oversight

Payments, Clearance, and Settlement: A Guide to the Systems, Risks, and Issues

Published by the Government Accountability Office on 1997-06-20.

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

                United States General Accounting Office
rij. A/^        Report to the Chairhian
                Committee on Banking and Financial
                Services .
                House of Representatives

June 1997
                PAYMENTS,
                CLEARANCE, AND
                SETTLEMENT
                A Guide to the Systems,
                Risks, and Issues




                                           <s>*




GAO/GGD-97-73
       United States
GAO    General Accounting OZflce
       Washington, D.C. 20548

       General Government Division

       B-270598

       June 20, 1997

       The Honorable James Leach
       Chairman, House Committee on
         Banking and Financial Services
       House of Representatives

       Dear Mr. Chairman:

      This report responds to your request that we provide information, about
      the nation's systems to effect financial transactions between purchasers
      and sellers of goods, services, and financial assets. As you know, these
      systems—often referred to as payments, clearcince, and settlement
      systems—are a vital part of the smooth functioning of our nation's
      economy and the free flow of economic activity worldwide. They allow
      ownership of products, funds, securities, futures contracts, and other
      financial instruments to be exchanged and settled among consumers,
      financial institutions, businesses, and others. They also play a criticzil role
      in maintaining the stability of financial meirkets and reducing systemic
      risk.

      As agreed, the objectives of this report were to

       describe the various payments, clearance, and settlement systems used in
       chis country;
       describe various emerging products and services, which we refer to as
       electronic commerce;
       identify and describe certain risks associated with these systems,
       products, and services, and discuss how those risks are mitigated; and
       identify and describe some significant issues relating to the systems,
      -products, and services that face users, regulators, and polic3TTnakers.

      For purposes of clarity, we present the information on systems, products,
      and services in four major sections: (1) clearance and settlement of
      wholesale payment systems; (2) clearance and settlement of equities.
      Treasuries, futures, and options; (3) clearance and settlement of retail
      payment systems; and (4) new and emerging financial products and
      services. An overview precedes each section, highlighting some of the
      main characteristics and other information associated with each type of
      system, product, or service. Each section is organized in the same
      way—description and use, basic data, processes, regulatory oversight, and
      risk and risk mitigation. The final section of the report, contains
      information on some significant issues raised by industry officials



      Pagel                            GAO/GGD-97-73 Payments, Clearance, and Settlement
              B-270598




             concerning these systems, products, and services. The remainder of this
             letter includes background information, a short overview of the sections,
             our scope and methodology, and comments from the Federal Reserve
             Board of Governors.


             The general term payment system refers to a mechanism for the transfer of
Background   monetary value and related information. Transfer of value can occur, for
             example, when a customer writes a check to a company and the funds are
             then transferred from the customer's bank account to the bank account of
             the company. Related information exchanged at the same time might
             include the identification of the payee and the payor, bank accoimt
             numbers, and the date of payment. Clezu-ance is the process of
             transmitting, reconciling, and in some cases, confirming payment orders or
             securities transfer instructions before settlement takes place. Settlement is
             the fined step in the transfer of ovmership. In a banking transaction,
             settlement is the process of recording the debit and credit positions of the
             parties involved in a transfer of funds; in a securities transaction,
             settlement includes both the trcmsfer of securities by the seller and the
             payment by the buyer.

             In order to promote the smooth functioning of the nation's economic
             activity, payment systems must provide for a reliable and accurate
             exchange, a measure of security for transactions, and finality of payment
             (i.e., settlement that cannot be reversed or withdrawn at a later time). In
             most cases, there is a delay between the exchange of instructions and
             information concerning a transaction and its final settlement. For
             example, when an individual deposits a check into his or her bank
             account, the bank then instructs the bank on which the check was drawn
             (payor's bank) to pay the specified amount to the individual's bank, which
             will, in turn, credit that amount to his or her account. The actual
             settlement—i.e., the transfer of funds from the payor's bank to his or her
             bank account—may not occur until several days after the check was
             deposited.

             TTiere is a trade-off between the security and speed of settlement and its
             cost. Wholesale systems for the exchange of large-vjdue payments or
             products tend to have greater security (greater risk controls) than do retail
             systems. The loss on one wholesale transaction could be thousands of
             times greater than that for a typical retail transaction. Speed of settlement
             also adds to security. With less time between clearance and settlement,
             there is less likelihood of a default by one of the involved parties, all other



             Page 2                           GAO/GGD-97-73 Payments, Clearance, and Settlement
           B-270598




           things being equal. However, increased security and timeliness generally
           come at an increased cost. An electronic transaction that settles
           instantaneously may cost as much as 50 times more than a transaction in a
           system that settles in 24 hours or more.

           Settlements can be "gross" or "net." Gross settlement mezms each
           transaction is settled individually. Net settlement mezms that parties
           exchanging payments will offset mutual obligations to deliver identical
           items (e.g., dollars and Deutsche Marks) at a time, such as the end of the
           day, after which only one net amount of each item is exchanged.

           Each system or product has associated with it some type of risk and, in
           some cases, several types of risk. For purposes of this report, we discuss
           some of the most important risks and risk mitigations associated with
           these systems, products, and services. For example, counterparty/credit
           risk arises from the potential that a borrower or counterparty will fail to
           perform on an obligation. Operational risk arises from the potential that
           inadequate irtformation systems, operational problems, breaches in
           internal controls, or unforeseen catastrophes will result in unexpected
           losses. Risk of fraud is risk of intentional deceptions that could result in
           monetary loss. Payment system participants, regulators, and service
           providers take steps to mitigate these risks. The risk mitigation strategies
           vary by type of system and are generally more rigorous for large-dollar
           transactions.


           The United States has a wide variety of payrnents, clearance, and
Overview   settlement systems. Some systems are used primarily for large-dollar
           payments, such as Fed wire' and the Clearing House Interbank Payment
           System (CHIPS),- others are used for the clearance and settlement of
           fmancial products, such as securities, futures, and options. These systems
           are mairJy used by m^or financial players, such as banks and other
           corporations, and are generally referred to as wholesale systems. Other
           systems are used for the smaller dollar transactions with which most
           consumers are familiar—e.g., checks, credit cards, and automated clearing
           house payments (such as electronic deposits of paychecks or Social
           Security payments). Generally, these smaller dollar systems are referred to
           as retail systems.


           'Fedwire is the electronic funds transfer system operated by the Federal Rpsprve.

           -CHIPS is a private-sector electronic funds transfer system run by the New York Clearing House
           Association (NYCHA).



           Page 3                                     GAO/GGD-97-73 Payments, Clearance, and Settlement
B-270598




New, consumer-oriented products, such as stored-value cards, are now
being introduced. A stored-value card is a credit-card-sized device with an
implanted computer chip, that has a certain value and can be used for a
variety of applications including financial transactions. New services, such
as electronic money, are also being tested and marketed. Electronic
money is funds held in an online account that can be transferred over the
Internet between ciny two parties, including consumer to consumer. These
new products and services have not yet gained wide acceptance, but many
private-sector companies are planning for the rapid expansion of these
and similar products in the future.

The types of risk we discuss in this report are generally present in all
payments, clearance, and settlement systems. For example, operational
risk, such as the risk of computer failure, is inherent in all systems. One
type of mitigation strategy for operational risk focuses on having adequate
computer back-up systems. We do not discuss all relevant risks or
mitigation strategies but focus on some of the more important ones.

Many significant issues have been raised by industry officials, regulators,
and others regarding the operations, use, and regulation of payments,
clearance, and settlement systems. For large-dollar transactions, some
have raised the issue of the appropriateness of some institutions using less
secure payment systems to reduce their costs of transfers. Others have
raised issues about new and emerging products, such as stored-value
cards and home banking. For example, some said these products are being
offered, by both banks and their nonbank competitors, yet banks are
subject to a much greater degree of regulation of these products than are
nonbanks. Also, many have raised questions about the appropriate
regulatory structure for these products and services. Security issues for
both wholesale systems, such as Fedwire and CHIPS, and emerging
services, such as home banking, have also been raised. The enormous
volume and rapid growth in foreign exchange transactions have led to
discussion and studies of how to better reduce risk in this market. Finally,
many private industry officials, especially private payment system
providers, have raised issues for some time about the ability of the Federal
Reserve to be both a regulator of payment systems and a fair competitor in
delivering these payment services.




Page 4                         GAO/GGD-97-73 Payments. Clearance, and Settlement
              B-270598




              To obtain information on and describe retail and wholesale payments,
Scope and     clearance, and settlement systems; to identify risk and risk mitigation
Methodology   strategies;' and to identify issues concerning these systems, we:

              interviewed officials from international and federal financial regulators,
              including the Bank for International Settlements, the Board of Governors
              of the Federal Reserve System; the Federal Reserve Banks of New York,
              Richmond, Boston, and San Francisco; the Office of the Comptroller of the
              Currency; the Federal Deposit Insurance Corporation; the Office of Thrift
              Supervision; and the Securities and Exchange Commission;
              interviewed officials and analyzed statistics and documents from various
              private-sector payments system providers and participants, including the
              National Automated Clearing House Association, the New York Clearing
              House Association, Visa International, the Society for Worldwide
              Interbank FinancialTelecommurucations (S.W.I.F.T), the Chicago Board of
              Trade (CBOT), the Chicago Mercantile Exchange (CMK), and their
              respective clearing organizations—the Board of Trade Clearing
              Corporation and the CME'S clearing house division;
              interviewed officials and analyzed statistics and documents from various
              consumer groups.

              To identify new and emerging products and services, their'associated risk
              and risk mitigation strategies, and related i.ssues, we interviewed officials,
              and analyzed statistics and documents from the following:

              consultants with expertise in the development of commercial sites on the
              Internet;
              representatives of software/hardware companies developing products for
              electronic commerce and electronic banking applications;
              law firms and others with knowledge of legal issues involved in the
              development of commercial applications for the Internet;
              representatives of stored-value card corporations; and
              officials from other organizations involved in the development of these
              products and services.

              We did our work primarily in Washington, D.C, and New York between
              January 1996 and April 1997 in accordance with generally accepted
              government auditing standards.




              'U'c did not test the ;i(lc(|uacy of any of tlii' risk mitigation l(.'chni(|U('s discussed in this n^port.



              Pages                                           GAO/GGD-97-73 Payments, Clearance, and Settlement
                    B-270598




                    We requested comments on a draft of this report from the Federal Reserve
Federal Reserve's   Board of Governors. The Federal Reserve's written comments along with
Comments and Our    our responses appear in appendix I. In addition, the staff of the Board of
Evaluation          Governors provided technical comments that were incorporated in this
                    report as appropriate. We chose not to incorporate all of the Federal
                    Reserve's complex, technical suggestions, because our purpose, as stated,
                    was to provide basic information on the systems at a consistent level of
                    detail.

                    The Federal Reserve expressed concern about the manner in which we
                    categorized various risks in the payments systems. In addition, the Federal
                    Reserve suggested that some types of risks, such as liquidity risk, were
                    excluded from our discussion. The Federal Reserve also found our
                    discussion of the legal and regulatory framework for the various payment
                    mechanisms to be confusing because it addressed regulation of
                    transactions in some instances and supervisory regulation of the parties in
                    others. The Federal Reserve pointed out that in its view our dreift report
                    did not discuss similar payment systems in a mcinner that provided easy
                    comparison or assessment of differences.

                    The Federal Reserve also raised concerns about our presentation of the
                    issues concerning traditional wholesale and retail payments systems and
                    new and emerging products and services. In some instances, the Federal
                    Reserve suggested that our discussion of the issues was incomplete. In
                    other cases, it noted that the potential problems we raised about new
                    emerging products and services also apply to more traditional products
                    and services such as credit cards and checks. Finally, the Federal Reserve
                    suggested that on several issues our draft report did not fully account for
                    the actions that the FederEiI Reserve has taken to mitigate potential
                    problems.

                    As we state in our report, our purpose in providing information on risks
                    and risk mitigations was to highlight some of the more important risks
                    raised by payment industry officials and others with respect to specific
                    payment systems. Our intent was neither to provide an exhaustive list of
                    all types of risks present in all payment systems nor to evaluate which
                    ones are more or less important. Many public- and private-sector
                    organizations categorize risk in different ways; we attempted to be
                    consistent but also tried to use the same terms used by our sources.
                    Although the Federal Reserve expressed concern that liquidity risk was
                    not specifically identified, liquidity risk generally was not one of the major
                    risks raised by industry officials and others we interviewed.



                    Page 6                           GAO/GGD-97-73 Payments, Cleairance, and Settlement
 8-270598




Our purpose in discussing the legal and supervisory framework was to
provide a general overview of the applicable laws, regulations, and where
it might be unclear to the reader, the supervisory framework for these
systems and products. For all the products and services, we discuss the
legal and regulatory structure. In some instances, where we felt additioncd
information would be helpful to the reader, we also discuss supervision of
the products and services. Our report was not intended to provide a
comprehensive survey of the supervision and oversight of these payment
system products and services.

With regard to the ease of comparison of various payment systems, our
purpose in this report was to provide basic information on each of these
systems, products, and services, not to provide a comparative study of
them. But we do present the information in a consistent format and report
compairable statistics to the extent possible.

The purpose of presenting information on issues regarding payment
systems was to highlight rather than discuss in depth, evaluate, or resolve
potential problems and concerns that were raised by industry, public
sector, and other officials. A detailed analysis of the various factors that
would need to be taken into consideration in addressing these issues, or
that could affect how these issues can be resolved, was beyond the scope
of this report. Section 5 of the report is not designed to include a
comprehensive list of all of the issues in the payments, clearance, and
settlement environment.

With regard to issues related to new and emerging products and services,
we agree that some of these issues may be applicable to more traditional
payment systems. Again, our purpose was simply to highlight the issues
raised by industry officials in connection with these new products and
services. We have reviewed and incorporated where appropriate
information the Federal Reserve has provided on actions it has undertaken
to mitigate potential problems associated with some issues.


We are sending copies of this report to the majority and minority Members
of the House and Senate Bjmking Committees, Agriculture Committees,
and Commerce Committees, and to other interested parties. We will also
make copies available to others on request.




Page 7                          GAO/GGD-97-73 Payments, Clearance, and Settlement
B-270598




This report was prepared under the direction of Susan Westin, Assistant
Director, Financial Institutions and Markets Issues. Other major
contributors to this review are listed in appendix II. If you have any
questions about this report, please call me at (202) 512-8678.

Sincerely yours,




Jean Gleason Stromberg
Director, Financial Institutions
   and Markets Issues




Pages                              GAO/GGD-97-73 Payments, Clearance,.and Settlement
KJmPPCE

Page 9    GAO/GGD-97-73 Payments, Clearance, and Settlement
                        Overview of Clearance and Settlement of Wholesale Payment                   15
Section 1                    Systems
Wholesale Payment       Fedwire Electronic Transfer of Funds                                        17
                                S.W.I.FT.                                                           27
Systems                 Clearing House Interbank Payments System                                    28
                        Settlement of Foreign Exchange Transactions                                 37
                                Bilateral and Multilateral Netting of Foreign
                                Exchange Transactions                                               46


                        Overview of Clearance and Settlement Systems of Equities,                   47
Section 2                  Treasuries, Futures, and Options
Equities, Treasuries,   Equities Clearance and Settlement                                           48
Futures, and Options    Treasuries and the Fedwire Book-Entry Securities System                     58
                        Futures                                                                     66
                        Exchange-Traded Options                                                     77


                        Overview of Clearance and Settlement of Retail Payment                      91
Section 3                  Systems
Retail Payment          Checks                                                                      93
Systems                     Electronic Funds Transfer                                              107
                        Credit Cards                                                               108
                        Automated Clearing House                                                   116


                        Overview of New and Emerging Financial Products and Services               131
Section 4                   The Internet                                                           132
New and Emerging        Stored-Value Cards                                                         133
Financial Products      Electronic Banking                                                       ' 141
                        Financial Services Over the Internet                                       148
and Services
                        Issues Related to Payments, Clearance, and Settlement Systems             157
Section 5
Issues




                        Page 10                      GAO/GGD-97-73 Payments, Clearance, and Settlement
                                                            Contents




                                                            Appendix I: Comments From the Board of Governors of the Federal
Appendixes                                                  Reserve System                                                           170

                                                           Appendix II: M^or Contributors to This Report                             179



                                                                                                                                     180
Glossary
                                                           Table 1.1: Selected Data on Fedwire Funds Transfers                         18
Tables                                                     Table 1.2: Risk and Risk Mitigation for Fedwire                             22
                                                           Table 1.3: Selected Date on CHIPS Transfers                                 30
                                                           Table 1.4: Risk and Risk Mitigation for CHIPS                               34
                                                           Table 1.5: Risk and Risk Mitigation for Foreign
                                                              Exchange Transactions                                                    43
                                                           Table 2.1: Data on NSCC and DTC                                             50
                                                           Table 2.2: NSCC Clearance and Settlement Process
                                                              for Depository Equity Shares                                             51
                                                           Table 2.3: Risk and Risk Mitigation for Equities                            56
                                                           Table 2.4: Data on GSCC and Fedwire                                         60
                                                           Table 2.5: Two Types of Trade Comparisons                                   62
                                                           Table 2.6: Risk and Risk Mitigation for Treasuries                          65
                                                           Table 2.7: Data on GSCC and Fedviire                                        69
                                                           Table 2.8: Steps in the Futures Clearing Process                            70
                                                           Table 2.9: Two Types of Settlement                                          71
                                                           Table 2.10: Risk and Risk Mitigation for Futures                            75
                                                           Table 2.11: Total Volume of Exchange-Traded Options
                                                              Contracts Cleared in 1995                                               82
                                                           Table 2.12: Steps in the Options Clearing Process                          84
                                                           Table 2.13: Two Types of Settlement                                        85
                                                           Table 2.14: Risk and Risk Mitigation for Options                           89
                                                           Table 3.1: Major Organizations That Process
                                                              or Exchjinge Checks                                                     95
                                                           Table 3.2: The Volume of Checks Processed, 1992-1995                       97
                                                           Table 3.3: Risk and Risk Mitigation for Checks                            104
                                                           Table 3.4: The Number of Major U.S. Credit Card
                                                              Companies' Cards, 1990-1995                                            109
                                                           Table 3.5: Risk and Risk Mitigation for Credit Cards                      114
                                                           Table 3.6: Examples of ACH Credit and Debit Transactions                  116
                                                           Table 3.7: Volume of ACH Transactions Processed by the Four
                                                               ACH Providers, 1992-1996                                              118




                                                           Page U                       GAO/GGD-97-73 Payments, Clearance, and Settlement




           ., ...l.<\iJii/rAli>iiiiiUAiL^i,\i^ ,mi.:r.i.'«»i*t. •
          Contents




          Table 3.8: Total Amount of Dollars Processed by Each
             ACH Provider, 1992-1996                                                   120
          Table 3.9: Risk and Risk Mitigation for ACH                                 129
          Table 4.1: Stored-Value Card Tests                                          135
          Table 4.2: Risk and Potential Risk Mitigation for Stored-Value Cards        139
          Table 4.3: Consumer Banking Activities Accessible
             By Electronic Means, 1996                                                 141
          Table 4.4: Risk and Risk Mitigation for Electronic Banking                   146
          Table 4.5: Risk and Risk Mitigation for Financial Services
             on the Internet                                                           155



          Figure 1.1: A Fedwire Funds Transfer Transaction                             20
Figures   Figure 1.2: A Typical CHIPS Transfer                                       . 31
          Figure 1.3: Final Settlement of CHIPS                                        33
          Figure 1.4: A Typical Foreign Exchange Transaction                           40
          Figure 2.1: T+3 Clearance and Settlement of Depository-Eligible
              Equity Shares                                                            52
          Figure 2.2: The 24-Hour Trading, Clearance, and Settlement Cycle             72
          Figure 2.3: An Options Listing                                               78
          Figure 2.4: T-t-l Trading, Clearance, and Settlement Cycle                   87
          Figure 3.1: An Example of a Paper Check                                      94
          b"1gure 3.2: The Federal Reserve System for Processing a Paper Check        100
          Figure 3.3: Clearance and Settlement Cycle of Credit Cards                  110
          Figure 3.4: The Average Value of an ACH Transaction, 1992-1995              119
          Rgure 3.5: lypical ACH Credit Transaction—The Direct Deposit
             of a Payroll                                                             122
          Figure 3.6: Typical ACH Debit Transaction—Bill Payment                      126
          Figure 4.1: A Typical Mondex Card Transaction                               137
          Figure 4.2: Illustration of an Electronic Bill Payment Process              144
          Figure 4.3: Credit Card Payments Over the Internet                          152


          Abbreviations

          AHMS          Account Balance Monitoring System
          ACH           Automated Clearing House
          AMEX          American Stock Exchange
          ASO           Additional settlement obligation
          ATM           Automated Teller Machine
          AVS           Address Verification Service



          Page 12                        GAO/GGD-97-73 Payments, Clearance, and Settlement
Contents




BIS        Bank for International Settlements
BOTCC      Board of Trade Clearing Corporation
CBCH       California Bankers Clearing House
CBT        Chicago Board of T r a d e
ecu        Chicago Clearing House Association
CPTC       Commodity Futures Trading Commission
CHECCS     Clearing House Electronic Check Clearing System
CHIPS      Clearing House Interbank Payment System
CME         Chicago Mercantile Exchange
CNS         Continuous net settlement
CRA         C o m m u n i t y Reinvestment Act
CST         Central Standard Time
cusip       Committee on Uniform Securities Identification
              Procedures
DCIA        Debt Collection Improvement Act of 1996
DM         Deutsche mark
DTC        Depository Trust Corporation
Dvp         Delivery-versus-payment
F:AF-2     Frankfurt Electronic Clearing System
FJCiio     Exchange Clearing House
hxCHO      Electronic Check Clearing House Orgarxization
ECP        Electronic check presentment
EDC        Electronic Data Capture
EKAA       Expedited F u n d s Availability Act of 1987
EFTA       Electronic F u n d s Transfer Act
EMS        Electronic Money System
EROC       East Rutherford Operations Center
ET         Eastern Time
FCM        Futures Commission Merchant
FDic       Federal Deposit Insurance Corporation
KRBNY      Federal Reserve B a n k of N e w York
FTC        Federal Trade Commission
GSCC       Government Securities Clearing Corporation
ics        Issuer's Clearing House Service
IRS        Internal Revenue Service
MCA        Monetary Control Act of 1980
MiCR       Magnetic Ink C h a r a c t e r Recognition
NACHA      National Automated Clearing House Association
NASD       National Association of Securities Dealers
NOCH       National Organization of Clearing Houses
NSCC       National Securities Clearing Corporation




Page 13                    GAO/GGD-97-73 Payments, Clearance, and Settlement
 Contents




NYACi I      N e w York A u t o m a t e d Clearing H o u s e
NYCHA        New York Clearing House Association
NYSE         New York Stock Exchange
occ          Options Clearing Corporation
OFAC         Treasury Office of Foreign Assets Control
OTC           Over-the-counter
PAX          Private ACH Exchange
pvp          Payment-vs.-payment
RTGS         Real-Time Gross Settlement System
S.W.I.F.T.   Society for Worldwide Interbank Financial
               Telecommunications
s-HTTP       Secure HyperText Transfer Protocol
SEC          Securities and Exchange Commission
SET          Securities Electronic Transaction
SSL          Secure Sockets Layer
TAP          Transaction at^usted payment
TLA          Truth in Lending Act of 1968
ucc          Uniform Corrunercial Code
www          World Wide Web




Page 14                         GAO/GGD-97-73 PaymenU, Clearance, and Settlement
Section 1: Wholesale Payment Systems • Overview

Overview of Clearance and Settlement of
Wholesale Payment Systems

                                   In this section of the report, we discuss the two primary wholesale
                                   payment systems in the United States, the Federal Reserve's Fedwire
                                   funds transfer service, and the Clerjing House Interbank Payments System
                                   (CHIPS), as well as foreign exchange transactions.



                                   Wholesale payments are large-value paymerits made by major financial
Main Characteristics               players, such as banks and other corporations.
                                   The Federal Reserve's Fedwire funds transfer service, primarily used for
                                   domestic payments, is a real-time, gross settlement system in which the
                                   Federal Reserve guarantees payment to the receiver of the funds, CHIPS, a
                                   private-sector multilateral netting organization, is used mainly to settle the
                                   U.S. dollar side of foreign exchange transactions.
                                   Foreign exchange transactions involving U.S. dollars, being an exchange
                                   of currencies, involve two settlements: dollars settled in the United States,
                                   and another currency settled in that currency's national payment system.


                                   In 1996:
Statistical Information
                                  Fedwire funds transfer service's average daily transaction amount was
                                  $989 billion, and the average amount per transaction was $3.0 million.
                                  CHIPS' average total daily treinsaction value was $1.3 trillion, and the
                                  average value per transaction was $6.2 million.
                                  On average in early 1995, nearly $1.2 trillion of foreign exchange trades
                                  were transacted globally per day.




                                  Page 15                          GAO/GGD-97-73 Payments, Clearance, and Settlement
                    Section 1: Wholesale Payment Systems • Overview
                    Overview of Clearance and Settlement of
                    Wholesale Payment Systems




                   Fedwire's funds transfers are regulated under subpzut B of the Federal
Regulatory         Reserve's Regulation J.
Information        Funds transfers processed over CHIPS are regulated under New York State's
                   version of the Uniform Commercial Code (ucc) Article 4A, and rules
                   adopted by the New York Clearing House Association (NYCHA).
                   Oversight of banks conducting foreign exchange transactions in different
                   countries is provided by the bank regulators in those countries.


                   The Federal Reserve is exposed to credit risk for those payments
Risk Information   transmitted over Fedv^ire that generate daylight overdrafts in a
                   participant's account.
                   A CHii'S failure to settle could create systemic risk and, in recognition of
                   this, a series of risk controls has been established.
                   Settlement failure in foreign exchange transactions could transmit
                   systemic problems internationally.




                   Page 16                             GAO/GGD-97-73 Payments, Clearance, and Settlement
Section 1: Wholesale Payment Systems * Fedvtire

Fedwire Electronic Transfer of Funds


                                   The Fedwire funds transfer system is one of the two primary large-dollar
Description and Use                electronic payments systems in the United States.' In 1996, Fedvnre's
                                   average total daily transaction value for the electronic transfer of funds
                                   was about $989 biUion; the average value per transaction was $3.0 million.
                                   The Fedwire funds transfer service allows depository institutions to
                                   transfer funds on their own behalf or on behalf of their customers; most
                                   Fedwire payments are related to domestic transactions. The Department
                                   of the Treasury and other federal agencies also use Fedwire to disburse
                                   and collect funds.



Key Terms
Q   Daylight overdraft             A daylight overdraft is a negative position in an institution's Federal Reserve
                                   account at any time during the business day.

