Report to Cc-mgressional Cornmi ttees -GAO CLEARANCE AND SETTLEMENT REFORM The Stock, Options, and Futures Markets Are Still at Risk 141098 United States GAO General Accounting Office Waahiugton, D.C. 20548 General Government Division B-236443 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 1 EJxecutive Summary 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 managed. The Working Group reported in May 1988 that unprecedented trading volumes and price declines during the market crash causedthe following: Page 2 GAO/GGD-90-33 Clearance and Settlement ----i- 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. 23-28.) Page 3 GAO/GGD!W33 Clearance and Settlement I 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. 29-39.) 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 that: l a routine, inter-market, information sharing system is developed and used to assessthe inter-market risks posed by joint members(Seep. 38); and 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. 1 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 recommendations. 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 Made 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 Role 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 Improved 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 Liquidity 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 Sharing 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 Treasury 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 Corporation Appendix VII: CommentsFrom the Chicago Mercantile 107 Exchange 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 Settlement Figure 2: The Structure of Options Clearanceand 13 Settlement Figure 3: The Structure of Futures Clearanceand 14 Settlement Page 8 GAO/GGIMO-33 Clearance and Settlement Abbreviations 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 hboduction 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 1 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 settled. 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. 26,lQW 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 Introduction 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 Introduction I ‘Figuw 1: The Primary Linkage8 In Stock Clearance and Settlement Exchange Clearing Organization Depository 1 New York Stock Exchange National Association of Securities Dealers Depository Trust Company National Securities L/ Clearing Corporation Boston Stock Exchange I 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 Introduction 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 i\ 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 Set$ement , 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 Introduction 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 Introdaction 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 Introduction 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 power. 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 ‘, . chapter1 Introduction 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 Chapter1 Introduction 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 organizations. 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 IntmducUon 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, chapter. Evaluation 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 Introduction 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. I 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 discrepancies. 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 data; 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 frames; 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 quickly. 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 chaptm2 TradeProcessingsystemsAre ReiugImproved 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 Thirty. 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 FFrcigress Made in ChangingClearing Or$adsation Risk-ManagementSystemsHas Be@xSlow 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 obligations, . 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 actions: / . received a cash infusion from their parent firm, . had their operations and financial obligations taken over by another firm, . 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 that: . 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 Chapter3 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 credit. . 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¬ 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 decline. 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 accounts. 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 ~P--~chaneinecleulne 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 organizations; 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: Evaluation 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 information, l the differences in settlement time frames between and derivative NSCC markets, . the limited number of participants that are also membersof futures NSCC 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 organizations. 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 QJ?t 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 participants. 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 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 crisis. . 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 settlement. 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 issue. 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 chapter4 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 deadlines. 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 include: . “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 time. . 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 1992. 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 chapter4 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 chapter4 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 markets. . 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 Cbnclusions / 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 frames. 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 I occ said that the report doesnot sufficiently emphasizethe benefits of Cor&ents and Our cross-margining in reducing risk and cash flows. Evalbation 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 gmuearb-rt;ses 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 defaults. 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 clearing oraanrzatrons. 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. (continued) 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 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 exchangesand NASD towards a more automated reconciliation cycle and earlier trade reporting by members, Working to implement Group of Thirty recommendation to move settlement to 3 days after the trade date. 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. _.-.-- -.~------i- (continued) 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. l.._.l---- ---- 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. - .---I 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 partrcrpants. 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. (continued) 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 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 WA.5HlNCTON UNDER SECRETARY December 14, 1989 t Dear ogel : w 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 Risk." 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 problems. 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 , Robert Js-ft . G auber Under Secretary for Finance Mr. L. Fogel Richard Assistant Comptroller General General Accounting Office Washington, DC 20548 Page 60 GAO/GGDM-33 Clearance and Settlement * Appendb III C&men@ From.the Securitiesand Ekc/hangeCommission 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 Pre_ldent 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 obligations. 