Futures,   options,    & stock                                           32                      3%
                                       Options    & stock                                                      126                   13%
                                       Futures    & options                                                     20                      2%
                                       Futures    & stock                                                       12                      1%
                                       Total clearing members belonging to
                                       clearing organizations in more than one
                                       market                                                                  190                  20%
                                       Only futures                                                            273                  28%
                                       Only options                                                             13                      1%
                                       Only stocks                                                             487                  51%
                                       Total Clearing Members                                                 963                  100%
                                       aPercentages do not add up to the total due to rounding.
                                       Source: Securities Clearing Group and Board of Trade Clearing Corporation.

Working Group                          and seek resolution of the complex problems raised by the market crash
Identified Problems                    of October 1987. The Working Group is chaired by the Secretary of the
                                       Treasury and its members are the Chairmen of the SEC,CFTC,and FXS.We

                                       Page 18                                                   GAO/GGD9033 Clearance and Settlement


        categorized the clearance and settlement problems the Working Group
        and its individual members identified into three areas?
    l   the processingof information about trades,
    l   risk-management procedures used by clearing organizations, and
    l   payments to and from clearing organizations.
        Processingof information about trades and payment was a problem in
        the stock and options markets. Becauseof the unusually high trade vol-
        ume and volatility during the market crash, the trade processingsys-
        tems of clearing members, exchanges,and clearing organizations
        experienced problems. Trade data entry systems of member firms and
        exchangereconciliation systems were not always able to processtrade
        data quickly and accurately. For example, the percentageof stock
        trades that did not match on price or quantity doubled during the crash.
        In the options market, MX had problems obtaining and verifying price
        information neededto value and set options margins.7
        During the market crash, the risk-management systems of someclearing
        organizations were inadequate. Someclearing members in the options
        market had inadequate capital to meet their financial obligations. In all
        three markets, the Working Group was concernedthat guarantee funds
        were insufficient in size and not liquid. Clearing organizations also were
        not always able to determine the risk-exposure of their clearing mem-
        bers in other markets.
        Somepayments to and from clearing organizations were made after the
        usual time in the options and futures markets. Someclearing members
        did not have sufficient capital or credit to cover lossesand did not
        promptly meet their obligations to clearing organizations. The CMEand
        occ-two major clearing organizations in the options and futures mar-
        kets-met their legal obligation to pay in same-dayfunds but were late
        in paying clearing members. Banks were unable to immediately make
        credit decisions due to the large payments and associatedrisks.

        sWorking Group on Financial Markets, Interim Report to the President of the United States, May
        1988. Other discussions of clearance and settlement problems appear in Commodity Futures Trading
        Commission, Mvision of Trading and Markets, Follow-Up Report on Financial Oversight of Stock
        Index Futures Markets During October 1987, January 6,1988; Presidential Task Force on Market
        Mechanisms, Report to the Presidentnited           States, [Brady Report], January 1988; and U.S.
        Securities and Exchange Commission, Division of Market Regulation, The October 1987 Market Break,
        February 1988.
        7Margin is the amount of money or collateral deposited by a custumer to insure against loss on an
        options contract.

        Page 19                                                GAO/GGD99-33 Clearance and Settlement

                        The Group of Thirty, a private sector group concernedwith the working
Th/eGroup of Thirty     of the international financial system, reported in March 1989 on clear-
Re#om.mended            ance and settlement systems in world securities markets.8The Group
Cl&rance and            observed that the operational characteristics of clearanceand settle-
                        ment systems in each country were uneven in quality. According to the
Settlement Changes      Group of Thirty, this uneven quality could inhibit international invest-
                        ment flows and, under adverse circumstances,present a serious risk to
                        the world’s financial network. The Group concluded that agreement
                        among national marketplaces on clearance and settlement standards and
                        practices was desirable. The Group of Thirty made various recommen-
                        dations designedto achieve the objectives of matching trades on the
                        first businessday after the trade date and settling stock trades by 3
                        businessdays after a trade is completed.

                        Our objectives were to (1) describe the clearance and settlement difficul-
Objectives, Scope,and   ties experienced during the stock market crash of 1987 and (2) report on
Methodology             efforts undertaken by the financial institutions and federal regulators to
                        reform clearance and settlement processes.
                        Becausethis report deals with problems raised during the October 1987
                        stock market crash, it is limited to clearance and settlement for stocks,
                        stock options, and stock index futures instruments.QClearanceand set-
                        tlement of these instruments is the responsibility of the NsCC,the occ,
                        and the CME Clearing House Division. Sincethe BOM=C     was only indirectly
                        involved in the events of the October 1987 market crash, it will be dis-
                        cussedonly in relation to information sharing among clearing
                        On the basis of our knowledge of clearanceand settlement, we identified
                        clearance and settlement problems that we judged to be the greatest
                        threat to the stock, options, and futures markets. We assessedthe merits
                        of, and progress made in implementing, the related recommendations
                        made by the Working Group and the Group of Thirty. This report
                        describesprogress made in eliminating the most critical clearance and
                        settlement problems that emergedduring the October 1987 market
                        crash. Major problems are discussedin the text. Our assessmentof prog-
                        ress on the implementation of all federal recommendations for clearance

                        ‘Group of Thirty, Clearance and Settlement Systems In the World’s Securities Markets, March 1989.

                        QSt.ockindex futures instruments are agreements to buy or sell the market value of stocks included in
                        a particular stock market index.

                        Page 20                                                 GAO/GGNJO-33 Clearance and Settlement
                   chapter 1

                   and settlement reform, including those that we feel are less important, is
                   contained in appendix I.
                   Our audit and evaluation work was done from May 1988 through Sep-
                   tember 1989. To examine clearance and settlement in these three mar-
                   kets, we reviewed federal, clearing organization, and exchange
                   documents, including reports and regulations. We also interviewed offi-
                   cials from clearing organizations, exchanges,banks, and federal agen-
                   cies; broker-dealers; options market makers; and futures commission
                   merchants concerning progress made on implementation of Working
                   Group recommendations.The work was done in Washington, DC., New
                   York City, Chicago,San Francisco, Kansas City, Minneapolis, and Phil;-
                   delphia using generally acceptedgovernment auditing standards. GAO
                   requested and received formal comments from the Department of the
                   Treasury, SEC,CFTC,NSCC, oCc,and CME. FRSdid not make formal com-
                   ments on the draft report.

                        occ, and CME provided comments relevant to the content of this
Comments and Our   NSCC,
                   Roth NSCC and occ questioned the regulatory authority and practices of
                   CFrc over futures clearing organizations. NSCC said that futures clearing
                   organizations are regulated indirectly through CFTCoversight over
                   futures exchanges.occ said that the Commodity ExchangeAct doesnot
                   empower the CFTCto regulate futures clearing organizations.
                   CETC  claims authority over futures clearing organizations. In Commodity
                   Exchange Act Regulation 1.41, which implements the CFTC’S      responsibil-
                   ity to review contract market rules, the CFTCdefines a contract market
                   to “includ(e) a clearing organization that clears trades for a contract
                   market.” (See 17 CFR 8 1.41(a)(3) (1989).)
                   At least one court has upheld the validity of CFTC’S definition of contract
                   market as inclusive of clearing organizations.10The court observed that
                   in designating a contract market under the Commodity Exchange Act,
                   the CFTChas a broad statutory mandate to protect the public interest by
                   assuring the financial integrity of the contract. The court found that the
                   cnc could reasonably conclude that transactions in a contract that was
                   not securedby a clearing system would be contrary to the public interest

                   “Board of Trade Clearing Corporation v. United States, [1977-1980 Transfer Eider) Comm. Fut. L.
                   ReA8-1263                                                   (D.C. Cir. 1979).

                   Page 21                                              GAO/GGDSO-33 Clearance and Settlement
chapter 1

and ineligible for designation as a contract market. As a result, the court
ruled that the CFTC’S assertion of authority over clearing organizations
falls within the range of authority delegatedto it by Congress.
CFTC,in practice, does overseefutures clearing organizations. It reviews
clearing organization rule submissions.It also does audit and financial
rule enforcement reviews, including examination of clearing organiza-
tion risk-management programs.
CMEquestioned the report’s    lack of discussionof the events of October
13,1989. Although we agreethat the October 13,1989, decline did test,
to a limited extent, the changesmade in clearanceand settlement sys-
tems, the size of the decline did not approach that of October 19,1987.
CMEquestioned our methodology and said the   report has no qualitative
standards for comparing clearance and settlement acrossindustry seg-
ments and has not adequately quantified the problem or evidence.

This report was never intended to compare the clearanceand settlement
systems in the different markets except to note major differences
between clearance in settlement systems in stock, options, and futures
markets. Our conclusionsare basedupon judgments about federal
agency and clearing organization progress in responseto Working Group
recommendations.Such progress is not quantitative beyond indicating
that a particular Working Group recommendation has been completed,
that there has been someprogress in implementing the recommendation,
or that no progress has been made. Appendix I summarizesthe federal
agency and clearing organization actions in responseto Working Group
recommendations and our judgments as to the progress achieved.

Page 22                                  GAO/GGlMO-33 Cleamuce aud Settlement

Chapter 2

Trade Prwessing SystemsAre Being Improved

                    Sincethe crash, clearing organizations that experienced trade processing
                    delays identified the causesof their problems and have solved, or are in
                    the processof solving, those problems. The stock exchanges,NASD, and
                    NSCC are implementing systems to speedup the reconciliation processfor
                    unmatched trades and to acceleratetrade comparison time frames. The
                    occ has replaced its primary price information dissemination vendor
                    and enhancedits own price collection system.
                    On an average businessday, market participants buy and sell millions of
Effidient Trade     individual stocks, options, and futures instruments on the Nation’s
Pro&sing Systems    stock, options, and futures markets. The parties do not immediately
Are Crucial to      exchangecash for the instruments. Instead, they record the terms of the
                    trade and transfer the funds later. Payment for futures and options
Finahcial Markets   transactions must be made the next businessday after the trade. Pay-
                    ments for stock transactions normally occur 6 businessdays after the
                    trade date.
                    After the execution of a trade in one of the markets, either the exchange
                    or the participants in a trade, submit the details of the trade directly to
                    the clearing organization or indirectly through a clearing member for
                    processing.Clearing organizations, or their affiliated exchanges,match
                    key elements of each trade to ensure that buyers and sellers each have
                    accurate data and agreeto the terms of their trades. Typical elements of
                    a trade that are matched include the identities of the buyer and seller,
                    the number of shares or contracts, the price, and other information
                    about the trade, Without efficient trade matching systems, market par-
                    ticipants might experience delays in finalizing their trades. Delays can
                    expose market participants to unnecessaryfinancial risks becauseof the
                    uncertainty surrounding their trades. Clearing members who clear for
                    other market participants often guarantee that a customer trade will be
                    filled at the price at which the trade was originally supposedto be exe-
                    cuted, The clearing member is obligated to resolve unmatched trade
                    Clearing organizations are responsible for transferring funds and finan-
                    cial instruments among participants. These organizations have proce-
                    dures to ensure that buyers and sellers meet their financial obligations.
                    Clearing organizations also act as central processor,since all trades at
                    exchangesmust be reported to the organization for clearance and settle-
                    ment. Payments and transfer of financial instruments should be made
                    on time becausedelays can causeconcern about the financial soundness
                    of market participants.

                    Page 23                                 GAO/GGD-99-33 Clearance and Settlement
Chapter 2
Trade Proceesiug Systems he
JMng Improved

Clearing organizations and exchangesoperate a variety of automated
and manual accounting and data processingsystems.Although the spe-
cific clearance and settlement processesthat organizations use vary, our
review of clearing organization rules and procedures showed that each
clearing organization or its exchangemust be able to
set trade reporting requirements so that trade data are uniform and eas-
ily processedwithin established time frames;
establish trade matching systems capable of accurately matching trades
within specified time frames;
develop and maintain systems that quickly reconcile inaccurate trade
conduct financial surveillance of clearing members in order to monitor
their financial condition and therefore protect the financial stability of
the clearing organization;
establish payment and collection procedures so that clearing members
are able to meet their financial obligations within established time
establish accounting systems that keep accurate track of market partici-
pant obligations, payments, and receipts; and
develop and maintain lines of communication among market partici-
pants so that settlement payment and collection information moves
Efficient trade processingis necessaryto (1) calculate payments and
collections, (2) ensure the timely and orderly flow of settlement funds,
and (3) maintain market integrity. During the crash, clearance and set-
tlement systems in stock and options markets experienced various oper-
ational problems. Becauseof the extraordinary trading volume and
market volatility, trade processingsystems becamebacklogged and were
not able to processtrade data on time.
The Brady Report said that uncertainty among somemarket partici-
pants resulted from these problems and that somemarket participants
questioned the integrity of the markets. CIVCofficials told us that
although there were somereports of uncertainty, market participants in
general did not lose confidence in the clearanceand settlement systems
of the three markets.
Clearing organizations and exchangesrecognizethe important role that
their systems play in the markets, and they have improved or are in the
processof improving their trade processingsystems.

Page 24                                 GAO/GGD90-33 Clearance and Settlement

                      Clearing members and stock exchangeshad trade processingproblems
The toek Markets      during the crash but are in the processof improving their systems.
Ex rienced Problems   Becauseof the high number of transactions, somefirms reportedly had
in Tt eir Trade       problems entering all their data in a timely fashion. Also, according to
                      the February 1988 SECreport, the normal rates of unmatched trades for
ProcessingSystems     the NYSE,AMEX, and over-the-counter markets.(WC) are 1.6 percent, 2.4
                      percent, and 6.7 percent, respectively. However, on October 19, during
                      the market crash, the NYSErates more than doubled to 3.4 percent, and
                      AMEX and OTCrates more than doubled to 5.6 percent and 12.8 percent,
                      respectively. The trade processingproblems exposedmarket partici-
                      pants to a heightened degreeof financial risk since they could not be
                      assuredthat their trades were final at the price at which they were orig-
                      inally executed.
                      According to the February 1988 SECreport, the securities trade process-
                      ing industry could not processthe large volume of trades within estab-
                      lished time frames. During the crash clearing member trade entry
                      systems were unable to quickly report the greater volume of trades,
                      resulting in a much greater number of unmatched trades.
                      Also, stock exchangesrelied on a paper- and labor-intensive set of proce-
                      dures to reconcile unmatched trades, a complicated and time-consuming
                      process.The stock exchangesand stock clearing memberswere able to
                      reconcile most of these unmatched trades. However, they had to modify
                      their working hours to complete reconciliation. NYSEmembersresolved
                      over 140,000unmatched trades during the week of October 19,1987. It
                      becameapparent to federal regulators and 9~0s during this period that
                      the trade entry and trade reconciliation systems for resolving
                      unmatched trades neededimprovement. Sincethe market crash, the
                      stock exchangesand NSCChave taken steps to improve their trade
                      matching and reconciliation processesprimarily by eliminating the
                      paper- and labor-intensive procedures and shortening the reconciliation
                      time frame.

                      The exchanges,NASD,and NSCC are working to develop next-day trade
Stock Trade           comparison systems that should becomeoperational during 1990. They
ProcessingSystems     are working towards next-day trade comparison through their efforts to
Are Being Improved    (1) automate or otherwise improve trade reconciliation systems and (2)
                      acceleratetrade comparison time frames. When completed these efforts
            Y         would satisfy the Group of Thirty recommendation that equities move
                      to overnight comparison. These efforts will not satisfy the Working
                      Group recommendation of same-daycomparison.

                      Page 28                                GAO/GGD-90-33 Clearance and Settlement
Chapter 2
Trade Procees~   Systems Are
Being Improved

Automated trade reconciliation systems are currently operational at the
NYSE and NASD;however, although AMEXhas developed an automated
trade comparison system, AMEXstill relies on manual trade reconciliation
systems. The time frames for trade comparison have been acceleratedto
provide next-day trade comparison for those trades that match on origi-
nal comparison.
Each of the trading marketplaces-NYSE,AMEX,and NAsD-have made
different levels of progress in improving their trade comparison sys-
tems. In addition, NSCC has redesignedits recomparison system. The NYSE
has developed the overnight comparison system. This comparison sys-
tem was developed to automate trade reconciliation in NYSE-listed  equity
securities. At the time of the October 1987 market crash, trade reconcili-
ation in NYSE-listed securities was performed manually. The system lists
unmatched trade data on terminal screensat the beginning of the day
after the trade. During this day and the following day, members use this
system to reconcile these unmatched trades. At the end of each day, the
system transmits all compared trade data to the NSCC   for further
processing.This system began phased operation in April 1989 and is
now fully operational. The exchangeplans to compressthe reconcilia-
tion processto 1 day but has not yet set a date for the change over.

NSCC  has redesignedits comparison system. This system is operational
and provides for next-day trade comparison for trades in NYSE-listed
stock. Members are required to submit their trade comparison data to
the NsCC11 hours earlier than previously required. In turn, the NSCC
reports on the results of the comparison of this trade data 26 hours ear-
lier than before. When NSCC  made formal comments on a draft of this
report, in an attachment to its letter, it provided a more detailed descrip-
tion of the status of changesto its trade processingsystem, NSCC’S   com-
ments and attachment are contained in appendix V of this report.
AMEXhas developed an automated comparison system that is similar to
the NYSE’S system. The first phase is completed and will help automate
the trade reconciliation process.Similarly, AMEXefforts to acceleratethe
time frames to provide for next-day trade comparison are in the devel-
opmental phase and they are supposedto be coordinated with NYSE
efforts, It is unclear when AMEX’Snext day trade comparison process
will be fully operational.
The NASDsystems for unmatched trade reconciliation are already highly
automated. The NASDhad an automated system called the Trade Accep-
tance and Reconciliation Service (TARS)at the time of the October 1987

Page 26                                  GAO/GGD90-33 Clearance and settlement
                      Chapter 2
                      Trade Processing Syetemar Are
                      Belng Improved

                      market crash. TARSallowed membersto view unmatched trade data on
                      terminals and to enter corrections at once.During the market crash, it
                      helped members to quickly reduce a large number of unmatched trades.
                      At the time of the market crash, participation in TARSwas voluntary;
                      after the crash the NASDmade participation in TARSmandatory.
                      The NASDhas developed a new trading system called the Automated
                      Confirmation Transaction (ACT) system which, among other things, per-
                      forms trade comparison near the time of the trade and transmit “locked-
                      in” trade data to the NSCC. The market making member has 90 secondsto
                      forward the details of a particular trade to the NASD'SACTsystem. The
                      other member involved in that trade has 6 and l/2 minutes to view the
                      trade on his or her terminal and accept or decline the trade as reported.
                      The ACT system performs on-line trade comparison and later transmits
                      the locked-in trade data to the NSCC. The SEC recently granted approval
                      to the NASDto begin the phased implementation of the ACTsystem.

                      During the week of the crash, occ experienced settlement processing
Options Information   problems after it obtained inaccurate option price information from its
ProcessingSystems     vendors. The occ contracts with securities information dissemination
Are Being Improved    vendors to provide it with daily stock option price information. Daily
                      price information is essential to o&s operation becauseocc usesthe
                      data to calculate margins and to determine the value of securities held
                      as margin. Without accurate option pricing data, EC cannot accurately
                      assessand manageits financial risk. On the evenings of October 19, 20,
                      and 2 1, occ had to manually correct over 6,000 option reports it
                      received from its vendors becausethe option prices reported by its ven-
                      dors were inaccurate. Despite these problems, occ distributed reports
                      within established time frames.
                      According to the SECmarket crash report, during the crash, CKXvendor
                      automated price reporting systems dropped the first digit from three-
                      digit option prices so that options prices reported to occ that had a
                      three-digit price were inaccurate. For example, if a particular stock
                      option sold for $152 per share, CMX’S  vendors reported the sale price at
                      $62 per share rather than $162 per share. The OCC,therefore, had to
                      manually correct each three-digit option price to determine the correct
                      price. To resolve the problem, occ replaced the primary price informa-
                      tion vendor that it had at the time of the crash with a new vendor. In
                      addition, CMXenhancedits own option price calculation system so that it
                      would not be totally dependent on vendors for option price information.

                      Page 27                                 GAO/GGD-90-23 Clearance and Settlement
                   Chapter 2
                   Trade Prockwlng SystRma Are
                   Being improved

                   Progresshas been made by exchangesand clearing organizations in
                   resolving the problems with trade processingsystems and procedures.
                   These problems were intramarket in nature and, therefore, were easier
                   to resolve. The solutions only required the efforts of federal regulators
                   and SROS in individual markets. Becauseof these improvements, trade
                   processingsystems appear less vulnerable to processingdelays today
                   than they were during the October 1987 market crash even though the
                   Working Group recommendation on same-daycomparison has not been
                   achieved in the stock market. These efforts should facilitate attempts to
                   shorten the stock settlement cycle as recommendedby the Group of

Cbmments and Our   market participants and our statements about market participants ques-
Ebaluation         tioning the integrity of the markets. SECsaid that while somemarket
                   participants may have had someuncertainty as to the timing of clearing
                   organization trade processing,the integrity of the markets was never
                   questioned in the securities and options area.
                   We have altered the report to acknowledge that there is a disagreement
                   between the Brady Report and SECand CFTCperceptions concerning
                   whether or not market participants were uncertain about the perform-
                   ance of clearance and settlement systems and, as a result, questioned
                   market integrity. The Brady Report says that “while no default
                   occurred, the possibility that a clearing house or major investment bank-
                   ing firm might default, or that the banking system would deny required
                   liquidity to the market participants, resulted in certain market makers
                   curtailing their activities and increased investor uncertainty.” (p. v) The
                   SECand CFTCreports do not develop an uncertainty theme or mention
                   market participants questioning market integrity.

                   Page 28                                  GAO/GGD-90-33 Clearance and Settlement
Chapter 3

        Made in ChangingClearing
Or$adsation Risk-ManagementSystemsHas
                           Clearing organizations use a variety of risk-management tools to ensure
                           that clearing members meet their financial obligations and that the
                           clearing organization is protected in the event of a clearing member
                           default. Although most of these worked during the crash, somerisk-
                           managementtools proved inadequate and causedthe following to occur:
                       l clearing member net capital was sometimesinsufficient to cover
                       . clearing organization guarantee funds may not have been adequate to
                         protect the clearing organizations in the caseof a major default by one
                         or more clearing members, and
                       . clearing organizations were unable to quickly and routinely determine
                         the financial exposure that their clearing membershad in other markets.
                           Since the crash, progress has been made to increase capital requirements
                           for clearing members and improve the liquidity of someguarantee
                           funds. However, an inter-market financial information system that
                           includes participation by stock, options, and futures clearing organiza-
                           tions doesnot exist. An information sharing system that includes all
                           markets would help clearing organizations (1) anticipate problems their
                           clearing members might have in making payments and (2) further pro-
                           tect their members.

                           Although margin requirements provide the basic level of liquidity pro-
Capital Requirements       tection for clearing members, capital requirements and guarantee funds
Held Ensure Clearing       also provide assuranceagainst the risk of failure of a clearing member.
Member Liquidity           Clearing organizations establish minimum net capital requirements for
                           clearing members.The minimum capital requirements are designedto
     I                     ensure that clearing members are able to withstand losses,thereby pro-
                           viding a layer of protection to the clearing organization. Clearing organi-
                           zations’ capital requirements should assurethat all clearing members
                           have enough readily available assetsto meet their obligations in a timely
                           manner do so without falling below the minimum capital requirement.
                           The CFTCand SECalso set capital requirements for broker-dealers,
                           options market makers, and futures commission merchants.l Clearing
                           organization capital requirements are generally higher than those set by
                           the CFWand SEC.

                           ‘See 17 CFR $1.17 (1989) for CFTC capital requirements and 17 CFR B 240.15c3-l(1989) for SEC
                           capital requirements.

                           Page 29                                             GAO/GGD-90-33 Clearance and Settlement
                            Chapter 3
                            Progress Made ln Changing Clearing
                            Organization Risk-Management Systems Haa -’
                            Been Slow

                            During the October 1987 market crash, somemarket participants,
Lihuidity and Capital       including clearing members,had too few funds to (1) meet their obliga-
Pioblems Occurred           tions from lossesin the market and/or (2) aid someof their customers in
D(iring the Crash           honoring their payment obligations. The result was that these clearing
                            members had to borrow money from banks or obtain it from other
                            sources.Although clearing membersroutinely borrow from banks for
                            this purpose on a daily basis, the amounts they neededduring the crash
                            were much higher than usual. In order to meet their payment obligations
                            or comply with their clearing organization capital requirements, market
                            participants and clearing memberstook one or more of the following
  /                     .   received a cash infusion from their parent firm,
                        .   had their operations and financial obligations taken over by another
                        .   liquidated someor all of their market positions to obtain cash and
                            reduce liabilities,
                        .   liquidated other assetsto obtain funds, or
                        .   obtained additional bank credit.
                            For example, WC officials said nearly 36 percent or 61 of CEC’S  members
                            received capital infusions from their parent companiesor partners sub-
                            sequent to the October 1987 market crash. In another case,a clearing
                            member was liquidated by the Securities Investor Protection Corpora-
                            tion when its parent company did not provide additional capital. Sev-
                            eral stock market participants, including at least one clearing member,
                            also received capital infusions from parent companiesor were taken
                            over by the parent company. According to CME officials, someof their
                            clearing member firms becametemporarily undersegregated. This was
                            becauseof the large deficits in the accountsof somecustomers,which
                            resulted from the sudden adverse market moves against the customers’
                            positions. The firms cleared up thelundersegregatedconditions by col-
                            lecting margins from customers and infusing funds from other sources
                            into the segregatedaccountsthe following day. Further, it is noteworthy
                            that, while most firms generally maintain between 10 to 20 percent
                            excessfunds in segregationto buffer against volatile markets, during

                            “The Security Investor Protection Corporation was created by Congress in 1970 to protect customer
                            deposits and security holdings against broker-dealer insolvency.

                            “The Commodity Exchange Act requires that a futures commission merchant must segregate any
                            funds received from a customer from the merchant’s own funds. All funds received by a futures
                            commission merchant to margin, guarantee, or secure the trades or contracts of ita commodity cus-
                            tomers, as well as funds accruing to those customers as a result of those trades or contracts, must be
                            separately accounted for and segregated as belonging to those customers.

                            Page 30                                                  GAO/GGD-90-33 Clearance and Settlement
                         Chapter 8
                         From    Made ln Changing Clearing
                         man        l&k-Management Syatema Has

                         this particular market, such amounts were insufficient. Therefore, since
                         the undersegregation was cleared up quickly and was solely due to the
                         unusually adverse market conditions, the CFTCdid not impose penalties.

                         The SIX crash report stated that many stock trading firms that clear
                         their own trades had no established lines of bank credit to increase the
                         funds available to them during periods of market volatility. To help
                         solve the cash liquidity problem that someof these firms experienced
                         during the crash, the SECsuggestedthat exchangesconsider one or more
                         of the following:
                         establish lines of bank credit;
                         apply higher per share capital requirements for firms that are unable to
                         establish lines of credit at banks;
                         require firms unable to obtain lines of credit to clear their transactions
                         through a clearing member with established lines of credit; and
                         establish a fund to finance these membersin emergencysituations.
                         To help solve liquidity problems during the crash, CFTCrecommended
                     .   the settlement agreementsbetween clearing organizations and settle-
                         ment banks should be clarified to establish that settlement bank confir-
                         mations, once communicated to the clearing organization, are final;
                         a procedure be developed for adjustment of Fedwire hours in market
                         emergenciesor periods of extreme volatility;
                         settlement banks should have increased accessto financial data that
                         would assist their evaluation of clearing member creditworthiness;
                         intraday margin calls should be used on a daily basis by all clearing
                         organizations as well as distribution of payments of excessmargin to
                         clearing members; and
                     .   a risk exposure information system be established.