Q   Federal Reserve account        A Federal Reserve account is a noninterest earning account that depository
                                   financial institutions maintain with a Federal Reserve Bank. The balance in a
                                   Federal Reserve account is maintained for purposes of (1) satisfying the Federal
                                   Reserve's reserve requirements and/or (2) settling payments cleared through the
                                   Federal Reserve. The balances in these accounts play a central role in the
                                   exchange of funds between depository institutions.

    Finality                       Finality is an irrevocable and unconditional transfer of payment.

Q   Net debit cap                  A net debit cap is the maximum dollar amount of daylight overdrafts an institution
                                   is permitted to incur in its Federal Reserve account. Under the Federal Reserve's
                                   policy, institutions are subject to two caps-a daily cap and a 2-week cap.

Q   Real-Time Gross                An RTGS system is a system that is said to operate in real-time if it processes
    Settlement (RTGS) system       each transaction as it is initiated rather than processing it in a batch.
                                   Gross settlement means that the system settles each transfer individually.




                                   'The other large-dollar electronic payment-s system, the Clearing House Interbank Payments System
                                   (CHIPS), is discussed separately in this report.



                                   Page 17                                   GAO/GGD-97-73 Payments, Clearance, and Settlement
                                       Section 1: Wholesale Payment Systems • Fedwire
                                       Fedwire Electronic Transfer of Funds




                                      Virtually all of the approximately 9,500 depository institutions with
Basic Data                            Federal Reserve accounts use them to transrrut funds transfers over
                                      Fedwire. In 1996, the total volume of dollars transferred over the Fedwire
                                      funds transfer service was $249 trillion. As shown in table 1.1, for the
                                      period of 1992 through 1996, the volume and the average daily transaction
                                      value of Fedwire funds transfers increased, but the average value of a
                                      Fedwire funds transfer transaction remained relatively constant at about
                                      $3.0 million.

Table 1.1: Selected Data on Fedwire
Funds Transfers                                                                                                                          Percent
                                                                                                                                         change
                                                                      1992          1993           1994          1995           1996     1992-96
                                      Average number of
                                      daily transfer
                                      messages                    267,000        277,000       287,000        302,000       328,000            23%
                                      Average daily                   $787          $824           $841          $888           $989
                                      transfer value                 billion       billion        billion       billion        billion         25
                                      Average value per              $2.9           $3.0          $2.9           $2.9          $3.0
                                      transfer                      million        million       million        million       million               3
                                      Fees per
                                      transaction'                   30.53         $0.53          $0.53         $0.50          $0.50           -6
                                      "Both the sender and the receiver of a Fedwire funds transfer are charged a fee. in January 1997,
                                      the transfer fee was reduced to $0.45.

                                      Source: Federal Reserve Bank of New York.




                                      Fedwire is a real-time gross settlement (RTGS) system. The Fedwire funds
Processes                             transfer system operates from 8:30 a.m. Eastern Time (ET) to 6:30 p.m. ET.^

                                      The Fedwire funds transfer operating system essentially consists of two
                                      components:

                                      A high-speed, nationwide communications network (FEDNET) that
                                      electronically links all Federal Reserve Banks and branches with
                                      depository institutions;'^ and




                                      -Ui'ginninK on Dec. 8. \'.)'J~. the Fedwire funds transfer service is scheduled to open at 12:30 a.ni. (ET)
                                      andclost-alGiHOp.ni. (ET).

                                       This network is used by depository institutions to access a variety of Federal Reserve .services,
                                      including Fedwire.



                                      Page 18                                      GAO/GGD-97-73 Paymente, Clearance, and Settlement
                                     Section 1: Wholesale Payment Systems • Fedwire
                                     Fedwire Electronic Transfer of Funds




                                    A computerized capability to process and record individual funds and
                                    transfers'* as they occur.

                                    Fedwire allows depository institutions to transfer funds on their own
                                    behalf or on behalf of their customers. Each depository institution using
                                    the Fedwire funds transfer system must have a Federal Reserve account
                                    with its respective Federad Reserve Bank. Figure I.l illustrates how a
                                    typical funds transfer transaction between two customers is transmitted
                                    over Fedwire.




                                    *A separate system, the Fedwire securities transfer service is discussed in the securities section
                                    (Section 2) of this report



                                    Page 19                                     GAO/GGD-97-73 Payments, Clearance, and Settlement




^Ji^;M<tat'm.\W*liht}Jrfitf^to,t.
                                                      Section 1: Wholesale Payment Systems • Fedwire
                                                      Fedwire Electronic Transfer of Funds




Figure 1.1: A Fedwire Funds Transfer Transaction

        ^             Custonner A requests $1M                                                                                                       "    Once the Fedwire transaction Is
                in its depository account at Bank A                                                                                                   completed, Bank B makes the designated
                 to be transferred to Customer B's                                                                                                    $1M payable and available to Customer B
                     account located at another                                                                                                            on the day payment occurs."
                        depository institution.




              Bank A transfers $1 f*^ for Customer A                                                                                           ^            Once the payment of $1 tul Is
              by sending a message over Fedwire                                                                                                     credited to Bank B's account, the Fedwire
                authorizing the Federal Reserve to                                                                                                          funds transfer Is completed.
             electronically debit Bank A's account at                                                                                                    For most funds transfers Involving
            the Reserve Bank for S I M and to transfer                  Federal Reserve System                                                             online depository Institutions,
                  the $11^ to Bank B's account.                                                                                                    the time that elapses between when a funds
                                                                                                                                                       transfer message Is sent and when a
                                                                                                                                                   payment Is received Is a matter of seconds.




                                                                i . ^ y i i - i I.VI i i j i i T i i - . i i - - - 1 1 i-T i i - r - i i / w
                                                                :-• .'.'s:y r-yt^r)H'v^'f*'is.'i^i^'!^"::''-ym




                                                          ^     Fedwire




                                                      ^According to a Federal Reserye Bank of New York publication, once a funds transfer is
                                                      completed, the funds are generally available for immediate withdrawal.



                                                      Source: Federal Reserve.




                                                      Page 20                                                                             GAO/GGD-97-73 Payments, Clearance, and Settlement
                           Section 1: 'Wholesale Payment Systems • Fedwire
                           Fedwire Electronic Transfer of Funds




Fedwire Offers Immediate   A critical feature of Fedwire is that it offers immediate finality. Immediate
Finality                   finality of payment sets Fedwire apart from any other electronic payment
                           system operating in the United States. Under Regulation J, the Federal
                           Reserve "guarantees" the payment to the depository institution receiving
                           the Fedwire transaction and assumes any credit risk if there are
                           insufficient funds in the Federal Reserve account of the bank sending the
                           payment.


Changes in Fedwire's       The Federal Reserve is undertaking several enhancements to Fedwire's
Operating Environment      operating environment for the purpose of reducing risk related to funds
                           transfers and increasing the usefulness of Fedwire. Two significant
                           changes affecting the Fedv/ire funds transfer service are the expansion of
                           Fedwire's operating hours and a new, expanded message format for funds
                           transfers.

                           As previously mentioned, the Fedwire funds transfer system operates from
                           8:30 a.m. ET to 6:30 p.m. ET. Beginning on December 8, 1997, Fedwire's
                           funds transfer online operating hours are to be expanded to an 18-hour
                           operating day, from 12:30 a.m. ET to 6:30 p.m. ET. The Federal Reserve's
                           decision to extend Fedwire's funds transfer operating hours was part of its
                           response in addressing the potential risk arising from the growing volume
                           of cross-border payments. The extension of Fedwire's hours for funds
                           transfers means that Fedwire would be open while m^jor foreign financial
                           centers are open. Cross-border payments are discussed in more detail in
                           the Foreign Exchange segment of this section.

                           The Federal Reserve is in the process of expanding the Fedwire funds
                           transfer message format, which is to be fully implemented by year-end
                           1997. The expanded transfer format is intended to improve efficiency in
                           the payments mechanism by reducing the need for manual intervention
                           when processing and posting transfers, and by making the format more
                           compatible with the formats used by CHIPS and the Society for Worldwide
                           Interbank Financial Telecommunication (S.W.I.F.T.). In addition, the
                           expanded format permits the inclusion of additional originator and
                           beneficiary information, as required by Treasury regulations.


                           Funds transfers through Fedwire are regulated under subpart B of Federal
Regulatory Oversight       Reserve's Regulation J. This part of Regulation J generally incorporates
                           Article 4A of the Uniform Commercial Code (ucc) as the governing law for
                           the Fedwire funds system. The ucc is a set of model state laws governing



                           Page 21                             GAO/GGD-97-73 Payments, Clearajice, and Settlement
                                          Section 1: Wholesale Payment Systems • Fedwire
                                          Fedwire Electronic Transfer of Funds




                                          commercial and financial activities, ucc Article 4A sets out the rights and
                                          obligations of the various participants in a funds transfer, including those
                                          of the originator, intermediary institutions, and the beneficiary.

                                          Subpart B of Regulation J also directs each Reserve Bank to issue
                                          operating circulars governing funds transfer operations. These circulars
                                          cover such matters as operating hours, security, authentication, and fees.


                                          For the purposes of this report, we discuss some of the most important
Risk and Risk                             risks and risk mitigations associated with Fedwire.
Mitigation
Table 1.2: Risk and Risk Mitigation for
Fedwire                                   Risk                                Risk mitigation
                                          Counterparty credit risk            Net debit caps (including zero caps)
                                                                              Account balance monitoring systenn
                                                                              Dayligtit overdraft fees
                                          Operational risk                    Back-up facilities
                                                                              Automated recovery
                                          Fraud risk                          Data security:

                                                                              • Encryption

                                                                              • Authentication procedures

                                                                              • Access controls



Risk 1: Counterparty                      Because the Federal Reserve grants finality (i.e., final and irrevocable
Credit                                    credit) to the recipients of funds sent over Fedwire, the Federal Reserve
                                          Bank assumes any credit risk if there are insufficient funds in the Federal
                                          Reserve account of the depository institution sending the funds. For
                                          example, if Bank A, in our hypothetical example (see figure 1.1), had an
                                          insufficient account balzmce to cover the funds transfer, the Federal
                                          Reserve, in its sole discretion, may allow Bank A to overdraw its account.
                                          While Bank A's account is overdrawn, the Federal Reserve would be at
                                          risk for any losses should Bank A fail. This credit risk, commonly referred
                                          to as a daylight overdraft, is present even for an overdraft position that
                                          occurs only briefly during the day. The Federal Reserve requires
                                          depository institutions to eliminate any daylight overdrafts by the close of
                                          Fedwire each day. From 1986 to 1996, the average daily peak daylight
                                          overdrafts for funds transfers increased from $63 billion to $68 billion.



                                          Page 22                             GAO/GGD-97-73 Payments, Clearance, and Settlement
              Section 1: Wholesale Payment Systems • Fedwire
              Fedwire Electronic Transfer of Funds




             Daylight overdrafts, if not repeiid by the end of the day, could become
             unsecured overnight overdrafts. The Federal Reserve attempts to
             discourage overnight overdrafts by imposing high monetary penalties and
             taking administrative action against institutions that incur them
             repeatedly.

Mitigation   Net debit caps. In 1985, the Federal Reserve Board adopted a program of
             maximum limits, or net debit caps, for each depository institution. A net
             debit cap is a maximum level of daylight overdrafts that a depository
             institution may incur in its account at the Federal Reserve. The dollar
             amount of a specific net debit cap is determined by an institution's capital
             and is a multiple of the institution's capital. The multiple is to be based on
             the fmancial strength of each institution. The strongest institutions may
             obtain a higher cap multiple than that obtainable by riskier institutions.
             The most risky institutions are to be assigned a zero net debit cap and
             prohibited from originating a Fedwire funds transfer that would cause
             their account to become overdrawn, or, in an extreme case, the Federal
             Reserve may terminate the institution's online access to Fedwire. In some
             cases, the Federal Reserve may require weak depository institutions to
             collateralize their overdrafts. A recent Federal Reserve study found that
             net debit caps seemed to have restrained the growth of daylight overdrafts
             that are not related to securities transfers during the 1986 through 1993
             period.^

             According to the Federal Reserve's Policy Statement on Payment System
             Risk, depository institutions that use intraday Federal Reserve credit in
             amounts that exceed 40 percent of risk-based capital on a single day or, on
             average, over a 2-week period must establish their daylight overdraft caps
             by a self-assessment process. This process is required in order to establish
             a cap in any one of the Average, Above Average, or High categories. A
             high-cap multiple would permit the 2-week average of daily peak daylight
             overdrafts to be 1.5 times the depository institution's capital. Reserve
             Banks also have the authority to reduce an institution's Fedwire net debit
             cap urulaterally.




             ''Heidi Richards, "Dayligtit Overdraft Fees and the Federal Reserve's Payment System Risk Policy,"
             Federal Reserve Bulletin, Dec. 1995.



             Page 23                                    GAO/GGD-97-73 Payments, Clearance, and Settlement
                      Section 1: Wholesale Payment Systems • Fedwire
                      Fedwire Electronic Transfer of Funds




Mitigation            Account balance monitoring. Net debit caps are permitted at the
                      discretion of the Federal Reserve Banks. Using Fedwire's Account Balance
                      Monitoring System (ABMS), the Reserve Banks can hold or reject funds
                      transfers that may cause account holders to exceed their net debit caps.
                      ABMS allows the Reserve Banks to monitor depository institutions' account
                      positions and payment activity on a real-time basis.

Mitigation            Daylight overdraft fees. In September 1992, the Federal Reserve Board
                      adopted a policy under which the Federal Reserve Banks would, beginning
                      in April 1994, charge a fee to depository institutions for average daylight
                      overdrafts in deposit accounts with Federal Reserve Banks as a
                      supplement to the existing net debit cap policy. The Board set the initial
                      fee at an annual interest rate of 10 basis points (0.10 percent) of
                      chargeable daily daylight overdrafts.'' In April 1995, the fee was increased
                      to 15 basis points." The chargeable overdraft is the institution's average
                      per-minute daylight overdraft for a given day, less a deductible amount
                      equad to 10 percent of its risk-based capital.

                      The Federjil Reserve study mentioned earlier also found that the
                      imposition of daylight overdraft fees resulted in a decline in the average
                      per-day overdrafts by depository institutions. Specifically, the study •
                      showed that the aggregate intraday peak overdrafts fell approximately 40
                      percent, from nearly $125 billion per day on average, during the 6 months
                      preceding April 14,1994, to about $70 billion in the 6 months following the
                      introduction of daylight overdraft fees on April 14.^


Risk 2: Operational   Because of the enormous value amd importance of the funds transfers sent
                      over Fedwire daily, any temporary outages in the Fedwire electronic
                      system could pose significant economic and financial risks. Moreover, a
                      prolonged outage of the Fedwire electronic system could cause an
                      unacceptable disruption of the U.S. payment system.




                      "A basis point is ono-hundrcdth of one percent.

                      'Originally, the Board had planned to increase the lee to 25 basis points as of Apr. 1996, but in early
                      1995, the Board determined that a smaller fee increase to 15 basis points would be more appropriate.
                      In addition, the Board decided to wait 2 years before evaluating the results of the Apr. 1995 increase.
                      This .stated rale is based on the current 10-hour Fedwire funds transfer operating day. On Dec. 8, 1997,
                      the stated rate for the 18-hour operating day is to be 27 ba.sis points.

                      "Richards, p. 1071.



                      Page 24                                     GAO/GGD-97-73 Payments, Clearance, and Settlement
                                                     Section 1: Wholesale Payment Systems • Fedwire
                                                     Fedwire Electronic Transfer of Funds




Mitigation                                          Back-up facilities. If an operational disaster should occur to the primary
                                                    computer at the East Rutherford Operations Center (EROC), the Federal
                                                    Reserve has designed i"c-Jv,ire to automatically resume payment
                                                    processing almost instaritcuieously at its back-up computer at the EROC
                                                    site. If the entire EROC site is down, a remote database is designed to allow
                                                    Fedwire to resume payment processing at its secondary back-up center
                                                    (Federal Reserve Bank of Richmond) within 60 to 90 minutes of a decision
                                                    to relocate operations. The infrastructure is in place to allow Fedwire to
                                                    resume payment processing at its tertiary site should an operational
                                                    disaster occur at both the primary and secondary data centers.

Mitigation                                          Automated recovery. Fedwire databases are duplicated for
                                                    instantaneous availability in the event of a database device failure. If a
                                                    database recovery is required, each participant has to retransmit only
                                                    those pa>Tnents that were previously sent on Fedwire and indicate the loss,
                                                    of payments through the recovery report. Fedwire tests its contingency
                                                    plans in multiple mandatory exercises annually against a variety of
                                                    simulated events, which include computer, site, and network outages.


Risk 3: Fraud                                       There is the potential that fraudulent transfers could be transmitted over
                                                    Fedwire. For example, a computer hacker could make an unauthorized
                                                    funds transfer over Fedwire, or a bank employee could perform
                                                    unauthorized wire transfers.




                                                   Page 25                              GAO/GGD-97-73 Payments, Clearance, and Settlement


             .   :i,M,lt^tki»m^i»iU^SULi,.U,J,:i^tmMSIlli
              Section I: Wholesale Payment Systems • Fedwire
              Fedwire Electronic Transfer of Funds




Mitigation   Data security measures. The Federal Reserve has implemented a variety
             of data security measures to protect the integrity, confidentiality, cind
             continuity of the Fedwire system. These measures include access,
             authentication, and verification controls; data encryption; procedural
             controls over such processes as application changes, data entry and
             database updates; physical security; and personnel standards. These
             controls are designed to prevent tampering with, destroying, or disclosing
             Fedwire data, either by Federal Reserve employees or outside hackers.
             For example, Fedwire messages between depository institutions and the
             Federal Reserve are encrypted and authenticated to prevent interception
             and alteration. Access controls, such as unique user identification codes
             and passwords, aiQ also a primary means for preventing unauthorized
             transfers. For example, employees at a depository institution must use a
             valid and unique user identification code and password to enter and send a
             Fedwire message, and that message must come from a connection
             associated with that employee's institution.

             Depository institutions also have strong incentives to establish security
             procedures to govern their initiation, verification, and receipt of Fedwire
             funds transfers as well as other funds transfers. In peirticular, a depository
             institution assumes full liability for any Fedwire funds transfers executed
             from its authorized connection to the Fedwire system. Furthermore,
             Article 4A of the ucc, through its allocation of liability for erroneous or
             fraudulent transfers, encourages the establishment of commercially
             reasonable security procedures. A review of depository institutions' funds
             transfer security procedures is also a component of the banking
             regulators' programs.




             Page 26                             GAO/GGD-97-73 Payments, Clearance, and Settlement
                         Section 1: Wholesale Payment Systems • Fedwire
                         Fedwire Electronic Transfer of Funds




                         Society for Worldwide Interbank Financial Telecommunications (S.W.I.F.T),
S.W.I.F.T.               incorporated in Belgium, is a cooperative owned by over 2,800 banks from
                         around the world, including over 150 from the United States (owning
                         13 percent of the shares). It operates a network that processes and
             S.W.IP.T.   transmits financial messages among members and other users in 137
                         countries. The United States accounts for more usage than any other
                         country.

                         Users

                         S.W.I.F.T. messages convey information or instructions between financial
                         institutions:

                         Messages are formatted and contain information about the originator,
                         purpose, destination, terms, and recipient.
                         The largest use of S.W.I.F.T. is for payment messages, through which one
                         institution transmits instructions to another to make payments.
                         Other messages are used to confirm the details of a contract entered into
                         between two users, such as a foreign exchange trade or an interbank
                         deposit placement.
                         For securities, S.W.I.F.T. messages can transmit orders to buy or sell or
                         convey instructions concerning delivery and settlement.

                         Statistical Information

                         An average; of 2.4 million messages of all types were processed by SWIFT.
                         per day in 1995.

                                 estimates that the value of the payments messages was $2 trillion
                         S.W.I.F.T.
                         per day.




                         Page 27                            GAO/GGD-97-73 Payments, Clearance, and Settlement
Section 1: Wholesale Payment Systems * CHIPS

Clearing House Interbank Payments System


                                   The Clearing House Interbank Payments System (CHIPS) is one of the two
Description and Use                large-vjilue electronic pajmnents systems in the United States. The other is
                                   Fedwire. cinps, which is privately owned and operated by the New York
                                   Clearing House Association (N^CIIA), begjin operations in 1970 as an
                                   electronic replacement for paper checks in international dollar payments.
                                   Although Fedwire payments are principally related to domestic
                                   transactions, U.S. dollar payments related to "foreign transactions" (such
                                   as the dollar leg of foreign exchange and Eurodollar placements) flow
                                   primarily through CHIPS.

                                   Although CHIPS transfers are irrevocable, they are fmal only jifter the
                                   completion of end-of-day settlement." CHIPS nets its transactions on a
                                   multilateral basis. Thus, if a bank receiving a CHIPS transfer makes fimds
                                   available to its customers before settlement is complete at the end of the
                                   day, it is exposed to some risk of loss if CHIPS does not settle. However, in
                                   its 27 years of operation, CHIPS has never failed to settle.




                                  •'In contra.st. Fedwire offers ininu'dialc llnalily of settlement—the Federal Rcserv'e "guarantees" the
                                  payment and iis.sumes any cre<lit risk.



                                  Page 28                                     GAO/GGD-97-73 Payments, Clearance, and Settlement
                           Section 1: Wholesale Payment Systems • CHIPS
                           Clearing House Interbank Payments System




Key Terms
^   Multilateral netting   Multilateral netting is an arrangement among three or more parties to net their
                           obligations. The obligations coveretd by the arrangement may arise from
                           financial contracts, transfers of funds, or both, the multilateral netting of
                           payment obligations normally takes place in the context of a multilateral net
                           settlement system.

Q j Net debit cap           Net debit cap is the quantitative limit placed on the debit positions that participants
                            in a funds transfer system can incur during the business day.

Q   Systemic risk          Systemic risk is the risk that the failure of one participant in a transfer system,
                           or in financial markets generally, to meet its required obligations will cause
                           other participants or financial institutions to be unable to meet their obligations
                           (including settlement obligations in a transfer system) when due.

    S.W.I.F.T              Society for Worldwide Interbank Financial Telecommunications (S.W.I.F.T.) is
                           an international financial payment cooperative organization that operates a
                           network that facilitates the exchange of payment and other financial messages
                           between financial institutions throughout the world.



                           At year-end 1996, there were 103 CHIPS participants representing financial
Basic Data                 institutions from 29 countries, CHIPS participants may be commercial
                           banks. Edge Act corporations,'" or investment companies. To be a CHIPS
                           participant, a financial institution is required to maintain a branch or an
                           agency in New York City. A nonparticipant wishing to make international
                           payments using CHIPS must employ one of the CHIPS participants to act as
                           its correspondent or agent.

                           As shown in table 1.3, both the volume and the average daily transaction
                           value of CHIPS transfers have increased, although the average size of a
                           transfer payment has remained relatively constant for the period 1992
                           through 1996. In addition, the number of ciiii's participants has decreased
                           during the same period.




                           '"Edge Act conioration.s are <()ri)()ration.scharten.'d hy the K<'(li.'ral Rcsfnc! to engage in inlernational
                           banking for fmancing trade. The Hoard of Governors acl.s on applications to estal)lish Edge Act
                           corporations and also examines the coqrarations and their sul)sidiari('s.




                           Page 29                                       GAO/GGD-fl7-73 Paj-ments, Clearance, and Settlement
                                     Section 1: Wholesale Payment Systems • CHIPS
                                     Clearing House Interbank Payments System




Table 1.3: Selected Data on CHIPS
Transfers                           Data                                      1992          1993         1994          1995          1996
                                    Average number of daily
                                    transfer messages                      154,439      167,311       181.667       203,318       212,544
                                    Average daily value of
                                    transfers                         $942 billion     $1 trillion   $1 trillion   $1 trillion   $1 trillion
                                    Average value of a
                                    transfer                             $6 million   $6 million     $7 million    $6 million    $6 million
                                    Average fee per
                                    transaction"                                .15           .15           .15           .15           .15
                                    Number of CHIPS
                                    participants                               122           121           115           111           103
                                    "The lee listed in the table is an average fee based on the three transaction lees that CHIPS
                                    charges its participants. CHIPS charges a participant 18 cents per transaction for the first 80.000
                                    transactions per month that it sends or receives. After a participant sends or receives over 80,000
                                    transactions per month. CHIPS charges the participant 13 cents per transaction. Also, CHIPS
                                    charges participants 40 cents per transaction for any transaction without an account number.

                                    Source: CHIPS.




                                    Figure 1.2 illustrates a typical CHIPS transfer.
Processes
                                    Example: A wholesaler in Paris wishes to pay $1 million to a U.S. software
                                    supplier for a shipment of consumer software. The FYench wholesaler
                                    instructs his bank in Paris (Bank A) to debit the FVench franc equivalent of
                                    $1 million from his account and to arrange payment of the dollar amount
                                    to the U.S. supplier's account in Bank B in New York. This payment of
                                    dollars represents a typical CHIPS transaction. Bank A has a branch in New
                                    York. Both Bank A and Bank B are participants in CHIPS.




                                    Page 30                                   GAO/GGD-97-73 Payments, Clearance, and Settlement
                                                    Section 1: Wholesale Payment Systems • CHIPS
                                                    Clearing House Interbank Payments System




Figure 1.2: A Typical CHIPS Transfer




                                                                                                         f
           Through an automated system,                                                                      Poy lo: IJ.iiik B
          an employee of Bank A s branch                                                                     For: Acct ol sottwaro Co.
               in New Yort( enters the                                                                       From: NY br ol B.nnk A
        payment information into the branch's                                                                Amount: St.000.000 .
             CHIPS interlace computer.




                                                                    New York Clearing House

                                                                                                      ' CHIPS screens the amount against limit
                                                                                                      controls. If the payment fits within controls.
                                                                                                        CHIPS sends the payment message to
                                                                                                          Bank B's interlace computer (which
                                                                                                       authenticates the message), and records
                                                                                                      a debit for Bank A and a credit for Bank B.




   9       I ' ) The central CHIPS computer
       authenticates, stores, and acknowledges      CHIPS
                      the massage.
                                                              - ^ 'iJliHi      I if]'
       (b) Bank A's branch bank, via its computer
        interface, releases the payment message
                         to CHIPS.



                                                    Source: NYCHA.




                                                    Page 31                                   GAO/GGD-97-7,3 Payments, Clearance, niid Setlleineiit
                           Section 1: Wholesale Payment Systems • CHIPS
                           Clearing House Interbank Payments System




                           The transaction between Bank A and Bank B is not settled until CHIPS
                           settles at the end of the day. If Bank B makes the $1 million available to
                           the U.S. software supplier prior to final settlement. Bank B could expose
                           itself to some risk of loss.

The Final Settlement of   Figure 1.3 illustrates thefinalsettlement of CHIPS. Throughout the day, the
CHIPS                     103 CHIPS participants continuously exchange payments among
                          themselves. As transactions flow, CHIPS continuously recalculates each
                          participant's single net position vis-a-vis all other participants combined.
                          This is called multilateral netting. (See discussion in foreign exchange
                          transactions later in this section.)