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 (continued...) 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 SCCP. 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 (continued...) 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 (continued...) 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 area. 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 discussion. &?-/ 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. Sincerely, Richard G. Ketchum Director 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 discussed. 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 I 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 below. A. Information Information sharing has long been a Commission priority. In financial rule enforcement reviews since 1985, Commission staff Y Page76 GAO/GGD-90-33 Clearance and Settlement , AppendLvIV CemmentekomtheCommedityFutures Tradin8Cemmission 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 AppendirrlV CemmentsFremtheCemmodityFutures 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 1987. 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 , Appendixrv 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 systems. 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- tive. 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 Y 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 Director Page82 GAO/GGD90-33 Clearance and Settlement Appendix IV CmnmentaFromtheC4mmmdityPntnrea Trading Commidon / The following are GAO’S comments on the Commodity Futures Trading I Commission’sletter dated January 29, 1990. I 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 Report. 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 ClekwingCorporation 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 , APPendixV Commen~F'romtheNationsJSecnritlee ClearingCorporation 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 depositories. 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 organizations. 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 F 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 transaction. 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 Thirty. 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. Y 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 system. 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, QPTIONS. AND FUTURES MARKETS HAVE NOT BEEN FULLY RESOLVED - 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 reached. Page93 GAO/GGD-90-33 Clearance and Settlement Appendix v Commenta From the Natlonal Securih CleeringCerperetien 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. Page94 Appendix V CommentsProm the National fJecuriU Clearlng Corporation Attachment A. NEW LISTED CLEARANCE SYSTEM (Implemented August 18, 1989) Processins 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 specialist. 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 Ckxnment.8F'romtheNeUonalSecuritles 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. OTC COMPARISON CYCLE ACCELERATION (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 Y 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 process. 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 AppendixV 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 $60,000 in capital in excess of whatever the capital requirement established by the SECand desig- nated examining authority. 9. The sentencehas been altered on p. 32 to indicate that a clearing member default occurs when the member fails to pay for the receipt of a stock instrument and, on the options and futures side, fails to pay for lossesincurred in market movements. 10. The text has been altered on p. 34 to indicate that NSCChas taken steps to increase the liquidity of its clearing fund. Page 98 GAO/GGJMM-S3 Clearance and Settlement - Chmmenb From the National Seeuritiea Clearing Caporation 11, A sentencehas been added on p. 37 indicating that the scz has moved beyond the planning stage and is currently working on a central data base and other suggestedimprovements. 12. We agreethat the stock clearance and settlement system should be. strengthened by further reducing or mitigating known risks and have altered the text to make this more explicit. Seep. 37. 13. We have omitted the word “stock” on p. 40. 14. The text has been modified on p. 41 to indicate the exact nature of the withdrawal or default and its effect on NSCC. 16. We mean netting of obligations among clearing organizations in dif- ferent markets or intermarket netting, not intramarket netting. The text has been changedon pp. 47 and 48 to indicate that we mean netting of payments among clearing organizations in different markets. 16. This sentencehas been deleted. Page 99 GAO/GGDgO-3g Clearance and SeMlement Ap&-dix VI C@nmentsFrom the Options CjlearingCorporation Nota: GAO comments sup$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 2 Page 101 GAO/GGD9&33 Clearance and Settlement Appendix VI CommentsFrom theOptions ClearlngcorpOration 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 dnothpaPraS= 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. Qneofth~&~2%Ore~found 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 3 Page 102 GAO/GGD-90-33 Clearance and 8ettlement I Appendix VI CemmentsFromt.heOptiona 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 4 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 * * Activity 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 5 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. Sincerely, Chairman of the Board Y 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 i2tsz!i- chwExacullva OHker 31m33m 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 understanding. 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 C 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." we 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. 2 Page 108 GAO/GGD90-33 Clearsnce and Settlement AppendixM Ccmment5FrcmtheChkago MercantileExchange 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. 3 Page109 GAO/GGD-90-33Clearanceand Settlement AppendixM CommentsFromtheChtcago 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 4 Y 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 5 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 6 Page 112 GAO/GGD-90-33 Clearance and Settlement Appendix VII ~mmente~mtheChiCUge Mercantile&change organizations and exchanges have never been invited, even as non- voting observers, to participate in this aspect of information sharing. 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 exchanges. 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 AppenaixVU CommentaPromtheChicago MercantileExchange 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 report. 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 8 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 innovation. 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 9 Y 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 marketplace. 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 10 Page 110 GAO/GGD-90-33 Clearance and Settlement Appsndlr vu CtmunenteFromtheChicago 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. Sincerely, 11 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 serves. 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 report. 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 arrangements. 10. Information sharing issuesare discussedon pp. 34-37 of the report. Commentson information sharing are discussedon pp. 38-39 of the report. 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- managementissues. Page 119 GAO/GGD90-33 Clearance and Settlement AppendixM 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 I / Preeti Jain, Evaluator New iYork Regional Officje Evelyn Aquino, Evaluator San Prancisco Regional Office Page 121 GAO/GGMO-33 Clearance and Settlement Page 122 GAO~GIMO.LU Clearance and Sektlement l 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. .I
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)