                         An NSCCofficial said that increasing a member’s capital requirement,
NSCCHas Maintained       except to significantly higher levels that would restrict accessto NSCC
Current Capital          membership, would not protect NSCCagainst risk of financial loss. NSCC
Requirements             prefers to rely on the guarantee fund in which members are required to
                         deposit to collateralize their risk. Also, according to NSCCofficials,
                         increasing a member’s capital requirement would limit participation in
           v)            NSCCsince fewer members would be able to qualify. Sincethe market
                         break, NSCChas maintained its member capital requirement that its

                         Page 31                                  GAO/GGD90-33 Clearance and Settlement
                        Progress Made ln Changing Clearing
                        Orgfudzation lUskManagement Systems Haa
                        Been Slow

                        membersmaintain $50,000 in capital in excessof whatever the mem-
                        ber’s capital requirement is as established by the SECand the member’s
                        designated examining authority.
                        An SEC official said that increasing capital requirements of clearing
                        memberscreates burdens for smaller clearing members.He also said
                        that increasing capitalization will not solve the liquidity problem of
                        assetsnot being liquid enough to be readily accessible.

                        The SEC,in May 1989, approved an occ rule that increasesnew clearing
0(X Has Increased Its   members’ membership requirements for net capital from $150,000 to
C&pita1Requirements     $1,OOO,OOO. In addition, the amount of capital new and current clearing
                        membersmust maintain after membership is granted was raised from
                        $100,000 to $750,000.

                        According to a CMEofficial, since the crash, CMEincreasedthe minimum
CME Has Increased Its   capital requirement for its clearing members from $1 million to $1.6 mil-
Cbpital Requirements    lion per member in 1987 becauseof the volatility of contracts and the
                        CME'Sconcern over financial safeguards.

                        Most futures, options, and stock clearing organizations have established
Guarantee Funds Help    guarantee funds to pay off the debts to the clearing organization of
Provide Market          clearing membersthat default on their payment obligations4 A default
Integrity               occurs when a member fails to pay for receipt of securities or lossesit
                        incurred in the marketplace. By guaranteeing buyer and seller perform-
                        ance on contract provisions, clearing organizations becomeobligated to
                        make these payments in the event of member insolvency. Clearing orga-
                        nizations require that all their members contribute to the fund and spec-
                        ify the amount and type of contribution. The contribution is subject to
                        partial or total loss in the event the member or another member defaults
                        on its payments.
                        The Working Group recognizedthe importance of guarantee funds being
                        in the form of cash and/or instruments easily convertible to cash. They
                        want clearing organizations to be able to quickly pay off a defaulting
                        member’s clearing organization in the event of a default. Most funds

                        4The guarantee fund is called the “security deposit” by the CME and the “clearing fund” by the OCC
                        and NSCC.

                        Page 32                                               GAO/GGD-90-33 Clearance and Settlement
                         Chapter 8
                         Progress Made in ChangLng Cleiu.ing
                         m:n         IbkManagement      Syeteme Haa

                         consist of somecombination of cash, U.S. Treasury securities, and bank
                         letters of credit.
                         Each clearing organization has its own method of determining the
                         amount members contribute to the fund, developed in consultation with
                         federal regulators. The contributions are basedon the level of financial
                         risk the clearing organization is willing to accept. These organizations
                         base contributions on the volume and the nature of businessthat their
                         members conduct.

                         The market crash raised concern among federal regulators that some
Cleating Organizations   clearing members’ guarantee fund contributions may not have been suf-
Rev&wed Their            ficient to meet their payment obligations, and that someclearing organi-
Guatantee Fkmds          zations might not have been able to quickly pay for losseshad one or
                         more major clearing members defaulted. The Working Group recognized
                         the potential for problems and recommendedthat the stock, options, and
                         futures clearing organizations review the adequacy of their guarantee
                         funds and assessthe adequacy of the guarantee fund contribution of
                         each clearing member. The Working Group also recommendedthat fed-
                         eral regulators encourageclearing organizations to assessthe liquidity
                         of the guarantee fund and, if appropriate, require that guarantee funds
                         be in the form of cash or cash equivalent.

                         Stock clearing organizations had major portions of their guarantee funds
                         in letters of credit. Letters of credit are consideredless liquid than cash
                         or cash equivalents becausebanks that issue letters of credit may
                         choosenot to honor them. However, failure to honor a letter of credit is
                         a serious matter and can have adverse consequenceson a bank’s reputa-
                         tion and credit. The SECreported that in October 1988, five securities
                         clearing organizations, including depositories, had an estimated $1.08
                         billion in aggregateclearing fund deposits that consisted of $500 million
                         in U.S. Government Securities, $212 million in cash, and $296 million in
                         letters of credit.
                         All the major clearing organizations reviewed the adequacy of their
                         guarantee funds. The following briefly summarizesthe results of their
                         reviews and actions taken:
                     .   Prior to the 1987 market crash, the NSCC proposed to changethe way it
                         calculates member contributions to the guarantee fund to reflect more

                         Page 33                                      GAO/GGD-SO-33 Clearance and Settlement
                             chaptem 3
                             Progress Made ln Changing Clearing
                             non         Ri&Management Systema Haa

                              closely the risks the member has assumedin the market. The SEC tempo-
                              rarily approved the new method until December1990. The new calcula-
                             tion method is more risk-based but may decreasethe amount of funds
                              available in NSCC'Sfund. The NSCCcontinues to rely on the use of letters
                             of credit in its guarantee fund. NSCCofficials said that they have never
                             had to draw upon a letter of credit in the 11 years of their existence.
                             Only 74 of their 410 members use letters of credit. SECofficials said that
                             given the vital role that NSCCplays in securities markets and the conse-
                             quencesof its failure, caution would dictate less reliance on letters of
                         .   SECand NSCCcomment letters indicate that two recent changeshave been
                             initiated to increasethe liquidity of NSCC'Sguarantee fund. On October
                             25,1989, NSCCfiled a proposed rule changewith SECto increase the mini-
                             mum cash contribution for those memberswho use letters of credit and
                             to limit the percentageof a member’s deposit that may be collateralized
                             with letters of credit. Also, on December7, 1989, NSCCaccepteda com-
                             mitted line of credit at $200 million.
                             The occ raised its minimum guarantee fund contribution for stock
                             option members from a minimum of $10,000 to $76,000 per member.
                             The CME,in February 1988, adopted rules that resulted in CME increasing
                             its guarantee fund from $4.6 million to about $36 million, eliminated the
                             use of letters of credit in its fund, and changedthe method it usesto
                             calculate each member’s contribution from a flat rate to a rate basedon
                             the member’s average daily margin requirement.

                             Clearing organizations in the stock, options, and futures markets have
Clearing Organizations       no single system to routinely monitor the financial exposure of clearing
C&not Routinely              membersthat do intermarket business.The clearing organizations,
Monitor the Financial        therefore, may not be able to completely monitor risk becausethey have
                             only a partial view of their clearing members’ overall financial
Exposure That                condition.
Clbaring Members
H&wein All Other             As part of their risk-management activities, clearing organizations daily
                             assessthe financial risks that each clearing member has in its market.
Markets                      The typical risk-assessmentthat clearing organizations make includes,
                             but is not limited to, a determination of the following:
                             the capital the clearing member has available,
                             the money the clearing member needsto fulfill its market obligation, and
                             the money the clearing member would need in the event of a market

                             Page 34                                 GAO/GGD-90-33 Clearance and Settlement
                       Chapter 8
                       Roereae Made ln (3mglng Clearing
                       @p&on      Rbk-Maumgement Systems Hae

                       Each organization has the procedures and systems in place to make
                       these daily risk-assessmentswithin its own market. However, about 30
                       clearing members operate in the three markets and may buy and sell
                       stocks, options, and futures all in the sameday. These activities may or
                       may not involve both intermarket and single-market trading strategies.
                       During the crash, someclearing organizations frequently communicated
                       with other market clearing organizations and exchangeaudit depart-
                       ments, but there was no established system in place to do this routinely.
                       As a result, one clearing organization could not quickly identify a spe-
                       cific clearing members’ financial problems and made managementdeci-
                       sions on the basis of inaccurate or incomplete information.
                       The SECreported that on October 21,1987, the occ was notified by one
                       of its clearing member’s settlement banks that the bank would not honor
                       a $3.I. million margin payment request for the firma6The WC analyzed
                       the risks associatedwith the clearing member’s position and decided to
                       relieve the clearing member of its margin payment, primarily because
                       CCCwas holding $12.6 million in collateral from that clearing member.
                       However, according to the report, occ later learned that the clearing
                       member also was having difficulty financing a $30 million settlement
                       obligation at NSCC.To protect itself, occ placed somerestrictions on the
                       clearing member, including daily capital computations and reporting
                       requirements, capital restrictions, and a prohibition against opening new

                       As of August 1989, NSCC doesnot use the futures intermarket informa-
NSCCDoes Not           tion sharing system. This system is a potential mechanism that clearing
Participate in the     organizations could use to help reduce intermarket risks. The BCVCC
Futdres Intermarket    administers a futures clearance and settlement intermarket information
                       sharing system. The system compiles payment and collection data on
Infoi-mation Sharing   common clearing membersthat do businessthrough two or more of the
Systbm                 Nation’s futures clearing organizations. Each night, these organizations
                       provide settlement information to the sorcc for each of their joint clear-
                       ing members. The next morning, futures clearing organizations can
                       accessthe system to obtain this information. The system enablesclear-
                       ing organizations to monitor their clearing firms’ activities and helps
                       assessthe financial risks that their members have in their own and in
                       other futures markets.

                       “Settlement banks in the options and futures markets make payment between clearing organizations
                       and clearing members.

                       Page 36                                               GAO/GGD-W-33 Clearance and Settlement
Or&nb&m      i&k-Management   Syatema HM

The occ signed a May 6,1988, agreementto join the information sharing
system managedby BUICC.However, as of September 1989, the occ had
not participated in the system becauseof concernsabout how the sys-
tem operates. occ officials expressedconcern that confidential data pro-
vided might be used for competitive purposes. For example, occ said
that the administrator of the system has first accessto the data and
may be able to receive margin payments from a common member that is
facing financial difficulties before other clearing organizations. Because
of these and other concerns,occ suggestedthat a neutral organization
should operate the information system. CFTCofficials told us that the
BUN%information sharing system operates with a confidentiality agree-
ment that guards against the misuse of data. They said that they told
occ that its cross-margining program would not receive regulatory
approval without occ’s participation in the intermarket information
sharing system, In October 1989, the occ joined this intermarket infor-
mation system.

As of September 1989, stock clearing data from NSCCis not shared with
other clearing organizations through the system managedby BcTr’CC.
EKJKC officials said that the system is technologically capable of accom-
modating data on stock clearing members. Becausestocks settle in 5
days rather than in 1 day aa do futures and options, somerefinements to
the system need to be incorporated before it can processstock data.
NSCChas not   decided whether data on stock clearing members should be
included in the system. In addition, NSCCrules do not provide for the
sharing of confidential data with futuresclearing organizations.
NSCCdoesnot routinely share’stock clearing information with futures
clearing organizations, although NSCCofficials said that they support the
concept of intermarket information sharing. NSCCofficials expressed
concernsabout information sharing arrangements, becauseof the differ-
ent settlement time frames in the futures and stock markets. NSCCsaid
that an arrangement to advise each other about a dual member not mak-
ing a payment may be more useful than the exchangeof settlement data.
NSCCalso said that it has more common clearing members with WCthan
with futures clearing organizations and, therefore, has primarily
focused on options market information sharing.

Page 36                                    GAO/GGD90-33 Clearance and Settlement
             According to SEC,the stock and options clearing organizations created
             the Securities Clearing Group (SCG)in 1988 in an effort to establish a
             formal information sharing systema The SCGhas formalized by contract
             existing information sharing arrangements among stock clearing organi-
             zations, including settlement, margin, and position information. The SCG
             plans to explore various improvements as follows:
             development of a central databasethat would maintain financial data on
             clearing members;
             improvement of SECfinancial report requirements to strengthen clearing
             agency surveillance;
             development of arrangements that would permit the application of a
             defaulting member’s margin, settlement credits, and guarantee fund con-
             tribution to meet outstanding obligations at other stock clearing
             development of a system to net clearing members’ separate settlement
             debits and credits acrossstock clearing organizations; and
             development of routine settlement information sharing among SCGmem-
             bers and futures clearing organizations.

             NSCC'Scomment letter notes that the SCGis currently creating the data
             base and doing work on several other of the above items. Although no
             specific time frame has been specified for completing the above tasks,
             these improvements, if implemented, should improve information shar-
             ing among stock and options clearing organizations.

             Although federal regulators and SROS have made progress in implement-
Condusions   ing intramarket or market-specific recommendations,they need to
             strengthen the stock, options, and futures clearanceand settlement sys-
             tem by further reducing or mitigating known risks.
             During the past 22 months, federal regulators and SROS have not imple-
             mented someof the inter-market recommendationsthat seek to resolve
             problems causedby the linked nature of markets and intermarket trad-
             ing strategies. Whereasintramarket recommendationscan be imple-
             mented by individual federal regulators, intermarket recommendations

             ‘The SC%includes OCC, NSCC, Depository Trust Company, Midwest Clearing Corporation, Midwest
             Securities Trust Company, Stock Clearing Corporation of Philadelphia, and the Philadelphia Deposi-
             tory Trust Company.

             P8ge 37                                               GAO/GGD-30-33 Clearance and Settlement
                       chapter 3
                       Progress Made ln Clmnglng Clearing
                       Organhtion Bisk-Management Syeteme Iian
                       Been Slow

                       require a coordinated effort among the various affected parties. Differ-
                       ent traditions in each market and differences of opinion on the merits of
                       particular solutions are impeding change.
                       A major intermarket problem that still exists is the lack of an informa-
                       tion sharing system. Clearing organizations in the three markets con-
                       tinue to assumeunnecessaryrisk becausethere is not an inter-market
                       information sharing system to evaluate intermarket risks when clearing
                       membersparticipate in multiple markets.

                       We recommendthat SECand CFE reassessthe adequacy of clearing
Rkommendations         organization use of letters of credit in their guarantee funds.

                       We also recommendthat the Secretary of the Treasury, as Chairman of
                       the Working Group, ensure that a routine inter-market information shar-
                       ing system is developed and used to assessthe intermarket risks posed
                       by joint members. The Secretary, working with other membersof the
                       Group as well as the exchangesand their clearing organizations, should
                       identify responsibilities, assigntasks, and set time frames for accom-
                       plishing this recommendation.

                       SECsaid that we should consider NSCC’S concernson information sharing
Comments and Our       more carefully. These concernsare:
                   l B(JTCC accessto confidential information about clearing members,
                   l the possibility that futures clearing organizations may misinterpret pay/
                     collect data and take inappropriate action on the basis of that
                   l the differences in settlement time frames between        and derivative

                   . the limited number of        participants that are also membersof futures

                     clearing organizations, and
                   . other information that is more useful to clearing organizations than the
                     size of pay/collect obligations.
                       occ said the report does not define the arrangements that constitute
                       competitively neutral and efficient information sharing and that the
                       ~crrccsystem has serious drawbacks. occ is concernedthat since BmCC is
                       the system operator, the other clearing organizations are less than equal
                       partners. occ implies that norcc may be able to take advantage of the

                       Page 38                                   GAO/GGD90-33 Clearance and Settlement
chapter 23
Progreeo M8de ln Ckanglng Clearing
zon         Rh3k-Management Syetenu Ha9

information flow to protect itself relative to other clearing
We only use the BCYIWinformation sharing system as an example of a
way to implement the Working Group recommendation for centralized
collection and availability of clearing member’s risk-exposure informa-
tion. We agree that such a system should not provide an advantage to
one or more of its participants. A risk-exposure information sharing sys-
tem for joint clearing membersshould be jointly designed,operated, and
controlled by clearing organizations in the three markets and could
prove valuable in mitigating risks. Each participating clearing organiza-
tion should have equal accessto confidential information about joint
clearing members.

A confidentiality agreementis currently in effect between futures and
options clearing organizations. NSCCcould sign this agreement.This con-
fidentiality agreement could be monitored and enforced by the clearing
organizations participating in the system. Becauseinformation useful to
a clearing organization in one market may not be useful to a clearing
organization in another market, the kinds of data displayed in the sys-
tem could be agreed upon in advanceby all clearing organizations. So
that data are not misinterpreted and inappropriate actions are not
taken, an understanding could be developed on how to interpret data,
including the implications of different settlement time frames, and
actions appropriate to certain types of data. NSCCparticipants who are
not joint clearing memberswould not be in such a system.

Page 39                                   GAO/GGDQQ-33 Clearance and Settlement
Chapter 4

@reditand Late Payment Problemsin the Stick,
 / ions, and F’uturesMarkets Have Not Been
wy Resolved
                       Prompt payment or settlement is a cornerstone of efficient clearance
                       and settlement systems. The Brady Report stated that during the crash,
                       late payments to and from clearing organizations led to a loss of confi-
                       denceby somemarket participants and speculation that someclearing
                       membersor clearing organizations could not meet their financial obliga-
                       tions. Two principal problems that led to late payments have not been
                       fully resolved. First, the adequacy of available clearing member credit
                       facilities in supporting payments is unclear. Second,someproposals to
                       reduce cash demands on clearing memberswith intermarket positions
                       have not been studied or fully implemented.

*@editand Late         During the market crash, payments among market participants were
                       much higher than usual. On October 19,1987, CMErequested over $2.5
Payment Problems       billion in payments from its members.The next day, CMErequested an
Dvring the Crash       additional $900 million from its members.For trade date October 19, occ
                       drafted $1.18 billion. For trade date October 20, occ drafted $938 mil-
                       lion from its members.Margin payments at CMEon an average day are
                       $100 million. o&s average daily margin payments are $470 million.
                       During the week of October 26, clearing corporations processedover
                       $100 billion in deliveries. Somemarket participants did not have suffi-
                       cient capital or accessto bank credit to make their payments on time.
                       The unusually large fund transfers among somemarket participants
                       resulted in the use of all their available bank credit. Somebanks had to
                       make decisions about providing additional credit to clearing members in
                       excessof their credit limits. In certain instances,banks delayed confirm-
                       ing payments to clearing members and clearing organizations until the
                       banks were assuredthat market participants were financially sound.
                       Rather than rely on bank credit, other clearing membersobtained addi-
                       tional capital from their parent corporations.

                       Options and futures market participants rely on commercial banks to
Stock, Options, and    pay and collect funds for their market transactions. Banks establish
Futures Markets Rely   accounts for each of their options or futures market participants and
on Banks for Timely    transfer funds to settle payment obligations when requested. In the
                       stock market, clearing members and their clearing organizations or
Payment and Credit     depositories settle their payment obligations by certified check. Many
                       market participants typically do not have adequate funds in their bank
            Y          accounts to pay for their market obligations and, therefore, rely on
                       banks for short-term loans. The majority of these bank loans are on a
                       securedbasis and the participant must provide collateral for the loan.

                       Page 40                                 GAO/GGD-9033 Clearance and !Settlement
                               Credit and I&e Payment Robleme ln the
                               Stock, Options, and Futures Markets Have
                               Not Been Fully Resolved

                              Collateral that banks accept varies and usually consistsof stocks, bonds,
                              treasury bills, and other assets.Somebanks also provide loans on an
                              unsecured basis to a small number of well-capitalized market

                              late in paying their clearing organizations during the market crash. In
Mem’ ers Were Late            addition, three NSCC clearing members, one that was also an occ clearing
Payi Ifg Their Clearing       member, defaulted or withdrew from the clearing organization or depos-
                              itory membership. Two of the three memberswere in a credit position or
Orgtiizations During          had a clearing fund deposit to cover their settlement debts. The other
the crash                     member causeda $400,000 loss to NSCC. According to the SEC February
                               1988 Report, between October 19 and October 30,1987, clearing mem-
                              bers made late payments to stock clearing organizations approximately
                              60 times. These late payments were similar to late payments made dur-
                              ing the preceding and following months in terms of frequency and
                              amounts. On October 19, 20, and 21, cxc received late payments from
                              several of its members. According to CME,clearing banks were late in
                              confirming member payment for 26 of CME'S90 clearing members.Thir-
                              teen of those payment confirmations were between a half hour and an
                              hour late on October 20. These late payment confirmations violated
                              clearing organization rules and increased clearing organization risk. CFTC
                              officials said that although somepayment confirmations from clearing
                              banks to the CMEHouse Division were late, by the time of the opening of
                              the S&P 600 contract for trading, all payment confirmations were
                              received by CME.

                              Someclearing memberswere late in paying or did not pay their clearing
                              organizations for a variety of reasons,including the following:
                          . The clearing member or one or more of its customers were unable to
                            cover lossesin the market.
                          . The clearing member had insufficient funds to pay for its lossesin the
                            market, and its parent company was unable or unwilling to provide
                            additional funds.
                              In addition, the following factors may have contributed to delayed set-
                              tlement payments:
                          l   The clearing member neededmore time to secureadditional collateral.
                              The value of collateral used to obtain credit at banks had depreciated
                              with the large decline in stock prices.

                              Page 41                                     GAO/GGD9@33 Clearance and Settlement
                                  Chapter 4
                                  Credit and Late Payment Problem in the
                                  Stock, Options, and Futures Markets Have
                                  Not Beem F’nlly Resolved

                           One bank would no longer accept options contracts as loan collateral.

                         l Somebanks delayed extending additional credit to market participants
                           until their creditworthiness was established.
                         l According to a CMEofficial, senior bank officials at somebanks outside
                           Chicago were not available to make credit-approval decisionsduring this
                         . The federal wire transfer system essential for fund transfers did not
                           work on several occasions.
                         l Clearanceand settlement processingdelays of noncash margin calls at
                           the CMEresulted in payment delays.

                                        officials told us that renegotiated settlement agreementswith
Rhised Settlement                cm
                                 banks should help prevent any late payments in the futures clearance
Abreements and                   and settlement system. As of October 21,1988, the CMEand each of the
Routine Intraday Pays            four Chicago settlement banks have entered into uniform agreements
                                 that clearly specify the obligations of parties in honoring settlement
tid Collects Will Help           instructions received from the clearing organization and the timing and
Resolve Late Payment             finality of payments between clearing members and clearing organiza-
Ptiblems                         tions. The agreement unambiguously requires each clearing bank either
                                 to pay member obligations through irrevocable credits to the respective
                                 clearing organization’s account or to inform the CMEthat the payment
                                 cannot be processedby a certain time before the opening of regular trad-
                                 ing hours. Under this agreement,to the extent that a clearing bank has
                                 not received funds from a clearing member when it commits to honor
                                 settlement instructions, it is making a credit decision. The clarification
                                 of that fact should causeclearing banks to assessthe basis upon which
                                 they are conferring credit to particular clearing members.
                                 CFTCofficials also said that the use of routine intraday pays and collects
                                 at CME,introduced in March 1988, should help prevent late payments in
                                 the futures clearance and settlement system. The CMEreports that its
                                 settlement banks have confirmed that the use of intraday settlement
                                 reducesthe period during which margin obligations remain unsatisfied
                                 and generally results in a smaller aggregatecash payment at morning

                                 Page 42                                     GAO/GGD90-33 Clearance and Settlement
                         cllapter 4
                         Credit and I.&e Payment Problem@ ln the
                         Stock, Optlona, and Futures Marketi Have
                         Not Been Fully Resolved

                        Although federal regulators, clearing organizations, clearing members,
                        and banks are aware of the credit problems that occurred during the
                        market crash, limited progress has been made in resolving credit prob-
      r Credit Is Not   lems. Market participants are still susceptible to cash flow problems and
                        restricted credit during volatile markets.
                        According to an official from a major options clearing member that
                        experienced severelate payment problems during the crash, the firm
                        continues to maintain investment portfolios and collateral funds similar
                        to what it held before the market crash. Market participants and the
                        banks that provide them credit have not reached any formal agreements
                        on ways to facilitate adequate, yet prudent, credit in all market situa-
                        tions. Many banks do not consider it prudent to accept options as collat-
                        eral becausethey are unfamiliar with valuing options.
                        Officials at banks in New York said that they increased credit to broker-
                        dealers after the crash and will do so again in any future crash for clear-
                        ing members who are worthy of credit. However, the current levels of
                        committed or securedlines of credit are unclear. Someclearing members
                        may be unwilling to pay for them since committed lines of credit are
                        more expensive than uncommitted lines of credit that can be withdrawn.
                        A CFTCofficial said that even committed lines of credit have provisions
                        so that banks can withdraw them in certain extreme situations.

                        SECofficials said that the acquisition of credit is the responsibility of the
                        clearing member and not that of the clearing organization. The Clearing
                        Organization Clearing Bank Roundtable is focusing on credit facilities of
                        clearing members and is considering ways to seethat clearing members
                        have adequate’credit. l Becauseof confidentiality and privacy concerns,
                        clearing members and banks have been reluctant to openly discussthe

                        CKX’Srules require occ to pay its members at a specified time, and are
The OCCWas Late in      not contingent on the receipt of funds from other members.The WC
Paying Its Ciearing     made late payments to all of its clearing members on October 20, 1987.
Members                 WC delayed paying its membersfrom 2 to 2-l/2 hours becauseit did not
                        receive prompt payment from various clearing members.According to

                        ‘The Clearing Organization Clearing Bank Roundtable was created by the CME and B0K.C to open
                        lines of communication among futures and securities clearing organizations, their respective federal
                        regulators, and the banks that provide settlement services for the clearing organizations and their
                        members. It meets quarterly.

                        Page 43                                                 GAO/GGD-90-33 Clearance and Settlement
                   Credit and Late Payment Problems In the
                   Stock, Optlone, and Future@ Marke& Have
                   Not Been Fully Reoolved

                   the Brady Report, late payments to clearing membersduring the crash
                   led to rumors concerning the viability of clearing organizations.

                   SEC and CFTC reported  that clearing organizations should pay their clear-
                   ing memberspromptly at settlement time in accordancewith clearing
                   organization rules and bylaws. SECand CFE also reported that payments
                   guaranteed by the clearing organizations should not depend upon the
                   clearing organization’s receiving funds from clearing membersthat owe
                   money to the clearing organization. The Working Group recommended
                   that the SEC and CFTC confirm that options and futures clearing organiza-
                   tion guaranteesensure timely payments to clearing membersin accord-
                   ance with clearing organization rules and bylaws. Since issuing its
                   report, the SECdiscussedthis issue with occ. On October 11,1989, occ
                   submitted a rule changeto SECfor its review and approval. occ officials
                   told us that the new rule will enable occ to make money settlements to
                   its memberson time.

                   On October 20,1987, the CMEmade late payments of margin funds from
CME Made Late      its Clearing House Division to 2 of its more than 90 clearing members.
Payments to Two    On October 19, in responseto unusual market price declines, the CME
Clearing Members   made three margin calls during the trading day (“intraday”).2 According
                   to a CME official, CMEdid not routinely make intraday margin calls and
                   did not have detailed procedures in place for processingnoncash collat-
                   eral. When the CME produced clearing and banking reports on October 20
                   for trading that occurred on October 19, the reports did not reflect cer-
                   tain intraday margin amounts that clearing members had already paid
                   to CME in securities. Becauseof this, somebanks were unsure of their
                   payment obligations for a certain period of time on October 20. CFIKoffi-
                   cials told us that although these funds were paid later than normal, they
                   were made within legal parameters for payment.
                   A CME official stated that the noncash margin processingproblem was
                   further compoundedby the size and number of payments that had to be
                   processedby the settlement banks, The large payments, in somecases,
                   delayed the credit-approval processat the settlement banks, a problem
                   that was compoundedby CME’S policy of only collecting intraday margin
                   payments from memberswhose contracts declined in value and not pay-
                   ing out intraday margin to clearing members whose contracts had

                   2Futuresmarket margin calls sre requestsby the clearingorganizationto its membersfor additional
                   cash for each contw!t that decreased in market value. Payment of margin celle by the clearing mem-
                   ber is required within a specifiedtime frame.

                   Page 44                                               GAO/GGlMMJ-33 Clearance and Settlement
                     chapt8r 4
                     credit and L&e Payment Probleme in the
                     stock, Optlone, end Futurea Marketi Have
                     Not Been Fully lkolvod

                     increased in value. Furthermore, CMEexperienced difficulties in getting
                     hold of senior decision makers at someclearing members and at some
                     non-Chicagobasedbanks early in the morning on October 29. The actual
                     processingof the payment instructions and the movement of funds were
                     delayed by the Fedwire being inoperable at two times during the day. As
                     a result, two clearing members received payment of a total of $1.6 bil-
                     lion 6 hours late on October 20.