                          Page 32                            GAO/6GD-97-73 Payments, Clearance, and Settlement
                                         Section 1: Wholesale Payment Systems • CHIPS
                                         Clearing House Interbank Payments System




Figure 1.3: Final Settlement of CHIPS



                                             Throughout the day. the 103 CHIPS participants
                                        continuously exchange payments among themselves. As
                                        transactions flow, CHIPS continuously recalculates each
                                            participant's single net position vis-a-vis all other
                                        participants combined. This is called multilateral netting.
                                                                       '   ':--.--••>--.-•''•'-'
                                                                                                   aSSMiSiBa




                                                          New York Clearing House

                                                    At 4:30 p.m. ET CHIPS closes
                                                      and notilies each participant
                                                and settling participant* ol its respective
                                                     net debit or net credit position.




                                                       CHIPS Account at FRBNY
                                                       Seining         ScMling
                                                       pnrticipnnt D   p.-irlicip.int H




                                                                                                                 J
                                                       Other scMling   Other ticttltng
                                                       pnrticip.tnts   pnrlicip.mls
                                                                                                       Fedwire
                                                                                                               5 ^

                                                                                       tCZJD                                 Net Positions


                                                         By 5:00 p.m.. those settling                                y      ^jLmilt^
                                                          participants in a net debit
                                                       position must send a Fedwire
                                                      funds transfer, in the amount of
                                                       their net debits, to the CHIPS
                                                     settlement account at the FRBNY,
                                                  • When all those settling participants
                                                         have paid into this account,
                                                        NYCHA sends Fedwire funds
                                                   transfers from the CHIPS account at
                                                       FRBIVY (0 settling participants
                                                           in a net credit position.
                                                        Prior to this, the nonsettling
                                                  participants (A.B.E.F) will have settled
                                                    with their settling participants and,
                                                         on average, settlement is
                                                    normally completed by 5:10 p.n\




                                        Page 33                                                    GAO/GGD-97-73 Payments, Clearance, and Settlement
                                           Section 1: Wholesale Payment Systems • CHIPS
                                           Clearing House Interbank Payments System




                                          'Settling participants take part in the actual settlement of CHIPS by sending or receiving the
                                          Fedwire payments used to effect settlement. Participants that are not settling participants must
                                          designate a settling participant to settle for ihem and that settling participant must agree to the
                                          designation.


                                          Source: NYCHA.




                                          After all the settling participants that are in a net debit position have paid
                                          in funds and participants that are in a net credit position receive a Fedwire
                                          funds transfer from NYCHA, the CHIPS settlement account at the Federal
                                          Reserve Bank of New York (FRBNY) reaches a zero balance." It is at this
                                          point that the transaction transmitted over CHIPS between Bank A and
                                          Bank B is settled and settlement is final.


                                          All CHIPS participants are supervised by the New York State Banking
Regulatory Oversight                      Department or a federal bank supervisor. A coordinated interagency full
                                          examination is to be conducted of CHIPS every other year and a limited
                                          examination is to be conducted in the alternate years between the full
                                          examinations, CHIPS transfers are governed by ucc Article 4A. The ucc is a
                                          set of model state laws governing commercial and financial activities, ucc
                                          Article 4A sets out the rights and obligations of the various participants in
                                          a wire transfer.


                                          For purposes of this report, we discuss some of the most important risks
Risk and Risk                             and risk mitigations associated with CHIPS.
Mitigation
Table 1.4: Risk and Risk Mitigation for
CHIPS                                     Risk                                Risk mitigation
                                          Operational risk                    Back-up facilities
                                                                              Autonnated recovery
                                          Systemic risk/counterparty         . Same-day settlement
                                          credit risk
                                                                              Bilateral credit limits
                                                                              Net debit caps
                                                                              Loss sliaring—backed up by collateral
                                                                              Membership requirements




                                          "FRBNY is not required to provide financial a.ssistancc lo ensure completion of the CHIPS seltlcinonl.



                                          Page 34                                    GAO/GGD-97-73 Payments, Clearance, and Settlement
                           Section 1: Wholesale Payment Systems • CHIPS
                           Clearing House Interbank Payments System




Risk 1: Operational        Because of the trillions of dollars sent over CHIPS, any temporary outage in
                           the CHIPS electronic system would pose significant economic and financial
                           risks.

Mitigation                 Back-up facilities. If an operational disaster should occur, the remote
                           database, established by CHIPS, is designed to allow CHIPS to resume
                           payment processing at its back-up center within 5 minutes of a decision to
                           relocate operations.

Mitigation                 Automated recovei-y. If the CHIPS database suffers damage, CHIPS has a
                           computerized method for rebuilding its database. Each participant can
                           automatically retransmit a payment previously sent if ciiii'S indicates the
                           loss of payments through the transmission of the recovery report.
                           According to an NYCHA document, CHIPS quarterly tests its contingency
                           plans against a variety of simulated events in mandatory exercises
                           involving all participants.


Risk 2: Systemic           The most significant risk to the financial stability of CHIPS is systemic risk.
Risk/Counterparty Credit   Systemic risk/counterparty credit risk occurs when one participant fails to
                           meet its obligations and causes other participants not to meet their
                           obligations. When high-dollar value payments are exchanged and the
                           turnover of funds within the arrangement is also high, the degree of
                           systemic risk is generally high as well.

Mitigation                 Same-day settlement. In 1981, NYCHA instituted same-day settlement.
                           Before same-day settlement, CHIPS transactions took up to 2 days to settle,
                           except in the case of a weekend or holiday, when it could take up to 4 days
                           to settle. According to an NYCHA publication, same-day settlement has
                           eliminated overnight exposure to failures, reduced float in the banking
                           system, and accelerated the availability of funds to customers.

Mitigation                 Bilateral credit limits. Since October 1984, NYCHA has required each
                           CHIPS participant to establish a bilateral credit limit with each of the other
                           CHIPS participants. Each CHIPS participant is required to indicate whether or
                           not it is willing to receive payment messages from other participants. If a
                           CHIPS participant is willing to receive payment messages from another
                           participant, it must set a limit on the maximum net-dollar amount that it is
                           willing to receive from that participant.

                           The CHIPS operating system continuously and automatically monitors
                           payment messages, checking them against bilateral limits. If a payment



                           Page 35                            GAO/GGD-97-73 Pa>'ments, Clearance, and Settlement
              Section 1: Wholesale Payment Systems • CHIPS
              Clearing House Interbank Payments System




             message would cause a participant to exceed the bilateral limit that the
             receiving participant has set for it, CHIPS is designed to not allow the
             payment message to be released.

Mitigation   Net debit caps. In 1986, NYCHA established a net debit cap for each CHIPS
             participant. This cap limits a participant's overall net debit position to all
             other CHIPS participants. The significance of the net debit cap is that it
             limits the total amount of credit exposure that any one participant can
             pose to the CHIPS system. Thus, if a participcmt defaults, the potential net
             loss to all other participants can be no greater than its net debit cap. For
             each participant, the net debit cap is equal to 3.0 percent of the sum of the
             bilateral limits set for it by the other participants.

Mitigation   Loss sharing—backed up by collateral. In 1990, NYCHA established a
             loss-sharing arrangement supported by pledged collateral to ensure that
             CHIPS settles even if a participant fails. Under the loss-sharing arrangement,
             each participant that has established bilateral limits with the failed
             participant agrees to assume an additional settlement obligation (ASO),
             equal to its pro rata share of the failed participant's net debit position. To
             ensure funding of the ASO, each participant is to provide collateral in
             advance equal to the participant's "maximum ASO." The maximum ASO is
             equal to $10 million or 5 percent of the highest bilateral limit granted to
             any other participant, whichever is greater. The collateral is U.S. Treasury
             securities, which are held in collateral accounts at FRUNY.

Mitigation   Membership requirements, CHIPS maintains membership requirements
             to ensure the financial stability of CHIPS and its participants. Moreover, to
             ensure the creditworthiness of CHIPS participants, NYCHA requires all
             participants to (1) be subject to a credit evaluation when they apply for
             membership, (2) subrnit copies of their financial statements, and (3) be
             subject to periodic review, which includes a credit review by the member
             banks.




             Page 36                             GAO/GGD-97-73 Payments, Clearance, and Settlement
Section 1: Wholescde Payment Systems • Foreign Exchange

Settlement of Foreign Exchange
Transactions

                                   A foreign exchange transaction is the trade of one currency for another,
Description and Use                for example a trade of U.S. dollars for German marks (DM). Foreign
                                   exchange transactions are typically settled through transfers of bank
                                   balances (deposits) in the respective currencies. This is a wholesale
                                   activity conducted amongfinancialinstitutions, especially banks, that may
                                   be trading for their own account or on behalf of others.

                                  Foreign exchange transactions are generated by cross-border activities,
                                  such as international trade and the purchase or sale of foreign assets, as
                                  well as by speculation on—or hedging against—moves in excheinge rates.
                                  The largefinancialinstitutions that offer to buy or sell foreign currencies
                                  for their customers commonly do a considerable amount of foreign
                                  exchange trading for their own account. This "proprietary" trading enables
                                  afinancialinstitution to have better market information for its customers
                                  and itself and may also be conducted to hedge the institution's own risks
                                  or in an attempt to profit from moves of exchange rates.




                                  Page 37                        GAO/GGD-97-73 Payments, Clearance, and Settlement
                          Section 1: Wholesale Payment Systems • Foreign Exchange
                          SetUement of Foreign Exchange
                          Transactions




Key Terms
^   Back office           Back office is a bank department responsible for recording and maintaining
                          tlie official records of \he bank and for processing transactions entered into
                          by the bank.

Q   Correspondent bank    A correspondent bank is a bank that, by arrangement, holds the deposits of
                          another bank and provides payments and other services for that bank.

g Hedging                 Hedging is engaging in financial transactions to protect against potential
                          adverse changes in the values of assets, liabilities, or off-balance-sheet
                          activities.

Q   Nettinc               Netting is an agreed offsetting of obligations by trading partners. It can reduce
                          a large number of individual obligations to a smaller number of obligations.

Q   Proprietary trading   Proprietary trading is buying or selling for the trading institution's own
                          account, in contrast to trading the institution does on behalf of its customers,

| j ] Speculation         Speculation is engaging in financial transactions, such as purchasing foreign
                          currencies, in an attempt to profit from anticipated changes in market prices.

    S.W.I.F.T.            Society for Worldwide Interbank Financial Telecommunications (S.W.I.F.T.)
                          is an international financial payment cooperative organization that operates
                          a network that facilitates the exchange of payment and other financial
                          messages between financial institutions throughout the world.


                          On an average day, there are nearly $1.2 trillion in foreign exchange trades
Basic Data                transacted globally, according to a survey conducted by central banks in
                          April 1995.'- This figure—after acljustment for exchange rate
                          changes—was 30 percent higher than that found in a similar survey
                          conducted in 1992. Of the 1995 amount, 83 percent—almost $1
                          trillion—involved U.S. dollars. To put this in perspective, the U.S. rhoney
                          stock at the end of 1995 was $3,509 trillion." About two-thirds of foreign
                          exchange transactions take place between bank dealers trading for their
                          own account.




                          '-Bank for Intemationiil Sculement-s, "Central Hank Survey of Foreign Exchange and Derivatives
                          Market Activity. 1995."

                          '•'U.S. money stock. M2 measure, is composed of currency outside banks, checking and savings
                          deposits, small time deposits, retail money market funds, and traveler's chocks.



                          Page 38                                  GAO/GGD-97-73 Payments, Clearance, and Settlement
             Section 1: Wholesale Pa}-ment Systems • Foreign Exchange
             Settlement of Foreign Exchange
             Transactions




            Example: A bank in New York (Bank A) has 200,000 German marks
Processes   (DM200,000) on deposit vnth its correspondent bank in Frankfurt,
            Germany (Bank X) and wishes to sell DM150,000 of that amount in
            exchange for U.S. dollars. It might be initiating this trade for its ovm
            account or on behalf of a customer.

            This vdll be a "spot" transaction, in which settlement will be 2 days after
            the trade is negotiated. Figure 1.4 illustrates how this transaction is
            processed.




            Page 39                             GAO/GGD-97-73 Payments, Clearance, and Settlement
                                                          Section 1: Wholesale Payment Systems • Foreign Exchange
                                                          Settlement of Foreign Exchange
                                                          Transactions




Figure 1.4: A Typical Foreign Exchange Transaction

                                                      New York
                                                           Banks                                 Method of
                                                  Initiating Correspondent      Payment        communication/
 Step    Process                                    bank         bank           system           messaging

         Trade day
        With the current exchange rate at DM
        1.50 per $1.00, oneot Bank A's
        traders enters into a trade contract
        with Bank B in Frankfun to sell DM                                                          ^
        150KforJ100K.
        Bank A's back oKice receives the
        contract information from the trader
        and enters it into its computer system.
        Trada day + 1
        The back office ol Bank A exchanges
        messages with the back office of
        Bank B to confirm the details ol the                                                         S.mJF.7.
        contract.



        Day prior to settlement
        II the confirmalions were in agree-
        ment. Bank A's computer system
        automatically sends a message to                   C ^   to Frankfurt
        Bank X (its correspondent in
        Franklurt), instructing Bank X to pay
        OM150K to Bank B on settlement
        day.                                                                                         &WI.F.T.

                                                                 ^
                                                i ^
        Starts In Frankfurt




                 10:00 a.m. in New Vorli
        Bank Y's computer debits $100K
                                                                 m^              CHIPS
        from Bank B's deposit account and
        generates a payment of SIOOK to
        Bank A via CHIPS.
                                                      X1<:=«$                      <5
        Settlement day + 1
        At Bank A, the back office verifies
        that the dollars were received and
        marks paid and that these transac-
        tions were in conformity with the
        original trade details.



    l"y^    Initiating bank in New York City.                          JTYJ In New York City, correspondent bank of Bank B.
 S.W.15.T. Society lor Worldwide Interbank Financial                 CHIPS The Clearing House Intettank Payments System, in
 .Ai ^     Telecommunication. An organization that transmits         / W : ^ New York, which processes and settles dollar payments
      '    payment and other financial messages between,                     among banks.
           financial institutions worldwide.




                                                         Page 40                                        GAO/GGD-97-73 Payments, Clearance, and Settlement
                                                   Section 1: Wholesale Payment Systems • Foreign Exchange
                                                   Settlement of Foreign Exchange
                                                   Transactions




                                                                         Frankfurt
                       j i
                                                                              Banks
                               Method of
                             communication/           Payment        Correspondent    Initiating
                               messaging               system             bank          bank       Process                                   Step

                                                                                                   Trade day



                                  J
                                                                                                   A Bank B trader enters into a trade
                                                                                                   contract with Bank A to buy DM150K
                                                                                                   for SIOOK.


                                                                                                   Bank B's back office receives the
                                                                                                   contract information from the trader
                                                                                                   and enters it into its computer system.

                                                                                                   Trade day + 1
                                                                                                   The back office of Bank B exchanges
                                                                                                   messages with the back office of
                                                                                                   Bank A lo confinn the details ol the
                                  &W.I.F.T.                                                        contract.



Frankfurt                                                                                          Day prior to solllcmeni
                                                                                                   Bank B's computer system automa-
                                                                                                   tically sends a message lo Bank Y
                                  S.W.1.FT.                                                        (its correspondent in l>iew York),
                                                                                                   instructing it to pay $100K lo Bank A
                                                                                                   on settlement day.

                                                                     to New York   ^ a


                                                                                                   Scttloment day
                                                                                                             11:00 a.m. In Frankfurt
                                                                                                             (5:00 a.m. In New York)
                                                                                                   Bank X's computer debits DM150K
                                                       EAF-2                                       from the account of Bank A and gen-
                                                                                                   erates a payment of DM150K lo
                                                                                                   Bank 8 via EAF-2.




                                                                                                   Settlement day -f 1
                                                                                                   At Bank B, the back office verifies
                                                                                                   that the marks were received and
                                                                                                   dollars paid and that these trans-
                                                                                                   actions were in confomiily with the
                                                                                                   original trade details.


                                     Initiating bank in Frankfurt.                    In Frankfurt, correspondent bank of Bank A.


                      EAF-2          Elekironische Abrechnung Frankfurt               Note: For more information, see S.W.I.F.T. and CHIPS.
                       .•'. ^ ^      (Frankfun Electronic Clearing System),
                      * "^^          the interbank payment system in                  Source: First Chicago NBD Corporation.
                                     Frankfurt.




                                                  Page 41                                      GAO/GGD-97-73 Pajmcnts, Clearance, and Settlement


            ^•''••**«w"*»*«.iiiiiilPl|.|.,J4 ..,4,111(11
                         Section 1: Wholesale Payment Systems • Foreign Exchange
                         Settlement of Foreign Exchange
                         Transactions




                        The timing of the steps in Figure 1.4 is typical but not universal. For
                        example. Step 5, shown as taking place on "Settlement day + 1," can take
                        place as late as settlement day -i- 2 in some banks. Similarly, the times of
                        the actions on settlement day (11:00 a.m. German time in Frankfurt, and
                        10:00 a.m. EST in New York) were chosen arbitrarily; these could occur at
                        any time during the open hours of the payments systems in the respective
                        cities.


                        Regulatory oversight of participating institutions in foreign exchange
Regulatory Oversight    trading is in the hands of the central banks and other regulators in their
                        respective countries. In the United States, this responsibility generally
                        belongs to the bank regulators. These regulators oversee the foreign
                        exchange trading activities of banks through their normal examination
                        procedures.

                        Over the last 22 years, the central banks of the major industrial countries
                        (the "Group of Ten," G-10 countries) have been working together on ways
                        to improve and to better coordinate their supervision of foreign exchange
                        trading.''' Since 1989, this group of central banks has issued a series of
                        studies on this topic, which included recommendations for private-sector
                        and central-bank actions that could decrease foreign exchange settlement
                        risk. In 1994 through 1995, a committee of the G-10 central banks surveyed
                        some 80 banks in their countries to determine current risk-control
                        practices. This survey identified practices for reducing risk and shortfalls
                        from these practices.


                        For purposes of this report, we discuss some of the most important risks
Risk and Risk           and risk mitigations associated with foreign exchange transactions.
Mitigation




                        '*nie G-10 countries include; Belgium, Canada, FVance, Germany, Italy, Japan, The Netherlands,
                        Sweden, Switzerland, United Kingdom, and the United States.



                        Page 42                                   GAO/GGD-97-73 Payments, Clearance, and Settlement


                       mmm
                                           Section 1: Wholesale Payment Systems • Foreign Exchange
                                           Settlement of Foreign Exchange
                                           Transactions




Table 1.5: Risk and Risk Mitigation for
Foreign Exchange Transactions                Risk                                                   Risk mitigation
                                             Herstatt risk (counterparty failure/default            Cretdit assessment antj control
                                             after one party has nnatde paynaent)
                                                                                                           illrtStiljJ'dp.Sfbsl^fpapd^^^^^^^
                                                                                                    Bil^t^iil;

                                                                                                    mm^^mmmMMm^mm
                                                                                                      2*affi
                                             Risk of extended and enlarged exposures



                                            Risk of gridlock

                                                     Shaded cells indicate that nnitigatloiis have been adopted by some participants or providers
                                                     but are not yet widely used. Unshaded cells indicate mitigations in general use.

Risk 1: Herstatt Risk                     A foreign exchjmge transaction involves full settlements in two different
                                          national payments systems; in the case illustrated in Figure 1.4, on
                                          settlement day DM150,000 were paid through the Frankfurt Electronic
                                          Clecuing System.(EAF-2) system in Germany and $100,000 through CHIPS.
                                          These systems are not linked in any way, and the settlements occur
                                          several hours apart. Bank A's correspondent in Frernkfurt paid out the
                                          German marks before Bank A received the dollars. In other trades (e.g.,
                                          Japanese yen for dollars), the gap between payment and receipt can be 17
                                          hours. For the entity that pays first, the risk is that the other party may fail
                                          to carry out its payment. If this is due to computer or other temporary
                                          problems, the first entity faces liquidity problems; if the failure is due to
                                          bankruptcy of the second entity, the first entity is exposed to loss of up to
                                          the full amount that it paid. This latter risk is commonly called "Hersi: "t
                                          risk," after the name of a German bank whose closure in 1974 occurred
                                          after it had received marks due to it on foreign exchange trades but before
                                          the corresponding dollar amounts were paid in the United States. One
                                          result was a temporary but severe disruption of payments across CHIPS; for
                                          the next few days, banks withheld payments, resulting in a chain reaction
                                          of other payments not being made.'^ Also, U.S. banks experienced losses. "^



                                          '"See the section on CHIPS for the risk mitigations .subsequently taken by that in.stitution and its
                                          participants.

                                          "'In addition to the risk that one party may fail after the other has made payment, there is also the risk
                                          that a party can fail before either party begins settlement In this case, the survi\'inn party would not
                                          pay or lose its side of the trade, but—in order to obtain or sell the desired amount of currency—it
                                          would have to enter into a new foreign exchange transaction with a different counterparty. Because
                                          the new contract might be at a less favorable exchange rate than the original one. counterparty failure
                                          prior to settlement creates exposure to potential loss, but such a loss would be only a fraction of the
                                          amount that might be lost if there were a counterparty failure at settlement.



                                          Page 43                                     GAO/GGD-97-73 Payments, Clearance, and Settlement
                        Section 1: Wholesale Payment Systems • Foreign Exchange
                        Settlement of Foreign Exchange
                        Transactions




Mitigation              Credit assessment and control. A major defense against default risk in
                        foreign exchange trading is adequate control of credit exposure. This
                        control can be exercised through careful analysis and screening of
                        potential trading counterparties, and the setting and enforcement of limits
                        on exposure to each counterparty. These controls are not universally
                        practiced. The survey by the G-10 committee found some banks in their
                        countries that do not set any limits on their settlement exposures.

Mitigation             Bilateral netting of gross payment obligations into smaller net
                       obligations. A way to reduce the magnitude of risk in foreign exchange
                       settlement is through netting. For example, two U.S. banks that actively
                       trade German marks might have entered into numerous contracts with
                       each other for settlement in that currency on a particular day. With a
                       netting arrangement in place, the two banks could replace these multiple
                       contract amounts with a single net amount to be sent through the German
                       payments system on that day. This can greatly reduce the amount of
                       settlement risk between the two banks. Some large trading institutions
                       have bilateral netting arrangements with each other. Not all banks
                       surveyed by the G-10 do so, however.

Mitigation             Multilateral netting. Such a practice, which involves the netting of both
                       sides of currency obligations among more than two trading institutions,
                       could further reduce the amounts to be settled in foreign exchange
                       trading.'" Little multilateral netting has been done thus far: one
                       arrangement, Ccilled ECHO, has begun operation in Europe. A group of U.S.
                       and Canadian banks plan to start another, called Multinet International
                       Bank."*


Risk 2: Extended and   Many banks assume that their exposure to settlement risk in foreign
Enlarged Exposures     exchange transactions is only for one day's trades, and is only an intraday
                       exposure. In fact, public- and private-sector studies have shown that these
                       exposures commonly are at lecist overnight and that the exposure to
                       settlement risk can be as high as the sum of 2 or 3 days' trades, depending
                       on the institution's own internal operational practices and its
                       arrangements with its correspondent banks. In Step 3 of Figure 1.4, Bank
                       A in New York followed the custom of sending payments instructions to its

                       ''In the United States. CHIPS, which serves as the medium for settling the dollar "lej;" of most foreign
                       exchange trades involving dollars, perfomis niultilaieral netting, but only for those dollar transactions
                       sent acro.ss it. Proposals for multilateral neltinj; of foreign exchange transactions would involve the
                       multilateral netting of both sides of trades.

                       '"The members of the Multinet project already not bilaterally among themselves trades in certain
                       currencies, using the VAUJNET system (see page? 4:j).



                       Page 44                                     GAO/GGD-97-73 Payments, Clearance, and Settlement
                    Section 1: Wholesale Payment Systems • Foreign Exchange
                    Settlement of Foreign Exchange
                    Transactions




                   correspondent bank (Bank X) a day in advance of settlement. If these
                   banks' systems are fully automated, this instruction might be irrevocable.
                   In that case, if Bank B (the German bank) was closed and declared
                   insolvent on settlement day, Bank A might nonetheless make scheduled
                   payments to Bank B not only on settlement day but also on the next day,
                   without receiving incoming payments from Bank B on either day. The
                   1994-1995 G-10 committee survey of meyor trading institutions found that
                   for some of these institutions the amoimt at risk, even to a single
                   counterparty, could exceed the institution's capital.

Mitigation         Operations improvements. To make exposure limits meaningful, they
                   must be buttressed by operations procedures that allow the institution to
                   halt outgoing payments up to settlement day, and to know whether
                   expected incoming payments have been received. The central banks' G-10
                   committee has recommended that all banks improve their operational
                   controls and efficiency.

Mitigation         Arrangements with correspondent banks to withhold payments.
                   Some banks have the ability to halt payments as late as settlement day,
                   and, in some cases, late on that day. In the previous example, if Bank A in
                   New York had appropriate curangements with Bank X, its correspondent
                   in Frankfurt, it might be able to have Bank X withhold the mark payments
                   from the Germzin payments system on settlement day until well after the
                   opening of that system, thus further reducing the time gap between
                   payment of marks in Germany and receipt of dollars in New York.


Risk 3: Gridlock   Tighter operations controls over outgoing payments are a two-edged
                   sword because they create gridlock risk for the market at the same time
                   that they protect the institution. If Banks A and X in figure 1.4 had an
                   arrangement such as described above, Bank A might withhold payment to
                   Bank B if it heard rumors that Bank B was in trouble, preferring to receive
                   funds from Bank B before pajing to it. Other banks might do the same
                   vis-a-vis Bzink B. Even if the rumors were false and Bank B were sound,
                   the withholding of payments to Bank B could create a liquidity problem
                   for the bank; with incoming payments not arriving until late in the day, the
                   bank could find it difficult to make its own scheduled payments, possibly
                   affecting others. This phenomenon occurred at the time of the attempted
                   coup d'etat in the Soviet Union in 1991, when a number of banks withheld
                   their payments to Soviet banks, thus making it difficult for the latter to
                   meet their obligations. Were such payment-withholding applied to larger




                   Page 45                             GAO/GGD-97-73 Payments, Clearance, and Settlement
                              Section 1: Wholesale Payment Systems • Foreign Exchange
                              Settlement of Foreign Exchange
                              Transactions




                             numbers of banks or to larger banks, the resulting gridlock could involve
                             broader systemic risk to financial markets more generally.


                             Bilateral and multilateral netting of payments in foreign exchange
Bilateral and                transactions can reduce the amount of exposure to counterparty risk.
Multilateral Netting of      Bilateral netting can be arranged between any two banks. Nonetheless,
Foreign Exchange             three organizations provide systems to facilitate bilateral netting among
                             members. As regards multilateral netting, there is one organization in
Transactions                 operation, and another that expects to commence operation in 1997. The
                             following explains the systems in detail.

                             Bilateral Netting Systems

                             Accord: This is a service offered to members by S.W.I.F.T. Members
                             subscribing to this service can have their payments messages matched and
    y«iV    Bilateral &
                             bilaterally netted by the Accord system. In May 1996, 27 institutions were
                             using this system.

        1^^
T r r a T f Multilateral
^^XMJLL Netting
HBBnB
                             FXNET: This system is owned by the U.K. subsidiaries of 12 major banks.
                             In May 1996, 70 banks used this system for bilateral netting.
     V^^^                    VALUNET: This system provides bilateral netting services to 10 U.S. and
                             Canadian banks for some of those banks' offices.

                             Multilateral Netting Systems

                           • ECHO (Exchange Clearing House): This system is based in London; in
                             May 1996, 13 banks were using it. FXHO calculates multilateral netting of
                             trades that are passed through it. For each currency, a user will have only
                             a single payment obligation or expected receipt. Settlement takes place via
                             traditional national payment systems into and out of ECHO accounts in each
                             country.
                           • Multinet International Bank: This is a project of the U.S. and Canadian
                             banks involved in VALUNET. Once in operation, it wall be a clearing house
                             to provide multilateral netting and settlement of foreign exchange
                             transactions among its members, initially in U.S. and Canadian dollars and
                             eventually in other currencies. For those trades that met its standards,
                             Multinet Bank would become counterparty.




                             Page 46                             GAO/GGD-97-73 Payments, Clearance, and Settlement
Section 2: Equities, Treasuries, Futures, and Options • Overview

Overview of Clearance and Settlement
Systems of Equities, Treasuries, Futures,
and Options
                                      In this section, we discuss the clearance and settlement systems for
                                      securities, such as equities and U.S. Treasuries, and derivatives, such as
                                      futures and options.


                                     The clearance and settlement systems of equities, Treasuries, futures, and
Main Characteristics                 options are similar yet distinctive to each pairticular market.
                                     The systems for equities and U.S. Treasuries center on the transfer of the
                                     ownership of securities from the seller to the buyer.
                                     The systems for futures and options center more on the transfer of risk
                                     and the value associated with that risk.


                                     Thousands of these types offinancialinstruments are traded each day
Statistical Information              through either organized exchanges or in the over-the-counter (OTC)
                                     markets.
                                     Hundreds of billions of dollars of each type offinancialinstrument are
                                     cleared and settled through clearing orgaiuzations each year.


                                     The Securities and Exchange Commission (SEC) and the Corrimodity
Regulatory                           Futures Trading Commission (CFTC) are the primary regulators and
Information                          oversee the actions of the clearing organizations under their jurisdictions
                                     to determine whether or not they are functioning in accordance with
                                     regulations and the law.


                                     The primary type of risk that clearin<? organizations face is counterparty,
Risk Information                     or credit risk.
                                     Clcciring organizations can mitigate counterparty risk by ha'ving strict
                                     admission standards and continually monitoring their members, and by
                                     requiring their participants to post "good faith" deposits and/or make
                                     payments that cover any potential significant market movements.




                                     Page 47                         GAO/GGD-97-73 PaymenU, Clearance, and Settlement
Section 2: Equities, Treasuries, Future, and Options * Equities

Equities Clearance and Settlement


                                      The National Securities Clearing Corporation (NSCC) clears and settles
Description and Use                   98 percent of all equity (stock) and corporate and municipal bond
                                      transactions in the United States. For the purposes of clarity, we will focus
                                      only on equities, NSCC is the clearing corporation for eight stock exchanges
                                      and is owned equally by the American Stock Exchange (AMEX), New York
                                      Stock Exchange (NYSE), and the National Association of Securities Dealers
                                       (NASD).'


                                      The Depository Trust Corporation (DTC) tracks the transfer of equities and
                                      corporate and municipal bonds cleared through NSCC via an automated
                                      book-entry system. During settlement, NSCC instructs DTC on which equities
                                      to move from one account to another, DTC also performs securities custody
                                      services for its participating banks and broker-dealers.

                                      Participants in the clearance and settlement of equities include exchanges;
                                      NSCC, and members of NSCC (referred to as Direct Participants); DTC; and
                                      settlement banks (banks that settle on behalf of direct participants).




                                      'One regional stock exchange, the Philadelphia Stock E.\t:hange. lias its owni clearing organization.



                                      Page 48                                     GAO/GGD-97-73 Payments, Clearance, and Settlement
                           Section 2: Equities, Treasuries, Future, and Options 'Equities
                           Equities Clearance and Settlement




Key Terms
Q   Bond                   A bond is a debt security representing a loan by the buyer to the corporation or
                           government issuing the bond; it may either pay interest, or it may be purchased
                           at a discount in price from the value at maturity.

    Book-entry system     A book-entry system is an accounting system that permits the transfer of
                          assets (e.g., securities) without the physical movement of paper documents
                          or certificates.

Q   Direct participants   Direct participants are financial institutions that transact with the clearing
                          organization, and all customers come to the clearing organization through them.

1 ^ Equity/stock           Equity, or stock, is an instrument that represents ownership in a company.

Q   Locked-in trades      Locked-in trades are transactions in which the details of the trade are matched
                          by a computer, usually at the place of the trade, before being sent to a clearing
                          organization. As a result, the clearing organization does not usually perform
                          a trade comparison.

Q   Open outcry           Open outcry is a competitive system in which floor participants verbally make
                          bids and offers to each other at centralized exchange locations.

1 ^ Specialist            A specialist is a member designated by an exchange to be the sole market
                          maker for a particular stock.



                          As of April 1996, NSCC served 1,974 brokers, dealers, banks, and other
Basic Data                financial institutions through approximately 400 direct participants, NSCC
                          processes over a nullion transactions on a daily basis that are worth
                          billions of dollars, according to NSCC.

                          According to DTC officials, DTC holds approximately $10 trillion of
                          securities that make up almost 99 percent of all stocks and nonfederal
                          bonds traded in the United States. (See table 2.1)




                          Page 49                               GAO/GGD-97-73 Payments, Clearance, and Settlement
                                   Section 2: Equities, Treasuries, Future, and Options • Equities
                                   Equities Clearance and Settlement




Table 2.1: Data on NSCC and DTC
                                                                                        1995
                                   NSCC
                                   Average daily volume oMransactions                   1,875,600 transactions
                                   processed
                                  Average daily value of transactions                   $92 billion
                                  processed
                                  DTC
                                  Securities delivered through DTC's                    $41 trillion
                                  book-entry system
                                  Value of securities in DTC's custody                  $10 trillion
                                  Sources: NSCC and DTC 1995 data.




                                  Equity shares trade, clear, and settle in a 3-day cycle referred to by
Processes                         industry participants as "T-(-3"—the cycle begins on the day of the trade
                                  ("T") and ends 3 days later (T+3) -with settlement.


The Trading Process               Investors may purchase equity shares through a securities broker-dealer.
                                  Equities are traded in two different kinds of markets—exchanges and the
                                  over-the-counter (OTC) markets. Through exchanges, member firms act for
                                  themselves and as agents (brokers) for customers, bringing their orders to
                                  a central facility—the exchange floor—to be executed. In exchange
                                  trading, orders may be executed in two ways: (1) against other orders—a
                                  bid to buy equities matching an order to sell equities—or, if there is no
                                  such order at an acceptable price, by (2) a sale to or purchase from a
                                  specialist. Trading is done through "open outcry," or orders can be inputed
                                  into an order management system. NYSE officials Sciid that 70 percent of
                                  their trades are done through their order management system (called
                                  Super DOT—Designated Order Turnabout System) and 30 percent are
                                  done through "open outcry." However, open outcry trades account for
                                  70 percent of the dollar value of all trades because they typically include
                                  large transactions or block trades of 10,000 shares or more.

                                  In the Nasdaq OTC market,- orders are handled by dealers working over the
                                  telephone or through a computerized small-order execution system; there
                                  is no central physical facility or trading floor. In this market, securities


                                  -Nasdaq stands for the National Association of Securities Dealers Automated Quotation .system.
                                  Nasdaq is the automated stock market for a portion of the non-exchange-listed securities. The OTC
                                  market for securities includes Nasdaq, the so-called "pink sheets"—privately published National Daily
                                  Quotation SheeLs—and the OTC Bulletin Board.



                                  Page 50                                   GAO/GGD-97-73 Payments, Clearance, and SetUement
                                     Section 2: Equities, Treasuries, Future, and Options • Equities
                                     Equities Clearance and SettJement




                                    firms c£m act as brokers or dealers with respect to any type of stock. A
                                    firm receiving a customer's order to buy stock can either sell the stock to
                                    the customer from the firm's inventory (if it is a dealer in that stock) or act
                                    as a broker by purchasing the stock from another dealer and then selling it
                                    to the customer.


The Clearance and                   Equities are cleared and settled through NSCC and DTC. Clearance begins
Settlement Process                  after the trade occurs and involves NSCC guaranteeing the trade and then
                                    netting the delivery and receipt of settlement obligations. Settlement
                                    usually occurs on T+3, with the equity shares settlement usuaUy
                                    performed through book-entry moves at DTC and the money settlement
                                    through NSCC Jind settlement banks. Equities that are eligible for
                                    depository processing through DTC enter the Continuous Net Settlement
                                    (CNS) System, which, according to NSCC officials, is where the vast majority
                                    of equity trades settle, NSCC has three different settlement systems: one for
                                    depository-eligible issues, one for the settlement of nondepository-eligible
                                    issues, and one for trades that bypass the netting process and are settled
                                    separately.

Table 2.2: NSCC Clearance and
Settlement Process for Depository   T+3 day                                            Clearance and settlement
Equity Shares                       T (trade date)                                     Trade occurs and trade information is sent
                                                                                       to M-SCC, mostly on a "locked-in" basis.
                                    T+1                                                Rf'sults of trade comparison and matching
                                                                                       are sent to direct participants.

                                    T+2                                                NSCC determines participants' net
                                                                                       settlement positions.
                                    T+3                                                Settlement date—securities are delivered
                                                                                       and payment is made.
                                    'NSCC officials said that the completion of transactions may not always occur on T+3.
                                    Source: NSCC.


                                    Figure 2.1 describes in a simphfied manner the T+3 trading, clearance, and
                                    settlement of a single depository-eligible equity trade that is not netted
                                    with other trades.




                                    Page 51                                  GAO/GGD-97-73 Payments, Clearance, and Settlement
                                    Section 2: Equities, Treeisuries, Future, and Options • Equities
                                    Equities Clearance and Settlement




Figure 2.1: T+3 Clearance and
                                      T (Trade Day)
Settlement of Depository-Eligible
Equity Shares
                                                    Buyer
                                                  Customer A
                                            purchases 100 shares ol
                                        slock at $10.00 a share through
                                      Broker A'Oirect Participant A (DPA).



                                                                                   .\nr i,iL-.
                                                                                r„ni,„..,> Sl,>fk




                                        T + 1 (Trade Day+1)

                                                  NSCC reports
                                           the confirmation ot the trade
                                                     with DPA.




                                       T + 2 (Trade Day +2)


                                                   NSCC reports
                                              the settlement position
                                                      to DPA.




                                      T + 3 (Trade Day +3) Settlement

                                         Equity Share Settlement
                                          DTC is instructed by NSCC
                                            to conduct settlement
                                                via book entry.
                                              Settlement occurs
                                            when DTC deducts 100
                                            shares from the seller's
                                          account (DPB) and places
                                           them in NSCC's account;
                                         NSCC then transfers the 100
                                         shares to the net buyer (DPA),




                                                                                           H«Sh«n:n
                                                                                        r,.>1,„>.a, Sl<„'Il




                                                                              Equity Share Settlement




                                    Page 52                                  GAO/GGD-97-73 Payments, Clearance, and Settlement



                                                                                                                                 J
                                   Section 2: Equities. Treasuries, Future, and Options • Equities
                                   Equities Clearance and Settlement




                                                                                                              T (Trade Day)
                                                                                          J^L
                                                                                                                              Seller



                                                                                  .^
                                                                                        mn                            Customers directs
                                                                                                              Broker B/Direct Participant B (DPB)
                                                                                                                     to sell 100 shares at
                                                                                                                        $10.00 a share.



                                                                                         IIHlSlinr,'*
                                                                                           Aiu: i,«.
       Trade occurs                                                                    r,.,t„„..„Si,«h
  nl the Exchange and
    trade data is sent
via computers to NSCC.




                                                                                                             T+1(TradBDay+1)
                                                                                       J^X
                                                                                        mi                               NSCC reports
                                                                                                                  confirmation of the trade to
                                                                                                                             DPB.




                                                                                                              T + 2 (Trade Day +2)
                                                                                       . ^ 1
                                                                                        nm                               NSCC reports
                                                                                                                    the settlement position
                                                                                                                            lo DPB.




                                                                                                              T + 3 (Trade Day +3) Settlement


                                                                                                                    Money settlement^
                                                              Fedwire
                                                                                                                Payment is periormed through
                                                                                                               settlement banks over Fedwire.
                                                                                                             NSCC requests payment from DPA
                                                                                                               via its settlement bank. DPA's
                                                                                                               buyer's settlement bank pays
                                                                                                               51,000 to NSCC's settlement
                                                                                                              bank. DPB's seller's settlement
                                                                                                                 bank receives S 1,000 from
                                                                                                                  NSCC's settlement bank.




                                                                            ^
                                                                     Money Settlement


                              Equity share and money seitlenieni is norrnnlly done on a net basis such that the single purchase ol 100 shares
                              would be combined with DPA's and DPB's oiher trades lo produce one net equity share selllement and money selllemDnt,

                              'Source: GAO analysis ol NSCC data.




                                  Page r,:i                                     GAO/GGO-97-73 Paymeiit-s. Clearance, ami Settlement



                         mm
                           Section 2: Equities, Treasuries, Future, and Options • Equities
                           Equities Clearance and Settlement




The 3-Day Clearance and
Settlement Cycle
Tracje Day (T)            The 3-day cycle of clearance and settlement for NSCC begins on the day of
                          the trade (T). Trade information is recorded at the exchanges and then is
                          transmitted to NSCC (via computers) through a variety of automated
                          marketplace trading systems.

                          Most of the trades are transmitted as "locked-in" transactions—the details
                          of the trades from the buyer and seller have already been matched by the
                          computer systems of the exchanges or OTC market, which means that NSCC
                          does not perform a trade comparison. However, if trades are not locked-in,
                          the buy and sell data have to be reported by direct participants to NSCC,
                          and NSCC then compares and matches the data.^ NSCC officials saiid that
                          trades mostly occur on a locked-in basis.^

                          Once the trade data have been compared, NSCC guarantees the transaction.
                          This is referred to as "novation" or the substitution of one party for
                          another (NSCC becomes the buyer to every seller and the seller to every
                          buyer). The guarantee begins on midnight of the day that the trade is
                          reported back to direct participants as having been compared.

T+1                       On T+1, results of the comparison and matching process are reported to
                          direct participants, NSCC transrtuts to direct participants computerized
                          reports (known as contracts) that show every buy and sell order reported
                          by the participant and the marketplace on T, and also confirm that each
                          transaction has been compared and is ready for settlement.

T+2                       Participants are informed of their net settlement positions for trades that
                          occurred on T and are due to settle on T+3. NSCC issues a report to direct
                          participants that tells them what their net settlement is that day and
                          projects what their net settlement will be on T+3. To do this, NSCC uses its
                          CNS system, which "reduces or nets the total number of financial
                          obligations requiring settlement." Participants then are advised whether
                          they are net buyers or net sellers for each issue of a stock.

T+3                       T+3 is settlement day for trades that began on T—to the extent that
                          securities are available for delivery, delivery will be made, and participants
                          vyith payment obligations will be required to pay. The participants' net

                          'These types of trades are coriiparetl in cithiT NSCC's Lisletl Compari.son System for exchange-listed
                          trades or the OTC Comparison System fnr trades in the OTC market.

                          •'However, municipal bonds and coniorale delit are .submitted for two-sided comparison.



                          Pa^e m                                      GAO/GGD-97-73 PaymenU, Clearance, and Settlement
                             Section 2: Equities, Treasuries, Future, and OpUons • Equities
                             Equities Clearance and Settlement




                            settlement positions are determined by the CNS system netting all their
                            trades due to settle that day against the prior days' unsettled long (buy)
                            and short (sell) positions (referred to as fail positions or unsettled
                            positions) idr each issue of equity.

Equity Settlement Has Two   Equity share settlement. The settlement of equities has two
Parts                       parts—equity share settlement and money settlement. The first phase is
                            equity share settlement. The movement of the shares takes place through
                            DTC accounts, NSCC instructs DTC to move shares from the accounts of net
                            sellers to NSCC'S account and then from NSCC'S account to the accounts of
                            net buyers. If the amount of shares is insufficient to satisfy all delivery
                            obligations, NSCC uses a random allocation algorithm to determine to
                            whom securities should be delivered. The CNS automatic delivery process
                            occurs in two cycles: (1) the night cycle at about 1:30 a.m. on (T+3) and
                            (2) the continuous "day cycle" later that day.

                            Money settlement. The final phase of settlement is the money
                            settlement. The CNS net money settlement is determined on T+3 and can be
                            settled with a single payment between NSCC and participants through
                            settlement banks.^ Every trading day, NSCC is to generate a settlement
                            statement. This statement is to include a line item that tells each
                            participant what its net CNS money obligation is, based upon the dollar
                            value of the participant's equity shares delivered and the dollar value of its
                            payment obligation. Each participant has a settlement bank that has
                            guaranteed that it will pay or receive the money settlement on the
                            participant's behalf.'' Settlement banks are required to make payment
                            before Fedwire's funds transfer system^ closes.


                            The Securities and Exchange Cortunission (SEC) oversees the actions of
Regulatory Oversight        NSCC to determine whether it is fimctioning in accordance with the law and
                            SEC regulations, NSCC establishes the rules governing its clearance and
                            settlement of equities, subject to SEC'S approval.




                            '^NSCC has operated a same-day funds settUinient system since F>b. ^2, 1990.

                            "In order to qualify as a settlement bank, each bank has to meet specific criteria established by NSCC.

                            "Fedwire rjfers to two separate electronic .systems—one for the electronic transfer of funds, and one
                            for the electronic transfer of book-entry securities.



                            Page 55                                    GAO/GGD-97-73 Payments, Clearance, and Settlement
                                          Section 2: Equities, Treasuries, Future, and Options • Equities
                                          Equities Clearance and Settlement




                                          For purposes of this report, we discuss some of the most important risks
Risk and Risk                             and risk mitigations associated with equities.
Mitigation
                                          Because Nscc guarantees the trades of its direct participants, it incurs risk
                                          from the time of the guarantee until the settlement of obligations and
                                          payments. As a result, NSCC is exposed to counterparty risk, and the
                                          amount at risk (or the exposure) is dependent on fluctuations in the
                                          market.

Table 2.3: Risk and Risk Mitigation for
Equities                                  Risk                                           Risk mitigation
                                          Counterparty/credit risk                       Requirement of strict membership
                                                                                         stantdards
                                                                                         Arrangement with DTC
                                                                                         Requirement of clearing fund account
                                                                                         Marking to market prices of all
                                                                                         unsettled securities
                                          Source: NSCC.




Risk: Counterparty/Credit                 When NSCC guarantees the matched trade, it becomes the buyer to every
                                          seller cmd the seller to every buyer. As a result, the clearing organization
                                          incurs counterparty risk—the possibility that the clearing member buyer
                                          or seller might default on its obligations.

                                          The amount of counterparty risk that NSCC is exposed to is dependent on
                                          fluctuations in the market. If a direct participant does not meet its
                                          settlement and payment obligations, NSCC—because of the guarantee to
                                          the direct participant buyer and the direct participant seller—must
                                          liquidate the direct participant's positions, and thus is exposed to market
                                          risk (the exposure to the possibility offinancialloss caused by adverse
                                          changes in the value of contracts).




                                          Page 56                               GAO/GGD-97-73 Payments, Clearance, and Settlement
              Section 2: Equities, Treasuries, Future, and Options • Equities
              Equities Clearance and Settlement




Mitigation    NSCC mitigates counterparty risk by (1) setting strict admissions standards
              to determine that every member is creditworthy upon admission to NSCC;
              and (2) arranging vnth DTC that—in the event participants are unable to
              complete money settlement and NSCC ceases to act on their behalf—shares
              delivered that day are returned to NSCC, or DTC makes payment to NSCC.

             NSCC requires all urtsettled securities or fcul positions to be marked to
             market prices and payment is to be made by direct participants to reflect
             changes in the market. The objective is to keep NSCC obligations as close to
             market prices as possible. In addition, NSCC requires participants to
             contribute to the clearing fund,* which is designed to cover market risk
             exposure.




             "According to NSCC, the clearing fund was established to secure direct participants' obligations to
             NSCC as well as other liabilities and losses if they occur.



             Page 57                                    GAO/GGD-97-73 Payments, Clearance, and Settlement
Section 2: Equities, Treasuries, Futures, and Options * Treasuries

Treasuries and the Fedwire Book-Entry
Securities System

                                      The Fedwire book-entry securities system services all marketable U.S.
Description and Use                   Treasury securities, many federal agency securities, and certain
                                      international agency securities. For simplicity, we v^ll focus on Treasury
                                      securities.

                                      According to Federal Reserve officials, 99 percent of marketable U.S.
                                      Treasury debt is in book-entry form. Treasuries settle through the Fedwire
                                      book-entry securities system, which is operated by Federal Reserve
                                      Banks.^ The Fedwire book-entry securities system is a real-time
                                      delivery-vs.-payment (DVP) gross settlement system that requires the
                                      irtunediate and simultaneous transfer of securities against payment.'"
                                      Depository institutions that maintain funds accounts at a Reserve Bank are
                                      eligible to maintain book-entry securities accounts at a Reserve bank, as
                                      are certain nondepository institutions, subject to certain settlement
                                      restrictions.

                                      The Government Securities Clearing Corporation (cscc) was established
                                      to provide a netting mechanism for the clearance and settlement of U.S.
                                      Government securities in both the primary and secondary markets for
                                      Treasury securities.'' The primary purpose of issuing Treasury securities is
                                      to raise money for the U.S. goverr\ment. A large secondary market also
                                      exists for Treasury securities, making it one of the most liquid markets
                                      (easy to buy and sell the securities without moving the price) in the
                                      world.'2

                                      Participants in the clearance and settlement of Treasury securities include
                                      the Federal Reserve, cscc, members of cscc referred to as Comparison
                                      members and Netting members, and clearing agent banks (banks that
                                      settle on behalf of members). GSCC and each of its members has a
                                      designated clearing agent bank that operates through the Fedwire
                                      book-entry for securities system.'''




                                      •'Fedwire refers to two separate electronic systems—one for the electronic transfer of funds, and one
                                      for the electronic transfer of book-entry securities.

                                      "Transfers of securities may also be made without payment.

                                      "Treasuries may settle outside of GSCC's process.

                                      '-'Secrmdary niarl<et.s consist of exchanges and OTC markel-s where financial in.slnmienl.s are bought
                                      and sold sub.scquent to original issuance, which took place in the primary market.

                                      '•'For the purposes of this report, we focused on GSCC's process, which is one mechanism for clearing
                                      and settling U.S. government securities.



                                      Page 58                                               GAO/GGD-97-73 Payments. Clearance, and Settlement




                                                                   x'^mti'J-At^.-m.'&'j.'-ln^-il.D.iiU M^'trvit.;ik''.tuk.i.j^   :   • ,^ .^\'^,...,^).'A'fu.}-..4>'^j.i-iiA.\'fiitJiA4tMt.i.(A.^'itt,i,i   '•••*
                                   Section 2; Equities, Treasuries, Futures, and Options •Treasuries
                                   Treasuries and the Fed'wire Book-Entry
                                   Securities System




Key Terms
| y Book-entry system              A book-entry system is an accounting system that permits the electronic transfer
                                   of assets (e.g., Treasury securities) without the physical movement of paper
                                   documents or certificates.

Q   Clearing agent banks           Clearing agent banks are Fedwire participants that are regularly engaged in
                                   the business of providing clearing services in eligible securities for members
                                   and GSCC.

    Comparison member              Comparison members are primarily government securities broker-dealers
                                   and clearing agent banks that are capable of interacting with GSCC operations.

    CUSIP                          CUSIP stands for the Committee on Uniform Securities Identification
                                   Procedures. Each type and issue of security will have its own unique
                                   CUSIP number.

0   DVP system                     A DVP (delivery-vs.-payment) system is a system that ensures that the
                                   final transfer of one asset will simultaneously occur if, and only if, the final
                                   transfer of another asset (or other assets) occurs.

    Netting members                Netting members are primarily banks and government securities broker-dealers
                                   that are capable of participating in netting sen/ices through GSCC.

Q   Open outcry                    Open outcry is a competitive system in which floor participants verbally
                                   make bids and offers to each other at centralized exchange locations.

I I I Real-time gross settlement   Real-time means a system that processes each transaction as it is initiated
                                   rather than processing by batch. Gross settlement means that the system
                                   settles each transfer individually.

    Repurchase agreement           A repurchase agreement is an agreement between a buyer and seller (usually)
                                   of U.S. government securities whereby the seller agrees to repurchase the
                                   securities at an agreed-upon price and, usually, on a stated date.

    Trade comparison               Trade comparison is the receipt, validation, and matching of data
                                   on the long (buy) and short (sell) side of a transaction and the
                                   reporting of such match.

    Treasury security              A Treasury security is a negotiable debt obligation of the U.S. government,
                                   backed by its full faith and credit, and issued with various maturities.

Q   UCC                            The Uniform Commercial Code (UCC) is a set of model laws governing
                                   commercial and financial activities.




                                   Page 5!>                             GAO/GGD-97-73 Payments, Clearance, and Settlement
                                       S e c t i o n 2: E q u i t i e s , Trea.suries, F u t u r e s , and O p t i o n s • T r e a s u r i e s
                                       T r e a s u r i e s and the Fedwire Book-Entry
                                       Securities System




                                      The trading volume of the treasuries market averages $200 billion per day.
Basic Data                            According to Federal Resewe Bank of New York officials, the Department
                                      of the Treasuty is the largest single issuer of debt in the world, with
                                      Treasuty securities accounting for approximately $3.5 trillion in par value
                                      or face value (represented by 62 bond issues, 144 note issues, and 52 bill
                                      issues) as of December 1996. According to Federal Reserve data. Treasury
                                      issues dominate the transaction volume in the book-entry securities
                                      system, representing roughly 70 percent of Fedwire securities transfer
                                      volume (see table 2.4).