                     Each clearing organization independently determines the overall risk its
Som&Proposals to     clearing members pose.Clearing membersthat operate in the futures,
Red&x Cash Demands   options, and stock markets simultaneously are required to meet margin
on CFearingMembers   requirements in each market. However, a member’s intermarket trading
                     positions are not normally a factor in determining its margin payment
With Intermarket     requirements in each market. Trades made in one market are protected
Positions Have Not   against potential losseswith trades made in another market, but margin
Led jto Reform       is collected in both markets, Becauseof these multiple market cash
                     demands, several options and futures market participants did not have
                     accessto enough cash during the market crash to meet all their payment

                     Industry and federal regulators made various proposals to increase the
                     liquidity of the markets by reducing cash demands on clearing members
                     and market participants during periods of market volatility. For exam-
                     ple, the Working Group suggestedthat exploring measuresto reduce the
                     size of net cash flow obligations should be a priority. As a result, the
                     Working Group reviewed a list of proposals and recommendedthat stud-
                     ies be undertaken to determine their costs and benefits, Somereform
                     proposals seek to eliminate unnecessarycash demands on market par-
                     ticipants by changing the way clearing organizations clear and settle
                     trades and calculate payments, Other reform proposals would increase
                     the liquidity of the markets by increasing the availability of bank credit.
                     Proposals to increase credit availability have included imposing uniform
                     rules as to how a bank as a creditor establishesclaim to securities that it
                     accepts as loan collateral. The SECand CFTChave reviewed the various
                     reform proposals, but someproposed reforms have not been imple-
                     mented becauseno consensusexists on which reforms are most appro-
                     priate and how they should be implemented. The suggestedreforms
                 . “Cross-margining,” or allowing clearing organizations in different mar-
                   kets to give credit to a clearing member for related market positions in
                   other markets, thereby reducing the amount of original margin funds

                     Page 46                                    GAO/GGD90-33 Clearance and Settlement
    Chapter 4
    Credit and Late Payment Problems in the
    Stoelc, Options, and Futures Markets Have
    Not Been Fully Resolved

     the clearing member must pay. For example, under a cross-margining
     system, a clearing member that traded futures contracts and offsetting
     options contracts to reduce the members’ exposure to market losses,
     would only have to make a single margin payment basedon the reduced
     risk of the combined positions.
l    Exploring other arrangements between clearing organizations in differ-
     ent markets that would reduce the cash payments among participants.
     One of these arrangements is netting of clearing member transactions
     and payment obligations. For example, if a clearing member had to pay
     $60,000 to one organization and collect $40,000 from another, under a
     netting arrangement the clearing member would only pay $10,000 in
     cash and the clearing organizations would net the difference by book
     entry. According to CFW,officials, netting would be difficult if trade
    guarantees in different markets becomeeffective at different periods in
.   Exploring the use of futures-style margins for options contracts, which
    would require daily pays and collects of margins on options, as is cur-
    rently done in the futures markets. This would in somecasesreduce the
    credit that market participants currently need to meet their payment
    obligations in the options market.
.   Consolidating stock, options, and futures clearing organizations’ opera-
    tions in order to reduce cash flows and simplify payment and opera-
    tional procedures.
9   Reforming state commercial laws to impose a uniform rule governing
    how banks aa creditors establish a claim to uncertificated securities,
    such as certain types of stocks or options contracts.
9   Resolving the ambiguity in bankruptcy rules concerning how to estab-
    lish a customer’s priority during the liquidation of a firm that had oper-
    ated both as a securities broker-dealer and a futures commission
    merchant. This is an incidental clearanceand settlement issue concern-
    ing coordinating the rights of securities and futures customers in the
    event of a default of a financial firm.
.   Shortening the S-day settlement time frame for routine stock transac-
    tions with the goal of reducing risk. This was also called for by the
    Group of Thirty who would like to seeall nations adopt systems that
    would settle stock transactions in 3 days after the trade by the year

    Of these reform proposals, cross-margining has been partially imple-
    mented by a pilot program. The other proposals are still in various
    stagesof discussion,in large part, becauseopinions vary widely on their
    merits and on how to implement them. The following is the status of the
    proposals listed above:

    Page 40                                     GAO/GGD-90-33 Clearance and Settlement
      Chapter 4
      Credit and Late Payment Problems in the
      Stuck, Optlone, and Futuree Marketa Have
      Not Been Fully Resolved

    9 Clearing organizations have initiated two cross-marginingpilot pro-
       grams. The occ and its futures-clearing subsidiary, the Intermarket
       Clearing Corporation (ICC),developed one program, and the occ and the
       CMEhave developed another program. Both programs, however, are lim-
       ited by CFIT and SECto firms trading on their own behalf, thereby
       excluding any use of customer funds. This limitation is necessitatedby
      the CFTCrequirement that customer funds be held separately from firm
       proprietary funds. Only a small number of clearing members are eligible
      to participate in cross-margining programs. As of August 1989, the CKX-
      ICCcross-margining program had only one active participant. The occ
       and CMEcross-margining program was approved by cmc and SECin Sep-
      tember 1989. According to a CMEofficial, as of October 31,1989, three
      firms were actively participating in the program. SECand CITC officials
      said that cross-margining programs will provide a test of one means of
      resolving cash flow problems and is a step towards integrating clearing.
      However, CFTCofficials said they are concernedthat the overall result-
      ing margin must not be too low. A CMEofficial said that if regulatory
      approval is extended to include customer positions, activity in the OCC-
      CMEprogram should increase.
l     Netting, which would result in the reduction of payments among clear-
      inghousesin different markets, has been discussed,but no specific
      approachesto netting of payments have been explored. No comprehen-
      sive studies of intermarket netting have been completed. CFTCofficials
      said that someclearing members would be reluctant to have a single
      bank aware of all their businesson major exchanges.Presumably, they
      could use knowledge of their cash flows to identify their trading strate-
      gies. CFX has requested from SECinformation on options cash flows in
      October 1987 that may be helpful to evaluating the impact of netting.
      CFTCofficials told us that while netting and cross-margining programs
      may improve liquidity, they may do so at the expenseof solvency.
      Reducedpayment flows may reduce the integrity of the clearance and
      settlement system by decreasingthe amount of cash deposited in clear-
      ing organizations, thereby reducing liquidity risks.
l     The Chicago Board of Trade (CBT) and CMEpetitioned CFTCin July 1988
      to changetheir existing rules that prohibit futures-style margin on
      options, These changes,if approved, would allow futures-style margin-
      ing on someoptions on futures contracts. The CETChas requested and
      reviewed public comments and is analyzing the arguments for and
      against this proposed rule change.As of December1989, CFTChad not
      acted on the petition. In 1982, the CFTCrejected a similar proposal
      becauseit said an investor may lose more than the original investment
      and inexperienced investors might take unnecessaryrisks. Neither the
      Chicago Board Options Exchange (CBOE)nor occ have petitioned SECfor

      Page 47                                    GAO/GGD$O-33 Clearance and Settlement
Credit and Late Payment Problem in the
Stock, Optlone, and Futures Markets Have
Not Been Fully Resolved

 futures-style securities options margins. SECis concernedthat adoption
 of futures-style margining for securities options could changethe eco-
 nomics of options trading by eliminating the usefulnessof certain strate-
 gies. They believe that such changescould eliminate as much as 30 to 60
 percent of options trading activity today. They also are concernedthat
 futures-style options margins, if applied to reduce initial margin depos-
 its, could increasethe ability of long option holders to leverage their
 investments and could permit holders to control substantial positions in
 securities index options at almost no cost, possibly increasing systemic
 risk. occ officials said that futures-style margining of options would
 increase market risk for their customers and present operational diffi-
 culties for their members, In addition, they said that futures-style
 options margins would reduce businessin the options markets. CMEoffi-
 cials said that they do not advocate futures-style margins for securities
 options. They said that the treatment of securities options in this man-
 ner could create an artificial need for cash in the options market if the
 stock market moved against an options position of someonehedging a
 stock position in the options market.
 “Coordinated,” “ integrated,” and “unified” clearing have been dis-
cussed.Opinions vary widely regarding whether and how clearing oper-
 ations could be coordinated or in someway centralized. Many clearing
organizations and market participants said they opposecentralized
clearing for all markets. Their arguments against centralized clearing
include the need for clearing organizations to be responsive to the needs
of individual markets, and the potential danger to the clearing system of
concentrated risk. According to CME,under the current system it is possi-
ble for one clearing organization to experience financial upheaval and,
conceivably, even ceaseto exist without having a major impact on other
parts of the market. Other clearing organizations and clearing members
have acknowledged the possible benefits of centralized clearing, citing
lower operational costs.CFTCofficials said that if cross-margining pro-
grams are successfuland the netting of cash flows among clearing orga-
nizations is adopted, integrated clearing might not be necessary.CFTC
officials said that integrated clearing would result in information shar-
ing. SEC and CFTCofficials said existing intermarket systems should be
improved first. An additional study of structural changesto clearance
and settlement systems, if necessary,could follow these improvements.
An American Bar Association committee is studying ways to resolve
uncertainty about how a creditor establishes a claim to uncertificated
securities, including certain types of stock and options contracts. This
uncertainty reducesthe availability of bank credit by discouraging
banks from accepting such securities as loan collateral. Uncertainty

Page 48                                    GAO/GGD-90-33 Clearance and Settlement
       Credit and Late Payment Problem@ in the
       Stock, Optlona, and Futures Marketa Have
       Not Been Fully Resolved

      arises becausecreditors’ claims to securities are governed by the com-
      mercial codesof the various states. Although most states have modeled
      their commercial codeson the Uniform Commercial Code,individual
      provisions vary from state to state and are subject to different interpre-
      tations in state courts. A bank extending credit for a multistate transac-
      tion may not know which set of rules apply. To eliminate uncertainty,
      the BusinessSection of the American Bar Association is studying ways
      of imposing a uniform set of rules on all participants in securities
    . An American Bar Association committee is studying an incidental clear-
      ance and settlement issue concerning coordinating the rights of securi-
      ties and futures customers in the event of a default of a financial firm.
      This issue concernsthe establishment of a customer’s priority during the
      liquidation of a firm that operated both as a securities broker-dealer and
      a futures commission merchant. Different bankruptcy rules apply to
      these two types of financial activities. Subchapter III of Chapter 7 of the
      Bankruptcy Code,which governs the liquidation of securities broker-
      dealers, establishes a priority for securities customers but leaves futures
      customers in the status of unsecured creditors. Conversely, bankruptcy
      regulations issued by CFTC,which govern futures commission merchants,
      establish a priority for futures customers but not for securities custom-
      ers. Whether securities or futures customers have priority to the assets
      of a firm that engagesin both activities is unclear.

      Resolving the ambiguity in bankruptcy rules is complicated by the fact
      that the SECand CFTCdo not have equal authority over bankruptcy rules
      applicable to firms under their respectivejurisdictions. The Commodity
      Exchange Act grants the CFTCbroad authority to issue regulations gov-
      erning the liquidation of a futures commission merchant, including the
      determination of what property is customer property or identifiable aa
      belonging to a particular customer and how the firm is liquidated. SEC,
      on the other hand, doesnot have any authority to issue bankruptcy reg-
      ulations and, therefore, has a limited ability to define the effect of the
      bankruptcy code on broker-dealers.
l     Although no agency has done a formal study of the costs and benefits of
      shortening the stock settlement cycle, the move to acceleratetrade
      matching systems and improve trade reconciliation processingshould
      facilitate achievement of the Group of Thirty recommendationsto settle
      all stock trades by 3 businessdays after a trade is made. However, other
      factors are instrumental to the successof earlier stock settlement.
      Although no technological impediments have yet surfaced, shortening
      the clearance and settlement cycle for stock transactions will require

      Page 49                                     GAO/GGD90-33 Clearance and Settlement
                  Chapter 4
                  Credit and Late Payment Problems in the
                  Stock, Optlone, and Future6 Markets Have
                  Not Been Pully Reeolved

                  changesin the institutional and retail sectors of the stock market. A pri-
                  vate sector review committee charged with implementation of Group of
                  Thirty recommendationsis currently discussing compressingthe settle-
                  ment period. They have reported that the current method of trade con-
                  firmation and affirmation with institutional clients will need to be
                  accelerated.The current institutional delivery environment will need to
                  be changed to an intraday, interactive trade confirmation system. They
                  also have recommendedthat by January 1,1992, all new issuesof cor-
                  porate securities, which include initial public offerings and secondary
                  distributions, be in book-entry only or certificateless format. Retail cus-
                  tomers will have to accept owning stocks without receiving certificates.
                  This would require extensive educational efforts, but, according to
                  securities industry officials, the cost saving of such an effort would far
                  outweigh the expenseof moving to a certificateless or book-entry-only
                  trade processingenvironment. Also, the mailing of personal checks as a
                  form of payment may have to be eliminated and electronic payment sys-
                  tems may have to be used.

                  Federal regulators and SROShave not implemented all the intermarket
 /                Working Group recommendationsdesignedto reduce cash demands.
                  Studies of netting of cash flows among clearing organizations and of
                  integrated clearing have not been completed. Although these recommen-
                  dations are more difficult to implement than market-specific or intra-
                  market recommendations,they could rectify problems that pose great
                  risks to clearance and settlement systems.

                  We recommendthat the SECand CFTCensure that appropriate mecha-
Recommendations   nisms are in place to assurethat payments required by clearing mem-
                  bers and clearing organizations are made within established time
                  We recommendthat the Secretary of the Treasury, as Chairman of the
                  Working Group, ensure that studies exploring ways to lessen
                  inter-market cash flow pressures and to simplify inter-market clearing
                  without diminishing safeguards against financial risk are completed and
                  acted on appropriately. The Secretary, working with other mem.bersof
                  the Group as well as the exchangesand their clearing organizations,
                  should identify responsibilities, assign tasks, and set time frames for
                  accomplishing this recommendation.

                  Page IO                                    GAO/GGDM-33 Clearance and Settlement
                   Ckapter 4
                   Credit and J&e Payment Problems in the
                   St41c4Options, and F’utures Markets Have
                   Not Been Fully Beaolved


                   occ said that the report doesnot sufficiently emphasizethe benefits of
Cor&ents and Our   cross-margining in reducing risk and cash flows.
                   Pilot cross-margining programs are a promising step in the direction of
                   recognizing componentsof related portfolios and smoothing out asyn-
                   chronous cash flows. However, current cross-marginingprograms only
                   apply to a limited cross-sectionof trading activity and may increase
                   liquidity at the expenseof solvency. Without further action by the CFTC
                   regarding various rule interpretations, an expansion of cross-margining
                   programs is not possible. Cross-margining programs do decreasethe
                   overall level of margin funds in the system.

                   CFE said that the report focuseson liquidity issuesto a greater extent
                   than it does on issuesof financial integrity and that the report empha-
                   sizesliquidity over solvency. CFTCsays there is a trade-off between
                   liquidity and protection against risk.
                   We recognizethe trade-off between liquidity and solvency and agree
                   that liquidity should not be improved at the expenseof solvency. Our
                   secondgeneral recommendation has been amendedto note this concern,
                   We say that studies exploring ways to improve liquidity and simplify
                   intermarket clearing should be completed and acted upon without
                   diminishing safeguards against financial risk.
                   CMEquestioned our grounds for     concluding that markets are still at risk.
                    The grounds for our overall conclusion that the markets are still at risk
                    are contained in appendix I. Although progress has been made in many
                    areas, particularly in the processingof trades, more needsto be done to
                    improve procedures to handle financial risk and to ensure that pay-
                   ments are made within established time frames. In particular, some
                    actions requiring intermarket cooperation have not been completed. An
                   intermarket information sharing system of risk-exposure information on
                   joint clearing members has not been completed, nor have studies been
                   undertaken exploring ways to lessenintermarket cash flows and sim-
                   plify intermarket clearing.

                   Page 51                                    GAO/GGD9033 Clearance and Settlement
Apjxsdix   I

S@&usof Reform Recommendationson
C/learanceand Settlementof President’s
Working Group on Financial Markets
               Working group recommendation                  Issue type             Action taken

               I: Trade Processing Issues
               The SEC and CFTC should review futures        Market-Specific        Completed
               and options clearing organization
                            of timely payments to clearing

               The SEC and CFTC should encourage             Intermarket            None
               OCC and futures clearing organizations to
               coordinate margin calls and settlements.

               The SEC should encourage movement             Market-Specific        Progress
               toward same-day trade comparison for
               stocks, and SEC and CFTC should foster
               progress toward online trade matching
               systems at the exchanges.

               Page 52                                             GAO/GGD-90-33 Clearance and Settlement
                                              Appendix I
                                              Statue of Reform Reconunendatione on
                                              Clearance and Settlement of Freeident’e
                                              Working Group on Financial Markets

                 Federal Regulator Action/Poeition                                  Clearing Organization Action/Position
SEC     I               CFTC                 FRS                      CME                    NSCC                 occ

                         Monitored             N/A                    Improved trade          WA                     OCC reviewed its
                         development of new                           processing systems                             ability to meet its
                         uniform agreements                           and procedures to                              payment obligations
                         between clearing                             handle multiple daily                          and SEC reported
                         organizations and                            margin pays and                                that, under current
                         settlement banks.                            collects.                                      market conditions,
                                                                                                                     OCC has sufficient
                                                                                                                     guarantee fund
                                                                                                                     resources to meet
                                                                                                                     isolated payment
Monitorad SRO            Monitored St30       WA                     lntraday margin calls    N/A                    Officials said the
discussrons.             discussions.                                were introduced. For                            business hours of
                                                                     intraday margin calls,                          non-Chicago banks
                                                                     CME now pays its                                do not lend
                                                                     excess margin funds                             themselves to this
                                                                     to members whose                                recommendation.
                                                                     contracts increased                             Also, Fedwire is not
                                                                     in value.                                       open at 7 A.M.
                                                                                                                     central time.
                                                                     Discussed with
                                                                     banks, federal
                                                                     regulators, and other
Approved pilot           Monitoring SRO       N/A                    CME instituted a pilot   NYSE: Implemented      N/A. The OCC does
implementation of        actions.                                    program for an           an on-line trade       not march trades.
NYSE online trade                                                    electronic trade order   matching system in     Options exchanges
matching system as                                                   routing system. CME      last quarter of 1988   match their trades
first step toward                                                    now has at least         as first step toward   and send matched
Overnight                                                            three intraday           an Overnight           trade information to
Comparison System.                                                   matches.                 Comparison System.     OCC.
Partial approval given
to NAS~Dproposal                                                                              NASD: implemented
regardi/ng the                                                                                and requires its
Automated                                                                                     members to use
Confirmation                                                                                  Trade Acceptance
Transaction S stem.                                                                           Reconciliation
Approved NS 6 C                                                                               System to facilitate
acceletation of trade                                                                         same-day or next-day
comparison functions                                                                          automated resolution
from 2,days after the                                                                         of unmatched trades.
trade date to the day
after the trade date
for NYSE, AMEX, and
NASD trades.

                                              Page 53                                            GAO/GGDBO-33 Clearance and Settlement
APpendir 1
Statue of Reform Reconunendationo on
Clearance and Settlement of Preeident’s
Working Group on F’hanclal Marketa

Working group recommendation                    Iraue type             Action taken

The NYSE, NASD, AMEX, clearing                  Market-Specific        Progress
organizations, and market participants
should identify costs and benefits of an
earlier settlement time frame for securities
and identify how a shorter time frame can
be implemented.

II. Risk-Manaaement Issues
Working Group should encourage                  Intermarket            Completed
establishment of regular meeting schedule
between futures and securities clearing
participants and federal regulators.

Clearing organizations should review            Market-Specific        Progress
adequacy of clearin member guarantee
fund contributions. Pederal regulators
should assess results of these reviews.

The SEC and CFTC should encourage               Market-Specific        Progress
securities and futures clearin
organizations to explore the 8 esirability of
converting portions of existing securities
and futures guarantee funds to cash or
cash eauivalents on an incremental basis.
Procedures should be implemented for            Intermarket            Progress
centralized collection and availability of
pay and collect information.

Page 64                                               GAO/GGD-PO-33 Clearance end Settlement
                                                  Appendix I
                                                  Status of Reform Becommendationson
                                                  Chwance and Settlement of Preeident’e
                                                  Working Qronp on Financial Markets

            I      Federal Regulator Action/Position                                     Clearing Organization Action/Position
  SEC.----- 1---
_.I--                     CFTC                  FRS                       CME                     NSCC                 occ
  Workinabo suooort       N/A                      N/A                    N/A                       No formal studv of      N/A
                           ’                                                                        recommendation.          ’
                                                                                                    Working with
                                                                                                    NASD towards a
                                                                                                    more automated
                                                                                                    reconciliation cycle
                                                                                                    and earlier trade
                                                                                                    reporting by
                                                                                                    members, Working to
                                                                                                    implement Group of
                                                                                                    recommendation to
                                                                                                    move settlement to 3
                                                                                                    days after the trade

  Participated in         Participated in         Participated in         Organizer and             Organized and           Participant in
  Clearing Bank           Clearing Bank           Clearing Bank           participant in            participated in         Clearing Bank
  Clearing Organization   Clearing Organization   Clearing Organization   Clearing Organization     Clearing Bank           Clearing Organization
  Roundtable.             Roundtable.             Roundtable.             Clearing Bank             Clearing Organization   Roundtable.
                                                                          Roundtable.               Roundtable. NSCC        Participant in
                                                                                                    representative chairs   Securities Clearing
                                                                                                    the Securities          Group.
                                                                                                    Clearing Group.
 Clearing organization    Reviewed and            N/A                     Increased                 Submitted to SEC        OCC increased its
 rule changes under       approved CME                                    re uirements in Feb.      proposed changes in     minimum clearing
 consideration.           increase in member                              19I 8 by adopting         contribution            fund contributions.
 Temporarily approved     contribution                                    risk-based rate for       requirement. New
 NSCC changes.            requirement.                                    member                    requirement is risk-
                                                                          contributions.            based. Rule filing
                                                                                                    pending at SEC.
 Clearing organization    Approved a CME rule     N/A                     Eliminated letters of     Reviewing increasing    N/A. OCC has no
 rule changes under       change to eliminate                             credit from its           the minimum cash        letters of credit in its
 consideration.           letters of credit.                              securit deposit in        contribution by         guarantee fund.
                                                                          April 1!i 89.             member.

 Has encoura ed           Sent correspondence     N/A                     Full participant in the   NSCC Board has          OCC participates in
 NSCC and 0 8 C to        to OCC encouraging                              futures and options       approved the            the BOTCC and SCG
 join BOTCC               OCC participation in                            intermarket               concept, but NSCC       information sharing
 information sharing      BOTCC information                               information sharing       noted concerns with     systems.
 system.                  sharing system.                                 system.                   current system.
  SEC officials noted
  concerns about
  confidentiality and
  problems with the
  aging of data. _.-.--

                                                  Page 56                                              GAO/GGD90-33 Clearance and Settlement
I   Appendix I
    Statue of Reform Recommendation6 on
    Clearance and Settlement of Prealdent’e
I   Working Group on Flna.ncial Markets

    Working group recommendation                 Issue type             Action taken

    Develop a trial reporting system of large-   Market-Specific        None
    trader data for OCC positions and consider
    changes to securities laws necessary to
    obtain large-trader data.

    III. Credit and Liquidity Issues
    The CFTC and SEC should monitor options      Market-Specific        Completed
    and futures self-regulatory organization
    progress in revision of settlement
    agreements with clearing banks.

    Federal regulators should review clearing    Intermarket            None
    member credit arrangements to support
    large payments to clearing organizations.

    FRB should explore earlier openina of the    Intermarket            Proaress
    Federal wire transfer system. Ma&et
    participants should assure smooth market
    operations on bank holidays.

    The CFTC and SEC should expedite             Intermarket            Progress
    consideration of the ICC-OCC pro osal for
    a pilot cross-margining program. 8 ther
    clearing organizations should be
    encouraged to consider cross-margining.
    The CFTC should evaluate whether floor
    traders and market makers can participate
    in cross-margining pilot programs.

    The CFTC and SEC should formulate a          Intermarket            Progress
    coordinated approach toward FCM/broker-
    dealer bankruptcy laws and identify areas
    requiring legislative action.

    Page 50                                            GAO/GGD-90-33 Clearance and Settlement
                                                   St&us of Refona Recommendations on
                                                   Chrance and Settlement of President’s
                                                   Worldng Group on Financial Markets

                   Federal Regulator Actlon/Poeltion                                    Clearing Organization Action/Poeltion
  SEC     j               CfTC                 FRS                        CME                    NSCC                 occ
   Proposed legislation    Offered to initiate      WA                    WA                      WA                      OCC has an internal
   in June 988 to          pilot program                                                                                  large trader reporting
   increas SEC large       whereby CFTC                                                                                   system. However,
   transac ion reporting   futures position data                                                                          OCC and SEC have
   require i ents.         would be used to                                                                               not developed an
   Legislat on was not     verify OCC futures                                                                             external large trader
   enacte cl as of Nov.    position data.                                                                                 reporting system for
   1989. 1                                                                                                                OCC positions.
 Monitor d review.         Monitored revisions,     N/A                  Finalized revised        N/A                     Reviewed
                                                                         a reements in Oct.                               agreements with
                                                                          18 88. Agreements                               banks and decided
                                                                         further specify                                  no revisions were
                                                                         settlement                                       needed.
                                                                         procedures and
                                                                         timina and finalitv of
                                                                         payments.          -
  Discussed at             Discussed at            Discussed at          Discussed at             Discussed at            Discussed at
  Futures/Securities       Futures/Securities      Futures/Securities    Futures/Securities       Futures/Securities      Futures/Securities
  Clearing Roundtable.     Clearing Roundtable.    Roundtable.           Clearing Bank            Clearing Organization   Clearing Bank
                                                                         Clearing Organization    Roundtable.             Clearing Organization
                                                                         Roundtable.                                      Roundtable.
 Expanded Fedwire          Supports FRS         Performed an internal    An official said         N/A                     Discussed with
 neither necessary nor     informal agreement   study and concluded      federal wire transfer                            members, FRS, and
 cost effective at this    to extended hours on that federal wire        hours should be                                  Securities Clearin
 time.                     an as-needed basis.  transfer hours do not    extended.                                        Group. Conclude 2
                                                need to be extended                                                       that wire transfer
                                                as a rule.                                                                problems did not
                                                                                                                          contribute to
                                                                                                                          problems during the
                                                                                                                          market crash.
 A roved in Oct.                                                         Initiated cross-         N/A                     1) The ICC-OCC pilot
 1!I 8 1 $ear ICC-OCC                                                    marginin program                                 cross-margining
 pilot cross-margining     cross-mar ining                               with OC 8, In Oct.                               program was
 program. CME-OCC          program. 8 ME-OCC                             1989. As of Oct.                                 approved in 1988. As
 cross-margining           cross-margining                               1989, the program                                of Aug. 1988, the
 propoql has been          proposal has been                             has three active                                 program had one
 approved.                 approved.                                     participants.                                    active participant.
                                                                                                                          2) Initiated cross-
                                                                                                                          marginin program
                                                                                                                          with CM if. In Oct.
                                                                                                                          1989. As of Oct.
                                                                                                                          1989, the program
                                                                                                                          had three active
 Referred the issue to     Referred the issue to   N/A                   WA                       Staff members           N/A
 the American Bar          the American Bar                                                       participate on ABA
 Association for           Association for                                                        committee.
 further study. Staff      further study. Staff
 members participate       members participate
 on ABA committee.         on ABA committee.

                                                   Page 67                                           GAO/GGD9@33 Clearance and fhttlement
    Appendix I
    Status of Reform Recommtmdation3 on
    Clearance and Settlement of President’s
    Working Group on FinandaJ Markets

,   Working group recommendation                    Issue type             Action taken

    Consideration should be given to whether        Intermarket            Progress
    le islation is necessary to establish federal
    ruPes for the transfer and pledge of stock
    and securities options.

    The practical impediments to and risk           intermarket            Progress
    implications of futures-style margining of
    options should be explored.