Table 2.4: Data on GSCC and Fedwire
                                                                                                                                             1995
                                      GSCC
                                      Annual dollar value of trades that GSCC processes for                                                  $65.9 trillion
                                      netting members
                                      Average daily dollar value of.trades that GSCC                                                         $263.6 billion
                                      processes for netting members
                                      Annual dollar value of net settlement obligations                                                      $16.3 trillion
                                      Average daily dollar value of net settlement obligations                                               $65 billion
                                      Fedwire book-entry securities system
                                      Annual origination (transfer) volume"                                                                  12.8 million
                                      Annual payment value of transfers"                                                                     $150 trillion
                                      Average daily volume of Treasuries originations                                                        36 thousand
                                      (transfers)
                                      Average daily payment value of transfers'"'                                                            $597 billion
                                      "Figures include all Fodwire-eligible securities, not just Treasuries.

                                      Sources: GSCC and Federal Reserve.




                                      For Treasuiies that are cleared and settled through cscc, the Fedwire
Processes                             book-enti'y securities system performs the book-entry transfer of the
                                      Trcasuiy securities through designated clearing agent biuiks operating on
                                      behalf of netting members and G.scc. The Fedwire book-enti'y securities
                                      system ordinarily operates from 8:30 a.m. to 3:30 p.m. Eastern Time (RT).'"'

                                      (iscc responsibilities include clearance (trade comparison, trade netting,
                                      and guarantee) and settlement. Treasuries that clear and settle through
                                      G.'^cc.: may clear and settle anywhere from "T+l" (trade date with next day
                                      settlement), to "T-t-15" (trade date with settlement in up to 15 days), to

                                      ".Thi' Ki'ilwirc liddk-cnirv si'ciiniii'S s.vslcm CI|)IMI.S cjirly iii.niri' instimccs lo iiiccl .si)('(.hil iirod.s and
                                      (.lose.s hitr iindtT special cJrc.Miinslaiice.'N.



                                      Pafie 6 0                                                   GAO/GGD-97-73 PajineMLs, Clearance, and S e t t l e m e n t
                           Section 2: Equities, Treasuries, Futures, and Options • Treasuries
                           Treasuries and the Fedwire Book-Entry
                           Securities System




                           "T-i-360" (in the case of repurchase agreements or "repos").'^ Participants
                           choose when they want to have the trade settled.


The Auction and Trading   Treasuries aie typically issued by an auction conducted by Federal
Process                   Reserve Banks accepting competitive and noncompetitive bids from
                          individual and institutional investors. Treasuries can then be bought and
                          sold in the secondaiy OTC market through commercial banks,
                          broker-dealers, and other financial service companies. The secondary
                          Treasury OTC market is primarily an institutionai investors' market.
                          According to Gscc officials, commercial banks, dealers, brokers, mutual
                          funds, and pension plaiis rather than indi'vidual investors typically
                          participate in this market. With respect to cscc, each participant in the
                          primary market and secondary markets for Treasury securities has to have
                          a netting member—if they are not already a netting member—in order to
                          clear and settle their Treasury trades through cscc.

                          GSCC clears and settles various types of Treasury security trades, such as
                          cash trades, forward trades (trades entered into today for settlement more
                          than 1 business day away), and repurchase agreements.'® Members
                          determine the types of trades they want as well as the settlement date.


The Clearance Process     Trade comparison is the first step in the clearance and settlement of
                          Treasury securities. There are two types of comparisons, matched and
                          locked-in. (See table 2.5)




                          '"Ciush setllcinciil. Of TreiLsiirics iti;ii soll.le on "T." or the day of t.he trade, will not clear and settle
                          through GSCC, .-Vcconlin); Ui GyCC officials, ca.sh settlement is a very common form of settlement

                          '"GSCC doe.s not clear and .settle options and futures on Treasuries. For more information see
                          clearance and scttloin(;nt of futures and options later in Section 2.


                          Page 61                                          GAO/GGD-97-73 Payments, Clearance, and Settlement
                                                          Section 2: Equities, Treasuries, Futures, and Options • Treasuries
                                                          Treasuries and the Fedwire Book-Entry
                                                          Securities System




Table 2.5: Two Types of Trade
Comparisons                                               Trade compadson type                Description
                                                          Locked-in                           The Federal Reserve Banks electronically deliver Treasury
                                                                                              auction purchases of GSCC participants in the primary
                                                                                              market to GSCC on a locked-in basis—that is, the trades
                                                                                              are already matched.
                                                          Matched                             Treasury securities traded in the secondary market by
                                                                                              GSCC participants are submitted to GSCC, which
                                                                                              compares and matches the buy and sell sides of the
                                                                                              trades. Comparison members submit the trade data by
                                                                                              electronic transmission or magnetic tape by 10:00 p.m.
                                                                                              on the night of each business day.' By 2:00 a.m., GSCC
                                                                                              sends confirmation reports—generated electronically-to
                                                                                              comparison and netting members that validate the
                                                                                              comparison of the trade data.
                                                          'The comparison process goes on.throughout the day and members may submit intraday data to
                                                          GSCC.

                                                          Sources: GSCC and the Federal Reserve.



                                                          After a trade is compared and matched and is eligible for netting, it is
                                                          netted through the netting system.'^ The netting system combines a
                                                          participant's total buy aind sell obligations for each cusiP number to arrive
                                                          at a single net debit, credit, or flat amount for that netting member.'^ Once
                                                          net settlement positioris have been determined and have been reported to
                                                          GSCC members, cscc becomes the legal counterparty to each party of the
                                                          trade and, as such, guarantees to the buyer and seller that the trade will
                                                          settle. This process is called novation, and it is usually completed before
                                                          2:00 a.m.


The Settlement Process                                    After net settlement amounts or positions have been determined and sent
                                                          to netting members, settlement can take place. The settlement of Treasury
                                                          securities includes (1) the Treasury securities transfer and (2) the
                                                          simultaneous payment for the securities.

Treasury Securities Transfer                              The Treasury securities settlement is done through clearing agent banks
and Payment                                               on behalf of the netting members, and cscc. Each clearing agent bank


                                                          "In order for nonrepurchase agreement trades to be eligible for netting, they must meet the following
                                                          re<iuirements: ( 0 the trade must be compared on a final-money basis (including comparison on a
                                                          locked-in basis); (2) the scheduled .settlement date must be no more than a prcestablished number of
                                                          business days after the date of comparison; (3) netting must occur on or before its scheduled date;
                                                          (4) data or each .side of the trade must be submitted by a netting member or an authorized locked-in
                                                          trade source; and (5) the underlying securities must be eligible for netting.

                                                          "Trades that have the same CUSIP number are netted together



                                                          Page 62                                    GAO/GGD-97-73 Payments, Clearance, and Settlement




                .' .^,   ^At:'^2^AiUu;'J^&d,.-'..'^-^ul
 Section 2: EquiUes, Treasuries, Futures, and Options • Treasuries
 Treasuries and the Fedwire Book-Entry
 Securities System




instructs the Federal Reserve wliich of its accounts to debit and which to
credit for the transfer of securities and payment.

 Once net settlement positions have been determined by GSCC, a netting
 member's clearing agent bank is informed by the netting member of the
 securities to be delivered to or received from GSCC and the payment
 against which those deliveries or receipts are to be made. If the member of
 GSCC is a clearing agent bank, then it would do this on its own behalf.
 To the extent such deliveries or receipts must occur between clearing
 agent banks, the clearing agent bank sends Fedvdre instructions to the
 Federal Reserve authorizing the Federal Reserve to transfer Treasury
 securities from its custody account (for the benefit of the net seller's
 account on the books of the clearing agent bank), to the account of the
 receiving clearing agent bank (for the benefit of oscc's account on the
 books of the receiving clearing agent bank).'^ This transfer is done in
book-entry form.
 GSCc's clearing agent bank then instantaneously redelivers the securities to
the net buyer's account on the books of its clearing agent bank. GSCC,
however, is not obligated to deliver securities to member buyers until it
receives securities from member seUers. Therefore, if a netting member's
clearing agent bank fails to deliver the securities for any reason (including
when the netting member does not have enough securities in its account),
GSCC fails to deliver securities to the net buyer member.
With respect to a clearing agent bank whose customer is a net seller of a
security, the clearing agent bank (or a bank member of GSCC acting on its
own behalf) will place a Fedwire securities delivery instruction to deliver
securities from the clearing agent bank's account at the Federal Reserve
Bank to the GSCC clearing agent bank's account at the Federal Reserve
Bank, unless the transfer can be made on an intrabank basis. The only
instruction necessary for transferring securities over Fedwire is made by
the deliverer of securities; therefore, the delivery instruction from the net
seller's clearing agent bank will result in a simultaneous debiting of funds
from the GSCC clearing agent bank's account at the Federal Reserve Bank
without any debit instruction from oscc's clearing agent bank. If a clearing
agent bank receiving securities has insufficient funds in its Federad
Reserve account to pay for the securities, the Federal Reserve Bank will
nonetheless complete the transfer (if it is within certain risk parameters),
and the clearing agent bank will incur a daylight overdraft in its account at
the Federal Reserve Bank.



'•The transfer of securities c -^ • :: done "intrabank," (i.e., both the net seller and GSCC use the same
clearing agent bank).



Page 63                                      GAO/GGD-97-73 Payments, Clearance, and Settlement
                                                   Section 2; Equities, Treasuries, Futures, and Options • Treasuries
                                                   Treasuries and the Fedwire Book-Entry
                                                   Securities System




Funds-Only Settlement                          The funds-only settlement is separate from the delivery and payment of
                                               the Treasury securities settlement. It pertains to the net debit or net credit
                                               dollar amount that each netting member owes or is due for its accounts.
                                               For example, settlement has to be made on margin or on any open net
                                               settlement position, and payment has to be made on other positions,
                                               including fail to deliver or fail to receive obligations, and transaction
                                               adjustment payments (TAP).-" The funds-only settlement occurs at 10:00
                                               a.m. and 11:00 a.m. each day and is made via the Fedwire funds transfer
                                               system. Unlike the Treasury securities settlement, GSCC will make a
                                               funds-only settlement whether or not it has received all funds-only
                                               settlement due it from members on that day.


                                               The Securities and Exchange Commission (SEC) oversees the actions of
Regulatory Oversight                           GSCC to determine whether it is functioning in accordance with the law £md
                                               SEC regulations.-' GSCC establishes the rules governing the clearance and
                                               settlement of Treasury securities that clear and settle through GSCC,
                                               subject to SEC approval.

                                              According to Federal Reserve officials, Treasury/government securities
                                              transactions are governed by a combination of federal and state law as
                                              well as Reserve bank operating circulars. Each agency that issues
                                              securities on Fedwire has promulgated regulations that establish a federal
                                              legal framework governing the transfer of rights and interests in
                                              book-entry securities by a Fedwire participant. These regulations also
                                              specify the status of Fedwire book-entry securities under state law, which
                                              applies to the transfer of rights and interests in the securities in the
                                              absence of governing federal law. In most cases, ucc Article 8 is the state
                                              law governing the settlement phase of securities transactions.


                                              For purposes of this report, we discuss some of the most important risks
Risk and Risk                                 and risk mitigations associated with treasuries.
Mitigation
                                              -"TAP refers to the dollar difference between the amount at which these securities arc to be delivered
                                              and received and the amount at which these securities arc traded. Since trades included in the netting
                                              process have been entered into at varying prices, in order for netting to work. GSCC must establish a
                                              single-system price for each CUSIP. GSCC docs so on each business day by use of cither a third-party
                                              source or by a par-weighted average for all compared trades in each CUSIP on that date. Tlic u.sc of
                                              this sy,stem's price—market price for all compared trades—(plus accrued interest) should cause the
                                              delivery and receipt of securities In occur at amounts that arc close to current market value, but
                                              different from c:ontract jmces.

                                              -'SEC is the primary agency that oversees GSCC, and the U.S. Treasury and the Federal Rcserv'e are
                                              considered to be "secondary" regulators, according to GSCC officials.



                                              Page 64                                    GAO/GGD-97-73 Payments, Clearance, and Settlement




         -..Aiij^a&ii^iM^SikilSsiii^iiiix^'tMkM^
                                           Section 2: Equities, Treasuries, Futures, and Options • Treasuries
                                           Treasuries and the Fedwire Book-Entry
                                           Securities System




                                          Because GSCC guarantees the trades of its members, it incurs risk from the
                                          time of the gucU'antee until the settlement of obligations and payments. As
                                          a result, GSCC incurs counterparty risk, but the amount at risk (or
                                          exposure) is dependent on fluctuations in the market.

Table 2.6: Risk and Risk Mitigation for
Treasuries                                Risk                                            Risk mitigation
                                          Counterparty/credit risk                          Requirement of strict membership
                                                                                            standards

                                                                                            Monitoring members' creditworthiness

                                                                                           ' Marking open positions to market prices

                                                                                           ' Maintaining a clearing fund
                                          Source: GSCC.




Risk: Counterparty/Credit                 When GSCC guarantees the matched trade, it becomes the buyer to every
                                          seller and the seller to every buyer. As a result, GSCC incurs counterparty
                                          risk—the possibility that the member buyer or member seller might
                                          default on its obligations.

                                          The cimount of counterparty risk that GSCC is exposed to is dependent on
                                          fluctuations in the market. If a member does not meet its settlement of
                                          obligations and payments, GSCC—because of the guarantee to the member
                                          buyer and member seller—must liquidate the member's position, and thus
                                          is exposed to market risk (the exposure to the possibility of financial loss
                                          caused by adverse changes in the value of securities).

Mitigation                                GSCC mitigates counterparty/credit risk by (1) setting strict admissions
                                          standards to determine that every member is creditworthy upon admission
                                          to GSCC and (2) routinely monitoring members' creditworthiness through
                                          financial reporting requirements and reviewing the clearing members'
                                          financial results.

                                          GSCC requires all unsettled securities or fail positions to be marked to
                                          market prices and payment is made by members to reflect changes in the
                                          market. The objective is to keep GSCC obligations as close to market prices
                                          as possible. In addition, GSCC requires members to contribute to a clearing
                                          fund that is designed to cover market risk exposure.




                                          Page 65                               GAO/GGD-97-73 Payments, Clearance, and Settlement
Section 2: Equities, Treasuries, Futures, and Options • Futures

Futures


                                       A futures contract obligates the holder to buy or sell a specific amount or
Description and Use                    value of an underlying asset, reference rate, or index (called the
                                       underlying) at a specified price on a specified future date.-- For instance, if
                                       an investor were to purchase a December futures contract, an agreement
                                      would be made to pay a specified price for a specified quantity of a
                                      commodity, such as wheat, metals, or live cattle, for delivery in December.
                                      The buyer (or seller) would have an obligation to purchase (or sell) the
                                      underlying commodity. However, the buyer could satisfy this obligation
                                      either by recei'ving and paying for the conunodity w hen the contract
                                      expired or by "offsetting"-^ the obligation prior to the contract expiring,
                                      which is how the majority of futures contracts are closed out. Futures
                                      previously were limited to commodities such as agricultural products and
                                      metals, but were extended in the 1970s to include financial futures on
                                      instruments such as Treasury bonds, foreign currencies, and stock
                                      indexes.

                                     Market participants may use futures to hedge their assets or liabilities, or
                                     to speculate on market movements by correctly anticipating price
                                     movements. According to market officials, the main function of a futures
                                     contract is to shift risks from those less willing or able to bear them to
                                     those more willing or able to do so.

                                     Participants in the clearance and settlement of futures contracts include
                                     exchanges, clearing organizations, clearing members, and settlement
                                     banks (or banks that settle exchange members' accounts). Futures are
                                     traded on 11 active exchanges in the United States. Nine futures clearing
                                     organizations serve the exchanges.

                                     F'utures clearing organizations may be either clearing houses, which are
                                     departments within an exchange, or clearing corporations, which are
                                     separately incorporated and independent from the exchange. During this
                                     report, we spoke to the Chicago Mercantile Exchange (CME) Clearing
                                     House Division and the Chicago Board of Trade (CBT) Board of Trade
                                     Clearing Corporation (BOTCC). For purposes of clarity, we will refer to the
                                     CME Clearing House Division and BOTCC as clearing organizations.




                                     -Underlyings include stocks, bonds, agricultural and other physical conunodities, interest rates,
                                     foreign-currency rates, and stock indexes.

                                     ''Offsetting means liquidating a purchase (sale) of futures contracts through the sale (purchase) of an
                                     equal number of futures contracts with the same delivery month, thus closing out a position.



                                     Page 66                                    GAO/GGD-97-73 Payments, Clearance, and Settlement
 Section 2: Equities, Treasuries, Futures, and Options • Futures
 Futures




Clearing members arefinancialinstitutions (generally large futures
brokers) that transact with the clearing organizations; all futures
customers and nonclearing members use a clearing member to clear their
trades through a clearing organization. Clearing members must belong to
the exchanges.

Settlement banks maintain the clearing accounts for the clearing
organizations through which pajmnents and deposits are made either to or
from clearing members' accounts to or from the clearing organizations.
Settlement in the futures market usually pertains to cash flow payments
that reflect changes in the market price. The clearing organization officials
we spoke to said they have designated up to eight banks as settlement
banks.




Page 67                               GAO/GGD-97-73 Payments, Clearance, and Settlement
                                  Section 2: Equities, Treasuries, Futures, and Options • Futures
                                  Futures




Key Terms
                                  A floor broker executes trades for customers and may also execute trades for
Q   Floor broker                  their personal or employer accounts.

                                  A floor trader executes trades only for their personal accounts. A floor trader is
    Floor trader                  also referred to as a "local.",

                                  A futures contract obligates the tiolder to buy or sell a specific amount or value
    Futures                       of an underlying asset, reference rate, or index (called the underlying) at a
                                  specified price on a future date. Underlying assets include stocks, bonds,
                                  agricultural and other physical commodities, interest rates, foreign-currency
                                  rates, and stock indexes.

    Futures commission merchant   A futures commission merchant is an individual, association, partnership,
                                  corporation, and trust that solicits or accepts orders for the purchase or sale
                                  of any commodity for future delivery on or subject to the rules of any contract
                                  market and that accepts payment from or extends credit to those whose
                                  orders are accepted. A futures commission merchant is the equivalent of a
                                  brokerage house in the securities industry.

I I I Hedging                     Hedging means to protect oneself from market risk. Typically, hedgers have
                                  a position in the underlying commodity and use futures or options on futures
                                  to create an opposite position.

Q   Offsetting                    Offsetting means liquidating a purchase (sale) of futures contracts through the
                                  sale (purchase) of an equal number of futures contracts with the same delivery
                                  month, thus closing out a position.

    open outcry                   Open outcry is a competitive system in which floor participants verbally make
                                  bids and offers to each other at centralized exchange locations.

    Options on futures            An option on a futures contract gives an investor the right but not the obligation,
                                  in exchange for a price (called a premium), to buy or sell a specified futures
                                  contract at a specific price (called the exercise price) within a specified period.

Q   Speculating                   Speculating means to take on risk in an attempt to profit from changes in the
                                  values of financial instruments.


                                  According to clearing organization officials, about 80 percent of the
Basic Data                        futures trading volume in the United States occurs at CBT and CMR. CI3T has
                                  its own separately incorporated clearing house—noTcc—and cMic has a
                                  clearing house division. Both clear and settle futures and options on
                                  futures traded on their respective exchanges.



                                  Page 68                              GAO/GGD-97-73 Payments, Clearance, and Settlement
                                     Section 2: Equities, Treasuries, Futures, and Options • Futures
                                     Futiures




Table 2.7: Data on BOTCC and CME,
1995                                                                                                                           Number of
                                                                                  Number of                                    options on
                                                                                      futures                                      futures
                                                                                   contracts         Average daily              contracts
                                                            Number of            cleared and            number of             cleared and
                                    Clearing                  clearing            eventually               futures             eventually
                                    organization                 firms                 settled           contracts                  settled
                                    BOTCC                            124         202,429,356                920,133            65,536,849
                                    CME                               83         159,787,862                634,079            43,366,350
                                    Sources: CME and BOTCC.




                                    Futures trade, clear, and settle in what is knowTi as "T-i-O"—trades are
Processes                           done with same-day settlement. The "T" represents the trading, clearing,
                                    and settlement in one 24-hour period, starting at 6:40 a.m. csT and ending
                                    24 hours later at 6:40 a.m. The: "0" indicates that there are no additional
                                    days in the process.


The Trading Process                 Most trading in the futures markets is done on the floor of the futures
                                    exchanges. The exchanges operate as auction markets where prices are
                                    determined by "open outcry." Trading is done in a tiered area of the
                                    exchange floor, called a "pit!" In addition, electronic trading may occur
                                    during regular trading hours and/or during a night session.-"* Trades done
                                    electrorucally are automatically matched and then settled in the same
                                    manner as are pit trades.

                                    Two types of traders execute trades on the floor of an exchange: (1) floor
                                    traders, or locals, are members of the exchange-^ and (2) floor brokers
                                    who may be independent or may be employees of firms referred to as
                                    futures commission merchants (FCM), which are members of the exchange.
                                    Floor traders trade exclusively for their own accounts. Floor brokers
                                    transact on the floor of the exchange on behalf of customers.-"




                                    -^Electronic trading occurs on "Project A" at CBT and on "GLOBE.X" at CME.

                                    -''Locals may lease a scat on the exchange and, thus, they themselves may not ho a member of the
                                    exchange.

                                    -"In addition, floor brokers may execute customer orders and trade for themselves or their finn's
                                    account (proprietary trading) during the same trading .session under limited circumstances, a practice
                                    referred to by industry officials as "dual trading."



                                    Page 69                                    GAO/GGD-97-73 Payments, Clearance, and Settlement
                                  Section 2: Equities, Treasuries, Futures, and Options • Futures
                                  Futures




The Clearing Process              The clearance of futures involves capturing, matching, and guaranteeing
                                  trades. Clearing organizations also clezu: and settle options on futures,
                                  which go through a clearance and settlement process similar to those of
                                  futures contracts.

Table 2.8: Steps in the Futures
Clearing Process                  Steps                                                  Clearing process
                                  (1) Capturing the trade data                           Clearing firms (FCMS)/traders input their
                                                                                         trade data to the clearing organizations."
                                  (2) Matching the trade data                            After receiving the trade data, the clearing
                                                                                         organizations match the data. Soon after
                                                                                         the trade data are submitted, the data are
                                                                                         matched.
                                  (3) Guaranteeing the trade                             Once pit trades have been matched, the
                                                                                         clearing organizations guarantee the
                                                                                         trades." The clearing organizations
                                                                                         guarantee to the clearing members that
                                                                                         the settlement obligations of the trade will
                                                                                         be met.
                                  'Electronic data do not have to be captured.

                                  "Clearing organizations also guarantee trades of the exchange of futures for the underlying
                                  physical asset, but the guarantee does not become effective until after the day of trie trade.

                                  Sources: CBT and CME.




The Settlement Process            On a day-to-day basis, the settlement of futures refers to the settlement
                                  payment of funds between the clearing members and the clearing
                                  organization.-^ There are two types of payments included in the daily
                                  settlement in the futures market: (1) the performance bond (also referred
                                  to as a margin deposit or "good faith" deposit) and (2) the variation
                                  settlement (also referred to as the mark-to-mcirket).




                                  -'The final closeout of a futures contract occurs by (1) settlement by delivery, (2) cash settlement, or
                                  (3) settlement by offset. For futures contracts in which the underlying physical asset is to be delivered
                                  (settlement by delivery), the clearing organization ensures that delivery and payment is made. Futures
                                  may also be settled by cash settlement rather than actual physical delivery. Cash settlement means
                                  that the buyer receives the cash value of the physical a.sset instead of the physical asset. For
                                  settlement by offset, an order would be entered to sell (or purchase) futures contracts of the same
                                  delivery month purchased (or sold) during the earlier transaction. The difference in value at liquidation
                                  is simply credited to or debited from the clearing member's account.



                                  Page 70                                     GAO/GGD-97-73 Payments, Clearance, and Settlement
                                      Section 2: Equities, Treasuries, Futures, and Options • Futures
                                      Futures




Table 2.9: Two Types of Settlement
                                     Type                        Settlement
                                     Performance bond or         Every clearing member has to post performance bonds with the
                                     margin deposit)^            clearing organization. Performance bonds cover the anticipated
                                                                 one-day loss that a clearing member's portfolio and its customers
                                                                 open positions might incur. The amount required is based on the
                                                                 value of the clearing member's open positions and an
                                                                 assessment of the amount of risk those contracts involve.
                                                                 Performance bonds are calculated at least twice each day for
                                                                 each clearing member at BOTCC and CME. If the performance
                                                                 bond is below the level established by the clearing organization,
                                                                 the clearing member must make a deposit.''
                                     Variation settlement        In addition to the performance bond, clearing members are
                                                                required to meet variation settlements—the amount that is
                                                                required when the clearing member's open positions are marked
                                                                to the market prices. At least twice a day at the BOTCC and
                                                                CME, the clearing organizations determine a settlement price for
                                                                each type of futures and options on futures contracts and mark
                                                                all open positions to that price, and payment is made to reflect
                                                                the change in market prices. By marking open positions to the
                                                                market price each day, clearing organizations prevent losses and
                                                                gains from accumulating over time.
                                     "Clearing organizations calculate the performance bond either on a gross or net basis. Gross
                                     margining requires clearing members to post margin on all of the long (buy) and short (sell)
                                     positions in their accounts. The long and the short positions cannot be used to offset each other
                                     in the case of a deficiency. Net margining requires margin to be posted on the difference
                                     betvi^een all long and short positions, calculated separately for the clearing members' accounts
                                     and its customers' accounts.

                                     "Clearing organization officials said that if a clearing member's performance bond is below a
                                     certain level and that member is to receive a variation margin settlement profit from the clearing
                                     organization, then the clearing organization will keep the profit and apply it toward the clearing
                                     member's performance bond.

                                     Sources: CBT and CIVIE data.



                                     Figure 2.2, along with the information that follows, describes in a
                                     condensed manner the events that take place during the T-t-0 trading,
                                     clearance, and settlement cycles.




                                     Page 71                                   GAO/GGD-97-73 Payments, Clearance, and Settlement
                                    Section 2: Equities, Treasuries, Futures, and OpUons • Futures
                                    Futures




Figure 2.2: The 24-Hour Trading,
Clearance, and Settlement Cycle                                                     Noon




                                   w   Clearance
                                                                                        12
                                                                                   Midnight
                                                                                                                    Trading
                                       and settlement cycle
                                                                                                                    7:20 a.m. Regular trading
                                       6:40 a.m.   Banks commit lo pay                                                        begins
                                                   final settlement ol
                                                   previous day's trades                                            2:00 p.m. Regular trading
                                                                                                                              endso
                                       11:30 a.m. Matched trades
                                                  submined at CME
                                                                                                              N ^
                                       12:15 p.m.
                                       12:30 p.m. Market price CME
                                                  uses in intraday
                                                  settlement
                                       1:30 p.m.   Match trades
                                                   submitted at BOTCC
                                       2:00 p.m.   Market price BOTCC
                                                   uses in intraday
                                                   settlement
                                       2:30 p.m.   Intraday settlement
                                                   made at BOTCC
                                       3:00 p.m.   Intraday settlement
                                                   made at CME
                                       8:00 p.m.   Final clearing begins
                                       11:00 p.m. Final settlement
                                                  calculated at CME
                                                                                   Nole: For clarity, this figure represents a condensation of the
                                       3:00 a.m.   Final settlement                clearance and settlement cycle.
                                                   calculated at BOTCC




                                                                           I
                                                                                 ^ Electronic trading, such as "Project A" (CBT) and "GLOBEX"
                                       6:40 a.m.   Banks commit to pay             (CME). may occur during regular trading hours and/or during E
                                                   final settlement               nigiit session.