    The Working Group should encourage the          Intermarket            None

    Futures and securities clearing                 intermarket            None
    organizations should identify costs and
    benefits of integrated clearing and
    determine how Integrated clearing could
    be achieved.

    Page 68                                               GAO/GGD-90-33 Clearance and Settlement
                                                      Status of Reform Recommendations on
                                                      (%xuance and Settlement of President’s
                                                      Working Group on F’hancial Marketi

           I       Federal Renulrtor Action/Position                                          Clearing Organization Actlon/Po&ion
 SEC       I              CRC                   FRS                           CME                      NSCC                 occ
  Submitted in June         WA                        N/A                     WA                       Staff members        Staff members
   1988 dr ft legislation                                                                              participate on ABA   partioipate on ABA
  that aut orized SEC                                                                                   commlttee.                Committee.
  to estab ish federal
  rules for the transfer
  and ple ge of
  securiti s
  transact on, including
  options, if SEC
  determi ed such
  rules ar needed.
  Referre state
  commer i ial law and
  choice c$ law issues
  to ABA committee.
-Reviewing CME and          Under discussion.         N/A                     Petitioned CFTC in        N/A                       Officials said futures-
  BOTCC proposals.          Reviewing CME and                                 July 1988 to change                                 style margins would
  Officialstcited lack of   CBT petitlons to                                  its existing rules that                             increase market risk
  interest bv OCC and       chanae CFTC rules.                                do not allow futures-                               for their customers
  Chicagd hoard of               -                                            style margins on                                    and present
  OptionsiExchange.                                                           options.                                            operations difficulties
                                                                                                                                  for their members.
- Under dlscussion in       Requested                 No specific action.    Officials said CME-        NSCC currently nets       Officials said CME-
  SCG and Futures/          information from SEC      General studies of     OCC cross-margining        payments with             OCC cross-margining
  Securities clearing       regarding the             netting are ongoing.   program is a step          Depository Trust          program is a step
  Roundtable.               potential impact of                              toward netting.            Company.                  toward netting.
                            netting. Officials said
                            they are not aware to
                            any practical way to
                            net cash flows across
_----.                      markets.
  Proposed legislation      Staff said integrated     FRS officials          Issued position paper      Officials said            OCC issued a report
  in June 1988 calling      clearing is best          cautioned against the saying that united          integrated clearing       on clearance and
  for SEC and CFTC to       achieved by               concentration of risk. clearing would             requires 1) resolving     settlement and
  facilitate linked or      information sharing of                           dramatically               jurisdictional disputes   discussed integrated
  coordinated               risk.                                            decrease the               among regulators, 2)      clearing in the report.
  clearance and                                                              financial integrity of     establishing uniform
  settlement of all                                                          the markets.               regulatory standards
  markets. Legislation                                                                                  across markets, and
  was not enacted, and                                                                                  3) expanding
  on other action has                                                                                   commonality of
  been taken. Staff                                                                                     procedures and
  said stujjies of                                                                                      policies throu hout
  integrated clearing                                                                                   the industry. 8 orking
  are premature.                                                                                        with Securities
                                                                                                        C$;;ing Group and

                                                      Page 69                                              GAO/GGDfMl-33Clearmee and Settlement
Apbendix II

C$xnmentsFrom the Department of
t$e Treasury

                                                    DEPARTMENT OF THE TREASURY

              UNDER   SECRETARY                         December     14,   1989

                        Dear             ogel   :
                              My staff and I have reviewed the copy of the draft report
                       you sent to Secretary   Brady entitled   Vlearance  and Settlement
                       Reform:    The Stock, Options,  and Futures Markets are Still    at
                              The Report should be a constructive    and timely addition    to
                       the work done since October 1937 on the subject       of clearance   and
                       settlement   in the equity, futures,    and options markets.     The more
                       the problems in this area can be highlighted       and examined the
                       better our chances of seeing real progress in solving        some of the
                              As the Report points out, there have been some achievements
                       in   expanding the capacity     of the clearance    and settlement systems
                       to handle heavier trading       volumes.    It is in coordinating  the
                       various clearing    organizations     and in assessing their risk
                       exposure that more progress is necessary.          We believe your report
                       will prove helpful     in this regard.
                               The Working Group on Financial      Markets ranks progress on
                       clearance    and settlement    issues among its highest priorities    and
                       will   do its part to advance your recommendations within         the
                       Working Group.       We believe the Working Group is an appropriate
                       forum in which the member agencies can address these issues and
                       formulate    approaches    to shared concerns.
                            It was a pleasure contributing    to your work on the Report.
                       I am certain it will be well received.
                                                                   Since          ,

                                                                       Js-ft . G auber
                                                                   Under Secretary    for      Finance
                       Mr.           L. Fogel
                       Assistant   Comptroller     General
                       General Accounting      Office
                       Washington,   DC 20548

                               Page 60                                                GAO/GGDM-33 Clearance and Settlement
Appendb III

C&men@ From.the Securitiesand

Note: GAO comments
supplemehting those in the
report texi appear at the
                                                                   UNITED   ST47    ES
end of this1appendix.
                                                SECURITIES      AND EXCHANGE             COMMlSSlOhl
                                                             WASHINGTON.     D.C     20549

                                                                            January          5, 1990

                             Richard L. Fogel
                             Assistant   Comptroller      General
                             General Government Programs
                             General Accounting      Office
                             441 G Street,   N.W.
                             Washington,   D.C. 20548
                                    Re: Clearance     and Settlement               Reform
                             Dear Mr. Fogel:
                                    The Commission has authorized          me to respond to your
                             request on November 21, 1989, for comments on a report
                              ("Report")      of the General Accounting        Office     (*'GAO") concerning
                             the progress of clearance and settlement                reforms in the stock,
                             options,      and futures markets since the October 1987 market
                             break.      The Report focuses on the recommendations made by the
                             President's       Working Group on Financial        Markets u ("Working
                             Group") and the Group of Thirty.          2/ As a general matter,
                             although GAO concludes that certain             clearance       and settlement
                             problems      that occurred during the October 1987 market break
                             have been solved, others require           further      attention.
                             Specifically,        GAO endorses the Working Group and Group of
                             Thirty    recommendations and recommends that the Working Group
                             take a leading role in implementing             the recommendations to
                             ensure that:        (1) a routine  intermarket       information     sharing
                             system is developed and used to assess the intermarket                     risks
                             posed by members of multiple          markets; and (2) studies exploring
                             ways to lessen intermarket         cash flow pressures and to simplify
                             inter-market      clearing   are completed and acted on appropriately.
                                    We appreciate   the opportunity    to comment on the Report.
                             Safe and efficient     clearance and settlement    of securities,
                             options and futures      transactions  are of the utmost importance
                             to the operation     of our nation's   financial markets.      Reducing
                             the risk   of loss due to weaknesses in the clearance        and

                             l/    Working Group on Financial               Markets, Interim     Rewort to the
                                       s'                                        (May 1988)("Interim    Report")
                                   Group of Thirty,   Clearance             and Settlement             Svstems in the
                                   -d's    Securities   Markets             (March 1989).

                                  Page 61                                                      GAO/GGD-90-33 Clearance and Settlement
                       Appendix III
                       Comments From the Securities and
                       Exchange Commission


                  Richard     L. Fogel
                  January     5, 1990
                  Page 2

                  settlement   system continues   to be one of the Commission's
                  highest priorities.     We support the general recommendations
                  contained  in the Report.     Our comments, detailed below, are
                  offered as a supplement to the Report.
                  I.     General    Comments
                         A.     Market Reform Legislation
                          We agree with GAO that coordination             of clearing     systems
                   for options,      futures  and equities      is essential.       Toward this
                  end, the Commission submitted to Congress in June 1988 proposed
                  legislation      that would direct      the SEC and the Commodity Futures
                  Trading Commission (IICFTC"), in consultation                with the Board of
                  Governors of the Federal Reserve System ("Fed"),                  to foster the
Seei comment 1.   development of coordinated           and linked intermarket         clearing
                  systems.      As the Report identifies,          clearance     and settlement
                  systems are complex and technical.              Many of the changes that
                  are likely     to be needed require        action by the CFTC, Fed and
                  SEC. For this reason, the Commission's proposed legislation
                  would clarify       SEC and CFTC authority,         and establish      a timetable
                  for agency and industry         action,    among other things,         by
                  requiring     both agencies to report to Congress on progress
                  toward linked and coordinated           intermarket      clearance     and
                  settlement     systems.     We urge GAO to focus on the legislative
                  proposals     currently    before Congress and to formulate             its views
                  on the need for that legislation.
                          The Commission also proposed that Congress amend Section
                  17A of the Securities           Exchange Act of 1934 to authorize               the
                  Commission, where necsssary to the safe and efficient                         operation
See comment 2.    of the national        clearance      and settlement        system, to promulgate
                  rules to clarify         and unify state commercial laws that provide
                  the framework for financing              securities,       options,    and futures
                  positions.       The Commission staff            is working with legal experts,
                  under the auspices of the American Bar Association's                         Section on
                  Business Law, to explore and address these concerns.                         (That
                  group, under the stewardship              of Robert Haydock, expects to
                  issue a report by May 1990.)                Some examples of how state
                  commercial laws affect           the settlement        process are noteworthy.
                  First,     state commercial laws preclude United States (V.S.")
                  depositories      from engaging non-U.S. custodians                  to safekeep, on
                  behalf of the U.S. depositories,                securities      outside the U.S.
                  As a result,      transfers      and settlement        of trades among U.S.
                  broker-dealers       in non-U.S. securities            generally      must occur
                  outside the U.S.; this is not only risky but an impediment to
                  efficient      and liquid     international        securities       markets.    Second,
                  notwithstanding        ambiguous results          under state commercial laws,
                  banks and broker-dealers            routinely      use agreements to pledge

                       Page62                                             GAO/GGD-90-33 Clearance and Settlement
                           Appendix III
                           timmente From the Securities end
                           Exchange Commission


                     Richard     L. Fogel
                     January     5, 1990
                     Page 3

                     securities      as a method to secure overnight              financing       of dealer
                     inventories.         In an effort      to clarify     the rights      of banks in
                     securities      subject to an agreement to pledge, the New York
                     commercial law was amended, somewhat hastily,                    after the October
                     1987 market break and raises further                 questions    because of
                     differences      between New York law and the laws of other states.
                     Third,     state commercial laws do not provide uniform rules that
                     spell out how lenders can obtain a perfected                    security      interest
                     in uncertificated         securities,     such as exchange-traded             options.
                     Approximately        ten states still      have not adopted the 1978
                     amendments to Article          Eight and Nine of the Uniform Commercial
                     Code (those amendments establish               new and exclusive         ways to
                     perfect     security    interests      in uncertificated        securities).         The
See comment 3.       lack of uniformity         creates a trap for the unwary lender.                    We
                     urge GAO to focus on this area so that Congress may benefit
                     from GAO's expert views when Congress considers                     the
                     Commission's legislative            proposals.
                            B.     Clearing    Funds and Reliance         on Letters      of Credit
                              We commend GAO for identifying,                as an issue of concern,
                     clearing     organization       reliance       on letters       of credit.      As a
                     supplement to the discussion                of this issue in the Report, we
                     note that the National           Securities       Clearing       Corporation       ("NSCC")
See comment 4.       has filed      with the Commission a proposed rule change that would
                     increase the cash and cash equivalent                     (a,        U.S. Treasury
                     securities)       deposits    individual        members must provide NSCC and
                     restrict     letter    of credit      deposits      to 70% of the member's
                     clearing     fund deposit requirement.                This, we understand,            would
                     have the effect        of increasing         the cash and cash equivalent
                     components of NSCC's clearing                fund to approximately           $150
                     million     and would reduce letters             of credit       to approximately        55%
                     of NSCC's aggregate required               clearing      fund deposits        (only 78 of
                     NSCC's 410 members use letters                 of credit).         In addition,       NSCC
                     has obtained a secure line of credit                   totalling       $200 million.
                     These changes will         give NSCC approximately               $350 million       in
                     liquid    assets and will        facilitate       NSCC's ability         to meet its
                     payment and guarantee obligations                 in a timely manner.             We are
                     continuing      to discuss with NSCC whether these changes are
                     adequate to meet NSCC's reasonably                  anticipated        payment
                            We would urge GAO to consider not only the composition            of
                     clearing    and guarantee funds at clearing      organizations,    but the
See comment 5.       size of those clearing     funds in relation     to the clearing
                     organization's     payment obligations     in normal and volatile
                     market conditions.      Not only must clearing      organizations    have
                     liquid    assets, they must have assets sufficient         to meet their
                     payment obligations     on a timely    basis.   We have sought to apply

                         Page 63                                                GAO/GGD-90-33 Clearance and Settlement
                    Appendix III
                    Comments From the Securities and
                    Exchange Canmission

                Richard   L. Fogel
                January   5, 1990
                Page 4

                this standard in our discussions          with NSCC and the Options
                Clearing    Corporation      (8VOCC88):we believe that both clearing
                organizations      have taken actions to meet that standard.             We
                urge GAO to apply the same standard in its review of other
                clearing    organizations.       For example, although the GAO report
                notes that the Chicago Mercantile           Exchange (I'CME") has
                increased     its guarantee fund to approximately         $40 million     and
                we understand      from CME officials     that they have obtained lines
                of credit     exceeding approximately       $250 million,   that may not be
                sufficient      to meet the CME's payment obligations         in volatile
                markets (u,          as the Report notes, the CME delayed payments of
                approximately      $1.5 billion    to two clearing     members for more
                than six hours on October 20, 1987).
                      C. Reducing     Cash Flows and Information            Sharing
                     The Report correctly   has identified    two important     areas
                for reform of clearance and settlement     procedures:      reducing
                cash flows within  and across markets 3f and increasing

                     In its discussion          of how market participants             who trade
                     across all three markets (stocks,                  options and futures)
                     represent   a link among the three markets, the Report
                     states that differences               among clearance      and settlement
                     systems in the three markets can sometimes hinder inter-
Now p. 17.           market trading          (page 20 of the Report).              The Report also
                     indicates   that if capital             to support intermarket
                     strategies     is limited,          clearance and settlement
                     differences      between markets can hinder an intermarket
                     strategy,   especially          in volatile      markets.        We assume that
                     the Report does not intend to imply that clearance                         and
See comment 6        settlement     facilities         should be designed to facilitate
                     intermarket      trading      strategies       based on limited        capital,
                     but rather that clearance               and settlement        anomalies should
                     not unnecessarily          restrict      capital    availability       other than
                     for prudential         reasons.
                     In addition,      the Report indicates        that market participants
                     cannot use the proceeds from their              stock market activities
                     to focus on the potential             need for financing      or capital
                     pending execution          of equity trades and settlement          of those
                     trades.     The example, however, overstates             the potential
                     problems.      If a market participant         has sold futures         and.
See comment 7        bought stock, he or she can borrow money using the stock
                     as collateral,       but like any other investor,           cannot expect
                     to receive funds (other than dividends               regularly     paid all
                     shareholders)       sufficient      to meet payment obligations           if

                   Page04                                               GAO/GGD-90-33 Clearance. and Settlement
                           Appendix III
                           Comments From the Securities and
                           Exchange Cwnmisaion

                 Richard     L. Fogel
                 January     5, 1990
                 Page 5

                 information  flows among clearing   organizations that serve those
                 markets (lWinformation  sharing").  4/ These two areas have been
                 a Commission   priority since October 1901 and much has been done
                 over the past two years to address them.

                 Zilu( . ..continued)
                           the futures position           increases    in value and the stock
                           position     decreases in value.          In this instance,
                           differences      between markets are irrelevant.            On the other
                           hand, if a market participant             has bought futures     and sold
                           stock,    the market participant          can draw from the proceeds
                           of the sale to satisfy            payment obligations    if the futures
                           contract     declines      in value.     Futures and equities     settle
                           on different       time frames, and this may give rise to a need
                           for financing        until   the equity trade has settled,        usually
                           five business days after the trade is executed.
                 A/    The Report separately            diagrams the clearance          and
                       settlement      relationship        among the exchanges and clearing
                       organizations        in the stock, options,          and futures     markets.
                       The figure diagramming the structure                 of stock clearance
                       and settlement          (page 13 of the Report) does not reflect
Now p. 12              the full     scope of the NSCC's, Midwest Clearing
                       Corporation's         (IIMCCI*) and Stock Clearing         Corporation   of
                       Philadelphia's          (l'SCCP*l) relationships      with the exchanges
See comment 8.         and depositories.            The three clearing       corporations
                       maintain     interfaces       among themselves and the depositories
                       that permit members to settle               trades, wherever executed
                        (u,      on the New York, American, Midwest or Philadelphia
                       Stock Exchanges, as well as over-the-counter                    through the
                       National    Association        of Securities       Dealers'    ('INASD")
                       NASDAQsystem) . Thus, the lines running from the
                       exchanges and the NASD should connect to NSCC, MCC and
                       The Report discusses         in general the organizations          involved
Now p. il.             in the clearance        and settlement      of futures    trades (page
                       16 of the Report).         The discussion        needs to clearly      spell
                       out why so few futures          clearing    organizations     handle most
                       of the trading       volume.      With   two exceptions     (be.,    the
                       Board of Trade Clearing           Corporation     ("BOTCC") and the
See comment 9.         Inter-market     Clearing    Corporation      ("ICCVl)), futures
                       contracts     traded on an exchange are cleared at only one
                       clearing    organization,      and those contracts        are not
                       fungible    between exchanges or their affiliated              clearing
                       organizations.        Thus, if 80% of the open interest            in all
                       futures    contracts     is on the CME and the Chicago Board of
                       Trade (IICBTII) , BOTCC and CME will           clear 80% of futures        contracts.

                           Page 68                                           GAO/GGD-90-33 Clearance and Settlement
                        Commenta From the lhcuritles    and
                        Exchange Commis8ion

                   Richard     L. Fogel
                   January     5, 1990
                   Page 6

                          1.      Reducing     Cash Flows
                                   a. Cross-Margin
                        The Report           discusses efforts      to implement intermarket
                  crose-margining            systems.     To date, the Commission and the CFTC
                  have approved a            cross-margining     arrangement between OCC and
                  ICC, 5/ and, on            a pilot   basis, a cross-margining     arrangement
                  between OCC and            CME. 4/
                          Nevertheless,      there are certain         impediments to the
                  expansion of cross-margining             arrangements that are not within
                  the control       of the Commission.         For example, while permitting
                  market maker participation           would increase the benefits              of
                  cross-margining,         our understanding       is that, without        further
                  action by the CFTC regarding            various rule interpretations,              such
                  an expansion is not possible.             z/ The Working Group recommended
                  that the CFTC evaluate whether market maker and floor trader
See comment 10.   participation        in the OCC-ICC cross-margining           pilot    would be
                  consistent       with its segregation        rules, 8/ and, if not, to
                  consider the desirability           of changing those rules.             As of the
                  date of this letter,          the CFTC has not interpreted           or changed
                  its rules to allow market maker and floor trader participation
                  in either      the OCC-ICC or CME-OCC cross-margining               pilots.      In
                  addition,      permitting     bank financing       in connection     with cross-
                  margining,       as OCC and CME proposed, also would expand the
                  benefits      of cross-margining.         The CME-OCCcross-margining
                  pilot,     however, at the CFTC's request,             does not include a
                  proposed bank financing          provision      pending further      analysis.      9/

                  w       m Securities   Exchange Act Release No. 26153 (October                     3,
                          1988), 53 FR 29567 [SEC File No. SR-OCC-86-171.
                  w       m Securities   Exchange Act Release No. 27296 (September
                          26, 1989), 54 FR 41195 [SEC File No. SR-OCC-89-011.
                  Ii/     m letter     from Jean A. Webb, Secretary, CFTC, to Lori R.
                          Burns, Assistant   General Counsel, CME, dated September
                          26, 1989.
                  a/      &.q~ Interim       Report   at 21.
                  2/      &g puma, note 6. We understand the CFTC staff
                          expressed concern about OCC and CME relinquishing       control
                          of options to banks participating in the pledge program

                        Page 66                                           GAO/GGD!N-33 Clearance and Settlement
                         Appendix Lll
                         Comments From the Securities and
                         Jbhange Conunhion

                   Richard     L. Fogel
                   January     5, 1990
                   Page 7

                           b. Delayed     Payments
                          The Report notes that,     in the derivative     markets, delayed
                   payments by clearing    organizations      to clearing   members caused
                   problems during the October 1987 market break. Specifically,
                   t.he Report notes that two CME members received           $1.5 billion six
                   hours late on October 20 and OCC clearing           members received
                   payments up to two and one-half        hours late during the market
                   break.    The delays reportedly     resulted    from trade processing
                   delays and the extended credit        approval process necessitated      by
                   unusually   large payment obligations.
                          The Report notes, however, that CME has taken steps to
                   resolve the problem (u,         improving  its automated systems to
See comriwnt 11.   reduce trade processing    time and increasing       its clearing   fund
                   from approximately    $4.6 million    to $35 million),    but suggests
                   that OCC has not revised its practices        to correct    the problem
                   of late payment to clearing      members. We do not understand the
                   basis for GAO's conclusions.
                           We believe    that a clearing    organization's       rules and
                   settlement       bank agreements should spell out clearly           respective
                   rights    and obligations.       As noted in the Report, we have
                   reviewed OCC's rules and settlement           bank agreements and believe
                   those rules provide adequate clarity             and certainty.        OCC'S
                   rules assure members timely payment of funds owed to them by
                   occ.     Although OCC will     not pay a member if f;hplr memker has not
                   satisfied      its payment obligations      earlier    that day, OCC remains
                   obligated     and will    pay all other members on a timely basis.
                           We also believe      it is appropriate    to measure a clearing
                   organization's       ability   to meet its anticipated     payment
                   obligations      during normal and volatile       markets (m discussion
                   above at item I. B.).          Accordingly,    we have reviewed OCC's
                   clearing     fund and financing      sources.    Based on our review, we
                   believe     OCC'e clearing      fund and other financing    sources are
                   sufficient.      W      For example, OCC's payment obligations       to the

                   WC . ..continued)
                          when the value of those options might otherwise              be used to
                          offset   losses incurred     in liquidating     a defaulting
                          clearing    member's obligations.        We continue to explore
                          with OCC, CME and CFTC staff ways to address these concerns.
                   19/     OCC has increased minimum clearing     fund requirements
                           bringing  its aggregate required    deposits up to $219.2
                           million.    $&.g Securities Exchange Act Release No. 27410

                         Page 67                                      GAO/GGD4JO-33 Clearenee end Betthmnt
     Ckmunenta From the Securitlea and
     Fixchange Commiseion

Richard     L. Fogel
January     5, 1990
Page 8

five members with the largest          collects    during October 1987 and,
more recently,    on June 30, 1989, totaled          less than $80 million
and $20 million,     respectively.       To meet these obligations,      OCC
maintained,    among other things,        a clearing    fund (that does not
include letters     of credit)     that exceeded $275 million      and $232
million,    in October 1987 and on June 30, 1989, respectively.
       Based on information     contained    in the Report, the CME's
clearing   fund during the October 1987 market break appears to
have been less than $10 million,         and since has been increased
to $35 million.     As indicated     above, we understand the CME has
obtained a $2'50 million     line of credit.         We are not sure,
however, if these resources,        standing alone, are sufficient      to
meet the CME's payment obligations          during volatile    markets.   As
noted in the Report, on October 20, 1987, the CME owed two
clearing   members approximately       $1.5 billion.
        c. Settlement    Time-Frames
       The Report notes the continued     lack of coordination     of
settlement    times across markets.     On the one hand, the Chicago
futures    markets use a limited    number of settlement    banks (i.e.,
between four and six Chicago banks) and obtain commitments from
those banks at approximately      6:40 a.m. (CST).       On the other
hand, OCC effects     settlement  through approximately     16 banks in
a number of cities     in several time zones at 9:00 a.m. C-T)
 (for payments'to    OCC) and at 10:00 a.m (CST) (for payments to
clearing    members).
         We believe OCC's arrangements facilitate          the settlement
process because they permit OCC clearing               members to effect
payments to OCC through banks with whom they maintain
traditional        banking relationships     for all of their      financing
activities.         Although OCC has committed to deliver         morning
settlement       instructions    to clearing    banks by 7:00 a.m. (CST)
instead of its current         practice    of delivering   instructions      at

WC-..      continued)
         (October 31, 1989), 54 FR 46668.           In addition,   OCC has
        submitted a proposed rule change to the Commission that
        provides    for the netting    across accounts of all cash
        settlement     obligations  to be settled      between it and any
        clearing    member to one pay or collect        amount.    m
        Securities     Exchange Act Release No. 27444 (November 15,
        1989)) 54 FR 48175. The proposal will             decrease the number
        and amount of funds transfers         considerably     and thereby
        further    decrease the likelihood       that OCC would be unable
        to meet its settlement      obligations.

   Page 68                                           GAO/GGIHO-33 Clearance and Settlement
                       Chunenta From the Securltles and
                       Exchsnge C4munission

                  Richard     L. Fogel
                  January     5, 1990
                  Page 9

                  9:00 a.m. (CST), it has not done so because many clearing
                  banks, particularly       those in New York, are not ready to receive
                  instructions    by 7:00 a.m. (CST). We understand that OCC would
                  be prepared to change its settlement            time frames if the
                  necessary systems (eLqt, Federal Reserve and member bank
                  payment systems) and personnel         (particularly       credit qfficers
                  and support staff)      were available     and ready to effect       payments
                  and make credit     decisions   at an earlier        hour. We are continuing
                  to explore this issue with OCC and bank regulators.
                         d. Futures-style         margin
                          The Report notes that the Working Group recommended
                  exploration       of futures-style        margin as one of several ways to
                  reduce intermarket          cash flows.       We believe the Report misstates
                  our position       on futures-style         margining.       In examining
                  proposals     by the CME and CBT to use futures-style                     margin for
                  futures     options contracts,          Commission staff has explored the
                  benefits,     costs, and risks of margining               securities        options as
                   if they were futures.           The Commission staff          is concerned that
                  adoption of futures-style             margin for securities           options could
                  change the economics of option trading                  by eliminating          the
                  usefulness      of certain      strategies,      such as covered call writing,
                  and foreclosing         some market participants,           such as investment
See comment 12.   companies and insurance companies, which are subject to
                  investment      restrictions.         We believe that these changes could
                  eliminate     as much as 30-50% of options trading                   activity      today.
                  Moreover,     futures-style        margin, if applied to reduce initial
                  margin deposits,          could increase the ability           of long option
                  holders to leverage their             investments      and could permit holders
                  to control      substantial      positions     in securities        through index
                  options at almost no cost, possibly                 increasing      systemic risk.
                         2. Information        Sharing
                         Considerable     progress has been made in efforts         to improve
                  intermarket     information    sharing.      For example, the Securities
                  Clearing    Group ("SCG18) has been formed by several clearing
                  agencies for the purposes of communicating            information    on
                  common members and to explore the development of other devices
                  of common interest        to SCG members, such as cross-lien
                  agreements. W         In addition,      at the SEC's and CFTC's urging,
                  OCC has agreed to participate           in the BOTCC's system for the

                  W      A cross-lien      agreement would permit one clearing     agency to
                         recover losses remaining after liquidating         a defaulting
                         member's account by obtaining        access to the member's
                         clearing     funds at other clearing     agencies.

                      Page09                                                 GAO/GGD-90-33 Clearance and Settlement
                      Appendix   m
                      Cmmente From the securities and
                      Exehsnige Conunb6ion

                 Richard L. Fogel
                 January 5, 1990
                 Page 10

                 routine     exchange of pay/collect           data among clearing
                 organizations.         We believe this is a positive              step toward
                 intermarket       information     sharing.      Moreover, futures         and
                 securities      clearing     organizations,       clearing      banks and their
                 regulators     meet quarterly        to discuss intermarket           clearing     and
                 payment system coordination             issues.      Also, the Working Group
                 meets regularly         to coordinate      regulatory      concerns.      Clearing
                 organizations        and regulators       are continuing        to pursue these
                 initiatives      with a view toward increased              information      sharing
                 and reduced cash flows.
                         The Report correctly           identifies      that the Working Group
                 urged NSCC participation             in the BOTCC's pay/collect              information
                 sharing system and that to date NSCC is not participating                            in
Se&comment 13.   that system.           We believe that NSCC has raised substantial
                 concerns that GAO should consider more carefully.                           Those
                 concerns include BOTCC access to confidential                       information      about
                 clearing     mQmbQrQ; the possibility             that futures        clearing
                 organizations,         including     the BOTCC, may misinterpret
                 pay/collect       data and take inappropriate                action based on that
                 information;       differences       in settlement         time frames between NSCC
                 and derivative        markets (NSCC effects            money settlement         in next-
                 day funds during the late afternoon,                   derivative      markets effect
                 settlement      in the early morning hours the next day); the
                 limited     number of NSCC participants              that are also mQmbQrS of
                 futures     clearing      organizations;        and other information           that is
                 more useful to clearing             organizations        than the size of
                 pay/collect       obligations.
                         We believe     it is important      for all clearing         organizations
                 to know the business mix of their members and the professional
                 market participants         whose trading      activity       is cleared through
                 those members: where and through whom those members conduct
                 business in other markets (and related                  clearing    organizations);
                 whether those firms are subject to greater than normal
                 surveillance:        and whether those firms have failed               to meet their
                 obligations      in a timely manner.         To this end, the securities
                 clearing     agencies and OCC, through SCG, have established                      a
                 common membership list,          which now includes           membership data from
                 the futures      clearing    organizations.         In addition,       SCG members
                 have agreed to notify         each other concerning             common members who
                 are placed on surveillance           or who default         on their     obligations,
                 and we have encouraged SCG to discuss with futures                      clearing
                 organizations       ways to share information            concerning     common
                 inter-market     clearing    members. We understand SCG plans to meet
                 with futures       clearing   organizations      within       the next few months
                 and we will use our best efforts             to encourage progress in this

                     Page 70                                               GAO/GGD9033      Clearance and &ttlement
                          Come&a F’rom the Securltles and
                          Exchange Co&ion

                   Richard L. Fogel
                   January 5, 1990
                   Page 11

                   II.      pther    Matte=

                            A.      Trade Matching   and Trade Processing        Systems

         I                The Report gives the impression
                   clearing   organizations  had difficulties
                                                              that stock and options
                                                                  matching trades during
Now p.2.+.         the October 1987 market break (pages 23-24 of the Report).             In
                   fact, trade matching systems worked well during the October
                   1987 market break and were able to process trade data without
See cominent 14,   incident.    The problem lay in the ability      of some execution
                   systems to execute trades on a timely basis or the ability            of
                   clearing   members to submit trade data to clearing       corporations
                   in a timely manner. w
                           The Report states that trade processing              problems during
                   the October 1987 market break caused uncertainty                  among market
                   participants       and caused them to question the integrity                of the
Now p, 2’6.        markets (page 31 of the Report).             The tone of this statement            is
                   too strong.        Although some clearing       organizations       were slow to
See cominent 15    determine clearing        members' settlement       obligations,       much of the
                   delay can be attributed         to the problems on the trade execution
                   side and the inability         of clearing     members to input trade
                   information      into the clearing      organizations'       systems.       In
                   addition,     although OCC delayed in paying its members on the
                   morning of October 20, 1987, we are not aware of any general
                   perception     that OCC might be unable to make those payments.
                   Therefore,     while some market participants           may have had some
                   uncertainty      as to the timing of the clearing            organizations'
                   trade processing,        at least in the securities          and options areas
                   the integrity       of the markets was not questioned.
Now p, 25.                The discussion    regarding   trade matching and reconciliation
                   systems includes      the Working Group's recommendation for same
                   day comparison but omits the Group of Thirty           recommendation
                   that equities    move to overnight      comparison (page 34 of the
                   Report).    The Commission has endorsed the Group of Thirty's
See comment 16.    recommendation.       To this end, we note that currently         over 95%
                   of all New York Stock Exchange and American Stock Exchange
                   trades and over 90% of over-the-counter          trades are now compared
                   before markets open on the morning after trade date.               We
                   believe that the Group of Thirty's         recommendation,     while noted
                   in the Introduction,       should also be referenced      in this

                   &?-/    m Division   of Market Regulation,            The October       1987 Market
                           Break (Feb. 1988) ch. 10 at 6-9.

                          Page 71                                          GAO/GGIMO-33Clearance and Settlement
                       Appendk lU
                       Commentg From the Securities and
                       Exchange Commission

                   Richard L. Fogel
                   January 5, 1990
                   Page 12

                         B.     Clearing   Organization      Risk Management Systems
Nowi pp. 37-38.           The conclusion   and recommendations section of Chapter
                   Three focuses on the need for further        change in the equity
                   clearance   and settlement   system, but does not address the need
                   for continued    improvements in futures     clearance    and settlement
See; comment 17.   (pages 54-56 of the Report).       We believe that,     in light    of the
                   discussion    in Chapter Three, there is a demonstrated          need for
                   continued   improvements in the settlement       systems in both the
                   equities   and futures markets.
                                                          * * *
                          If this Report is issued, we request             that a copy of this
                   letter   be appended to the Report.    Again,           thank you for the
                   opportunity    to comment on the Report.

                                                          Richard      G. Ketchum

                      Page 72                                             GAO/GGD-9033 Clearance and Settlement

                Appendix III
                Commenta From the Securities and
                Exchange C!ommbsion

                The following are GAO’S comments on the Securities and Exchange Com-
                mission’s letter dated January 6, 1990.

                1. We support sEc-sponsoredlegislation that directs SECand CFIY:to fos-
GAO /Comments   ter the development of coordinated and linked intermarket clearance
                and settlement systems.We believe the legislation, if enacted, will sup-
                port our recommendations.The expertise of both the SECand CFTCare
                neededto establish a timetable for industry action and implement Work-
                ing Group initiatives.
                2. These issuesare addressedon pp. 45-49 of the report.
                3. We agree that a uniform set of rules should be established concerning
                how a bank as a creditor establishes a claim to uncertificated securities.
                We support SECrule-making authority that would preempt state laws on
                perfecting a security interest.
                4. The text has been amendedon p. 34 to take account of these recent
                rule filings with SEC.
                6. We agreethat clearing organizations should have liquid assetssuffi-
                cient to meet their payment obligations on a timely basis. Although
                intraday margin pays and collects should diminish the size of any single
                futures payment, original margin deposits are usually sufficient to meet
                the payment obligations of futures clearing organizations. Seealso p. 6
                of CFTC’S comment letter where this matter is further discussed.
                6. We concur that clearance and settlement facilities should not be
                designedto facilitate inter-market trading strategies basedon limited
                capital and that clearanceand settlement anomalies should not unneces-
                sarily restrict capital availability other than for prudential reasons.
                7. The text has been changedon p. 17 to indicate that market partici-
                pants sometimesborrow against the value of their stock gains to cover
                lossesin the options or futures markets.
                8. The text has been changedon p. 11 to make this point. We have
                adjusted the title of figure 1 accordingly. The primary relationships in
                stock clearanceand settlement are as diagrammed in figure 1.

                Page 73                                  GAO/GGDfKl-33 Clearance and Settlement
    Commente From the Securities and
    &change cOmmisaion

    9. The text of chapter 1 indicates that most futures exchangesare affili-
    ated with a single clearing organization and that 80 percent of the
    futures trade volume is cleared by B(JIY=Cand CME.
    10. We agree with the SECthat CFE should formally evaluate whether or
    not market makers’ and floor traders’ participation in the occ-ICCcross-
    margining pilot is consistent with segregationrules and, if not consis-
    tent, the desirability of changing segregationrules.

    11. The text in chapter 4 on p. 44 has been altered to indicate that occ
    has submitted a rule changeto SECfor review and approval to correct
    the problems of late payments to clearing members.
    12. The text has been altered on pp. 47-48 to reflect SECconcern on
    futures-style margining of changing the economicsof option trading and
    possibly increasing leverage and risk.
    13. Seepp. 38-39 of this report where information sharing issuesare
    14. The discussion in the report is about trade processing,which
    includes the submission of trade data by clearing members,not just
    trade matching. We have altered the text on pp. 25-27 to make this point
    clearer. We agreethat the primary problems were not the initial match-
    ing process,but the late submission of data to that processand inade-
    quate reconciliation of trades that did not match on the first attempt.

    16. Reports of uncertainty have been attributed to the Brady Report,
    and the text discussingloss of confidence in the markets has been
    revised. Seep. 26 of the report.
    16. Efforts to achieve same-daycomparison in responseto the Working
    Group recommendation will also achieve overnight comparison in
    responseto the Group of Thirty recommendation. The text has been
    altered on p, 26 to note the Group of Thirty recommendation.

    17. The text has been altered on p. 38 to indicate that federal regulators
    of stock, options, and futures markets need to strengthen their respec-
    tive clearance and settlement systems by further reducing or mitigating
    known risks.

    Page 74                                  GAO/GGIMO-33 Clearance and Settlement

Appendix IV
Co@mentsFrom the Commodiml?utures
Trbg Commission

Note: GAP comments
supplemdnting those in the
report te ‘t appear at the
                                                          COMMODITY FUTURES TRADINQ COMMISSION
end of thii1, appendix.                                          ?ms K BTREET, N.W., WABHINQTON, DC -1
            I                                                                   (W 2544sM
                                                                          (201) B44ZW FACSIMILE
                                                                             110.822-9327 TELEK

                                   DIVISION OF
                             TRADINQ AND MARKETS

                                                                                                         January   29, 1990

                                    Mr. Richard Fogel
                                    Assistant   Comptroller      General
                                    General Government Programs
                                    General Accounting      Office
                                    441 G Street,   N.W.
                                    Washington,   D.C. 20548
                                                   Re:   &port       on Cleue              and Settlement          RefQEm
                                    Dear Mr. Fogel:
                                            The Commission has authorized                me to comment on the report
                                     ("Report")     of the General Accounting              Office    ("GAO") concerning
                                    clearance      and settlement         reform in the equities,         futures    and op-
                                    tions markets.          GAO endorses the recommendations of the Presi-
                                    dent's Working Group on Financial                  Markets ("Working Group") and
                                    the Group of Thirty.              Specifically,       GAO recommend5 that the
                                    Working Group take an active role in appropriately                       implementing:
                                     (1) a routine       intermarket       information       sharing system to assess
                                    intermarket       risk5 posed by joint members;               and (2) studies ex-
                                    ploring     ways to lessen intermarket               cash flow pressures and to
                                    simplify     intermarket        clearing      without   diminishing     safeguards
                                    against financial          risk.
                                          The Commission wholeheartedly       concurs that effective    clear-
                                    ance and settlement    processes are vital      to the proper functioning
                                    of the financial    markets.     The Commission has worked continuously
                                    since the October 1987 market break with other regulatory           bodies
                                    and self-regulatory    organizations    to improve those processes and
                                    thus support5 the general recommendation5 of the GAO.
                                           We appreciated   the opportunity                  to work with members of your
                                    staff in explaining     the steps taken                  by the Commission and the
                                    futures market5 to improve clearance                       and settlement   systems.   we
                                    believe that certain      aspects of the                 Report can benefit     from ad-
                                    ditional   information.     Our comments                 on the Report are set forth
                                    A.    Information
                                           Information  sharing has long been a Commission priority.   In
                                    financial    rule enforcement reviews since 1985, Commission staff

                                         Page76                                                          GAO/GGD-90-33   Clearance and Settlement

                 Mr. Richard      Fogel
                 Page 2

                 has recommended that exchanges explore means of routinely       ob-
                 taining  information     on members with exposures in more than one
                 market.    The Board of Trade Clearing Corporation     ("BTCC") pay and
                 collect data-sharing      system was well along in development prior
                 to the October 1987 market break, and the Commission‘s large
                 trader position     database has been in place since 1937.
                         Routine sharing among futures clearing           organizations      using
                 the BTCC data-sharing         system went on line in October 1988, and
                 has proven to be an invaluable          tool.      The BTCC developed this
                 system at its own expense and operates it on a costs only basis.
                 The Commission has sought to obtain participation                by securities
                 clearing     organizations     in this system for approximately         two
                 yeare.     The Options Clearing Corporation           ("OCC!") began to par-
                 ticipate     in October 1989, after signing an agreement to partici-
                 pate in May 1988. The National            Securities    Clearing    Corporation
                  ("NSCC") continues        to decline to participate.
                           The Commission has also been developing          a position  database,
                 which would use data from the Commission's large trader reporting
                 system, that would include information              about positions   of clear-
                 ing firms across futures          and futures    options markets.     This sys-
                 tem should be operational          in mid-1990.      While the system will
                 initially      use data concerning      futures positions,      this system
                 could incorporate       securities     data as well and the Commission has
                 offered OCC the opportunity          to participate.
                        OCC and NSCC have expressed concerns about protection                      of the
                 confidentiality      of the data in the BTCC system.                Their concerns,
                 however, seem unwarranted based on actual experience                      with the
                 system and the extensive          confidentiality       provisions       agreed to by
                 its users.      BTCC officials       advise that as an operational             matter
                 each participating       clearing     organization      has access to the pro-
                 cessed pay and collect         and surplus and deficit           information      on its
                 own members within       minutes of any other participant.                 The BTCC's
                 computer center receives          the data directly        from various clearing
                 organizations'     computer centers.            This information       is then pro-
                 cessed and stored in the BTCC's computer disk where it is acces-
                 sible at precisely       the same moment by all clearing               organizations
                 with terminals     linked directly         to the BTCC's computer center.
                 Thus, any clearing       organization       with a terminal       can access      the
                 information     at approximately        5:30 a.m. each day.
See comment 1.          The suggestion     that the BTCC has earlier        access to this in-
                 formation     is erroneous.       In addition,   OCC's claims that the BTCC
                 system would encourage a "race to the bank" by multiple                   clearing
                 organizations      seeking to receive security         in preference      to each
                 other seem inconsistent          with OCC's decision     not to synchronize
                 its daily settlements         with the earlier    settlements      of the Chicago
                 Mercantile      Exchange ("CMB") and BTCC. Despite recommendations of
                 the Working Group for harmonization            of settlement     timeframes,       OCC
                 continues     to collect    its settlements     at approximately       9:00 a.m.

                       Page78                                             GAO/GGD8@83ClesranceandSettlement
                         Trading Commission

                   Mr. Richard     Fogel
                   Page 3

                   each morning and pays at 10:00 a.m., although the CME and BTCC
                   collect   &   pey settlements   before the markets open at 7:20 a.m.
                   In connection   with the CMB/CCC cross margining program, the Com-
                   mission has suggested that CCC collect       &    key QB& funds contem-
                   poraneously.    This would facilitate    netting    procedures at common
                   banks and assure that cross-margining      actually     results in a re-
         I         duction in the number of payments made.
See comt-hent 2.          The OCC'a statements about the operation  of the BTCC infor-
                   mation sharing system are incorrect.     If OCC's allegations  are to
                   be published    with the Report, BTCC should be provided the oppor-
                   tunity   to respond to them.

Now p. 50.                The Report contains          a recommendation on page 16 that the
                   Securities     and Exchange Commission ("SEC") and the Commission
                   ensure that appropriate            mechanisms are in place to assure that
                   payments required         by clearing      members and clearing        organizations
See comment 3.     are made within        established      timeframes.       We believe that the ob-
                   jectives     underlying     this recommendation have largely              been
                   achieved.      Intra-day      variation     payments and collections           have been
                   made routine      since October 1987 and CME's settlement                  software can
                   accommodate payments made with securities                  as well as cash.        Such
                   enhancements have largely             solved any problems which might have
                   existed    regarding     timely payments.         Indeed, market participants
                   have informed us that makinq routine                intra-day    variation      payments
                   and collections       by clearing       members is one of the single greatest
                   improvements in clearance             and settlement      processes eince October
                           Another improvement in this area is the revision                   of settle-
                   ment agreements between clearing              organizations       and banks.      As of
                   October 21, 1988, the BTCC, the CM8 and each of the four Chicago
                   settlement      banks I/ entered into uniform settlement                agreements
                   which are intended to clearly             specify the obligations          of the
                   parties    with respect to the honoring of settlement                 instructions
                   received     from the clearing        organization      and the timing and fi-
                   nality    of payments between clearing             members and the clearing         or-
                   ganizations.        The agreements require          each clearing     bank either to
                   pay member obligations           through irrevocable        credits   to the re-
                   spective     clearing     organization's      account or to inform the re-
                   spective     organization      that the payment cannot be processed by a
                   time certain       before the opening of regular            trading   hours.

                   11    The CM8 entered into agreements             to add two settlement         banks
                         in New York in July 1989.

                        Page77                                             GAO/GGD-9&33Clearanceand&ttlement

                         Cemmen~ Fkom the Chmmodlty Futurea
                         WuUng C!ommi&on

                Mr. Richard       Fogel
                Page 4

                        The Report makes only passing reference            to these develop-
                ments    in discussing    payments to clearing        members by the CMR on
                October 20, 1987. The CM73opened for trading                 on time on that
                date and all clearing       members    were   paid within     the legal time-
                frame, that is in "same day funds,"            although it is true that
                payments to two clearing        members     occurred later than usual.         The
                Commiosionfs Division       of Trading      and Markets addressed the cir-
                cumstances related      to this matter on pages 55-56 of its m
                        t on Fm           Ovwt          of St-             Futures Markete
                        a October 1987, January 6, 1988 ("Follow-up              Report").    The
                problem was largely       caused by the fact that settlement             banks did
                not receive accurate instruction            sheets at the usual hour because
                certain    non-cash intra-day      variation     payments made on October       19,
                1987 were not accommodated by existing             software and therefore
                were not reflected      in the October 20 variation           calculations.
                Intra-day     variation   payments and collections         have since been made
                routine,    the applicable     software has been modified,           and this
                problem has not recurred.
                       To assure effective,            stable operation         of clearance   and set-
                tlement systems, receipt             of final,    irrevocable       payment comrnit-
                mente is the critical            fact.     When payment commitments          have fi-
                nality    and those commitments are honored through payment of same
                day funds, as occurred on October 20, market participants                        should
                have no cause to question the viability                    of the clearance     and
See comment 5   settlement        system.      To the extent that market participants              are
                encouraged to believe that isolated                 delays in their receipt         of
                funds constitute          a basis for questioning            the soundness of the
                aystam, they may be encouraged to take precautionary                        measures,
                such as delaying          their own payments to cuetomers or clearing                 or-
                ganizations,         which could have adverse impacts upon the market as
                a whole.        In addition,      we do not believe that any evidence has
                been developed that the incident               created a general lack of con-
                fidence in the futures markets, as the late payments only came to
                public    light      well after the actual event. 2/

                21      The SEC comment letter        also makes repeated reference        to this
See comment 6           incident,     implying   that the CME payments referred         to may
                        have been delayed because CME was unable to make such
                        payments and questioning         whether the CME has adequate
                        resources to weather future market crises.               The SEC fails   to
                        note, however, that in addition          to the fact that all
                        payments were made by the CME on October 20 in same day
                        funds, standing original         margin on deposit at the CME
                        exceeded by billions        of dollars   the variation     margin
                        payments made during October 1987. See Table 5, Follow-up
                        Report at page 66(a).         Uarqin is the first      line of defense
                        in a volatile      market and while we have encouraged efforts           by
                (Footnote     Continued)

                        Page 78                                           GAO/GGLWO-33 Clearance and Settlement
                           Chnmenta From the Commodity Futures
                           Trading Commission

                     Mr. Richard       Fogel
                     Page 5

Seecommlent7.             The Report states that settlement     bank payment confirmations
                     were over an hour late for thirteen    clearing  members. The CM8
                     haa advised Commission staff that only one such confirmation        was
                     over an hour late.   Follow-up Report at 44. All confirmations
                     were received before the market opened.

Now pp, 4 f3nd 29.          Existing       risk assessment tools are referred            to at pages 5
                     and 50 of the Report.             We believe that a complete assessment of a
                     firm’s     financial      risk would require         development of mechanisms
See comrrient 8.     whereby clearing          organizations        have access not only to data on
                     regulated      markets      such as securities,        stock options and futures,
                     but to data on unregulated              activities     such as foreign   exchange
                     transactions         and bridge financing          as well.   Both the CFTC and SEC
                     have been seeking legislation               addressed to obtaining      additional
                     information       related     to assessing the exposures of holding company

                     D.   &&,&ion        of Ca& Flowa
Nowp.17;                   We are concerned that there is an assumption on pages 22-23
                     of the Report that preservation         of intemarket      strategies     is more
                     important   than prudential      concerns.    Margin and capital       require-
See comment 9.       ments are intended to reduce systemic financial             risk,    and imple-
                     mentation   of margining     systems which result      in symmetric cash
                     flows may ease pressures on third party lenders.               The feasibility
                     of such measures should be assessed and regulators               should deter-
                     mine whether it would be sound public policy to adopt futures-
                     style margining    systeme.      Such a system need not be mandated for
                     markets in which it would not be appropriate             or desired.      In any
                     event, the overall     health and preservation        of the financial       mar-
                     kets  should take precedence over the implementation              of any

                     (Footnote      Continued)
                            the CM8 and other clearing          organizations       to augment and make
                            more liquid      their guarantee funds, such funds should not be
                            considered     as a substitute      for prudential        margin levels.
                            Such levels proved adequate during October 1987 and again in
                            October 1989 under very stressful             conditions.       Suggestions
                            that the CME is not financially            able to meet its obligations
                            under volatile       market conditions      cannot be supported by an
                            objective     assessment of CMB's actions,           contingency    plans and
                            capabilities.         The CME's payment record on October 20, 1987
                            might be usefully        contrasted    with that of the OCC which, as
                            the Report notes, made late payments to u                   of its clearing
                            members     on that date, even though OCC's payments are due
                            later in the trading         day than CMB's payments because of
                            OCC's midmorning settlement.

                          Page 79                                          GAO/GGD-go-39 Clearance and Settlement
                         Appendix IV
                         Commenti F’rom the Commodity Futures
                         Trading Ckmunission

                   Mr. Richard      Fogel
                   Page 6

                   particular      trading   strategy.  We believe that              the SEC comment
                   letter     (footnote    4 at page 3) makes essentially               the sAme point.

                   E.                            d Use of Let-            of Cr&
                          Commission staff supports the GAO's recommendation that the
                   SEC and CFTC assess the Adequacy of clearing             organizations'       use
                   of letters     of credit   in their guarantee funds.         Futures clearing
                   organizations     have made improvements in this area, including               the
                   CMB's elimination       of the use of letters     of credit     in ita guaran-
                   tee fund and increases        in the size of its guarantee fund.            The
                   CM?, hae also modified the basis on which it calculates                guarantee
                   deposit requirements       from a flat   rate to A risk-based        rate based
                   upon average daily margin requirements          for   the clearing      firm.     We
                   will   continue to encourage and facilitate         further    enhancements of
                   this nature.
See comment   10           The Report would be improved by inclusion                   of a discussion        of
                   the different      functions      performed by equities           clearing     guarantee
                   funds and futures        clearing     guarantee funds.           When these differ-
                   ences are analyzed,         equities     clearing       guarantee funds appear more
                   comparable to initial          margin deposits          in the futures      markets than
                   to futures     clearing     guarantee funds, which provide a financial
                   integrity     cushion Jo &&&g~             to initial       margin deposits.        The
                   NSCC, for example, does not require                 initial    margin deposits.
                   NSCC clearing      firms are required          to make deposits         to NSCC's
                   clearing    fund baaed upon a formula that reflects                   the firm's      set-
                   tlement exposure calculated             on a daily basis but generally              col-
                   lected only on a monthly basis.                By contrast,       futures    clearing
                   organizations      calculate      and collect       margin baaed upon settlement
                   exposure at least on A daily basis, such that clearing                        member
                   margin deposits       accurately      reflect     the risk of their outstanding
                   positions.      Futures clearing         organizations        maintain     guarantee
                   funds that stand as An additional               protection,       in the event that
                   margin deposits       of a failed      clearing       fim prove inadequate to
                   cover a default.
                            The SEC's comments concerning         the possible     insufficiency      of
                   the CME guarantee fund (836 million              in cash and U.S. Treasury
                   securities,       supplemented by over 8250 million           in lines of credit)
                   in periods of volatile          markets appear to equate futures            guarantee
                   funds, which augment protection            Afforded by margin deposits,           with
                   those of equities        clearing   organizations,       which may, in effect,
                   substitute      for margin deposits.        For example, the SEC expresses
                   concern that the CMB guarantee fund would be inadequate in the
                   context of payment obligations           of the magnitude of 81.5 billion
                   total     payments owed two fims on October 28, 1987. However, on
                   October 20, the CME held original             margin deposits      of over $4
                   billion,     in addition     to its guarantee      fund.