                                                                                  Source: GAO analysis ol CBT and CME data.




                                   Page 72                                     GAO/GGD-97-73 Payments, Clearance, and Settlement
                            Section 2: EquiUes, Treasuries, Futures, and Options • Futures
                            Futures




The 24-Hour Cycle
Hours                      Cycle

6:40 a.m. (CST)            The 24-hour cycle begins—settlement banks corrunit to pay or receive final
                           settlement on behalf of clearing members for the previous day's trades.^*

7:20 a.m.                  Regular trading begins at the exchanges.

11:30 a.m.                 For CME, trades that have been matched since the start of the day plus any
                           ac^justments to existing positions are used in CIVIE'S intraday settlement
                           calculation.

.12:15 p.m.-12:30 p.m. '   The market price is determined and is used in the intraday settlement
                           calculation at CME.

1:30 p.m.                  For I30TCC, trades that have been matched up vmtilthis time are used in
                           liOTCC's intraday calculation.

1:30 p.m.-2:00 p.m.        Clearing organizations calculate an intraday-settlement and transmit
                           reports showing the amounts of what is owed to or from the clearing
                           members to the settlement banks.^^ BOTCC uses the market price at
                           2:00 p.m. for its intraday settlement.

2:00 p.m.                  Regular trading ends at the exchanges in most pits.

2:15 p.m.                  BOTCC's intraday settlement is made by settlement banks on behalf of
                           clearing members.




                           -"The seltlcrnenl banks' commitment is irrevocable and will occur whether or not Fedwire opens. The
                           settlement amminl results from the previous days' trading and includes settlement on margin deposit
                           changes and mark-to-markct calculations done up to a specific time before 6:40 a.m. All payments
                           between settlement banks are made in Fedwire funds.

                           -""nie ii\triKlay selt.len\enl, includes the daily mark to market of all open positions to the current market
                           price variation seltlonicnt for the purjioscs of collecting the changes in market prices, including trades
                           executed (luring the electronic trading sessions, and the current day's trades matched before
                           10:30 a.m. at CME and 1:30 p.m. at BOTCC. In addition, at CME, if the performance bond is below a
                           l)anicular level, clearing members must make a deposit on that as well. BOTCC requires performance
                           bond settlements at 6:40 am. only.



                           Page 73                                      GAO/GGD-97-73 Payments, Clearance, and Settlement
                        Section 2: Equities, Treasuries, Futures, and Options • Futures
                        Futures




3:00 p.m.              CME'S intraday settlement is made, which is similar to its 6:40 a.m.
                       settlement.

8:00 p.m.              Final clearing begins at the clearing organizations.

11:00 p.m.             Final settlement is calculated at CME. Reports are sent to the settlement
                       banks.

3:00 a.m.              Final settlement is calculated at BOTCC and includes all-night trading done
                       up until 3:00 a.m. Reports are sent to the settlement banks.

6:40 a.m.              Settlement banks inform the clearing organizations that they will commit
                       to pay on behalf of the clearing members, ending the 24-hour clearance
                       and settlement cycle.


                       The Commodity Futures Trading Commission (crrc) oversees the actions
Regulatory Oversight   of the self-regulatory organizations—the clearing organizations and the
                       exchanges—to determine whether they are functioning in accordjmce with
                       the law and crrc regulations. Futures clearing organizations are
                       responsible for establishing the rules governing the clearance and
                       settlement of futures and options on futures, which are subject to approval
                       byCFTC.^"



                       For purposes of this report, we discuss some of the most important risks
Risk and Risk          and risk mitigations associated with futures.
Mitigation
                       Clearing organizations are exposed to risk from the time they guarantee
                       settlement obligations to the time clearing members make settlement
                       payments or offset (liquidate) their positions. As a result, clearing
                       organizations are exposed to counterparty risk, but the amount at risk (or
                       the exposure) is dependent on fluctuations in the market.




                       "At CME, the exchange establishes the rules that cover the Clearing House Division.



                       Page 74                                   GAO/GGD-97-73 Payments, Clearance, and Settlement
                                                            Section 2: Equities, Treasuries, Futures, and Options • Futures
                                                            Futures




Table 2.10: Risk and Risk Mitigation for                    ^ ^
Futures                                                    Risk                                            Risk mitigation
                                                           Counterparty/credit risk                        • Set admission standards

                                                                                                            • Monitor clearing members'
                                                                                                              creditworthiness

                                                                                                            • Audit departments

                                                                                                           • Capital requirements

                                                                                                            • Require performance bonds and
                                                                                                              variation margin settlements
                                                           Sources: CBT and CME.




Risk: Counterparty/Credit                                  When the clearing organization guarantees the matched trade, it becomes
                                                           the buyer to every clearing member seller and the seller to every clearing
                                                           member buyer; this process is called novation. As a result, the clearing
                                                           organization incurs counterparty risk—the possibility that the clearing
                                                           member buyer or seller might default on its obligations.

                                                          The amount of counterparty risk that clearing organizations are exposed
                                                          to is dependent on fluctuations in the market. If a clearing member does
                                                          not make settlement payments, the clearing organization^because of the
                                                          guarjintee to the clearing member buyer and the clearing member
                                                          seller—must liquidate the clearing member's positions, but until it does so,
                                                          the clearing organization is exposed to market risk (the exposure to the
                                                          possibility of financial loss caused by adverse changes in the value of
                                                          futures contracts).

Mitigation                                                Clearing organizations mitigate counterparty risk by (1) setting adrrussions
                                                          standards to determine that every clearing member is creditworthy upon
                                                          admission to the clearing organization, (2) routinely monitoring clearing
                                                          members' creditworthiness through financial reporting requirements and a
                                                          review of the clearing members' trading results, (3) having their audit
                                                          departments go through a prescribed set of audit tests for each clearing
                                                          member, and (4) having clearing members comply viath exchange rules for
                                                          minimum capital requirements. In addition, clearing organizations require




                                                          Page 75                                 GAO/GGD-97-73 Payments, Clearance, and Settlement




                     Mi-'flrtijitek^toi'a^.lklajt.m.v,.^ .v.. ;.L..it«'
                                                       Section 2: Equities, Treasuries, Futures, and Options • Futures
                                                       Futures




                                                      (1) performance bonds that they consider sufficient to cover the maximum
                                                      1-day loss that a clearing member's portfolio rtught incur and (2) variation
                                                      settlements in which all futures contracts are marked-to-market prices and
                                                      payment is made to reflect the change in market prices. (See earlier
                                                      section on settlements for further detail.)




                                                      Page 76                               6AO/GGD-97-73 Payments, Clearance, and Settlement




^,^ii^^iitli,SlMiiM^liktti&>.t}iMfMiillitfi,^.A.--'
Section 2: Equities, Treasuries, Futures, and Options • Options

Exchange-Traded Options


                                      options contracts give holders the right but not the obligation, for a price,
Description and Use                   called a premium, to buy or sell an underlying stock or other financial
                                      instrument at a specified price, called the "exercise" or "strike" price,
                                      before a specified expiration date. Options can be used to protect
                                      investors against losses in investments they ov^n, lock in profits on
                                      positions they already have, or speculate on expected price movements.

                                      An options contract can be terminated in three ways: (1) expiration,
                                      (2) exercise, or (3) closeout—the holder of the option enters into an equal
                                      and offsetting option contract. Options are usually bought and sold
                                      vdthout being exercised.

                                      Settlement in the options markets usually pertains to margin settlement,
                                      which is a payment that reflects changes in the value of the option. There
                                      is also a premium settlement that pertains to the amount that must be paid
                                      to buy the option, and an exercise and assignment settlement that pertains
                                      to an option that is exercised.

                                      The Options Clearing Corporation (occ) clears and settles all options
                                      traded on securities exchanges in the United States and is owned by five
                                      participating exchanges.^' All exchange-traded options are clecued and
                                      settled through occ. Exchange-traded options include options such as
                                      equity options, currency options, and equity index options.
                                      Over-the-counter (OTC) options, which are privately negotiated, also exist.
                                      For the purposes of this section, we will only discuss exchange-traded
                                      options.

                                      Exchange-listed options on futures are cleared and settled through futures
                                      clearing organizations. However, occ officials said that they clear and
                                      settle some options on futures through one of their subsidiaries for three
                                      exchanges. (See the section on the clearance and settlement of futures for
                                      further detail.)

                                      Participants in the clearance and settlement of options include exchanges,
                                      occ and its members (referred to as clearing members), and settlement
                                      banks (or banks that settle clearing members' accounts).

                                      Figure 2.3 illustrates an options listing, with an explanation of its various
                                      components.



                                      "Exchanges include the Chicago Board Options Exchange, American Stock Exchange, Philadelphia
                                      Stock Exchange, New York Stock Exchange, and the Pacific Stock Exchange.



                                      Page 77                                 GAO/GGD-97-73 Payments, Clearance, and Settlement
                                                    Section 2: Equities, Treasuries, Futures, and Options • Options
                                                    Exchange-Traded Options




Figure 2.3: An Options Listing


              Strike price is the price the underlying stock will be bought and sold for. For example, the
                           Exxon Call will give you the right to buy Exxon shares at $80, $85, and $90.
                           So, at a Strike Price of $90, you could buy 100 shares of Exxon for $9,000.

                        f Expiration of the call and put options contracts.

                                    11 Volume of the call options traded.
                                              Premium (price of the option) for a call option. The price of an 80
                                                      Jan option is 8 1/2 ($8.50) per share, which makes the
                                                      options contract price $850 ($8.50 x 100 shares).


                                                       11 Volume of put options traded.

                                                               (I Premium for put options.




   • Closing price of the underlying stock for each row of strike prices.
                   In the example, Exxon's stock is worth 87 1/2 or $87.50 per share.
                   Options buyers bid or make offers in 100 shares per option contract.


'' Name of the undedying stock.

                                                   Source; GAO Analysis.




                                                   Page 78                                    GAO/GGD-97-73 Payments, Clearance, and Settlement
                          Section 2: Equities, Treasuries, Futures, and Options • Options
                          Exchange-Traded Options




Options Can Be Used to   An investor who wanted to limit potential losses in investments already
Limit Losses or Make     owned might purchase a "put option." If an investor owns 100 shares of
Profits                  Exxon stock valued at 87 1/2 ($87.50) a share—and wants to hold the
                         stock in case the price of the stock rises—but thinks that the price of the
                         stock may fall below $80, the investor might purchase an "80 Jan Put,"
                         which will give the investor the right to seU Exxon stock at a locked-in
                         seUing price of $80 per share at any time before the option expires at
                         11:59 a.m. EST on the third Saturday of January. If an investor wanted to
                         make a profit and thought that the Exxon stock might rise above $90 a
                         share, the investor might buy a "90 Oct Call" at a locked-in buying price of
                         $90 a share. If the price rises above $90 a share, the investor can exercise
                         his or her right to buy Exxon stock at $90 a share. The investor can then
                         profit by reselling the shares at the market price. The investor could also
                         sell the option contract at a profit.




                         Page 79                               GAO/GGD-97-73 Payments, Clearance, and Settlement
                           Section 2: Equities, Treasuries, Futures, and Options • Options
                           Exchange-Traded Options




Key Terms
Q   Call opt ion          A call option is a contract that gives one the right, but not the obligation, to buy
                          a specified amount of an underlying asset, such as stocks or currency, at a
                          specified price by a certain date.

    Clearing member       A clearing mennber Is a financial institution that OCC determines is qualified to
                          interact with it on behalf of nnarket participants.

    Currency option       A currency option is a contract that gives one the right, but not the obligation,
                          to buy or sell a foreign currency at a particular price within a specified period.

Q   Equity index option   An equity index option is an option covering the price of a diversified stock
                          portfolio that matches a designated stock-index (a statistical indicator used
                          to measure changes in stock groupings).

    Exercise              Exercise means to make use of the "rights" in the options contract. For
                          instance, a buyer of a call option may exorcise the right to buy the underlying
                          asset at the particular price agreed upon (called the exercise or strike price)
                          when the contract was purchased.

Q   Floor broker          A floor broker executes trades for customers and may also execute trades
                          for their personal or employer accounts.

Q   Open outcry           Open outcry is a competitive system in which floor participants verbally make
                          bids and offers to each other at centralized exchange locations.

    Order-book official   An order-book official is an exchange official who accepts and executes limit
                          orders from customers-orders to buy or sell when the market reaches a certain
                          price.

Q Premmm                  The premium Is the amount that the buyer of an option pays the writer (or seller)
                          of the option.

    Put option            A put option is a contract that gives one the right, but not the obligation, to sell a
                          specified amount of an underlying asset, such as stocks or currency, at a
                          specified price by a certain date.




                          Page 80                               GAO/GGD-97-73 Payments, Clearance, and Settlement
                                              Section 2: Equities, Treasuries, Futures, and Options • Options
                                              Exchange-Traded Options




| y Registered option traders                 Registered option traders are those who trade on the exchange floor for their
                                              own account but have an obligation, similar to that of specialists, to make
                                              markets.

Q   Series of options                         A series of options consists of options of the same class that also have the
                                              same unit of trade, strike price, and expiration date.

    Settlement banks                          Settlement banks maintain the settlement accounts for clearing members
                                              whereby payments and deposits are made.

    Stock option                              A stock option gives the holder the right to purchase or sell a certain number of
                                              shares of stock at a particular price within a specified period.

03 Writer                                     An options seller is called a writer of options, a "covered" writer if owning
                                              the underlying asset and a "naked" writer if not. The writer of an option is
                                              obligated to sell (call option), or buy (put option), a specified amount of the
                                              underlying asset at a predetermined price when the buyer, or holder, exercises
                                              the option. The writer receives a premium paid by the buyer.



                                             According to occ officials, occ has 147 clearing members composed of
Basic Data                                   broker-dealers owned by U.S. securities firms and some of the major
                                             foreign banks and investment houses.

                                             As shown in table 2.11, occ clears and settles millions of options contracts
                                             annually. The primary type of option that occ clears and settles is the
                                             equity, or stock option, occ also clears a substantial portion of equity
                                             index options and a small portion of currency options.




                                             Page 81                               GAO/GGD-97-73 Payments, Clearance, and Settlement




             . .^^^a>iMMlii&i^-:iii)d»»^<ii,£Mf!^
                                     Section 2: Equities, Treasuries, Futures, and Options • Options
                                     Exchange-Traded Options




Table 2.11: Total Volume of
Exchange-Traded Options Contracts                              Total
Cleared In 1995                                            volume of                          Average         Average           Average
                                    Types of               contracts   Percent of                dally        dally call        dally put
                                    options                 cleared* total volume             volume"          volume"          volume"
                                    Equity options              174.4             60.7%           692.0        .   491.3 .        • 200.7
                                    Equity index
                                    options                     107.9             37.6            428.1            191.6            236.4
                                    Currency
                                    options                       5.0               1.7            19.8              8.7                n.o
                                    Total                      287.3               100%         1140.1             691.8            448.2
                                    "Volume in millions.

                                    "Volume in thousands. Columns do not total because ttie totals include interest rate options that
                                    are not included in the table.

                                    Note: Numbers based on 1995 data.

                                    Source: OCC data.




                                    Options trade, clear, and settle in what is known as "T+1"—i.e., options
Processes                           are settled one day after (+1) the day in which they were traded, with the
                                    "T" standing for the day of the trade.


The Trading Process                 Individual investors who want to purchase a call or put opdon may do so
                                    through a broker. The broker usually has a floor broker execute the trade
                                    on behalf of the customer. Exchanges also have automatic order execution
                                    systems for public customer orders.

                                    Trading in the options markets is done on the floor of options exchanges.
                                    The exchanges operate as auction markets. U.S. exchanges that trade
                                    options operate with either (1) competing market makers (dealers) for
                                    each class of options and exchange officials such as floor brokers or order
                                    book officials or (2) designated market makers for each class of options,
                                    with additional market making pro'vided by registered options traders.




                                    Page 82                                   GAO/GGD-97-73 Payments, Clearance, and Settlement
                       Section 2: Equities, Treasuries, Futures, and Options • Options
                       Exchange-Traded Options




The Clearing Process   occ officials said that their clearance and settlement process starts when
                       the exchanges provide coinputer data on matched trades—trades in which
                       the sell side and the buy side of the trade have been compared and
                       matched. (See table 2.12.)




                       Page 83                               GAO/GGD-97-73 Payments, Clearance, and Settlement
                                                 Section 2: Equities, Treasuries, Futures, and Options • Options
                                                 Exchange-Traded Options




table 2.12: Steps In the Options
Clearing Process                                Steps                                                    Clearing process
                                                (1) OCC receives nnatctied-trade data from               (a) Exchanges subnnit the matched-trade
                                                the exchanges via computer.                              data in a batch-once-a-day mode via
                                                                                                         computer to OCC no later than 1:00 a.m.
                                                                                                         after the day of the trade for clearance and
                                                                                                         settlement.purposes."
                                                                                                         (b) OCC officials said that their clearance
                                                                                                         system runs independently for each opions
                                                                                                         exchange, so that a problem at one
                                                                                                         exchange does not affect the other options
                                                                                                         exchanges.
                                                (2) OCC then guarantees the matched                      (a) When OCC has the matching trade
                                                trades.                                                  data, it issues a new contract and
                                                                                                         becomes the buyer to every seller and the
                                                                                                         seller to every buyer. This process is
                                                                                                         called novation.
                                                (3) OCC then performs what is known as                   (a) Exercise and assignments occur when
                                                exercise and assignment on a random                      a holder decides to exercise his or her
                                                basis. OCC receives an exercise notice from              rights to buy or sell the underlying asset."
                                                the holder's broker and then assigns the                 Because OCC keeps the records of all of
                                                exercise notice to one of its clearing                   its clearing members, when a holder
                                                members.                                                 decides to exercise its right to buy or sell
                                                                                                         an underlying asset, its broker has to
                                                                                                         submit an exercise notice to OCC.
                                                                                                         (b) OCC assigns the exercise notice to a
                                                                                                         clearing member that has a position in the
                                                                                                         unit of trade, which in turn assigns one or
                                                                                                         more of its customers who hold positions in
                                                                                                         that series of options.
                                                                                                         (c) The assigned clearing member is then
                                                                                                         obligated to sell o r b u y the underlying
                                                                                                         asset at the specified strike price.=
                                                "Exchanges also send OCC intraday trade information that OCC uses for risk management. But
                                                for clearance and settlement, exchanges submit trade data to OCC in a batch once a day. If an
                                                exchange is unable to provide matched trade information by the final deadline, OCC allows
                                                additional time.

                                                "If an option is held until it expires and it is not in the interest of the option holder to exercise the
                                                option at expiration, then OCC.does not settle the option. However, if the holder decides to
                                                exercise the option on the date of expiration, then the option goes through OCC's exercise and
                                                assignment process.

                                               . '^In the case of equity options, OCC then arranges with a slock clearing corporation (or the
                                                 delivery of the shares of stock instead of the exerci-se settlement amount. All other DVP for options
                                                 are exercised within OCC.

                                                Source: OCC.




                                                Page 84                                       GA6/GGD-97-73 Payments, Clearance, and S e t t l e m e n t




               rwsrWiP mS^viff.-J.swft'TSt-"
                                       Section 2: Equities, Treasuries, Futures, and Options • Options
                                       Exchange-Traded Options




Settlement Process                    OCC calculates the amount of money that is owed by buyers and due
                                      writers the day after a trade (T-fl). In the case of the buyer, the entire
                                      amount of money owed to occ is the amount of the premium which, while
                                      first paid to occ, is then passed on to the writer of the option. In the case
                                      of the writer, settlement refers to two settlement amounts (1) premium
                                      settlement and (2) margin settlement.'''- On the day after the trade (T+1),
                                      OCC notifies the buyer of the amount of cash premium that is due; at the
                                      same time, the writer of the option is notified by occ of the amount of
                                      margin that is due. Both amounts are due on T+1. (See table 2.13)

Table 2.13: two Types of Settlement
                                      Participant                           Type of settlement
                                      Buyer                                 Premium settlement (in this case it is the price the buyer
                                                                            pays for the option).
                                      Writer                                (1) Premium settlement.
                                                                            (2) Margin settlement."
                                      =OCC calculates the margin that the writer has to provide using its Theoretical Intermarket Ivlargin
                                      System, which is an option pricing model that estimates what it would cost to liquidate an option
                                      given the size of a margin interval. According to an OCC official, the margin interval is the range
                                      of potential market scenarios over which the risk of the option is being evaluated by OCC.

                                      Source: OCC.



                                      At the end of each trading day, occ calculates the net amount that each
                                      member either owes or is owed. The net figure includes (1) the cash
                                      premium that the writer is due on each option sold and (2) the margin due
                                      for each open position—a position that has not been exercised by buyers
                                      or holders.

                                      As shown in table 2.13, the first component of the writer's settlement is the
                                      premium settlement due to the writer, which is the price at which the
                                      writer sold the option to the buyer. This settlement should reflect the
                                      current market price at the time of the trade. The premium settlement is
                                      due on the day after the trade (T+1).




                                      •'-"ITie I'itial .seUlement. of an option can lie done either by (!Xcrci.so/;Lssignnicnl or liy closennl. OCC
                                      ofricials said llialonly alioul. 10 percent of options contracl-s are uxiTci.sed/a.ssij;ne(l. If a holder
                                      decided to close out il.s options ijrinr lu expiration, the holder would sell thai option in the market. The
                                      option sold would be coded as a closeout option .so that OCC's clearance and settlement system would
                                      eliminate the holder's open position.



                                      Page 85                                      GAO/GGD-97-73 Payments. Clearance, and Settlement
 Section 2: Equities, Treasxuies, Futures, and Options • Options
 Exchange-Traded Options




The second component of the vsriter's settlement is the margin settlement,
which is like a "good faith" deposit. One part of the margin settlement is
the daily mark-to-market value of the option, which reflects the current
market price of the option. For instance, as an option's price gains in
value, the options writer pays margin to occ and the buyer of the option
gets a margin credit. If the options contract loses value, occ reduces the
amount of margin required from the writer.*' The other part of the margin
settlement is the daily risk value of the option, which reflects the potential
change in the current market price of the option, occ calculates and
collects the margin settlement from the option writer until the option is
terminated.


Figure 2.4, along with information that follows, describes in a condensed
manner the events that take place during the T+1 trading, clejirance, and
settlement cycle.




'•'Because the buyer of an option does not have to exercise the option contract unless it is in his or her
favor, the buyer does not owe OCC money if the option price moves against him or her. Thus, if the
price of the option continues to move against him or her, the option's buyer—by not having to exercise
the options-only loses the premium settlement amount.


Page 86                                     GAO/GGD-97-73 Payments, Clearance, and Settlement
                                      Section 2: Equities, Treasuries, Futures, and Options • Options
                                      Exchange-Traded Options




Figure 2.4: T+1 Trading, Clearance,
and Settlement Cycle




                                        I a.m




                                                                          1         12    11
                                                                                 Midnight

                                                 e-  Clearance
                                                     and settlement cycle
                                                                                                Trading
                                                                                                8:30 a.m. Trading begins
                                                     6:00 a.m. OCC notilies
                                                               settlement banks of              3:10 p.m. Trading ends
                                                               final settlement
                                                               amounts                          6:00 p.m.   Currency option
                                                                                                            trading begins and
                                                     9:00 a.m. OCC paid final                               will end at 2:00 p.m.
                                                               settlement                                   the next day
                                                                                                            (20 hours later)
                                                     10:00 a.m. OCC pays final
                                                                settlement
                                                     8:00 p.m. Matched trade data
                                                               submitted to OCC                                                     HM
                                                     3:00 a.m. Margin requirements
                                                               are calculated




                                      Source: GAO analysis of OCC data.




                                      Page 87                                    GAO/GGD-97-73 Payments, Clearance, and Settlement
                           Section 2: Equities, Treasuries, Futures, and Options • Options
                           Exchange-Traded Options




Trading, Clearance, and
Settlement Cycle
Hours                      Cycle

6:00 a.m. (CST)            Settlement banks are notified of the final—margin and
                           premium—settlement amounts due from each clearing member, resulting
                           from the previous day's trading.

8:30 a.m.                 Trading begins for stock and stock index options at the exchanges for the
                          new trade day (T).^'*

9:00 a.m.                 All final settlement amounts are due to occ by each clearing member for
                          the previous day's trading—the T+1 settlement.

10:00 a.m.                OCC pays final settlement due members, resulting from the previous day's
                          trading—also T+1 settlement, occ does not pay members money owed
                          them until it has received the money it is owed at 9:00 a.m.

3:15 p.m.                 Trading ends for stock and stock-index trading.

6:00 p.m.                 Currency option trading begins, and it viall end at 2:00 p.m. the next day
                          (20 hours later).

                          Exchanges submit matched-trade data to occ until 1:00 a.m. Currency
8:00 p.m.
                          option trade data from the previous day's trading are processed along with
                          the stock and stock-index option data.

                          occ updates the clearing members' positions for the end of the trading
3:00 a.m.
                          session and calculates the members' settlement requirements, both margin
                          and premium. This settlement amount will be the final settlement that is
                          due by the clearing members at 9:00 a.m. and paid by occ at 10:00 a.m.,
                          which will end the T+1 trading, clearing, and settlement cycle.




                          "The Pacific Stock Exchange operates from 6:00 a.m. to 1:50 p.m. Pacific Time.



                          Page 88                                   GAO/G6D-97-73 Payments, Clearance, and SetUement
                                             Section 2: Equities, Treasuries, Futures, and Options • Options
                                             Exchange-Traded Options




                                             The Securities and Exchange Cormnission (sEC) oversees the actions of
Regulatory Oversight                         occ vvlth regard to exchange-traded equity options, equity index options,
                                             and currency options to determine whether it is functioning in accordance
                                             with SEC regulations and the law. The Commodity Futures Trading
                                             Commission (CFTC) oversees the actions of occ vvith regard to options on
                                             futures (see the futures section for further ir\formation on options on
                                             futures), occ establishes the rules governing the clearance and settlement
                                             of options, subject to the approval of SEC, or of CFTC in the case of options
                                             on futures.


                                             For purposes of this report, we discuss some of the most important risks
Risk and Risk                                and risk mitigation associated with exchange-traded options.
Mitigation
                                             occ carries risk from the time it guarantees a trade until the resulting
                                             position is terminated. As a resiilt, occ is exposed to counterparty risk, but
                                             the amount at risk (or the exposure) is dependent on fluctuations in the
                                             market.