                         Page 80                                               GAO/GGD99-33 Clearance and Settlement
                            Appendix N
                            C4munenta From the commodity FMures
                            lhadlng Commlsaion

                      Mr. Richard      Fogel
                      Page I

                               In reviewing    the adequacy of clearing           guarantee funds, the
                      length of the settlement           cycle is.also        a key consideration.         As
                      the Group of Thirty         clearance    and settlement        study and other
                      analyses of settlement          systems have concluded,           risk increases
                      with the length of the settlement               period.     The shorter the period
                      between trade execution           and settlement,        the lower the risk of
                      default.       Consequently,     the five-day       or greater settlement         period
                      in the equities        markets entails       a far greater risk of default
                      than the one-day settlement            period of the futures          markets, par-
                      ticularly     when accompanied by the now routine               intra-day    collec-
                      tion of margin in the futures markets.                   It may be constructive         to
                      review whether the security            available     to the equities      markets'
                      clearing     organizations,      whether characterized          as margin or guar-
See comment 11        antee funds, is adequate to addrees the risks of the five-day
                      equity settlement        cycle.
                      F.           e Processing
Now p. 26,                     The first    sentence of the first     full paragraph on page 25 of
                      the Report states that "[plrocessing           of information      about trades
                      and payment was a problem in the stock, options,                and futures
See comment 12.       markets."        There is also the implication       in Chapter 2, and par-
                      ticularly      at the top of page 33, that there were trade processing
                      problems in the futures markets.            There was no evidence of any
                      problems in the futures markets with respect to trade processing
                      and the text of the Report only discusses problems in the secu-
                      rities     market and at the OCC. Therefore,           we believe   all such
                      references       to trade processing  problems in the futures          markets
                      should be removed from the Report.
                      G.   Qther     Matters
Now p. 50.                    The conclusion    on page 16 of the Report that recommendations
                      designed to reduce cash demands "could rectify           problems which
                      pose great risks to clearance and settlement           systems" overstates
                      the situation.        It should be stated that potentially      such recom-
                      mendations could result        in measures to rectify    or reduce those
See comment 13        problems.      This raises a more general point,       to which we have
                      previously     alluded.    The Report appears to focus on liquidity
                      issues to a greater extent than it does on issues of financial
                      integrity    and risk management. There is often a trade-off          be-
                      tween liquidity       and protection     against risk.  The Report consia-
                      tently    emphasizes liquidity       over solvency as a paramount objec-
                            We note that on page 6 of the SEC comment letter,            the SEC
                      appears to be urging the Commission to permit bank financing             in
                      connection    with the CME/OCC cross-margining        program as a way to
                      expand the benefits      of cross-margining.       Banks have expressed
                      concerns to us regarding        such a pledge program and the Commission
                      is considering     the interests    of all parties    from a public policy
                      and regulatory     perspective.     We further   note that we have


                            Page 81                                              GAO/GGD-9033 Clearance and Settlement
                          Append& N
                         CommentsFrom the commodity Futuraa
                         Trading C%ambaaion

                   Mr. Richard     Fogel
                   Page 8

                   requested OCC to provide         an analysis  of     the bankruptcy      implica-
                   tions if cross-margining         were expanded.
                          We further    wish to note that the GAO is correct              in recog-
Now~p. 16          nizing the Commission's authority            over futures     clearing     organ-
                   izations    on page 20 of the Report.           The Commission's authority          in
See icomment 14.   this area is clearly       established     and has been vigorously          exer-
                   cised.     m,     u,     Board of Trade Cle&a           CDtion           v. United
                   m,         [1977-1980 Transfer      Binder] Comm. Put. L. Rep. (CCX)
                   'I 20,534 (D.D.C. Jan. 11, 1978), nffLd,            No. 78-1263 (D.C. Cir.
                   1979).     Thus, the suggestions       of OCC and NSCC that the Commia-
                   sion#s authority      over futures     clearing    organizations       is not es-
                   tabliahed     and that the absence of such authority             impedes coordi-
                   nation of clearance       and settlement      procedures among futures,           eq-
                   uities    and option markets, are erroneous.
                          The largest    and most sudden market adjustment    since October
                    1987 occurred during the period of October 13-16, 1989 and the
                   clearance    and settlement    systems performed in a quite stable
                   manner.    The latter    period is apparently   outside of the scope of
                   the Report, which is unfortunate       because it presented a nearly
                   ideal context in which to measure the adequacy of changes in
                   clearance    and settlement    systems and the regulation   thereof since
                   October 1987.
                         We thank you again for the opportunity   to comment on the
                   Report and reiterate   our support for its recommendations.   When
                   the Report is issued, please include a copy of this letter     as an
                   Appendix thereto.
                                                                        Very truly    yours,

                                                                        A Ad=uL At,     &M-/-
                                                                        Andrea M. Corcoran

                        Page82                                             GAO/GGD90-33 Clearance and Settlement
                Appendix IV
                Trading Commidon

    /           The following are GAO’S comments on the Commodity Futures Trading
    I           Commission’sletter dated January 29, 1990.
                1. Comments on the BUKCinformation sharing system are discussedin
GAO !Comments   detail on pp. 37-38 of the report.
                2. Becausesoliciting additional comments would delay issuanceof the
                report, we have decided not to allow EKTCC an opportunity to respond.
                3. Although we acknowledge that improvements made in intraday pays
                and collects and revised settlement agreementshave improved the time-
                liness of payments, the adequacy of available clearing member credit to
                support timely payment is not clear. Given the uncertain nature of clear-
                ing member credit arrangements, timely payment by clearing members
                continues to be an open question.
                4. Improvements in intraday variation payments and collections and in
                settlement agreementsare discussedin detail on p. 42.
                6. We agree that isolated delays in the receipt of funds by a clearing
                member from a clearing organization should not constitute a basis for
                the clearing member to delay payments to customers or clearing organi-
                zations. In addition, we do not take a position on whether there was or
                was not a general loss of confidence in the clearance and settlement sys-
                tems on October 19 and 20,1987. We attribute reports concerning lack
                of confidence in the clearance and settlement system to the Brady
                6. We agree that original margin on deposit at CME was adequate to meet
                variation margin payments to clearing members.
                7. We have altered the text on p. 41 to indicate that 13 settlement bank
                confirmations were between 30 minutes and 1 hour late. Four confirma-
                tions were over 1 hour late.
                8. We agree that this is an interesting and important issue deserving fur-
                ther study. However, it is not within the stock, options, and futures mar-
                ket scopeof this report.
                9. We concur that clearance and settlement facilities should not be
                designedto facilitate intermarket trading strategies basedon limited

                Page 83                                 GAO/GGD-90-33 Clearance and settlement
    (Xnnmen~ From the Commodity F&urea
    Tmdlng C0nunlUon

    capital and that clearance and settlement anomalies should not unneces-
    sarily restrict capital availability other than for prudential reasons.
    10. While this distinction is interesting, it is not necessaryto include it to
    understand the changesmade by clearing organizations to their guaran-
    tee funds since the October 19,1987, market decline.
    11. We agree that all clearing organizations should continually reassess
    whether their risk-management techniques and funds are adequate for
    their settlement cycle.
I   12. Chapter 2 has been altered to focus exclusively on trade processing
I   improvements in securities markets. It doesnot contain a discussion of
/   trade processingproblems in futures markets.
    13. We agree that liquidity should not be improved at the expenseof
    solvency. We have amendedour secondgeneral recommendation to note
    this concern. We say that studies exploring ways to improve liquidity
    and simplify intermarket clearing should be completed and acted upon
    without diminishing safeguards against financial risk. Seeour discus-
    sion of the issue on p. 61 of the report.

    14. CITC’S authority over futures clearing organizations is discussedon
    p. 21 of the report.

    Page 84                                   GAO/GGB9033   Clearance and Settlement
            1   L

Appendix V

Cdnments From the National Securities

Note: GAO comments
suppleme/nting those in the

                                                  National Securities    Clearing Corporation

                              Robert J Woldow
                              L,,      ,z :,
                              ,+r-+o.,       (.

                                                                                December 22, 1989

                              Richard L. Fogel
                              Assistant    Comptroller   General
                              General Government Division
                              United States General
                                     Accounting   Office
                              Washington,     D.C. 20548
                                                                   Re:    Clearance and Settlement     Reform:
                                                                         The Stock,  Options,    and Futures
                                                                         Markets Are Still    at Risk.   Draft
                                                                         Dated November 21, 1989.
                              Dear Mr. Fogel:
                              National       Securities      Clearing     Corporation        (NSCC), is pleased to
                              submit the following            comments regarding          the latest       draft    of the
                              above     captioned      General Accounting        Office     (GAO) report evaluating
                              the sufficiency            of industry      and federal         regulator      actions     in
                              response to clearance            and settlement        recommendations         made by the
                              President's        Working Group on Financial             Markets after the October
                              1901 stock market crash.               As a general commentary, this draft                 is
                              a factual       improvement over previous            drafts     which we have had the
                              privilege       of reviewing.        However, as noted below, several factual.
                              inaccuracies        remain,    and should be corrected,               and NSCC is still
See comment         1,        concerned        that     the continued         use of such phrases                as “many
                              clearing       organizations**       or v'some clearing            organizations"       when
                              referring         to derivative          market     clearing        organizations        who
                              experienced         problems,      casts a cloud over the stock clearing
                              organizations          in general       and NSCC in particular,               who did not
                              experience       the problems referenced.             Further,      we have noted below
                              events which have transpired               with which you may wish to update
                              your report.
Now p. 4.                     Fxecutlve  Summarv - Princinal  Findinas,                page 5.      You state     in the
                              second paragraph,  line 9 that:
                                       To obtain       S;omvlete  assessments    of a firm's     exposure,
                                       clearing    organizations   would need to share information    among
                                       their    counterparties   in other markets,     but there has been
                                       limited    progress in this area.      (emphasis added)

                                      Page 85                                             GAO/GGB90-33 Clearance and Settlement

                  Richard     L. Fogel                                                                Page 2.

                  We know the GAO is aware that corporate              eecurities,      options  and
                   index futures     activity     is for many of the thirty        plus firms,   you
Seei comment 2.   reference      as participating        in all three markets,        only part of
                  their     overall   activity.         Commercial paper,    foreign      equity and
                  debt and foreign          exchange activity      are examples of other such
                  activity.       Would not the reader be better served if you were less
                  broad in your findings           and simply stated *ITo obtain an expanded
                  view . ..'I.
                                                      .    *
                  EhaDter I - VariOUS Or~atlOnS                 are In volved in the Clearance
No&p.11           iand Settl m nt Process . In the second full paragraph on page 12,
                  you stateetEat:
                         Those exercising     their        options can do so through              one of the
                         three    stock clearing           organizations  and their               associated
                  In fact,       firms exercising         their options do so through The Options
                  Clearing         Corporation       (OCC).        OCC then assigns           the exercised
                  options       to counterparty            members       of OCC and transmits             paired
                  instructions         for the movement         of the underlying         securities       to one
Se4 comment 3.    of the three            stock   clearing        organizations.            When the stock
                  clearing        organization       incorporates          these security         deliver      and
                  receive      instructions       into their          systems, they become guaranteed
                  by the stock clearing               entity.         While actual       movement by book-
                  entry     of the underlying                 securities         may take place           at the
                  depository         pursuant      to instructions             from the stock clearing
                  organization,          such may not be required             if the deliver       and receive
                  instructions          net with existing             equal and opposite          receive      and
                  deliver     obligations       at the stock clearing             organizations.
Nowp.15           GtmDter 1 - Federal       Rea ution                 of Clearwe      and Settlement
                  Svstems      In the first   sentence               of the beginning    paragraph   of
                  this section   on page 17 you state               that:
                         Because of the potential     impact that a poorly     operating
                         system could have, clearance     and settlement  regulation     is
                         the responsibility  of the Securities  and Exchange Commission
                          (SW,   the Commodity Futures Trading Commission (CFTC), and
                         the Federal Reserve System (FRS).
                  This seems to imply that regulation             was imposed to either      correct
                  poorly      operating      systems   or prevent      operating     systems     from
                  deteriorating.          Rather, at least with respect to securities,             the
                  following      findings     of Congress were codified       as part of the 1975
                  Acts Amendments to justify           direct    SEC oversight    over securities
                  clearing     agencies       (Sec. 17A.(s)(l)):

                        Page86                                                  GAO/GGD9033ClearanceandSektlement
                       Appendix V
                       Chunents From the National Securities
                       (Xearhg Corporation

                 Richard      L. Fogel                                                             Page 3.

                        (A)      The prompt and accurate         clearance         and settlement     of
                                 securities    transactions,       including         the transfer     of
                                 record ownership and the safeguarding              of securities    and
                                 funds related    thereto,   are necessary         for the protection
                                 of investors     and persons facilitating             transactions   by
                                 and acting on behalf of investors.
                        (B)      Inefficient  procedures     for clearance    and settlement
                                 impose unnecessary      costs   on investors    and persons
                                 facilitating by and acting on behalf of investors.
                        (C)      New data processing       and communications     techniques
                                 create the opportunity     for more efficient,    effective,
                                 and safe procedures    for clearance and settlement.
                        (D)     The linking       of all clearance        and settlement     facilities
                                and the development of uniform standards and procedures
                                for clearance          and settlement      will   reduce unnecessary
                                costs and increase          the protection          of investors        and
                                persons     facilitating        transactions       by and acting         on
                                behalf of investors.
Now p, 15.       In this       last  paragraph  of the same section                    of   your    report
                 appearing      on page 18, you state that:
                        In the stock, options,        and futures      markets, the structure        of
                        regulation        is such that       self-regulatory         organizations
                         (SRO)--the clearing      organizations       and the exchanges--are       the
                        primary     regulators    and the federal         regulators    oversee the
                        actions     of the SROs to determine           whether or not they are
                        functioning      in accordance with regulations           and the law.
                 While you are correct              that in the stock and options                 markets,
                 clearing        organizations           and exchanges,         as self-regulatory
                 organizations          (SRO), are the first            line      regulators       and the
                 federal     regulators       oversee their      actions,       the use of the term
See comment 4.   "self-regulatory          organization"     is one, at least with respect to
                 clearing      organizations,          that we thought          was distinct         to the
                 securities       laws.      We understood      regulation        of futures      clearing
                 entities,      whether separate corporations              or divisions        of futures
                 exchanges, was subject to indirect               regulation       by the CFTC through
                 the futures       exchanges themselves.           We understood        that former SEC
                 Chairman Ruder had suggested that Congress grant specific                            direct
                 oversight      to the CFTC for commodities              clearing      organizations        to
                 place such at an equal regulatory               level with securities            clearing

                       Page 87                                               GAO/GGD90-33 Clearance and Settlement
                      Appendix  V
                      Comments From the National lsecurities
                      Cleering Corporation

                 Richard   L. Fogel                                                         Page 4.

                 This distinction        can be seen undar "The SEC Regulates Stock              and
Nojw p. 16.      Stock options        Clearance  and Settlement", on page 18 where               you
                 state that:
                       Through rule   reviews,    the SEC examines proposed clearing
                       agency rules for their consistency    with the Securities     lanu
                                     and regulations   issued by the SEC.        (emphasis
                 and, in your section    nmCFTC Regulates                Futures   Clearance     and
Ncjw p. 16.      Settlement", on page 19 where you state               that:
                       In rule        reviews,       CFTC examines      proposed     exchange    and
                       clearing        organizations      rules  for     consistency     with   m
                       $&&&g~.           (emphasis added)
                 Chaoter 1 - The Presidenfial   Workina Grouw Identified   Problems.
Nqw pp, 18-19.   In the last sentence in the text on page 23 and continuing     on to
                 page 24, you state that:
                       Trade data entry     systems of member firms,   exchanges,    and
                       matching systems   were not always able to process trade data
Se+ comment 5.         quickly   and accurately.    For example,   the percentage     of
                       stock trades that did not match on price or quantity     doubled
                       during the crash.
                 Your statement      implies   that the "matching system”     at NSCC was at
                 fault,    while in reality,     this was not the case.     Where both sides
                 were correctly      and timely submitted,     such trades matched.    As to
                 the increase      in the uncomparison       rate,  while   part of it was
                 caused by erroneous         submissions,   the primary    reason for this
                 increase     was the lack of submission       to NSCC of one side to the
                 chawter 2 - TBBpE PROCESSING SYSJJZMSARE T,ESS WLNERABLE - The
                 9                                             e'           ocess *
Now p, 25.       Svstems.   In the first sentence of this section beginning   on page
                 31, you indicate  that:
See comment 6.         Stock market      clearing      organizations . . . had trade
                       processing  problems during the crash but are in the process
                       of improving their     systems.

                      Page 88                                            GAO/GGD90-33 Clearance and Settlement

                       Conunsnb From the Natlonsl Securities
                       Clearing Corporation

                 Richard      L. Fogel                                                                Page 5.

                 As indicated            inprior     discussions        and written        comments,        we
                 disagras         with   your     statement        that    stock      market     clearing
                 organizations        had trade processing             problems.        True the market
                 places had certain          of their     automated trading          systems experience
                 delays.        True some member firms                  experienced         problems        in
                 forwarding      trading      information       to NSCC. And, true some trade
                 information       which did not match, because either                   no counter-side
                 information       was submitted        or counter-party        information       differed,
                 was not timely        reconciled       by member firms.            However, the trade
                 matching      systems of NSCC performed                exceptionally        well.       And,
                 matched trades were efficiently                 netted and the resulting              netted
                 obligations       completed settlement           at rates in excess of the then
                 year-to-date       average.
                 The major problem continually                referred      to, both in this section
                 and in your section             "Trade Matching          and Reconciliation              Systems
                 are Being Improved8', was the timely                  reconciliation            problem noted
                 above.       This is a procedure which takes place after our matching
                 system reports            back items to a submitting                  firm for which no
                 counter-side         match was received             (uncompared          trades)       or items
                 reported by NSCC to a firm which had not submitted matching data
                  (advisories).            Once the firms        reconcile      these unmatched items,
                 they      resubmit         them to NSCC for              processing.               All    three
                 marketplaces            undertook       steps     to facilitate               the members'
                 reconciliation         process.      The status of such marketplace                    steps is
                 described        in Attachment        A.     In addition,           in order to afford
                 members an earlier            opportunity      to receive        information,          and take
                 corrective         action     with   respect       to those items which do not
See p. 26.       initially        match, NSCC accelerated               its submission              and output
                 requirements        for its members. The status of these NSCC steps is
                 also described          in the Attachment.
                 We would hope that           you incorporate         these     status    descriptions        in
                 your report.
Now p. 28.                                        .    The last      sentence     of this      paragraph      on
                 paw        40 states:
                        These      efforts    should     facilitate    attempts to shorten the
                        stock      settlement      cycle      as recommended by the Group of

                       Page39                                                   GAO/GGIMO-33Clearance and Settlement
                                Appendix V
                                Comments From the National securities
                                Clearing Corporation

                        Richard     L. Fogel                                                                Page 6.

                        While this statement          is correct,     you do not provide               the reader
                        with     the basis       upon which you render             this       conclusion.            As
                        discussed       with you previously,        aside from the problems of the
                        U.S. mail which delays             customer      deliveries            of money and/or
                        securities,        it has always been recognized              that the current              T+5
Seellcomme”t   7.       settlement       cycle could not be shortened             until       unresolved       trades
                        could      be reconciled         and then      included          within      the normal
                        processing        stream for settlement.             Earlier         trade     submission
                        requirements          for matching      and an automated                 reconciliation
                        facility      enhance the potential          for earlier           settlement         from a
                        system6 perspective.            As, however, the U.S. G-30 Working Group
                        indicated      in their    November 22, 1989 letter             to the Street,           there
                        are many more significant           issues to T+3 settlement                that need to
                        be addressed.
                        mvter        3 - PROGRESS         IN CHANGING CWING      ORGANIWION RISE
                                      T SYS-       HAS BEEN SON - NSCC has Maintained     Current
                        C.w?ital ReB                    on page 45 in the last sentence of the
No& pp. 31-32.          first   full    paragraph-under    this heading, you state that;
                                Since   the market break,       NSCC has maintained    its    member
                                capital    requirement     of $75,000, which is higher     than the
                                $25,000   minimum   established   by the SEC.
                        NSCC does not require     $75,000 in capital       from its members. NSCC
                        requires     that its members maintain     $50,000 in capital       in excess
                        of whatever the member's capital       requirement     is as established     by
                        the SEC and the member's Designated           Examining Authority        (DEA).
Seecomment8.            Thus, if the Commission only required          a firm to maintain      $25,000
                        in capital,      then NSCC would require      the firm to have at least
                        $75,000 in capital.      The SEC Capital     Rules, however, vary by the
                        type of business in which a member is active.            Thus, if a firm is
                        required      by the SEC and/or    its DEA to maintain        $1 million     in
                        capital,    the firm's  NSCC capital   requirement     would be $1,050,000.
                        mvter    3 - Guarantee Funds Helv Provide                     Market Intenritv.               In
                        the second sentence     of the first full                     paragraph   under           this
                        heading, you indicate  that:
                                A default     occurs when a member fails               to pay for        losses      it
                                incurred    in the marketplace.


                                Page 90                                              GAO/GGD-9@33 Clearance and Settlement

                   Richard   L. Fogal                                                             Page 7.

                   While we cannot speak for the options            or futures    markets,      a
See commtlnt 9.    default  at NSCC occurs when a member fails        to pay NSCC its money
                   balance due for the net of securities      delivered    to it by NSCC and
                   the securities  it delivered    to NSCC. This is a major        difference
                   between the equities    and derivative    markets where the former is
                   payment for the receipt      of an actual   instrument      as compared to
                   payments for market movements, the profits         or losses referred      to
                   in your above quoted sentence.
                   chavter    3     Clearins  Oraanizations             Reviewed their    Guara t e
Now pp. 33-34.     El&xl&.   Please
                                 -    update your description            on page 48 regarding  tS:C
                   to include the following     two events:
                         0       On October          25, 1989 NSCC filed       SR-NSCC-89-16 with the
                                 Securities       and Exchange Commission.          The purpose of the
                                 proposed       rule    change is to modify          the amount of a
                                 Member’s       Clearing      Fund Required     Deposit     that may be
                                 collateralized        by letters    of credit.      Specifically,       the
                                 rule change will          increase the minimum cash contribution
See comnlent 10.                 for those Member8 who use letters                     of credit       from
                                 $50,000 to the greater              of $50,000      or 10% of their
                                 Clearing       Fund Required       Deposit,     up to a maximum of
                                 $1,000,000.         In addition,     the rule change will         provide
                                 that only 70% of a Member's Required                   Deposit may be
                                 collateralized         with letters     of credit.        The intended
                                 effect     of the rule change is to increase             the liguidity
                                 of the Clearing         Fund and limit      exposure to NSCC of any
                                 unusual risk from the reliance            on letters     of credit.
                                 This is a goal that the Commission           has endorsed     to
                                 insure   the liquidity     of the clearing      system in the
                                 event of a major      Member insolvency,   catastrophic   loss,
                                 or a major settlement     suspense.
                              The net effect     of this rule change, if approved by the
                              SEC, will     be to increase,  based on current    estimates,
                              the current      ca8h and government   obligations      in the
                              Clearing     Fund today from $100 to $150 million.          The
                              total    fund today is in excess of $400 million.
                        0     On December 7, 1989, the Board of Directors       of NSCC
                              unanimously   voted to accept a commitment letter    from
                              Rankers Trust Company which would provide  NSCC with a
                              committed line of credit  of $200 million.

                       Page 91                                              GAO/GGD-90-33 Clearance and Settlement
                           Appendix V
                           Comments From the National Securities
                           Clearing Corporation

                    Richard     L. Fogel                                                       Page 8.

                                     The net impact of these above two actions    converts   the
                                     NSCC Clearing  Fund, which today is composed of only 25%
                                     of what could be truly     called liquid  assets,   into a
                                     Clearing  Fund which is over 75% liquid.
                                          The   Secuties      Clearina    Grow   is -roving
Ndw p, 37.                                     - In the first    sentence on page 53 under this
                    heading,     your    report states that:
                            According     to SEC, the          stock    and options       clearing
                            organizations   created the Securities        Clearing Group (SCG) in
                            1988 in an effort     to establish      a formal information-sharing
                    While not wishing       to be in conflict     with what the SEC may have
                    advised    you was the purpose in forming            the SCG in 1988, NSCC
See comment   11.   would wish to point        out that it was NSCC who spear-headed            the
                    formation     of this group following     the Market Break of 1987, and
                    it is NSCC today         who currently      chairs      this organization.
                    Further,    information   sharing is but one of the many goals of this
Now p, 37.          group most of which appear in your report under this section                  on
                    page 54.      And, the SCG is not planning         to explore these various
                    areas but is in fact doing significant           work in the creation      of a
                    central   data base and several of the other items listed.
Now p. 37.                 ter 3 - Conclusions        In the first     paragraph   on page 54 under
                    this     heading, you state'that:
                            Although    federal   regulators   and SROs have made progress      in
                            implementing          intra-market       or      market    specific
                            recommendations,        they need to do more to reduce risk         by
                            strengthening     the stock clearance   and settlement  system.

                    We respectfully          suggest    again that   the stock    clearance     and
                    settlement      system per se worked,          in 1987 and works today,
See comment   12.   exceptionally      well.      Perhaps, what you had intended        to say is
                    that federal      regulators      and SROs need to strengthen        the stock
                    clearance     and settlement     system by further   reducing or mitigating
                    known risks.
                         ter 4 - CREDIT AKp LATE PAYMENT PRQJj&&$SSIN THE STOCK,
                    Stock.  Ootions and Futures   wet       Relv on Bank      f r Timely
                    m                 . In the first  seitence,  you inditatz    that:
Sqe comment   13.           Stock . . . market    participants       rely on commercial      banks to
                            pay and collect   funds for their        market transactions.

                           Page 92                                         GAO/GGD-90-33 Clearance and Settlement
                            Commenta From the National Se!curitlea
                            Clearing Corporation

                      Richard     L. Fogel                                                             Page 9.

                      The word %tockll ehould be omitted.     This               is a description       of the
                      payment eystem for options and futures.
                            ter   4 - SQme Cleers             were Late Pavina their Clearigg
Now p. 4’ 11                                  a the Crash . In the second sentence of this
                      section     on page 59, you state that:
                             In addition,     three NSCC clearing     members, one which was also
                             an   OCC clearing       member, defaulted    or withdrew    from the
                             clearing    organization   or depository   membership.
                      While this sentence is factually          correct,      without     saying      more it
                      could    lead the reader       to perceive         that     there     was a major
                      settlement   crisis   at NSCC. A5 you have been advised,                   two of the
See comment 14.       three members were either        in a credit        position      or had clearing
                      fund deposits     to cover their    settlement       debits.      Only one of the
                      members defaulted     and the net total        loss to NSCC who guaranteed
                      over $126 million     worth of stock transactions              for this       firm was
                      lees than $400,000.       A small amount when one realized                  that NSCC
                      had over $440 million     worth of Clearing         Fund backing it up.
                            ter 4 - Prwals            to Reduce Cash Demands on Clearins            Member
Now p. 46.            tith    Intermarket      Positions    have not Led to R fozm             On page 6;
                      under this heading,           in the paragraph      beginnitg       with "Exploring
                      other arrangements         between clearing       organizations...",        you omit
                      the fact that each of the stock clearing              organizations       today have
See comtiwnt    15.   either,      combined and netted        settlements     between themselves        and
                      their     affiliate     depositories,      or established        cross-endorsement
                      programs which have the same effect.                 This fact should also be
Now p, 47.            referenced        in the last paragraph on page 67. Further,               your last
Now p. 47.            sentence of the paragraph on page 65 states that:
                             According     to BOTCC officials,      netting already exists   when a
See comijnent   16.          clearing     member uses the same bank for settlement         activity
                             at different     clearing   organizations.
                      Unless you are referring          only to future5          clearing     organizations,
                      this statement      is potently        incorrect.        If netting      in fact takes
                      place at the clearing          bank, how can the bank retain                    the legal
                      right    to accept a credit          from one clearing          agency     for a member
                      and refuse to pay a debit balance for the same member to another
                      clearing    agency.     HOW, further,         are obligations        due at 6~30 a.m.
                      Chicago time in Fed Funds netted                    with     afternoon        settlement
                      obligations      in next day Clearing               House Funds.             Netting      of
                      settlement    payments can only truly             take place when times,              forms
                      of funds,      and legal       obligations          with     respect      thereto       are
                      conformed by all parties.              This realization         comes   to light       only
                      when thoughtful       analysis     is made of the problems,             which the SCG
                      is attempting     to do, and consensus and agreement on solutions                         is

                            Page93                                               GAO/GGD-90-33 Clearance and Settlement
     Appendix v
     Commenta From the Natlonal Securih

Richard   L. Fogel                                                 Page 10.

In responding to your request for comment on your previous draft,
we forwarded a very detailed       mark-up of your report.     While some
of   our     corrections     were   incorporated,     some were         not.
Accordingly,      our comments this time attempt  to only address broad
areas, rather than attempt to catch every factual        inconsistency.
We truet  the above has been helpful to the GAO, and stand ready
to discuss in greater depth our comments, at your convenience.

      Appendix V
      CommentsProm the National fJecuriU
      Clearlng Corporation

Attachment      A.

                            NEW LISTED CLEARANCE SYSTEM
                            (Implemented    August    18,   1989)

Between 6:00 p.m. and 8:OO p.m. on the evening of each trading
day, NSCC receives        locked-in    trades   from the NYSE and Amex
trading   systems.      NSCC's T-Contract      process   then passes the
locked-in   transaction     data to NSCC's surveillance,      billing,  and
pending trade systems before reporting         the results    in print  and
machine readable form to the members which usually          occurs between
10:00 p.m. and Midnight       the same day.   [n.b. NSCC's stated output
time to participants     is Midnight.]

     t of -de        Date     t NTDL
While the T-Contract           system     is processing,        and completely
independent       of that     function,       the NTD process          begins     at
approximately      5:OO p.m. on the evening of trade date.                 At this
time, participants        may begin to submit trade input              for trades
other than from NYSE and Amex trading                systems.     The system is
capable of receiving       multiple     (regular-way)     transmissions      from  a
single member firm for these trades before the scheduled T+l 2:00
a.m. cutoff.         Also at 5:00 p.m.,          NSCC initiates       concurrent
editing,   providing     enough participant       data is received,       to begin
the immediate matching process.
As participants'         data is received,           transactions        are edited      and
then processed         through      the immediate          multi-part        audit   trail
match.      In addition      to the normal trade matching criteria,                     such
as security,       price,     quantity,       and clearing         broker,     the audit
trail    match also uses the executing                  badges,       contra    executing
badges and time of execution                  within      a two minute         window to
compare the trades.           After all editing          and immediate matching is
completed,     transactions        are processed in the final                match.      The
final    match is an exact share quantity                  match using audit trail
data     when     possible        but     not      required,          trade     quantity
summarization,         suggested        name and partial               suggested     name.
Partial     %uggested name applies          only to an omnibus account and a
After the final     match is completed NSCC generates       a Results   of
Comparison,  or ROC file,      for each exchange.      The exchanges use
this file to build their data base of uncompared transactions         for
subsequent member firm on-line       trade resolution.      The exchange
systems  are usually    open for business at 7:00 a.m. on T+l.

      Page 95                                               GAO/GGD30-33 Clearance and Settlement
           Appendix V
           Clearing Corporation

    Attachment       A.                                                   Page 2.

    To accommodate participants     who miss the 2:00 a.m. deadline       and
    the final   match, NSCC developed a safety net feature.       The safety
    net consists    of sending the late data, after    it has been edited,
    to the respective    Exchanges' trade resolution     system the morning
    of T+l.      NSCC and each exchange      monil.ors    the use of this
    mechanism to ensure it is not abused.
    Shortly after the ROC files    are created for the exchanges, member
    firm machine readable     and print     output is available.     This
    usually occurs anywhere from 3:00 a.m. to 4:00 a.m. on T+l.       The
    actual hard copy print   output is also distributed     to the member
    firms by approximately  7:00 a.m..

    Beginning approximately        7~00 a.m. each business day participants
    begin     accessing     the NYSE and Amex on-line           terminal       based
    correction     systems.     (The NYSE system became fully           operational
    with trades of July 18, 1989 and the Amex system with trades of
    November 24, 1989.)        Currently,     P&S corrections  are submitted        on
    T+l while floor      adjustments      are processed on T+2.       The NYSE and
    Amex plan to move the floor           adjustment   process to the afternoon
    of T+l sometime in the first          quarter of 1990.
    Regardless of what day adjustments          are processed,   the results   are
    transmitted      back to NSCC in the evening             of the same day,
    processed between 6:00 p.m. and 6:30 p.m..                 NSCC then reports
    these adjustments       back to the participants      by approximately    8:30
    p.m. that   evening      in machine readable       and print    format.    All
    compared transactions        are then pended for settlement         in either
    CNS or the Balance Order Accounting              System depending       on the
    securities  eligibility      for book-entry    movement.

                             (Implemented on May 5, 1989)
    On May 5,     1989 NSCC enhanced it8 Over-The-Counter            (OTC) Clearance
    ;E:t;;,by     implementing    a Night of Trade Date (NTD) initial            match
                 moving up the trade resolution          process one day.           The
    locked-in     trade process was also modified           to accept additional
    locked-in      trade input     from the NASD's Automated           Confirmation
    Transaction       (ACT) service.       (The ACT system allows participants
    to lock-in        all   the post execution       steps,    i.e.,     reporting,
    comparison,         and sending      locked-in   trades     to the clearing
    organization       or in this   case, to NSCC which is the hub processor


           Page 96                                        GAO/GGD-99-33 Clearance and Settlement
     Appendix V
     comments From the National Securitiee
     Clearing Corporation

Attachment    A.                                                 Page 3.

for  all securities    clearing      corporations.)  OTC Comparison Cycle
Acceleration     was developed       in conjunction  with the NASD's ACT
system. The NASD plans to           implement ACT in stages which began
with a pilot    with trades on      November 17, 1989.
To accomplish      the NTD matching,   participants are required  to
submit their     non-system trade input before 2:00 a.m. on T+l.  By
enhancing    the its OTC system, NSCC was able to remove system
interdependencies        between the NTD match and the adjustment

The implementation     of the OTC cycle acceleration   allowed NSCC to
distribute      the results      of comparison   to the NASD's Trade
Acceptance     and Reconciliation      Service  before  8:00 a.m. the
following   day (T+l).      TARS is a terminal   based system that was
implemented by the NASD in the Summer of 1983 to automate the
trade correction    process. It has been operational    ever since.

    Page 97                                      GAO/GGD-99-33 Clearance and Settlement
               Comments From the National Securities
               Clearing Corporation

               The following are GAO'Scomments on the National Securities Clearing
               Corporation’s letter dated December22, 1989.
               1. The use of the word “some” in the executive summary and first chap-
    Comments   ter is for the purpose of brevity. Chapters 2 through 4 identify the orga-
               nizations referred to in the overview and first chapter.

               2. The text of the executive summary has been altered on p. 4 to reflect
               NSCc's suggestion.

               3. occ has suggestednew wording here, which we have adopted on p. 11.

               4. CFTCalso usesthe term “self-regulatory organizations.” The Commod-
               ity Exchange Act is not explicit on CFTCoversight of futures clearing
               organizations. However, CFTCclaims direct regulatory authority over
               clearing organizations by defining “contract market,.” over which it has
               clear regulatory authority, to include clearing organizations. At least one
               court has upheld this authority. Seethe discussion on pp. 21-22.
               6. We have deleted the words “matching systems.” We do not say or
               intend to imply that NSCC was responsible for unmatched trades. See
               chapter 2 for a more extensive discussion of this issue.

               6. The reference to stock clearing organizations has been deleted.
               7. The focus of chapter 2 is changesin trade processingsystems in
               responseto the crash. Other issuesthat would facilitate movement to a
               shortened stock settlement cycle are mentioned at the end of chapter 4
               on pp. 49-60.
               8. The text has been altered on pp. 31-32 to indicate that NSCC'Scapital
               requirement for its membersis to maintain $60,000 in capital in excess
               of whatever the capital requirement established by the SECand desig-
               nated examining authority.
               9. The sentencehas been altered on p. 32 to indicate that a clearing
               member default occurs when the member fails to pay for the receipt of a
               stock instrument and, on the options and futures side, fails to pay for
               lossesincurred in market movements.

               10. The text has been altered on p. 34 to indicate that NSCChas taken
               steps to increase the liquidity of its clearing fund.

               Page 98                                 GAO/GGJMM-S3 Clearance and Settlement
Chmmenb From the National Seeuritiea
Clearing Caporation

11, A sentencehas been added on p. 37 indicating that the scz has
moved beyond the planning stage and is currently working on a central
data base and other suggestedimprovements.
12. We agreethat the stock clearance and settlement system should be.
strengthened by further reducing or mitigating known risks and have
altered the text to make this more explicit. Seep. 37.
13. We have omitted the word “stock” on p. 40.

14. The text has been modified on p. 41 to indicate the exact nature of
the withdrawal or default and its effect on NSCC.
16. We mean netting of obligations among clearing organizations in dif-
ferent markets or intermarket netting, not intramarket netting. The text
has been changedon pp. 47 and 48 to indicate that we mean netting of
payments among clearing organizations in different markets.
16. This sentencehas been deleted.

Page 99                                 GAO/GGDgO-3g Clearance and SeMlement
Ap&-dix VI

C@nmentsFrom the Options

Nota: GAO comments
sup$lementing those in the
rep+t text appear at the
end pf this appendix.

                             December      8,   1989

                             Mr. Richard      C. Fogel
                             Assistant     Comptroller      General
                             United    States   General     Accounting          Office
                             General    Government     Division
                             441 G Street      NW
                             Washington,      DC 20548
                             Dear   Mr.    Fogel:
                                   We at The'Options        Clearing      Corporation     (the "OCC")
                             thank you for this      opportunity        to submit     formal  comments                on
                             your draft  report    entitled       Clearance
                             and dated      November      21,   1989.
                                     We commend the efforts       of your staff        and appreciate      the
                             inclusion      of several     of the OCC'a prior      comments.      As we
                             have discussed        with you, however,      several     areas of the
                             report    remain    incorrect    or misleading.       We understand      that
                             several     of these may have been adjusted           after    our review     of
                             the draft      which was sent to us, but for the record              we can
                             only comment on that draft          which we received.          We will
                             address     the areas of concern       point    by point.
Now :p. 20
                                         ts of the      October      1987 marke_t eraah.          it   will
                                        ed onlv in      rela.tion     to informationrina                      UUQLU

                                     The report         purportedly       examines      clearance      and
                             settlement        in the stock,         options,.     and futures       markets.       Yet
                             the Board of Trade Clearing                  Corporation        is not part       of the
See domment 1.               study.       BOTCC is the world's             largest      futures     clearing
                             organization.            It clears      stock index futures,            which were
                             involved       in the October          1987 crash.         Moreover, an
                             information         sharing      system developed          by BOTCC is presented
                             in the report          as if it is a key solution                 to certain     U.S.
See domment 2.               market      problems.         The systems, practices              and processing
                             capabilities         of BOTCC, however,            including        BOTCC's practices
                             and capabilities            in administering          the information          sharing

                                Page 100                                                  GAO/GGIMO-33 Clearance and Settlement
                     Appendix i’I
                     Commenta Frem the Options
                     Clearing C!mporation

                  system,      appear to be overlooked              or    ignored           generally       by GAO.
                  This is      quite  perplexing.
Now p. I.

                           This comparison     is    inaccurate           and mieleading,     aa the
                  extent      of each agency'8       regulatory           authority,    and the
                  attendant      regulatory   practices    and philosophies,    differ
                  significantly.         For example, the SEC’s authority       over
                  securities      clearing   organizations    is detailed    and is
                  explicitly      eet   forth   in   the     Securities          Exchange           Act    of   1934
                  as amended. In fact this authority         includes     a variety  of
See cominent 3.   clearly   stated public policy   objectives      regarding     the
                  nation's   securities  clearance  and settlement       mechanisms.    In
                  contrast,    the Commodity Exchange Act (the "CEA") does not
                  empower the CFTC to regulate         future8    clearing organizations
                  per 88 or as part      of a national      system having  stated
                  characteristics,     but rather     assumes that by regulating         the
                  contract     markets the CFTC will      have an effect   on clearance
                  and aettlement        operations         and practices.              Further,           the CEA
                  does not eetabliah     explicit        public    policy   and national
                  eyatems objectives     for clearing           and settlement.      The
                  disparity  in regulatory        practices       and philosophies      has
                  inhibited  market   and clearing          coordination.
Now pp. 43-44.    Paas         - D      OCC m+e                                 t-    all      of   it-    clearina

Now pp. 43-44.

                        This is incorrect;            steps have been taken to correct
                  the problem.    Subsequent          to the October crash, for example,
                  the Margin Committee of            OCC's Board of Directors  formed a
                  subcommittee to examine            all     aspects       of    our        financial       backup
                  system and to recommend,          where necessary,   appropriate
See comment 4.    revisions    to our practices.         One of the recommendations of
                  that    subcommittee was that OCC should net all pay and
                  collect    obligations     to a single pay or collect        amount for
                  each clearing       member across account types, rather than
                  within    each account as had been our practice.             Because we
                  had been effecting        settlement    account by account,       if a firm
                  owed funds to OCC in one account and was owed funds by OCC
                  in another account, conceivably            OCC could fail to collect
                  from    and at the same time pay a potentially           defaulting
                  member. To avoid that consequence, OCC made late payments
                  on October      20.    We have filed    rule changes with the


                     Page 101                                                        GAO/GGD9&33 Clearance and Settlement
                               Appendix VI
                               CommentsFrom theOptions

                            Securities        and Exchange     Commission  to net settlements      across.
                            account types          and the Commission has requested       comments on
                            this    filing.        When approved,   this  change in practice     will
                            enable       OCC to make money settlement        on time without   risk    of
                            potential       clearing     member default.
Now ip. 35                            -                                                    on October               19SL
                            f&e   OCC was notifisd              bv one of       its     clearinP                I

                                    OCC mav not        evse                           aotten   paid    bv the

                                    As the SEC is aware,               and as we pointed       out to GAO in
See aomment 5.              our prior      written      comments and in discussions,               this   summary
                            is incorrect.           OCC JLPB aware of the firm's              $30 million
                            settlement       obligation        with NSCC, which related            to a stock
                            loan.      Because the firm's              bank had reached       100% of ite
                            advance rate,         it initially          refused     to extend   further     credit.
                            Realizing      the firm's        liquidity        problem,    OCC reduced     its
                            margin     requirement       to free up collateral             so that the bank
                            would lend the firm additional                    funds necessary      to meet the
                            NSCC settlement.

Now Pp. 4,5,36,   and 50.

                                     s.     Fur--t                         suapssta                   a svstgm
                                          d bv BOW        for     the   &WJJSI    of w

                                   Such recommendations              respecting         information        sharing     are
                            vague and ill-considered.                  First,      the report        does not define
                            what arrangements,            terms and conditions               constitute
See comment 6.              competitively         neutral      and efficient          information         sharing.
                            Second,     the report        implies      that the BOTCC pay/collect
                            information       sharing       system satisfies            public     policy     and
                            market     coordination         requirements,          when in fact this            system
                            has serious       drawbacks.          Third,      information         sharing     is
                            inadequate:       our markets         need effectively             coordinated


                               Page 102                                                        GAO/GGD-90-33 Clearance and 8ettlement

         Appendix VI
         Clearing corporation

    mechanisma     for        reducing        risk    within      the    existing        linked
    market   context.
             It is difficult            to address        the first         point,        since      it ia
    unclear     what types          of information           GAO thinks           should be
    shared.       As for the BOTCC pay/collect                      information             sharing
    system,     OCC joined          this    system in response                 to regulator
    insistence       and we continue             to have strong              reservations            about
    it8 efficacy         and its character.                 The risks         which can be
    associated       with information              sharing       -- depending             on the
    information        shared,        the methods used, and the context                            in
    which data is shared -- need to be understood                                  well when
    making policy         recommendations.                In particular,              the structure
    of the BOTCC arrangement                  may have substantial                  repercussions
    over the long term.                 Because BOTCC is the system operator
    and also is the only system "participant"                               with significant
    contractual        rights       and remedies,           other participating
    clearing      organizations            are far from equal partners.                          In such
    an arrangement,           the clearing           organization-creditor                   with
    superior      knowledge         and information            is better          positioned           and
    may in fact be able to take advantage                           of the information
    flow to protect           iteelf      relative        to other        entities.            A
    suitable      information           sharing      agreement        should be structured
    so that the eharinq               does not provide             competitive            advantage
    to any of the participating                    clearing        entities.            Ideally,
    information        sharing        programs       should be administered                    by an
    independent        party     with due regard             to competitive               and
    operational        impact.          We would have expected                   such concerns           to
    be self-evident           to the GAO.
             Additionally,            apart     from its potential                 to reveal       points
    at which one clearing                  organization's            draft       is offset       by
    another's         obligation         to pay, the exiatinq                  BOTCC system is of
    limited      benefit.           Moreover,        that benefit            is outweighed          by
    the risk        of      a) fostering          clearing        organization           complacency
    in the absence of valid                   legal      rights      of offset         and       b)
    triggering         a race to the bank account                     of a member -- a race
    which under the BOTCC syetem                       and existing            clearing
    procedures         will     always be won by the system                        operator.        Now
    that     OCC is a participant,                  we question         the technical
    competence         of the system,             which is not handling                 options
    correctly.           BOTCC, due to its system problems,                            has created
    mismatched         data that         it has disseminated,                  causing       the CME to
    question       OCC data         transmitted          to it by BOTCC. On at leaat
    one occasion,            September        15, 1909, in particular,                    BOTCC has
    miBuBed      system information                by telephoning              the bank involved
    in a settlement,              rather      than OCC. These are the types                         of
    problems        for which OCC has no contractual                           remedy,       and point
    out clearly          the need for an independent                      processor.            Given
    our experience,             it aeems doubtful               that NSCC could easily                 be
    brought      in.       Further,        to be meaningful,               intermarket


        Page 103                                                          GA0/GGD90-88 Clearance and Settlement
                        Appendix VI
                        Comments From the Optlone
                        Clearing Ciwporation

                  information       sharing       with respect     to equity        securities     should
                  include     sharing     of bank regulator          information        concerning
                  bank clearing        activities      and risks       to the extent          that banks
                  are participants          in equity     clearing       organizations.
                            Most      importantly,             however,      information           sharing
                  arrangements              are a poor second best.                     Much more meaningful
                  are mechanisms                which reduce risk              by integrating             collateral
                  and credit            facilities           and establishing             a network         of legally
                  enforceable             creditors’           remedies,        including        in particular
                  priority          security          interests.           Two 8uCh mechanisms                are the
                  numerous interfaces                     maintained        between OCC and the nation’s
                  stock depositories                    and OCC's cross-margining                    arrangement
                  with the Chicago Mercantile                           Exchange.         While the report
See domrnent 7.   mentions          cross-margining                in passing,        the report          emphasizes
                  information             sharing         and does so without              precision.
                  Cross-margining                provides          greater     benefits        than information
                  sharing        without         drawbacks.             As we have discussed                with you,
                  cross-margining                 involves         the calculation           of a single            margin
                  amount in recognition                      of a hedged position                in which each
                  side of the hedge is traded                           in a separate          market.
                  Cross-margining                provides          both financing          relief       and enhanced
                  risk      management           in functionally             unified       markets.           The
                  concept        of     cross-margining               was endorsed         by !&e Revert             of the
                                                     Force on -et                 Mecbm              (The Brady
                  CondaSiOn),              the BapPrt            of the V&&&l             GrOUD on Fw
                  Market          (The Presidential                  Working      Group),      the CFTC's u
                              on Stock *Futures                                                              * *
                              October           1982, and the       I I * SEC's    m      October       1987      Mz&&&
                                                    bv the Divw                of Market                                The
                  goals      of the OCC/CME cross-margining                           mechanism         are (li to
                  recognize           all     components           of a related         portfolio,          and
                  thereby,          recognize           the true risk          of a given member's
                  activity,            (2) to facilitate                the pledging         of portfolio            assets
                  to finance            asynchronous             cash flows,         and (3) to facilitate
                  the netting             of settlements              between OCC and CME and thereby
                  reduce the payments                     system impact           of intermarket            hedged
                  positions          while       preserving           the independence             of the two
                  clearing         organizations              and, thus,          assuring       their      ability      to
                  respond        to the unique               needs of their           market participants.
                           Perhapa      of greatest        systemic         significance,           cross-
                  margins      eliminates        excessive        initial        margin       requirements
                  securely      through       the use of legally               enforceable          liens    that
                  span separate          clearing       entities,         and in that way facilitates
                  both payments          and obligation           netting        within       various      markets.
                  Cross-margining           enhances       the financial             integrity        of the
                  clearance       and settlement           mechanisms          in the cross-margined
                  markets      by substituting           correlated          positions,          which have
                  offsetting        risk    characteristics,              for cash (or cash
                  equivalent)         margin     deposits,        which have a static                 value.      And


                       Page 104                                                            GAO/GGD-9033 Clearance and Settlement
        Appendix Vl
        Comments From the Options
        Clearing Corporation

    cross-margining           provides         clearing       organizationa,        banks,   and
    regulators         with more accurate              information        about the true
    risk     of intermarket          activity.           Also,    cross-margining         -- when
    coupled      with a carefully              constructed        pledge     program    -- can
    facilitate         the financing           of asynchronous           cash flows.
    Accordingly,          as we have discussed,                rather     than emphasizing
    simple     5nformation          sharing,       the GAO report           should   recommend
    st,rongly      the expansion          of cross-margining              ao that market
    makera,      floor     tradera,       and other market professionals,
    including        major institutional               investors,        can take advantage
    of its beneficial            effects.
         We appreciate           your     cooperation       in   incorporating        these
    comments into your           final.    report.

                                                  Chairman       of the    Board


        Page 105                                                   GAO/GGIMO-33 Clearance and Settlement
                Appends VI
                Comments Prom the Optlone
                Clearing Corporation

               The following are GAO'Scommentson the Options Clearing Corporation’s
               letter dated December8, 1989.

               1. EKXCC  clearance and settlement systems are not included in the scope
G&O Comments   of this report. During the October’1987 crash, the primary concern of
               regulators and SROSwas with CME'Sstock index futures contract and its
               interrelationships with the stock and options markets.
               2. We do not intend to endorsethe FXJXCinformation sharing system, but
               only to use it as an example of a way to implement the Working Group
               recommendation for centralized collection and availability of pay and
               collect information. An information sharing system jointly managedand
               controlled by system participants would be most desirable. This issue is
               further discussedon pp. 38-39.
               3. Although the Commodity ExchangeAct is not as explicit as the Secur-
               ities ExchangeAct in laying out CFX’Sregulatory authority, CFIY:regu-
               lates futures clearance and settlement in much the sameway as SEC.
               Both CFTCand SECreview clearing organization rules and do evaluations
               of clearing organization operations and practices. This issue is further
               discussedon p. 21.

               4. The text on p. 44 has been modified to indicate that on October 11,
               1989, a corrective rule changewas filed with the SEC.

               6. The SECcrash report is paraphrased here. The sentencebeginning
               with “We believe....” has been deleted to eliminate speculation and the
               sentencebeginning “To protect itself...” has been added on p. 35 in
               responseto occ suggestions.
               6. A risk exposure system should be jointly designed,managed,and con-
               trolled by its participants. We agreethat system participants should not
               be able to use the information for competitive advantage. This issue is
               further discussedon pp. 38-39.
               7. Cross-margining programs do not solve all cash flow problems.
               According to CFTCdocuments,cross-margining programs only apply to a
               limited number of contracts and limited categoriesof market partici-
               pants. Even if expanded to other financial instruments and market par-
               ticipants, cross-margining programs lower the levels of margin funds in
               the financial safeguard system. Regulators will need to be careful not to
               increase liquidity at the expenseof solvency.

               Page 106                                GAO/GGD-90-33 Clearance and Settlement
Appendix VII

Cknrnents From the Chicago
Mercadile Exchange

Note: GAO comments                               _..                                         .   . _       .
supplem&ting     those in the
report tedt appear at the
end of thi(s appendix.                                   CHICAGO MERCANTILE EXCHANGE

                                         December 18, 1989
                                         Mr. Richard   Fogel
                                         Aseistant   Comptroller  General
                                         General Government Programs
                                         United Statas General Accounting               Office
                                         441 G Street,   N.W.
                                         Washington,   D.C. 20548
                                         Dear Mr. Fogel:
                                         The Chicago Mercantile           Exchange is pleased to have the opportunity
                                         to provide formal comments on the draft report entitled                      llClearance
                                         and Settlement          Reform.l@ We believe       the efficient       operation       and
                                         financial      integrity     of the clearance     and settlement        systems are a
                                         vital      element in the success of the nation's              financial        markets.
                                         A better understanding           of these complex mechanisms among Congress,
                                         regulatory       agencies,      and the general      public    will     significantly
                                         contribute        to the improvement         of the clearing         and settlement
                                         process and ultimately             bolster   the competitive        position       of the
                                         United States in world financial               markets.     Thus, we welcome the
                                         General Accounting Office's             (GAO) report    as a contribution         to that
                                         Although in your transmittal             letter   to Congress you state that the
                                         report    II ..,evaluates         the sufficiency       of industry   and federal
                                         regulator      actions...'fi     we find this draft of the report wanting in
                                         several    important         areas.    More specific     comments are made below,
                                         but in general we have the following                areas of concern:
                                                       the report    ignores the events of October 13, 1989, a
See comment 1.                                         nearly ideal context in which to measure the adequacy of
                                                       changes    in clearance  and settlement systems  and the
                                                       regulation   thereof:
See comment    2.                                      the report     ignores    major elements of the existing   system,
                                                       particularly      with    respect to information  sharing:
                                                       conclusions     are drawn without     qualitative     standards for
See comment 3.                                         comparing the clearing      and settlement        practices      across
                                                       industry    segments and with only limited           quantification
                                                       of a problem and supporting       evidence, either statistical
                                                       or testimonial.

                                                         30 South Wacker Drive   Chicago, lllinols 60806       312/930-1000
                                LONDON                          NEW YORK                         WASHINGTON,      DC                  TOKYO

                                               Page107                                                 GAO/GGD-9033Clearanceand       Settlement
                              Appendix VII
                              Commenta From the Chicago
                              Mereentile Exchange


                 We understand      that many of these shortcomings       were the result    of
                 a decision      to limit   the scope of the report.     Because we feel the
                 public    interest    would be served by a broader scope, we will        draw
                 attention      to a number of areas where a change in scope would
                 increase the utility        of the report.  Our detailed    comments are set
                 forth below.

                 Our difficulties         with this draft report begin with its subtitle:
                 "The Stock, Options, And Futures Markets are Still                  at Risk.V1 This
                 is alarmist.         Furthermore,       the report makes no effort       to measure
                 the relative       levels of risk in different         segments of the clearing
                 and settlement         system, to quantify        the current    level of risk as
See omment 4.    compared to 1987, or to evaluate what amount of risk is appropriate
                 for a clearing        organization       to shoulder.    Absent such support,
                 see no grounds to conclude that the markets are "...st.ill                 at risk."
                 The report        describes      differences      in clearance      and settlement
                 practices      in different      market    segments, but makes no evaluation         as
                 to the relative         risk of those practices.           Throughout    the report
See bomment 5.   there is an assumption             that uniformity      in the risk profile          of
                 clearing      organizations         is desirable,     but there       is never an
                 explanation      as to why this would be good public policy.
                 Risk is inherent         in the financial       markets.     Fundamentally,     clearing
                 organizations         exist     to control      that risk,       and to share losses
                 according to an established              formula in the event those controls             are
                 less than totally           successful.       Congress, the American public,             and
                 the competitive         position      of U.S. financial        markets would be much
                 better    served if the General Accounting                   Office   asked the truly
                 important     question        about clearing       organizations:       Would risk be
See comment 6.   reduced if those financial                 markets which do not have organized
                 clearing    facilities         developed them? Those markets, which include
                 foreign    exchange and many types of public and private                    debt, dwarf
                 the exchange traded              securities,      options,      and futures    markets.
                 Although never discussed by the GAO, very strong incentives                         are at
                 work to cause existing                clearing     organizations      to continue         to
                 improve their operation.             What incentives       exist with respect to the
                 safety of those other markets?
                 Cateaories        of the Renort. .
                 The GAO's report         correctly      divides     the issues surrounding           the
                 operation      of clearing        organizations        into    three     of the four
                 appropriate      categories.        The three identified           topics     are trade
                 processing,     risk management, and credit and settlement.                  The fourth
                 topic,     the operation        of risk       sharing     rules,     is never fully
                 discussed.        In our comments on each of these sections,                     we will
                 clearly     show that the practices            in the futures        industry     are of
See comment 7.   outstanding      quality   and worthy of emulation            in the clearance       and
                 settlement     of other exchange traded instruments.


                          Page 108                                            GAO/GGD90-33 Clearsnce and Settlement

Nowp.;           The report          correctly       notes on page 28 that                 llefficient         trade
                 processing        systems are crucial           to financial       markets."          It goes to
                 great length to describe                the trading         process systems in stock,
                 options       and futures        markets,      but never explores             the incentives
                 which give rise to increased                  efficiencies.           We believe         that the
                 driving      force behind increases             in efficiency        is b.                       The
                 positive       results      of competition        can be readily        seen among futures
                 clearing      organizations        and by comparing trade processing                    practices
                 between the futures               and securities         industries.            For instance,
                 multiple       clearing      organizations        possess two specifically               positive
                 attributes;          they promote          innovation        through       competition           and
Seecom   3nt8.   facilitate        the risk management function                 by housing the clearing
                 agency and the exchange within                        a single        or closely           related
                 institution.           Many of the innovations            in securities          clearing,       for
                 example continuous              net settlement,          were developed            by clearing
                 organizations           (in this     case, the Pacific            Clearing         Corporation)
                 which are no longer in business.                     GAO never analyzes whether the
                 current lack of competition              among securities         clearing       organizations
                 might explain            the delays       in implementing           the Working Group's
                 recommendations with respect to faster trade comparison for stocks.
                 Trade processing   in the futures      industry     is qualitatively        superior
                 to that in the securities    industry.       First,     it is superior      in terms
                 of timing.   At the Chicago Mercantile         Exchange, over half the day's
                 transactions    are matched prior         to the closing          bell.       SYmilar
                 figures describe the situation      at other futures exchanges since the
Seecomment9.     introduction   of intraday   trade matches.           Bin00   trade     matahing     is
                 performed       by   the    clearing      organisation         in   much     of   the    futures
                 industry,      the information         from those matched           trades    is immediately
                 ~r,"~l~~~~f~~l~t~~~posee~                                     where     apprwr~ate,         it,    is
                                                                   sharing     with       other     clearing
                 organizations.         Securities      clearing    organizations         do not have any
                 direct    information      as to how today's trading           has impacted the risk
                 profile     of their clearing       members until        the end of the day beaause
                 that    is when they receive          the matched trade         data.       GAO makes the
                 point that trade reconciliation               takes longer for stocks (although
                 it provides      no objective       standard for determining              adequate trade
                 match time frames), but totally               ignores the qualitative             advantage
                 that many futures         clearing     organizations       possess.
                 The second area where trade processing                  is superior        in the futures
                 industry     is with respect to the audit trail.                 At the Chicago Board
                 of Trade and the Chicago Mercantile                Exchange, the record reguired
                 for submission of trade data also contains vital                      information      about
                 the audit trail        (which has been an important            concern of the GAO in
                 other studies).          For example,       the account number of the customer
                 on whose behalf the trade was executed is included.                            This allows
                 immediate comparison of matched trade data to the data base of
                 large trader       information      (which does not exist            in the securities
                 industry)      for risk       evaluation,       market surveillance,             and trade
                 practice     compliance purposes.