Table 2.14: Risk and Risk Mitigation for
Options                                      Risks                                          Risk mitigation
                                             Counterparty/credit risk                        » Monitoring of the clearing nnember's
                                                                                              cretjitworthlness

                                                                                             • Possible requirennent of additional
                                                                                               margin for less creditworthy
                                                                                               clearing members

                                                                                             > Guarantee of matched trades only

                                                                                             ' Requirement of margin thai acts as
                                                                                               collateral

                                                                                             ' Maintaining guarantee fund




                                             Page 89                               GAO/G6D-97-73 Payments, Clearance, and Settlement



                           jnaSjiMitiatL*^
                                                                  Section 2: Equities, Treasuries, Futures, and Options • Options
                                                                  Exchange-Traded Options




Risk: Counterparty/Credit                                         occ guarantees the performance of each clearing member to the other
                                                                  clearing member of each trade. As a result, it incurs the risk that a clearing
                                                                  member might default on its obligations.

                                                                  The amount of counterparty risk that occ is exposed to is dependent on
                                                                  fluctuations in the market. If a clearing member does not make settlement,
                                                                  occ—because of the guarantee to the clearing member buyer and clearing
                                                                  member seller—must liquidate the clearing member's positions, but until it
                                                                  does so, occ is exposed to market risk (the exposure to the possibility of
                                                                  financial loss caused by adverse changes in the value of options.

Mitigation                                                        occ mitigates counterparty/credit risk by (1) monitoring the
                                                                  creditworthiness of its clearing members and (2) having the ability to
                                                                  require additional margin for less creditworthy clearing members. In
                                                                  addition, occ requires a margin from each clearing member (see the
                                                                  section on settlement) and maintains a guarantee fund'"' that occ may use
                                                                  when it needs to.




                                                                 ''The guarantee fund is funded by OCC assessing clearing members on their past month's open
                                                                 positions. The assessment is an amount that members pay once a month and is calculated separately
                                                                 from the other settlement amounts.



                                                                 Page 90                                  GAO/GGD-97-73 Payments, Clearance, and Settlement




j.^:.^.   ..... ,...d..-,i..fe>y*iae<   U^^^W^.i-i'iM?*.'^^   mmmmi
Section 3: Retail Payment Systems * Overview

Overview of Clearance and Settlement of
Retail Payment Systems

                                                       In this section of the report, we discuss small-dollar retail payment
                                                       systems, including checks, credit cards, and the automated clearing house
                                                       (ACH).



                                                       Retail payments are primarily small-dollar payments that are used by
Main Characteristics                                   consumers or businesses in payment for goods and services.
                                                       Unlike checks, ACH transactions can be either credit or debit transactions.
                                                       In ACH credit transactions, funds flow from the originator (payor) to the
                                                       receiver (payee). Settlement for an ACH credit transaction is generally final
                                                       by the opening of business on the banking day following the settlement
                                                       day.
                                                       In ACH debit and check payments, the payee collects funds from the payor.
                                                       The interbank settlement for check and ACH debit transactions is typically
                                                       final by the opening of business on the banking day follovwng the day
                                                       checks are presented or ACH debit transactions are provisionally settled.


o^„j.-^|.'_„1 IrifciYTnuHnn                       * ^^ ^Q^^, approximately 63 billion paper checks were written in the United
                                                    States.
                                                  • In 1995, credit card transactions accounted for approximately 14.9 billion
                                                    transactions.
                                                  • In 1996, approximately 4.0 billion payments totaling $12.1 trillion were
                                                    processed on ACH.


                                                      Checks are governed by articles 3 and 4 of the Uniform Commercial Code
Regulatory                                            (ucc); the Expedited Funds Availability Act (EFAA), implemented by the
Information                                           Federal Reserve Board of Governors' Regulation CC, "Availability of
                                                      Funds and Collection of Checks"; and, when handled by the Federal
                                                      Reserve Bzmks, subpart A of the Federal Reserve's Regulation J.
                                                      The primary regulations for credit CcU-ds are the Equal Credit Opportunity
                                                      Act of 1974 and the Truth in Lending Act of 1968, implemented by the
                                                      Board of Governors of the Federal Reserve System's Regulations B and Z,
                                                      respectively.
                                                      The basic rules that govern ACH are the National Automated Clearing
                                                      House Association (NACHA) Operating Rules and Guidelines. In addition,
                                                      ACH is governed by ucc Article 4A for commercial ACH credit transactions,
                                                      31 CFR 210 for transactions originated by the federal government, the
                                                      Electronic Fund Transfer Act and the Federal Reserve's Regulation E for
                                                      consumer transactions, and the Reserve Banks' ACH operating circular for
                                                      transactions processed by the Federal Reserve.



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             •_..;.«.lii^*JUeito>i5lttMO;'J'i»- •ilii^ij!Aii.iilJ«.u,-.ij^:
                                            Section 3: Retail Payment Systems • Overview
                                            Overview of Clearance and Settlement of
                                            Retail Payment Systems




                                            Consumer delinquency and default are the principal risks that confront the
Risk Information                            credit card industry.
                                            Depository institutions that originate ACH debit transactions and that
                                            collect checks are exposed to the potenticd risk that some of the
                                            checks/debit transactions will be returned unpaid.
                                            Depository institutions that originate ACH credit transactions are exposed
                                            to potential temporail credit risk if a corporate customer does not fund the
                                            payment on settlement day.




                                           Page 92                              GAO/GGD-97-73 Payments, Clearance, and SetUement




           sm''imA^sii-i-tm*ii<i'i^''Si-'-'^'
Section 3: Retail Payment Systems * Checks




                                    The paper check, the most frequently used and oldest noncash payment
Description and Use                 instrument in the United States, is used by individuals, businesses, and
                                    governments to pay for goods and services. According to the National
                                    Organization of Clearing Houses (NOCH), over 63.4 billion paper checks
                                    were written in the United States in 1996.^ Paper checks constitute the
                                    largest volume of noncash payments made in the United States. In this
                                    section, we discuss the clearance and settlement of commercial checks
                                    dravm on financial institutions.-

                                    As illustrated in figure 3.1, a paper check includes the names of the payor
                                    and the payee, the amount of the check, and the name of the paying bank.
                                    In addition, the magnetic ink character recognition (MICR) line at the
                                    bottom of the check permits checks to be processed on high-speed
                                    equipment. It includes a number that identifies the bank upon which it is
                                    drawn and the account number of the check writer. Before checks are
                                    processed, the amount of the check is also encoded in magnetic ink at the
                                    bottom of the check.




                                    'Estimates of the total number of checks written for any given period must be considered imprecise
                                    estimates because the specific number of checks that are cleared through clearing houses,
                                    correspondent banks, and by direct presentment is unknown. A comprehensive survey of the number
                                    of checks written has not been conducted since 1979.

                                    -In 199C, the Federal Re.scr\'e Banks processed neariy 430 million paper checks for the federal
                                    government; however, the volume of government paper checks is expected to decline as a result of the
                                    enactment of the Debt Collection Improvement Act (DCIA) of 199G, Pub, L. No. 104-134, Section 31001,
                                    which requires that all federal payments, except Internal Revenue Service (IRS) payments and
                                    payments to individuals who certify that they do not have bank accounts, be issued via electronic
                                    funds transfer by Jan. 1, 1999.



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                                                                                                                                           /
                                                     Section 3: Retail Payment Systems • Checks
                                                     Checks




Figure 3.1: An Example of a Paper Check

        Payor's name
        • Number of the check                                                                             Routing number
                                                                                                          is repeated in a different
                                                                                                          format from that shown
                                                                                                          below and is used in
                                                                                                          manual processing.




  aci aciLacjLocjLicjincjLicjiniiiLicjiacJucjLDCJiacJLicJiacJiaE IiacJiacJiacJLic
  3 7 ^ No. 687                                                 ^ 12-3-45       '^
  m                                                                  00
  El    Cons m e r A
  E     123 Main Street
             Anywhere, U.S A 00000                                        2-anu.a\\j        1,   19 g2_
                Pay To
             The Ordrr Of       Conhanu !B                                                            $    7500

   £]
                                                                                                             Dollars
   a    /    First NnUonal Bank
   El        y\n>'\vhcTc, U.SA.
   c]
   3        Memo                                                              d oniumzz          ^
   El       .;13190828B;0981234567;0687                                          0000007500                                            _
  Is
                                  '^.lS'P»S^^!9%i^!i!<^Jg;S^ig!^J'af.^
            MICR                                   Payor's                   Check number                       Dollar amount
            Number:                                account number                                               is printed by the first
            Magnatic ink                                                                                        bank receiving the
            character                         Check digit:                                                      check.
            recognition                       This number, combined with tfie first
            number                            eight digits, verifies the routing number's
                                              accuracy.
        ' Payor's                       Payor's bank:
          bank                          These four digits are the payor bank's
                                        institutional Identifier.
        Payee                      Check routing symbol:
                                   The first two digits identify the payor bank's Federal
                                   Reserve district.
                                   The third digit identifies the Federal Reserve office
                                   (head office or branch) or special collection arrangement.
                                   The fourth digit shows the payor bank's state or special
                                   collection arrangement.

                                                   Source: The Story of Checks and Electronic Payments. Federal Reserve Bank of New York.




                                                   Depository institutions have the following alternative methods of clearing
                                                   and settling checks.



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                                      Section 3: Retail Payment Systems • Checks
                                      Checks




                                      On-us checks. When checks are deposited into the same bank on which
                                      they were drawn, banks will settle these items in-house. Such checks are
                                      referred to as "on-us" checks.

                                      Interbank checks. Interbank checks are checks not drawn on the
                                      depository institution at which they were deposited.

                                      Direct presentment. Depositary banks can present checks directly to the
                                      paying bank.
                                      Correspondent banks. Correspondent banks can settle the checks that
                                      they collect for other institutions, known as respondents, by using
                                      accounts on their books or by sending Fedwire funds transfers.
                                      Clearing house association. Bsmks can form a voluntsiry association
                                      that establishes a meeting place for the exchanging of checks drawn on
                                      those banks. Typically, banks participating in check clearing houses use
                                      the Federal Reserve's net settlement service to effect settlement for the
                                      checks exchanged each business day.
                                      Federal Reserve Banks. The Federal Reserve System operates a
                                      comprehensive, nationwide system for clearing and settling checks drawn
                                      on depository institutions located in all regions of the United States.

                                      There are approximately 150 check clearing house associations in the U.S.
                                      Three of the large clearing house associations in the U.S. are the California
                                      Bankers Clearing House (CBCH), the Chicago Clearing House Association
                                      (CCH), and the New York Clearing House Association (NYCHA). NYCHA,
                                      established in 1853, is the nation's first clearing house association. Smaller
                                      depository institutions typically use the check collection services of
                                      correspondent banks or of the Federal Reserve.

Table 3.1: Major Organizations That
Process or Exchange Checlts
                                      Federal Reserve          The Federal Reserve System processes commercial checks
                                      System                   through its 12 Reserve Banks, 24 branches, and 10 regional
                                                               check processing centers. Also, the Federal Reserve processes
                                                               federal government checks and postal money orders.
                                      CBCH                     CBCH provides check exchange services to over 100
                                                               depository institutions located mainly in California.
                                      CCH                      CCH provides check exchange services to its 8 member banks
                                                               and its 260 affiliate members.
                                      NYCHA                    NYCHA provides check exchange services to its 10 member
                                                               banks and to 131 other depository institutions.
                                      Sources: Federal Reserve Board. CBCH, CCH, and NYCHA.




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                            Section 3: Retail Payment Systems • Checks
                            Checks




Key Terms
    Cash letter             A cash letter is a group of checks, accompanied by a listing of the checks,
                            which is sent to a clearinghouse, a correspondent bank, or the Federal
                            Reserve for collection.

    Check                   A check is a written order from one party (the payor) to another (the payee)
                            requiring the payor to pay a specified sum on demand to the payee or to a
                            third party specified by the payee.

    Check clearing          Check clearing is the movement of a check from the depository institution
                            at which it was deposited back to the institution on which it was written; the
                            funds move in the opposite direction, with a corresponding credit and debit
                            to the involved accounts.

    Check truncation        Check truncation is the practice of holding a paper check at the bank at which
                            it was deposited (or at an intermediary bank) and electronically forwarding
                            the essentia! information on the check to the bank on which it was written.
                            A truncated check is not returned to the writer.

Q   Depositary bank         A depositary bank is the bank at which a check is first deposited.

Q Float                     Float is checkbook money that appears on the books of both the check writer
                            (the payor) and the check receiver (the payee) while a check is
                            being processed.

1 ^ MICR-line Information   fyllCR-line information refers to data characters at the bottom of a check. The
                            magnetic ink character recognition (MICR) line at the bottom of a check includes
                            the routing number of the payor bank, the amount of the check, the number of
                            the check, and the account number of the customer.

Q   Paying bank             A paying bank is the bank at which a check is payable and to which it
                            is sent for payment or collection.

    Presentment fee         A presentment fee is a fee that a bank receiving a check may impose on
                            the bank that presents the check for payment.




                            Table 3.2 shows the volume of checks handled by the Federal Reserve and
Basic Data                  three m^or check clearing houses from 1992 to 1995. In 1995, the Federal
                            Reserve Banks handled 15.5 billion checks, a decrease of 19 percent from




                            Page 96                             GAO/GGD-97-73 Payments, Clearance, and Settlement
                                   Section 3: Retail Payment Systems • Checks
                                   Checks




                                  the volume of checks they handled in 1992.^ The following factors have
                                  contributed to this decline:

                                  adoption of the same-day settlement regulation;"*
                                  increased competition from private clearing houses; and
                                  banking consolidation, resulting in more "on-us" checks, which do not
                                  need to be cleared.

Table 3.2: The Volume of Checks
Processed, 1992-1995                                                                                                           Percent
                                                              1992                        1995                                 change
                                  Federal Reserve^            19.1 billion                15.5 billion                              -19%
                                  CBCH                        1,294 million               1,554 million                             +20
                                  CCH                         384.7 million               562.8 million                             +46
                                  NYCHA                       492.6 million               335.7 million                             -32
                                  ^These numbers refer only lo commercial checks; they do not include federal government checks
                                  and postal money orders that are processed by the Federal Reserve.

                                  Sources: The Federal Reserve System 1995 Annual Report. CBCH, CCH, NOCH, and NYCHA.



                                  At the same time, the volume of checks processed by two of the three
                                  msyor private clearing houses, CBCH and ccH, has increased for the period
                                  of 1992 through 1995, as shown in table 3.3.




                                  'Annual Report: lOOo. Board of Go\emors of the Federal Reserve System, p. 30,3.

                                  'Before the Board of Governors adopted the same-day settlement rule, which became effective on
                                  .Ian. 2. 199'1. private collecting banks, unlike the Federal Reserve Banks, did not have the right to
                                  present checks to paying banks and to demand settlement in same-day funds. Since the same-day
                                  settlement nile became effective, more collecting banks have tiegun to present checks directly lo
                                  paying banks. Banks have historically had bilateral agreements with each other under which they have
                                  e.xchanged checks directly. In some cases, paying banks imposed presentment fees, but not in all
                                  cases. Even today, banks exchange checks directly at later times than permitted under the same-day
                                  settlement rule using bilateral agreements.


                                  Page 97                                   GAO/GGD-97-73 Payments, Clearance, and Settlement
             Section 3: Retail Payment Systems • Checks
             Checks




            As previously mentioned, banks have several alternative methods for
Processes   clearing and settling checks. Figure 3.2 describes how the Federal Reserve
            System processes and clears checks. The Federal Reserve System operates
            a comprehensive, nationwide system for clearing both loccd and nonlocal
            checks. When checks are processed by the Federal Reserve, they aie
            sorted through a check sorter and settled by debits to the Federal Reserve
            accounts of tlie paying banks and credits to the Federal Reserve accounts
            of the collecting banks. In order to facilitate the clearing of checks
            nationwide, the Federal Reserve uses both air transportation and ground
            transportation networks to deliver checks. Checks, which are drawn on
            banks in regions far from the payee bank, are frequently shipped by air to
            the city in which the payor bank is located. Locally, checks are delivered
            by ground transportation.




            Page 98                             GAO/GGD-97-73 Payments, Clearance, and Settlement
                                        Section 3: Retail Payment Systems • Checks
                                        Checks




Processing a Check                      Figure 3.2 shows how a paper check would be processed through the
                                        Federal Reserve System, using the following example.

                                        Example: A consumer (Consumer A) in Philadelphia orders four books
                                        from a book company (Company B) in Los Angeles.
                                        The total cost ofthe order is $75.
                                        The consumer pays for the books by mailing a check to Company B.




                                       Page 99                              GAO/GGD-97-73 Payments, Clearance, and Settlement




       •^ivji^^gtmsMi^Mi^m^m^   iiiiuitflEJai^siKBSii.''!?!
                                                      Section 3: Retail Payment Systems • Checks
                                                      Checks




Figure 3.2: The Federal Reserve System for Processing a Paper Check

                                                                                        "«"
                                                  .U;«h«.iA.t oonoo
                                                                                                         0          The Federal Reserve Bank
O        Company B receives Consumer A's
        check for $75 and deposits the check
                                                  J.-.-i..«^           ^
                                                                        ' -^ , .^...-                          of Philadelphia receives the bundle of
                                                                                                               checks shipped to it by the LA Branch.
            into its account with Bank B.         ^^              ^
                                                  iiili^—iiHtf^i^yy'i^V^ e   uUMjunuu                      Using high-speed sorters, it verifies the dollar
                                                                                                         amount and number ol the checks received from I
                                                                                                         the LA Branch, sorts them by the banks on which |
                                                                                                            they are drawn, and bunciles them by those
                                                                                                                           paying banks.




Q         Bank B codas the value of the
       checks it received Irom Company B
    (using magnetic ink) on the bottom of the
      check: bundles it with other checks It
  received in deposits on day 0. and deposits
the bundle of checks with the LA Branch ol the
   Federal Reserve Bank of San Francisco in
  the evening. Bank B credits Company B for
   the value of its deposit as 'unavailable' or
              'uncolloctod' funds.




Q                TTie LA branch sorts
           the checks deposited by Bank B
          using high-speed sorters that read
     the magnetic ink characters on the bottom
         of the checks to verity the amount of
         Bank B's deposit and to son checks
    by their various destinations. Consumer A's
       check will be bundled with other checks
        drawn on banks located in the check-
           processing territory served by the
        Federal Reserve Bank of Philadelphia,




             The Los Angeles Branch
          ships the bundle of checks to
          the Federal Reserve Bank of
        Philadelphia by air transportation.




                                                    Page too                                  GAO/GGD-97-73 Payments, Clearance, and Settlement
                                                      Section 3: Retail Payment Systems • Checks
                                                      Checks




                                                                                                                     «*     The Philadelphia Reserve Bank delivers
                                                                                                                           the checks to the paying banks. Including
                                                                                                                                  Bank A, via ground carriers




                                                                                                                     Q       After Bank A receives its checks, the
                                                                                                                             Philadelphia Reserve Bank debits Its
                                                                                                                           Federal Reserve account and credits the
                                                                                                                           LA Branch through the Federal Reserve's
                                                                                                                          accounting system. Almost simultaneously
                                                                                                                          the LA Branch credits the Federal Reserve
                                                                                                                                      account of Bank 8.




                                                                                                                     0         Bank A processes the checks using
                                                                                                                            its sorting equipment, capturing data on
                                                                                                                         the value of each check written by each of Its
                                                                                                                           customers. Using this Information, Bank A
                                                                                                                                  debits Consumer A's account.




                                                                                                                    O        Bank B makes the $75 available
                                                                                                                                    lo Company B.




                                                  Source: G A O analysis of information provided by the Federal R e s e r v e B o a r d .




                                                  Page 101                                       GAO/GGD-97-73 Payments, Clearance, and Settiement




.^-,\....m.itMiMM^lnitlix'^*VJX,^^'•1^•i*^.0*r-A^^^
                      Section 3: Retail Payment Systems • Checks
                      Checks




                      According to industry officials, extensive use of the paper check
                      contributes to some of the inefficiency that is present in the U.S. payment
                      system. One of the goals of any payment system is to facilitate the safe,
                      sound, and efficient transfer of value between receivers and providers of
                      goods and services in a timely maimer. According to a payment system
                      expert, paper instruments, such as checks, are considered substandcird
                      from a payment system design perspective.


New Technologies in   In the last few years, clearing house associations, the banking industry,
Check Processing      and the Federal Reserve have been actively developing and pursuing a new
                      technology that may shorten the amount of time it takes to clear and settle
                      checks and, thus, improve the overall efficiency of the payment system.
                      This new check technology is called electronic check presentment (ECP).
                      EC? is a process by which the MiCR-line information is sent electronically to
                      the paying bank. A number of large cormnercial banks participate in the
                      Electronic Check Clearing House Organization (ECCHO), formed in 1990.
                      ECCHO drafts rules and designs formats for electronic check processing
                      among its members. Banks that are ECCHO participants can exchange
                      electroruc check data zunong themselves before the paper checks are
                      physically presented for payment.

                      EC? may include check truncation and may be supported by check imaging
                      technology. Check truncation is a process by which the paper checks are
                      retained at some point in the collection process, and only the check
                      information is sent forward to the paying bank, ECCHO is developing a set
                      of national rules for check truncation. Check imaging is a process by
                      which a picture is taken of the front and back of the chieck, and the images
                      are stored on electronic media for retrieval when needed.

                      The Federal Reserve also offers ECP products to paying banks. During
                      1996, the Federal Reserve presented electrorucally to the paying bank
                      nearly 1.4 billion checks, or 9 percent of checks collected by the Federal
                      Reserve. This is an increase of approximately 100 percent over the 1994
                      level.

                      As of January 1996, 2,221 depository institutions used the Federal
                      Reserve's ECP service. This is a 37-percent increase over the number of
                      depository institutions that were using the Federal Reserve's ECP service in
                      Jjmuary 1995. In 1992, NYCHA created the Clearing House Electronic Check
                      Clearing System (ciiECCS), in which ECP is a key component.




                      Page 102                            GAO/GGD-97-73 Payments, Clearance, and Settlement
                                                                                         Section 3: Retail Payment Systems • Checks
                                                                                         Checks




                                                                                         Although the use of check truncation and imaging is steadily increasing, it
                                                                                         is not clear how much check volume will be affected by these methods in
                                                                                         the foreseeable future. The reluctance of some banks to invest in the
                                                                                         technology, and consumer preference for their returned checks, may
                                                                                         restrain substantial growth in check truncation and imaging. One Federal
                                                                                         Reserve official predicted that check truncation would not be widely used
                                                                                         until consumers accepted the fact that their checks would not be returned
                                                                                         to them. Moreover, under current law, depositary banks must physically
                                                                                         present checks to paying banks to obtain settlement for the checks.


                                                                                         Articles 3 and 4 of the Uniform Commercial Code (ucc) provide the legal
Regulatory Oversight                                                                     framework for check processing. In 1987, Congress enacted the Expedited
                                                                                         Funds Availability Act (EFAA), which lirnits the time that banks can
                                                                                         withhold funds from checks deposited into customer accounts before the
                                                                                         funds are made available for withdrawal. The law was implemented in
                                                                                         September 1988 through the Federal Reserve Board of Governors'
                                                                                         Regulation CC, "Availability of Funds and Collection of Checks."
                                                                                         Regulation CC also includes a number of provisions designed to accelerate
                                                                                         the collection of checks and the return of unpaid checks to the banks of
                                                                                         first deposit. Among other things, EFAA and Regulation CC generally
                                                                                         require institutions to make funds from local checks available by the
                                                                                         second business day after the day of deposit; funds from nonlocal checks
                                                                                         are to be available by the fifth business day after the day of deposit.

                                                                                     Also, those checks that are collected or returned through the Federal
                                                                                     Reserve are governed by subpart A of the Federal Reserve's Regulation J.
                                                                                     Regulation J establishes the procedures, duties, and responsibilities ofthe
                                                                                     sending and paying banks.




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           j f . m i i i t . f .•JL, A i j i ^ : . i , - L w . . , . •iM.-.rtlt.'.<lWg
                                           Section 3; Retail Pajment Systems • Checks
                                           Checks




                                          For purposes of this report, we discuss some ofthe most important risks
Risk and Risk                             and risk mitigations associated with checks.
Mitigation

Table 3.3: Risk and Risk Mitigation for                                                                                                   • M i
Checl<s                                   Risk                                                  Risk mitigation
                                          Return item risk                                      Credit monitoring
                                                                                                Large-dollar return notifications


                                          Check fraud risk
                                                                                                Elecfronifi^h^k^ipre^
                                                                                                Positive pay
                                                                                                                                           m
                                                                                                Elef^iiiiclpKSclc'piiB^e^                 v^
                                                  Shaded cells indicate mitigations that have been adopted by some participants or providers
                                              ^ ^ but are not yet widely used. Unshaded cells indicate mitigations in general use.


Risk 1: Return Item                       A check will be .returned to the depositary bank unpaid if the paying bank
                                          determines not to pay the check. This is called a return item. Return item
                                          risk is a m^or risk facing institutions that collect checks. Some of the
                                          reasons for which a check may be returned are insufficient funds in the
                                          account, a closed account, a stop payment order, a fraudulent signature, or
                                          the failure of the paying bank. A recent Federal Reserve survey on
                                          returned checks processed by the Reserve Banks showed that it takes, on
                                          average, 5.5 calendar days for local and nonlocal checks to complete a full
                                          return cycle from the depositary bank to the payor bank and back to the
                                          depositary bank.^

                                          The risk faced by depositary banks depends on when they make funds
                                          available to their customers. Banks are obligated under EFAA to make
                                          funds available to their customers in accordance with mandatory funds
                                          availability schedules. Thus, a depositary bank may be required to make
                                          funds available to the customer before a check is returned to the
                                          depositary bank unpaid. When the depositary bank receives a return item,
                                          it will charge back its depositing customer's account for the item even if it
                                          has already made the funds available to the depositing customer. The
                                          depositary bank may be exposed to some risk if the customer does not
                                          have sufficient funds in his or her account to cover the returned check.
                                          When a paying bank returns the item to the depositary bank, the paying
                                          bank does not necessarily have to return the item tlirough the same
                                          clearing mechanism from which it received the item.


                                          ''Report 10 the Congress on Funds AvailabiliLy Schedules :m(l Check Fraud at Depository Institutions,
                                          Board of Governors ofthe Federal Rcseri-e .System, Oct. 1990, p. 22.



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                        Section 3: Retail Payment Systems • Checks
                        Checks




Mitigation              Credit monitoring by financial institutions. For the purpose of
                        reducing the return item risk faced by depositary banks, the Federal
                        Reserve recommends that depository institutions perform a credit
                        assessment of those customers for which they collect large-dollar volumes
                        of checks. Also, the Federal Reserve recommends that institutions monitor
                        the payment activity of their customers and take appropriate action when
                        credit limits are exceeded.