                       Page109                                                    GAO/GGD-90-33Clearanceand              Settlement
                          Merceatile Exchaage

                      The CWE recognize8       the importance      of improving     the audit trail.
                      We have taken certain         steps toward those improvements,           and have
                      8overal additional       steps in the early stages of implementation.
                      Currently,    other information      about the time of entry of the order,
                      the clearing     members and individual       brokers involved      in the actual
                      execution    of the trade,      and the type of account being traded are
                      all present on the trade record at the time it is submitted                    for
                      matching.       This virtually      eliminates      the need for post-trade
                      requests for data submission,        which can delay an investigation        many
                      days.    It also provides a strong incentive           for clearing    members to
                      submit audit trail     information     on a timely basis since their trades
                      will   not match if they do not.
                      Our final      note with respect to the section               on trade   processing    is
                      that notwithstanding            the need for improvements which we and other
                      organizations        continue to make (the CME introduced             another intraday
                      trade match, for a total of four, on December 8, 1989), one section
Nowlp.42.             of the report          implies      an unreasonable    performance       standard.     On
                      page 33 the report               complains     that   during     October,     1987, the
    I                 securities        industry,      9'. ..had to modify working hours to complete
                      reconciliation.*'           Regardless      of the increases       in efficiency      and
                      capacity       in trade        processing      on all      futures     and securities
                      exchanges, the requirement                to work overtime to handle unexpected
                      spikes in volume will             always be present.

                      This oection       has significant             omissions     and could be further
                      improved with the development                  of comparative      standards.         With
                      respect     to   information          sharing       there     are   eleven      clearing
See comment 10.       organizations     which are cited in the introductory                 section of your
                      report.     Ten of the eleven          partiaipate       in the futures      industry~s
                      information    sharing     ryetm       abnialsterod        by the Chicago Board of
                      Trade Clearing         Corporation          (CBOTCC).        The Options        Clearing
                      Corporation    (OCC) was recently             persuaded by the CFTC to join the
                      syetem. While progress in expanding this network may not have been
                      as rapid as one might hope, it has been accomplished.                          There has
                      been a long-standing         invitation         to NSCC to join the system.              It
                      appears that only the addition               of the NSCC to the system stands in
                      the way of universal        implementation.            In addition    to this system,
                      a far reaching      information        sharing agreement is in place between
                      the CWE and the OCC with respect to cross-margining.
                      The quality      as well     as quantity        of the information         that  is
                      available     about mutual       clearing       member6 through      the CBOTCC
See bomment IO.       administered     system has been dramatically          improved since October
                      1987.      These changes were made early             in 1908.       Not only is
                      information     about mark-to-market         cash flows shared, but options
                      premium payments are separately           accounted for and surplus/deficit
                      margin information      is shared.         Many clearing     organizations      and
                      exchanges have fully      incorporated      this shared data into their risk
                      management systems and run a complete analysis            of daily information


                          Page 110                                             GAO/GGD9O-33 ClearanceandSettlement
                          ApQendix MT
                          Commente From the Chicago
                          Mercantile Exchange

                  relative         to historical              patterns         and     adjusted         net     capital        of
                  clearing        members.
                  The CWE believes               that the OCC's comments as reported                            on page 52
                  with respect to the integrity                          of the CBOTCC as administrator                          of
                  this shared information                   system are not well founded.                      We have over
                  a decade           of experience             in the daily          eharing        of this          type of
                  information          with the CBOTCC, and have not had a single incident.                                      in
                  which unfair           advantage was taken.                Additionally,          the problem cited
                  by the OCC is not a function                        of who administers           the system, it ie
                  entirely         a function           of when the OCC chooses to establish                                   its
                  settlement          deadlines.           The Chicago futures            clearing          organizations
                  require        settlement           (of     both payments to as well                       as from the
                  clearing         organization)            at 6~40 a.m. local              time.           occ does not
                  settle       until     9~00 a.m. in the case of payments due OCC, and 10~00
                  a.m. in the case of payments due from OCC. Regardless                                                of who
                  administers          the information              sharing system, OCC is placing                      itself
                  and its clearing             members at risk that funds will not be forthcoming
                  at this later settlement                   time.        Such a failure        could be because of
                  payment to another clearing                     organization,       but equally likely,                 oince
                  the OCC's markets have already been open for 30 minutes before
                  settlement          of the previous             day's obligations            are due, because of
                  new information              available         to the banker about the current                          day's
                  market situation.
                          t Deuents,            . There is a major omission in the analysis                                      of
                  information            sharing.            There is only            limited          mention        of the
See comment 11.   involvement          of the audit departments                  (sometimes referred              to as the
                  financial         surveillance          departments)        of the exchanges and their role
                  in information              sharing.           It is these departments                     which,       under
                  futures        and securities             law as well as exchange rule,                          have the
                  inspection          powers over the books and records of clearing                                 members.
                  They function            as the "Designated Examining Authority                          (DEA)," in the
                  case       of       securities,             and the           "Designated             Self-Regulatory
                  Organization            (DSRO)," in the case of the futures                         industry.           Since
                  1978 there has been a group in the futures                                  industry          called         the
                  Joint      Audit         Committee,          which exists          specifically              to develop
                  standard procedures and to share information.                                  Although there had
                  been considerable               informal         information      sharing among futures                      and
                  securities            self-regulators,                another      group,          the       Intermarket
                  Financial          Surveillance         Group (IFSG) was formally                   brought together
                  at     the initiative             of the Chicago Mercantile                    Exchange with the
                  purpose of developing                  standard procedures and sharing information
                  across the futures                 and securities            industry.         This group, which
                  meets quarterly              and shares information                 by telephone              on a daily
                  basis     if     necessary,          consists         oi representatives              of every eelf-
                  regulatory           organization,             as well        as the Securities                   Exchange
                  Commission and the Commodity Futures Trading                                    commission,             which
                  participate          as observers.
                  Audit departments  play                  a key role in the total  operation   of the
                  risk management system.                   At the CME, part of the mission statement

                         Page111                                                           GAO/GGD9os8Clearasce andSettlement
       Appendix VII
       Comment.8 From the Chicago
       Mercantile Exchange

of the Audit Department is the protection            of the Clearing   House.
Major improvements in risk management have been made since 1987 in
our Audit Department.         A separate risk management unit has been
established    whose primary function       is to evaluate     the impact of
changing market conditions       on the financial     health of our clearing
members.     An on-line    risk management system, called         the Account
Risk Management System (ARMS) has been developed for its use, which
takes information      from our large trader data base and calculates
the impact of current         market prices    on those positions.        This
allow8 us to monitor the concentration            of risk among accounts of
a particular    clearing     member,  as well as to track particularly
risky accounts across clearing        members.
A    risk   management survey             has been developed             by our Audit
Department,     and was recently          adopted by all of the members of the
Joint Audit Committee.            This survey is a comprehensive analysis                  of
the risk management and credit               policies     at every clearing         member.
The CME will         administer       it to "high risk"           firms   first.        Once
administered      by the DSRO, the results            will be shared with all other
members    of the Joint Audit Program.               The survey by no means limits
itself    to questions         about the futures           industry     component of a
clearing    member's business;          it examines practices         in the equity and
over-the-counter        principal-to-principal            markets as well.         An Audit
Information        System     has been established               to track        financial
information      from all clearing          members and display         key ratios      on a
computer     terminal.          Other procedures,            such as debit/deficit
reviews,    continue to be enhanced.
Elements of information            sharing involving        the audit departments of
the various       exchanges receive           limited     attention      in the report.
Since    August,        1979)   the New York Stock Exchange                     (NYSE) has
performed      certiiin      audit    functions       of major broker/dealers                on
contract     for the CME and many other futures                 exchanges.        This is a
clear example of intermarket              information       sharing.      In cases where
a clearing      member is dually          registered       as a broker/dealer           and a
futures    commission merchant (FCM), standard industry                       practice     has
long accepted the filing             of the SEC's FOCUS report              for notifying
futures regulators         and self-regulators          of key capital       and financial
information.        Discussions      among the futures and securities               industry
at the Intermarket            Financial       Surveillance        Group are currently
taking place to merge the form 1FR of the futures                     industry      with the
FOCUS Report of the securities               industry.
Many studies of the 1987 crash have ignored the vital                      contribution
that information        sharing among audit departments                across industry
sectors made to controlling               risk in both October,         1987 and again
in October 1909. The GAO report could be an appropriate                        mechanism
to remedy this         oversight.           Audit departments       have always been
active participants           in riskmanagement        information    sharing,     and are
sparing       no effort         to continue         to improve      these     functions.
Interestingly,        while       GAO notes the creation           of the Securities
Clearing       Group,      it      neglects      to   ask why futures            clearing

       Page 112                                               GAO/GGD-90-33 Clearance and Settlement
                           Appendix VII

                    organizations     and exchanges have never been invited, even as non-
                    voting    observers,   to participate  in this aspect of information
                     It is true that clearing                organizations       have limited      abilities       to
                    monitor their clearing             members        in all other markets.         What the GAO
                     fails   to recognize       is that this limitation               does not apply to risk
                     in other exchange listed                  markets.       There is a good information
                    sharing system in place for these risks,                     and it is being constantly
                    strengthened.         The hole in the system, which is where most of the
See corn! ent 12.   risk to the U.S. financial                   syetem rests,      i8 in the off-•rahange,
                    over-the-aounter,             prinoipal-to-prinaipa~                 markets      for       such
                    instruments     as foreign exchange, debt instruments                    and swaps. These
                    are largely     unregulated         markets, and thus there is nobody from whom
                    to obtain      information           or with whom to share information.                        In
                    addition,     the ability            of broker/dealers           and other entities            to
                    engage in risky          bridge         loans and junk bond financing                  in non-
                    reporting    affiliates         compromises the value of what information                      is
                    available.      A complete report would have focused on this problem,
                    which was pointed out to GAO staff                      in our initial     discussions       but
                    for some reason determined                      to be out of scope prior                 to the
                    preparation      of the current draft of the report.
                           al Recui$ements, . This area of the report would be greatly
                    improved by the development of an objective                        standard of analysis.
                    GAO reports that CMEhas increased its minimum capital                          requirements
                    to $1.5 million        and that the OCC has increased its minimum capital
                    requirements       at entry to $1 million.                 No evaluation     of adequacy is
See c0m:mer-d13.    made. OCC only requires                   its clearing       members at the minimum to
                    maintain $750,000 in capital.                    Barriers   to entry do not help handle
                    risk management during periods of extreme volatility                         since the odds
                    of a major market move on the day a firm becomes a clearing                               member
                    are remote.      What provides protection                 is the level of capital          which
                    must be maintained.              Nowhere does GAO point out that CME minimum
                    maintenance requirements               are twice OX's,         and twenty times NSCC'8.
                    The CME and many other futures clearing        organizations        employ twice
                    daily mark-to-market     revaluation    of all positions       (a policy which,
                    iS applied to the savings and loan industry,              probably would have
                    saved the American taxpayer hundreds of billions              of dollars).       We
                    also have a settlement      policy which transmit8       payment instructions
                    to settlement     banks to pay funds to clearing          members at the same
                    time as instructions      to pay the Clearing     House (instead        of first
                    collecting    funds and an hour later paying them out, which implies
                    that the latter       is contingent     on successful       completion     of the
                    former).      As a result,      the CME believes      it has the strongest
                    clearing    and settlement        system of all        futures     and options
                    A more thorough   analysis   of capital   adequacy by GAO would be
                    desirable in other important   areas.   Comments by NSCC and SEC (see
Now p, 32.          pages 45 and 46) to the effect     that additional  capital  would be

                          Page113                                                 GAO/GGD-90-33ClearanceandSettlement

                       burdensome on small clearing              members are reported,         but never
                       critically    evaluated.       The fact of the matter      is that in both 1987
                       and 1989 it was relatively          small firms in the securities         industry
    ,                  that doiaultod      on their obligations      to the clearing     organizations.
                       However, it is the case that minimum capital             requirements     are only
                       part of the picture.         It is equally    important    that as a firm grows
See Comment      13.   beyond the minimum threshold           for clearing     membership its capital
                       requirements     grow with it.       Capital   adequacy is just as important
                       at a major Wall Street broker/dealer           as anywhere else.      At the CME,
                       we have a position          based capital      rule,    where minimum capital
                       requirements      increase      as the number of a clearing               member's
                       positions    increases.        We are unable to determine          whether other
                       clearing    organizations       have similar      rules  by reading      this    GAO
                       The CME believes     that our record with respect to risk management
                       is very strong.       In the history      of our Exchange, there has never
                       been a default     by a clearing      member nor has a customer of a CME
See bomment      14.   clearing    member ever lost any money as a result             of the clearing
                       member's insolvency.       The record in the futures industry          as a whole
                       is very good as well.        No FCWbecame insolvent        in October 1987, a
                       claim that the securities          industry    cannot make with respect           to
                       broker/dealers.     Risk management in general and information             sharing
                       in particular     continues    to be enhanced.         To suggest that risk
                       management in the futures       industry    is a candidate    for ltreform,vg     as
                       does the title    of the report,       is less than fair.
                                       Rules, .
                       A complete evaluation       of clearing      and settlement      policies    should
See bomment      15.   have turned to clearing         organization      loss sharing      rules at this
                       point.     Although the GAO provided a limited           discussion      of changes
                       in guarantee funds, we would like          to point out that this is but one
                       element     of the loss sharing         provisions     in place at clearing
                       organizations      in the futures    industry.
                       A key development           in the loss sharing               arrangements     at futures
                       clearing     organizations,        which was begun by the CBOTCCwell before
                       October 1987 and fully            implemented at the CME since then, is the
                       parent guarantor        rule.      The parent guarantee,             which may be found
                       in CME Rule 901.L, requires               that all         individual       and corporate
                       owners of five (5) percent or more of a clearing                        member guarantee
                       the performance of the house account of the clearing                         member to the
                       clearing     organization       without    limit     in proportion        to their    share
                       of ownership       and/or control.           This guarantee           does RQ& apply to
                       obligations      of customers,       nor does it subject the guarantor(s)                to
                       assessment in the event of the failure                 of another clearing         member.
                       It prevents a parent corporation               or individual(s)          from creating     a
                       shell subsidiary        or affiliate     to shelter         its obligation      to pay for
                       trading     losses which are incurred              on its behalf.            GAO's report
                       notes a case in the securities                   industry,        on page 43, where a
Now pp. 29-30.         clearing     member defaulted         and the parent company did not provide

                             Page114                                               GAO/GGD-3033C1earasceasd&U,lement

                              Appendix VU
                              Comments From the Chicago
                              Mercantile   Exchange

                        additional     capital.       It makes no attempt to analyze whether the
                        parent guarantee innovation         of future8 clearing    organizatione     would
                        have avoided that situation,            or whether a parent guarantee          rule
                        could be an appropriate         mechanism to avoid the SEC's concern about
                        higher      capital      requirements       limiting    access      to   clearing
                        organizations       in certain   instances.
                        While the report recognizes          that the CM?2has increased its pool of
                        security     deposits    (as we call our guarantee fund), no mention is
                        made of our unique oommon bond rule which supplements this fund.
                        In the event of a default          by a clearing       member which could not be
                        satisfied     by its margins and other assets available           to the Clearing
                        Hou88, its parent guarantee,          the surplus funds of the Exchange, and
                        the aggregate security          deposits    of all clearing     members,    the CME
                        would then invoke its liability             rule which looks to all clearing
                        members for remedy.          The balance of the unsatisfied         default    would
                        then be allocated         among the clearing          membership according      to a
                        preeet formula, taking into account each clearing               member's adjusted
                        net capital,     trading volume and share of open interest.              Consistent
                        with the CME's policy         of providing      the highest level of safety in
                        the provision       of clearing    services,      this common bond has recently
                        be revised to strengthen          the formula and prevent any possibility
                        of a clearing      member avoiding       its share of an assessment.
                        A comprehensive analysis         by the GAO in its report on clearance and
                        settlement       would have led to the recognition           of these additional
                        elements of loss sharing             arrangements.       Application       of such a
                        standard might have led GAO to question why these arrangements are
                        limited      to clearing  organizations      in the futures      industry.     At the
                        very      least,    this  would be further          evidence      to support      the
                        proposition       that a diversification        of providers      of clearance    and
                        settlement       services  results      in strength    through competition        and
                               t and Settlements,     .

                        We believe that there are certain            elements of the changes in credit
                        and settlement       practices     which merit greater           attention       than is
See comment   16.       provided by the GAO in its report.              Three steps have been taken by
                        the CM!4since October 1907 to modify our settlement                  procedures,      and
                        the success of these steps was evident                  in October 13-16, 1989.
                        First,    we have fully       automated a twice daily mark-to-market,                   so
                        that funds move both to and from the Clearing                   House    by 3~00 p.m.
                        each afternoon,       and morning banking reports accurately                 reflect    a8
                        many intraday      settlement     calls as occurred.          Second, we have, in
                        conjunction    with the CBOTCC, entered into highly detailed                    standard
See comment   15.       settlement     agreements with         all    of our settlement            banks.       In
                        addition    to clarifying      when payments (both incoming and outgoing)
                        become irrevocable,         they also stipulate           the deadline         for   bank
                        response based on when the bank receives                    information        from the
                        clearing    organization.       Third,     in recognition      of the large volume
                        and amounts of funds transfers          for daily settlement         between Chicago


                             Page 115                                             GAO/GGJHO-33 Clearance and Settlement
                           Appendix VII
                           Chnmente From the Chicago
                           Bfereentile Exchange

                     and New York, the CME in August 1989 added two New York based banks
                     to our list           of  settlement    banks.       The addition     of these two
                     institutions,          Bankers Trust Company and Chemical Bank New York,
                     will     potentially       reduce the inter-Reserve          District   transfer      of
                     funds      to settle         CME contracts        thus   increasing      safety     and
                     efficiency.          Had GAO investigated     the current situation        respecting
                     settlements,         it would have found absolutely           no payment problems
                     involving      futures     clearing   organizations     in October    1909.
                     Various mention is made of unusual settlement               practices    without any
                     analysis    as to their       importance.      GAO notes on page 50 that            the
                     NSCC still    requires      daily settlement       by certified      check, without
                     noting that this might be unusual in an era of electronic                       payment
                     systems and without        acknowledging     that these checks are for (bank)
                     clearing    house funds, in effect           delaying    settlement     finality      an
                     additional    day.      By contrast,      the twice a day settlement             in the
                     futures industry       and the payments to and from OCC are in "same day"
                     funds transferred       via the Federal Reserve System's FEDWIREnetwork.
                     The relative    merits     of these practices        stand in stark contrast          to
                     one another.
                     There is no analysis          of clearing       organization   rules with respect
                     to the timing        of their     substitution       between the obligations       of
                     clearing     members     which were party to the original            trade and the
                     potential     impact of such rules on the risks to customers.               When the
                     clearing       organization       must      commit      itself   to    guarantee    a
                     transaction,       and its      ability,      if any, to "back out" certain
                     transactions,      is a key element of the safety and soundness of the
                     The existing         draft of the report devotee a great deal of attention
                     to the adequacy of credit             facilities        to support clearing         members.
                     It correctly          notes that there is some question                 as to whether the
                     regulation         of such credit      facilities        is the proper function         of a
                     clearing      organization,     although clearly            they have some interest       in
                     the matter.            The report     ignores      the area which should concern
                     clearing       organizations,       and that         is their        access to committed
                     credit     facilities      on their     own behalf.           The CMB completed a $250
See;comment    17.   million      committed credit        facility        from a consortium        of 14 major
                     international          banks in July,          1989.      GAO does not mention this
                     facility,         nor does it        mention       that      no other      U.S. clearing
                     organization          has a larger       committed         facility.       Again,    such a
                     comparison ;aight improve the overall                   quality      of the report.
Now pp.   46-47.     Finally,     in the discussion       on pages 65 and 66 of future8         style
                     eettlementa       for options,    there is no mention of the fact that
                     treatment      of securities    options   in this manner would create vast
                     asymmetries      in cash flow between stocks and securities            options.
                     This is especially         true of positions     which include   ownership of
                     stock (which is not revalued daily)and           a short call position.       The
                     CME believes      that futures style settlement       would make an important
S&comment      18,   contribution        to risk     reduction    in the      futures  markets       by

                           Page 110                                             GAO/GGD-90-33 Clearance and Settlement
      Appsndlr vu
      Mmv8lltue ExchangeJ

eliminating     cash flow   asymmetries.    We have never advocated      it   for
securities     options.

We believe   the GAO’s report,      with the revisions      suggested above,
can perform    a vital service    in contributing      to the understanding
of the complex issues     of clearance      and settlement     in the stock,
options,   and futures markets.       We believe that safe and efficient
clearance and settlement     are vital   to America's financial      markets.
In our view, many important     improvements to these systems have been
made since October 1997, and a careful         examination   of the behavior.
of these systems during the period October 13 to 16, 1989 would
provide the GAO with assurance that the stock, options and futures
markets are not at risk nearly to the extent the current             draft    of
the report   would lead one to believe.
We appreciate       this opportunity to comment on the GAO’s report,    and
the professionalism        exhibited  by GAO staff   in conducting   their
inveetigation.          We look forward   to working   with you on this
important      topic in the future.


     Page117                                       GAO/GGD9@&3 ClearanceandSettlement
                 Appendix VII
                 Comments From the Chicago
                 Mercantile Exchange

                 The following are GAO’S comments on the Chicago Mercantile Exchange’s
                 letter of December18, 1989.
                 1. Although we agreethat the October 13,1989, decline did test, to a
    0 Comments   limited extent, the changesmade in clearanceand settlement systems,
”                the size of the decline and the volume of trading did not approach those
                 of October 19,1987.
                 2. We disagree that the report doesnot discussmajor elements of infor-
                 mation sharing. The information on p. 36 discussesthe BCYKC risk-expo-
                 sure information sharing system. Issuesraised in this and other
                 comment letters on the BOTCC  information sharing system are also dis-
                 cussedon pp. 39-40 of the report.
                 3. The report was never intended to be a comparative analysis of simi-
                 larities and differences in clearance and settlement practices in stock,
                 options, and futures markets. We baseour conclusion upon judgments
                 about federal agency and clearing organization progress made in
                 responseto Working Group recommendations.Such progress is not
                 quantifiable beyond indicating that overall a particular Working Group
                 recommendation has been completed, that there has been someprogress
                 on it, or that no progress has been made. Seeappendix I for the status of
                 Working Group recommendations.

                 4. Our judgement that the clearance and settlement systems of stock,
                 options, and futures markets are still at risk is basedupon the fact that
                 many Working Group recommendationsmade in May 1988 in response
                 to events on October 19 and 20, 1987, have not been implemented.
                 Although progress has been made on a number of issues,many changes
                 have yet to be completed.
                 6. The risks assumedby a particular clearing organization should be
                 consistent with the market and financial risks specific to the market it
                 6.We agreethat this is an interesting and important issue deserving fur-
                 ther study. However, it is not within the scopeof this report.
                 7. We agree that risk sharing rules are important elements in the safe-
                 guards of clearance and settlement systems. However, the Working

                 Page 118                                 GAO/GGD-90-33 Clearance and Settlement

    Appendix VII
    Commenta From the CNcago
    Mercantile Exchange

    Group did not identify risk-sharing rules as problematic during the Octo-
    ber 1987 crash and, therefore, they do not fall within the scopeof this
    8. It is not the purpose of this report to examine the relative merits of
    different organizational arrangements of clearing organizations in stock,
    options, and futures markets. The opposite argument to the position
    taken by CMEis that multiple clearing organizations are unnecessarily
    duplicative and that there are economiesof scale with fewer and larger
    clearing organizations. Large clearing organizations that are user-con-
    trolled can be innovative. Futures clearing may not be as competitive as
    implied here, with CMEand BOTCCdominating the market.
    9. The scopeof our work did not include judging the relative advantages
    or disadvantagesof futures clearing versus securities clearing
    10. Information sharing issuesare discussedon pp. 34-37 of the report.
    Commentson information sharing are discussedon pp. 38-39 of the

    11. We added the phrase “and exchangeaudit departments” on p. 36 of
    the GAOreport. Although we consider the role of audit departments to be
    important to the financial integrity of clearanceand settlement systems,
    the role of audit departments was not called into question during the
    October 1987 crash by the Working Group and, thus, is outside the scope
    of our report.
    12. We agreethat financial instruments outside the stock, options, and
    futures markets can pose serious risks for financial systems. However,
    this issue is outside the scopeof the report.
    13. We did not do a comparative analysis of the levels and relative mer-
    its of minimum capital standards of clearing organizations in the differ-
    ent markets. This is not a Working Group issue and is outside the scope
    of our report.
    14. The Working Group thought that the adequacy of clearing member
    guarantee fund contributions, the liquidity of guarantee funds, and cen-
    tralized collection and availability of pay and collect information were
    worthy of examination in the futures markets. We consider these risk-

    Page 119                                GAO/GGD90-33 Clearance and Settlement
Commenta From the Cldcago
Mercantile J&change

16. Loss sharing rules were not identified by the Working Group as an
area of concern. It is thus outside the scopeof our report.
16. We agreethat revised settlement bank agreementsand intraday
pays and collects were not sufficiently highlighted in the previous draft.
We have added a section on these issueson p. 42 of our report.
17. The Working Group focus was on clearing member credit, not clear-
ing organization credit.
16. We have modified the text on p. 47 to mention CME'Sopposition to
futures-style margins for securities options.

Page 120                                GAO/GGD-90-33 Clearance and Settlement
Mqjor Contributors to This Report

                        Xavier Richardson, Project Director
Gendral Government      Patrick Dynes, Project Manager
Dividion, Washington,   Edward Samario, Evaluator
D.C. ~
                        William Ryczek, Sub-Project Manager
        o Regional      David Cummings, Evaluator
                        David Arseneau, Evaluator

                        Preeti Jain, Evaluator
New iYork Regional
                        Evelyn Aquino, Evaluator
San Prancisco
Regional Office

                        Page 121                              GAO/GGMO-33 Clearance and Settlement
Page 122   GAO~GIMO.LU Clearance   and Sektlement

    Page 123   GAO/GGDBO43Clauance and Settlement
 liklated GAO Products

                Financial Markets: Preliminary Observationson the October 1987 Crash
                (GAO/GGD~~-38,January   1988).
               DevelopmentsSincethe Market Crash of October 1987 (GAO/T-~~~-88-33,
               April 1988).
                Financial ServicesIndustry Issues(GAO/W-SQ-4TR, November 1988).
               Financial Markets: Status of Computer Improvements at the New York
               Stock Exchange (GAO/IMTEC-88-36,April 1988).
               Securities Regulation: Securities and Exchange CommissionOversight of
               Self-Regulation (GAO/GGD-86-83, September 1986).
               Securities and Futures: How the Markets Developedand How They Are
               Regulated (GAO/GGD-86-26,May 1986).

(222244)       Page 124                              GAO/GGIMKX33   Clearance   and Settlement
!---c--   *-          .-___      ---------I            ..._..-....--_-_.-    -111”-1-111--

               ---   -----     .-..--.--_---   -.--_
                              Rtyws1.s         for c’opiw of (;A() rq~ort,s shor~ld lw set11 10:

                              1i.S. Gtttwral Accounting                      Offiw
                              I’osl, Off’ictt Box 6015
                              (;ai t.htwtmrg, Maryland                      2087’7

                              rl’t~ltq~hotw 202-275-6241

                              The first, five copies of each report                          are free. Additional   copies are
                              $2.00 t?ach.

                              l’here is a 25% discount                      on orders for 100 or more copies mailed to a
                              sirtgle address.

                              Orders tmtst bc prepaid by cash or by check or money order made
                              out, to the Sul)c.‘rittt~ttd~nt, of Documents.