Mitigation             Large-dollar return item notification. Federal Reserve Regulation CC
                       requires that when a paying bank decides to return a check of $2,500 or
                       more, it must provide a notice of nonpayment to the depositary bank. The
                       notice must be received by
                       4:00 p.m. local time for the depositary bank on the second business day
                       following the banking day on which the check was presented to the paying
                       bank. A paying bank can send the notice of nonpayment by several means,
                       including the return ofthe check to the depositary bank; a telephone call
                       or telex to the depositary bank; a special, nonvalue Fedwire funds transfer
                       notice; or a telephone call to a Reserve Bank with a request to forward the
                       notice.

Mitigation             Electronic check presentment. The exchange of electronic check
                       information may reduce risk to the depositary banks because it permits
                       them to deliver check data to paying banks more quickly than is currently
                       done with paper checks. The shorter time for check information delivery
                       could pemtit the paying banks to (1) identify checks that cannot be paid
                       and (2) notify the depositary bank about those returned checks, using an
                       electronic return notice, up to 1 day earlier than would occur with the
                       physical exchanging of paper checks. If a depositary bank could be
                       notified of a return item earlier, then the risk might be reduced because
                       the depositary bank would know sooner that the check was not being paid
                       and that funds should not be made available to the depositing customer.




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             ^...^iica^^. •..
                       Section 3: Retail Payment Systems • Checks
                       Checks




Risk 2: Check Fraud   Check fraud is a problem for the banking industry. The same Federal
                      Reserve survey on check fraud cmd check returns estimated that in 1995,
                      the value of all check-fraud losses at commercial banks, credit unions, and
                      savings institution was $615 million for 529,000 cases of check fraud."
                      Also, for that year, commercial banks' check fraud losses ($487 million)
                      represented approximately 1 percent of their profits. The survey also
                      found that local checks accounted for about 72 percent of the total dollar
                      losses reported in the Board's survey.

                      One example of check fraud is check kiting. Check kiting may take many
                      forms, but often it involves the writing of checks on two or more banks for
                      the purpose of fraudulently obtaining interest-free unauthorized loans.
                      Other types of check fraud include forgery, altered checks, counterfeit
                      checks, and paperhanging. Forgery occurs when a person forges the
                      account holder's signature or the endorsement. Altered checks are checks
                      that have information, such as the amount, altered without the payor's
                      approval. Counterfeit checks are imitations or copies of genuine checks.
                      Paperhanging refers to checks that are deliberately written on closed
                      accounts.

Mitigation            Positive pay. Corporations use positive pay to guard against check fraud.
                      Under these arrangements, a corporation sends an electronic file of
                      information on all checks issued to its bank. The bank compares this
                      information with electronic information about checks presented for
                      payment. If a check presented for payment is not included in the
                      positive-pay information, the corporation is notified and requested to
                      make the pay/no pay decision.

Mitigation            Electronic check presentment ( E C P ) . AS in the case of return item risk,
                      ECP may reduce check fraud by providing the depositary bank with
                      information about unpaid checks earlier than the information is currently
                      provided. By speeding the transmission of the MICR information, ECP may
                      allow the paying bank to identify checks that cannot be paid earlier and to
                      notify the bank of first deposit earlier of an impending returned check,
                      possibly before the funds are made available to the depositing customer.




                      ''Report lo the Connress nn Fumis Availability Schedules and Check Fraud at Depository Institutions,
                      Board of Governors of the Federal Reserve System, Oct. 1996, p. 5.



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                            Section 3: Retail Payment Systems • Checks
                            Checks




                           Electronic Funds Transfer (EFT) is the trarisfer of funds from one account
Electronic Funds           to another by electronic rather than by paper-based instructions, such as
Transfer                   checks. EPT can save time and money in the payment system by eliminating
                           paperwork.

                           Types of EFT Systems'

  ctronic Funds Transfer   Consumer electronic payments are small-dollar payments, such as
                           transactions made via the ACH,^ at automated teller machines (ATM),
                           point-of-sale payments using debit cards, and the use of telephones or
                           personal computers to irutiate bill payments.
                           Electronic benefits transfers are electronic payments for social security,
                           pension, and welfare payments; student loans; aind unemployment
                           compensation.

                           Statistics

                           In 1994, federal and state governments transferred about $500 billion in
                           benefits to recipients.

                           Federal benefits: approximately $400 billion.
                           State benefits: approximately $95 billion.

                           The Financial Management Service ofthe U.S. Treasury estimates that it
                           costs the government 42 cents to issue and mail a paper check but only 2
                           cents to process an electronic payment.

                           Developments

                           The number of EFT transactions should increase as a result of the passage
                           of the Debt Collection Improvement Act of 1996, which will substantially
                           reduce the use of checks as a federal payment instrument by January 1999.
                           The EFT provisions of DCIA require that all federal payments (except iRS tax
                           refunds and payments to individuals without bank accounts) be issued by
                           EFT.




                           'Wire transfers, such as Fedwire, are considered electronic funds transfers.

                           "ACM is discussed later in the retail payment systems section.



                           Page 107                                   GAO/GGD-97-73 Payments, Clearance, and Settlement
Section 3: Retail Payment Systems • Credit Cards

Credit Cards


                                     A credit card is a payment card issued to a person for purchasing goods
Description and Use                  and services and obtaining cash against a line of credit established by the
                                     issuer. Credit cards can be of two types: those issued by merchants and
                                     vendors, such as department stores or oil companies, and general purpose
                                     credit cards issued by banks, such as VISA and MasterCard. Credit cards
                                     allow a consumer cardholder to pay off his or her entire outstanding
                                     balance or to make minimum monthly payments and carry over balances,
                                     on which interest is charged. In addition, a cardholder may be able to
                                     receive cash advances under a preapproved line of credit with a credit
                                     card, either through a bank teller or an automated teller network (ATM), for
                                     which the cardholder is charged a finance charge.

                                    The two dominant bank-issued general purpose credit cards are VISA and
                                    MasterCard. Before 1971, participating banks could not be a member of
                                    both VISA cmd MasterCard; this was changed as a result of antitrust
                                    concerns. Today, issuers can issue both VISA and MasterCard credit cards.
                                    A number of nonbank companies also issue credit cards, such as American
                                    Express, Discover, and Diners Club.



Key Terms
Q   Credit card company              A credit card company is a company that owns the trademark of a
                                     particular credit card, and it may also provide a number of marketing,
                                     processing, or other services to the members using the card services.

    Credit line                      A credit line is the maximum amount of credit available in an open-
                                     ended credit arrangement, such as a bank credit card, which the lender
                                     may change at any time. The line is disclosed in the credit card
                                     agreement.

    EDO                             Electronic Data Capture (EDC) is a point-of-sale terminal that reads
                                    the information embedded in the magnetic stripe of banks cards. These
                                    terminals electronically authorize and capture transaction data, thus
                                    eliminating the need for a paper deposit.




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                                                    Section 3: Retail Payment Systems • Credit Cards
                                                    Credit Cards




                                                The use of general purpose credit cards in the United States has grown
Basic Data                                      substantially since 1981. In 1995, credit card transactions accounted for
                                                approximately 14.9 billion transactions.

                                                As shown in table 3.4, since 1990, VISA and MasterCjird have increased the
                                                number of cards in use by 84 percent and 63 percent, respectively.

Table 3.4: The Number of Major U.S.
Credit Card Companies' Cards,                       In tnillions
1990-1995                                                                                     Number of cards
                                                Credit card company                              1990       1995          Percent change
                                                VISA                                             120.1     221.1                      84%
                                                MasterCard                                        88.2     144.1                       63
                                                American Express                                  25.9      26.7                            3
                                                Discover                                          37.8      45.1                        19
                                                Source: Faulkner & Gray.



                                                In 1995, the total charge volume of VISA, MasterCard, American Express,
                                                and Discover was $70.9 billion, which was a 318-percent increase from
                                                1985.


                                                The clearance and settlement of credit card transactions involve three
Processes                                       parts—authorization, clearance, and settlement. Authorization is the
                                                process by which the issuer of a credit card (card-issuing bank) approves
                                                (or decUnes) a transaction at the point of sale. Clearance is the process by
                                                which a credit card company collects data about a transaction from a bank
                                                (referred to as an acquirer or the merchant's bank) and delivers the data to
                                                the card-issuing bank, which will, use the information to post the
                                                transaction to the cardholder's account. Settlement is the process by
                                                which a credit card company collects funds from the card-issuing bank
                                                and pays funds to the merchant's bank for the cleared transactions. Figure
                                                3.3 illustrates how a credit card transaction clears and settles after a credit
                                                cardholder makes a purchase at a store (merchant). Every credit card
                                                transaction involves the cardholder, the card-issuing bank, a credit card
                                                company, a merchemt, and the merchant's bank.




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          .. ,.i..,^.^.,*iji^M^s6^m^jm^kmhVisti^^
                                                      Section 3: Retail Payment Systems • Credit Cards
                                                      Credit Cards




Figure 3.3: Clearance and Settlement Cycle of Credit Cards
 AirthoriJ.ition



 O    A cjfdholder uses a major credit card
            to make a purchase from
                  a merchant.




 "     The merchant electronically submits
  the cardholder's CCC draft, along with all the
    other credit card dratis, lo its bank at the
                  end of the day.


                                                          ''!t>Jirv'.'bt:'"«'<it''ly~*'




      The merchant's bank credits the
    merchant's account. The merchant's
                                                                  F                           The major credit card company
 bank submits the cardholder's draft, as well
   as other credit card drafts, to the major
            credit card company.
                                                      ilMll^                                receives the drafts and sends them
                                                                                                to each card-issuing bank.


                                                          Merchants b.ink




                                                    Page 110                              GAO/GGD-97-73 Payments, Clearance, and SetUement




            .,^^^.A^.m«iii¥j'Mi'4i»litr%tiiuui))i&^^M'k
                                          Section 3: Retail Payment Systems • Credit Cards
                                          Credit Cards




     The major credit card company
        deterimines the amount ol
   money that each card-issuing bank
(including the cardholder's bank) owes




                                                                                        O       The card-issuing bank then bills
                                                                                            the cardholder and eventually receives
                                                                                                 payment Irom the cardholder.




                                         Note: Ivlajor credit card companies operate a mullilateral settlement system.

                                         Source: GAO.




                                         Page i l l                                GAO/GGD-97-73 Payments, Clearance, and Settlement




.       ..^....^Mtiiitie^iiahkjiiiaM^iiiMiiM^^^
                                  Section 3: Retail Payment Systems • Credit Cards
                                  Credit Cards




Authorization (Step 1)           A cardholder selects goods or services from a store (or merchant) and
                                 presents a credit card as payment. The sales clerk of the store swipes the
                                 card through one ofthe store's EDC terminals and keys in the amount of
                                 the transaction. The authorization request is transmitted electronically
                                 through the credit card company to the issuer of the credit card." The
                                 card-issuing bank then approves or declines the transaction based on the
                                 cau-dholder's account status, and the approval or disapproval is
                                 transmitted electronically to the store through the credit card company. If
                                 the transaction is approved, the salesperson then produces a sales draft
                                 for the customer to sign.

Clearance (Steps 2 Through 4)    At the end of the day, the merchant submits all of its credit card
                                 transaction data electronically (credit card drafts) to its b£mk(s). The
                                 merchant's bank then credits (or pays) the merchant for its transactions.
                                 At this point, the store has been paid and is out of the cycle.'" The
                                 merchant's bank is then responsible for getting paid for the transaction,
                                 and sends the transaction data electronically to the credit card company.
                                 The credit card company electronically sends the credit card drafts
                                 (transaction data) to each card-issuing bank.

Settlement (Steps 5 Through 8)   After the card-issuing bank receives the transaction data, the credit card
                                 company collects funds from the card-issuing bank's account and transfers
                                 funds to the account of the merchant's bank, thus ending the cycle for the
                                 bank. The card-issuing bank will then present the transaction as an item
                                 on the cardholder's next monthly statement, and once the cardholder pays
                                 the card-issuing bank, the cycle will be complete.

                                 The payment and receipts of member banks (card-issuing banks and
                                 merchant banks) of the credit Ccud company are done throu)2h each
                                 member (or its correspondent bank) and the credit card company's
                                 settlement banks over Fedwire Funds Transfer System (see section on
                                 Fedwire Funds Transfer for details on how it works)." For each
                                 card-issuing bank, the credit card company adds up the credit card
                                 company's transactions for the bank and sends it the net settlement



                                 "If a member bank or iLs designated proccs.sor serve as bdlh the Ciird-issuinjj bank/processor and the
                                 merchant's bank/proces.sor, then authoriziition, clearing, and settlement may be handled entirely by
                                 the member bank or proces.sor as "on-us" transactions. In this case, a credit card company would not
                                 be directly involved in processing the on-us transaction.

                                 "The merchant will get paid an amount minus a merchant iliscount fee, which is retained by the
                                 merchant's bank.

                                 "VISA'S settlement banks have to meet specific operational and credit rating ty|)e criteria.



                                 Page 112                                    GAO/GGD-97-73 Payments, Clearance, and Settlement
                        Section 3: Retail Payment Systems 'Credit Cards
                        Credit Cards




                       amount.'- Payment is made by the card-issuing bank submitting payment
                       to the credit card company (through its settlement banks over Fedwire)
                       for transactions plus fees and charges due to the credit card company. The
                       credit card company then pays the merchant's bank for the transactions
                       and collects fees and charges from the merchant's bank.

                       Because of the international aspect of a credit card company's business,
                       the m^or credit card companies operate on a daily processing cycle on
                       Greenwich Mean Time, which starts at 7:00 p.m. EST and ends 24 hours
                       later at 7:00 p.m. EST. Thus, settlement for the merchant's bank in the
                       United States usually occurs 1 calendar day after a transaction is
                       submitted to the credit card company because of the hours of Fedwire.
                       Settlement for the card-issuing bank occurs once it has received payment
                       from the cardholder.

                       Each member bank of a major credit card company may be required to
                       maintain collateral with the credit card company. The collateral is meant
                       to cover the potential losses that the credit card company may incur if the
                       member bank fails.'^


                       The primary federal laws governing credit card issuance and operation are
Regulatory Oversight   the Equal Credit Opportunity Act of 1974 and the Truth in Lending Act of
                       1968 (TLA). These laws are implemented through Federal Reserve
                       Regulations B and Z, respectively. Regulation B prohibits lenders,
                       including credit card companies, from discriminating against credit
                       applicants and establishes guidelines for gathering and evaluating credit
                       information. Regulation Z requires uniform methods for computing the
                       cost of consumer credit and disclosing credit terms, prohibits the
                       unsolicited issuance of credit cards, and limits cardholder liability for
                       unauthorized use.

                       Other laws applying to credit cards are the Fair Credit and Charge Card
                       Disclosure Act of 1988, the Fair Credit Billing Act of 1974, and the Fair
                       Credit Reporting Act of 1970. The Fair Credit and Charge Card Disclosure
                       Act amended the T\A to require that applications for credit cards that are
                       sent through the mail, canvassed by telephone, or made available to the
                       public (e.g., at counters in retail stores) must contain information about
                       key terms of the account. The Fair Credit Billing Act amended the TLA to

                       '-According to VISA offidals, most of the netting for VISA is <lone on a multilateral basis.

                       '•"If a card-issuing member bank fails, VISA may have paid a nierchaiu's bank for the transactions but
                       be unable to collect funds from the member bank.


                       Page 113                                    GAO/GGD-97-73 Payments, Clearance, and Settlement
                                           Section 3: Retail Payment Systems • Credit Cards
                                           Credit Cards




                                          specify how creditors must respond to billing complaints from consumers,
                                          requiring that creditors handle consumer accounts fairly emd promptly.
                                          The Fair Credit Reporting Act entitles consumers to know the source for
                                          the credit information and allows them to correct errors in the reported
                                          information.


                                          For purposes of this report, we discuss some ofthe most important risks
Risk and Risk                             and risk mitigations associated with credit cards.
Mitigation
Table 3.5: Risk and Risk Mitigation for
Credit Cards                              Risk                           Risk mitigation
                                          Fraud risk                     Neural network
                                                                         Address verification service
                                                                         Issuer's clearing house service
                                          Credit risk                    Credit monitoring



Risk 1: Fraud                             Risk from fraud involving credit cards includes unauthorized use of lost or
                                          stolen cards, fraudulent applications, counterfeit or altered cards, and the
                                          fraudulent use of a cardholder's credit card number. Lost or stolen credit
                                          cards account for approximately 50 percent of till credit card fraud, and
                                          fraudulent and counterfeit cards account for approximately 7 percent and
                                          11 percent of credit card fraud, respectively. If cardholders report the loss
                                          of their credit cards, they are responsible, at most, for $50. The issuing
                                          bank or the merchant pays the costs of any fraud involving credit cards.
                                          The merchant is responsible for paying any costs related to credit card
                                          fraud if the merchant does not do at least one of the following three things:
                                          obtain an authorization, the cardholder's signature, or the electronic
                                          imprint of the card. According to an industry official, usually the issuing
                                          banks are responsible for paying approximately 70 percent of the cost of
                                          credit card fraud while the merchants are responsible for paying the other
                                          30 percent.

Mitigation                                Neural network. The neural network allows a card-issuing bank to track
                                          the cardholder's spending patterns and to detect any spending
                                          discrepancies and thereby prevent potential credit card fraud. For
                                          example, if a cardholder, who typically purchases airplane tickets to
                                          domestic destinations, starts purchasing an excessive number of airpkme
                                          tickets to international destinations, the neural network may alert the
                                          issuing bank and the cardholder of potential fraud.



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                                                SecUon 3: Retail Payment Systems • Credit Cards
                                                Credit Cards




Mitigation                                     Address Verification Service. The mail-order catalog industry
                                               developed a program called Address Verification Service (AVS). AVS jdlows
                                               mail and telephone order companies to verify a cardholder's billing
                                               address online. This program is designed to reduce fraudulent use of a
                                               cardholder's credit card number. Using AVS, the mail and telephone order
                                               companies can verify the address the customer provided as well as the
                                               billing address on file with the card issuer. If the two addresses are
                                               different, then the mail or telephone order company may suspect fraud.

Mitigation                                     Issuer's Clearing House Service, VISA and MasterCard have developed a
                                               type of clearing house database. Issuer's Clearing House Service (ics), to
                                               detect fraudulent credit applications, ics allows issuing banks to compare
                                               credit card applications against a database of invalid addresses and Social
                                               Security numbers. The ics database includes information such as Social
                                               Security numbers, names, and dates of birth of credit card apphcants.


Risk 2: Credit                                 Consumer delinquency and default are the main credit risks involving the
                                               use of credit cards. If a cardholder fails to pay for the charges, then the
                                               issuing bank is liable to pay the merchant's bank.

Mitigation                                     Credit monitoring. The card-issuing bank is responsible for monitoring
                                               and controlling credit risk resulting from consumer delinquency and
                                               default. Issuing banks can mitigate the risks of consumer delinquency
                                               through the normal authorization process of charges and credit reviews of
                                               cardholders. For example, during the authorization process, when the
                                               credit card is swiped, the card-issuing bank can deny authorization of a
                                               transaction if the consumer had been delinquent in paying the credit card
                                               bill. The issuing bank can establish financial standards to be used during
                                               the application process to protect itself from delinquent consumers.




                                               Page 115                             GAO/GGD-97-73 Payments, Clearance, and Settlement




             ,., •,r.iMif^i^wbi^imiSf^^i>£^i^^'i^^j-j>
 Section 3: Retail Payment Systems * ACH

 Automated Clearing House


                                        An automated clearing house (ACH) network is an electroruc batch
Description and Use                     processing system by which payment orders are exchanged among
                                        financial institutions. The ACH began, in 1972, as a system operated by the
                                        Federal Reserve Banks at the request of members of local ACH
                                        associations. It is designed for high-volume, predominantly small-dollar
                                        recurring payments, such as payroll, mortgage, car loan, or Social Security.

                                        An ACH payment can either be a credit transaction or a debit trar\saction. In
                                        an ACH credit transaction, funds flow from the originator to the receiver,
                                        and in a debit transaction, funds flow from the receiver to the originator.
                                        Every ACH transaction, regardless of whether it is a credit or a debit
                                        transaction, must have an originator of the transaction, a receiver of the
                                        transaction, an originating depository institution, and a receiving
                                        depository institution. Listed in table 3.6 are examples of ACH credit and
                                        debit transactions.

Table 3.6: Examples of ACH Credit and
Debit Transactions                      ACH credit transactions                   ACH debit transactions
                                        Payrolls                                  Consumer bill payments:

                                                                                    • Mortgage and loan
                                                                                    • Insurance premiums
                                        Government benefit payments:

                                          • Social Security
                                          • Federal employee retirement
                                          • Disability
                                        Corporate payments to contractors and     Corporate cash concentrations
                                         vendors
                                        Corporate tax payments                    Corporate tax payments
                                        Source: Federal Reserve.


                                        There are four ACH processors operating in the Uruted States that process
                                        ACH transactions:

                                        (1) American Clearing House Association (American), (2) Federal Reserve
                                        System (Federal Reserve), (3) New York Automated Clearing House
                                        (NYACH), and (4) VISANet ACH (VISA).

                                        The Federal Reserve and VISA are national ACH providers, NYACH and
                                        American are regional ACH providers.




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                                                              Section 3: Retail Payrhent Systems • ACH
                                                              Automated Clearing House




Key Terms
Q      ACH operator/processor                                 An ACH operator/processor is a central clearing facility that receives batches
                                                              of ACH credit and debit transactions from originating depository institutions,
                                                              edits, sorts, and distributes the transactions to receiving depository institutions,
                                                              and facilitates the settlement among participants.

Q Batch processing                                            Batch processing is the transmission or processing of a group of related
                                                              electronic payment instructions.

Q      Clearing house                                         A clearing house Is a voluntary association of depository institutions
                                                              that facilitates the exchange of payment transactions, such as checl<s,
                                                              automated clearing house transactions, and large-value funds transfers,
                                                              and the settlement of participants' net debit or credit positions.

      File                                                    A file is a group of entries transmitted by originating institutions or to receiving
                                                              institutions by ACH operators. A tile may contain one or more batches of entries.

0"originator                                                  An originator Is a person or an organization that Initiates an ACH entry.

      Originating depository                                  An originating depository Institution is a financial Institution that initiates and
      institution                                             warrants electronic payments processed through the ACH network on behalf
                                                              of its customers.

Q     Receiver                                                A receiver is the individual or organization that has authorized an originator to
                                                              initiate an ACH credit or debit transaction entry to the receiver's account with the
                                                              receiving depository institution.

      Receiving depository                                    A receiving depository institution Is a financial Institution that maintains
      institution                                             accounts for individuals and corporations that receive ACH credit and
                                                              debit transactions.

      Return item                                            A return item is a transaction that has been returned by a receiving depository
                                                             institution because it cannot be posted. For example, the receiving customer
                                                             may not have an account with the Institution or may not have sufficient funds
                                                             in his/her account to fund a debit transaction.




                                                             The volume of ACH payments has been increasing rapidly. In 1996,
Basic Data                                                   approximately 4 billion payments, totaling $12.1 trillion, were processed
                                                             on the ACH. This is a 55-percent increase in the volume of payments since
                                                             1992.




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    yitt^;:^i«f-^v4ikK$'   i?5S%i!^,(S,; ,^WMmim\^^£B?.
                                                     ^•'!fet1li^&1tt^lt»«ktl;.|...;l,«u>riM.,^•aA^•.«»ii»a4^^'')^l^^•^^
                                                            Section 3: Retail Payment Systems • AGH
                                                            Automated Clearing House




                                                            The Federal Reserve processes both commercial and goverrunent ACH
                                                            payments. In 1996, the Federal Reserve processed approximately
                                                            2.4 billion commercial ACH transactions, almost 80 percent of all interbank
                                                            commercial ACH payments. Cunently, all government ACH payments are
                                                            processed by the Federal Reseive.'^ Moreover, as a result ofthe Debt
                                                            Collection Improvement Act of 1996, Section 31001(x), the volume of
                                                            government ACH transactions is expected to increase substantially, DCIA
                                                            Section 31001 (x) requires that all federal payments, except Internal
                                                            Revenue Service payments 3Jid payments to individuals who certify that
                                                            they do not have bank accounts, be issued via EFT by January 1, 1999.

                                                            NYACH serves nearly 800 commercial banks, savings banks, savings and
                                                            loans, and credit unions, and processes approximately 10 percent ofthe
                                                            ACH'S commercial transaction volume in the United States, VISA serves over
                                                            290 financial institutions in the United States, and the American ACH serves
                                                            approximately 100 financial institutions. As shown in table 3.7, the volume
                                                            of cdl ACH providers is increasing.

                    Table 3.7: Volume of ACH
                    Transactions Processed by the Four      Items in millions
                    ACH Providers, 1992-1996                                                                                                           Percent
                                                            ACH provider                                                 1992             1996         change
                                                            Federal Reserve: commercial                                  1,275           2,372                  86%
                                                            Federal Reserve: government                                    531             625                  18
                                                            NYACH                                                          185             317                  71
                                                            American                                                        49               93                 90
                                                           VISA                                                            151             311              106
                                                            Note: Double counting exists in the volume figures for the private processors. The volume figures
                                                            for NYACH, American, and VISA include some ACH entries that are sent or received from the
                                                            Federal Reserve.

                                                           Sources: Federal Reserve Board's 1995 Annual Report, American. National Automated Clearing
                                                           House Association (NACHA), NYCHA, and VISA,



                                                           The fees charged by ACH providers for processing ACH transactions are
                                                           significantly lower than the fees assessed for Fedwire funds transfers and




                                                           '^Government payments refer only lo payments originated by the federal government. All other ACH
                                                           payments are referred to as commercial, including those originated by state and local governments.
                                                           Although the Federal Reserve processes ACH government payments for the Treasury, the Treasury is
                                                           not statutorily mandated to use the Federal Reserve.



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iil^f.'4>.T,;'itA            ^^.v.-^4.j^^t^ii^itfe4ifea^li'»^,aSa
                                              Section 3: Retail Payment Systems • ACH
                                              Automated Clearing House




                                              the Clearing House Interbank Payment System (CHIPS)'^ transfers. For
                                              example, the separate fees charged the originator and the receiver are
                                              typically slightly less than a penny. As of January 2,1997, the fee charged
                                              to the sender and the receiver of a Fedwire is $0.45 per transfer. The fee
                                              for a CHIPS transfer ranges from $0.13 to $0.40, depending upon the
                                              participant's monthly transaction volume and other factors.

                                              As shown in figure 3.4, the average value of an ACH transaction has stayed
                                              consistently around $4,000; in 1995, the average value of an ACH
                                              transaction was $3,847. In comparison, in 1995, the average value of a
                                              Fedwire funds transfer was $2.9 million.


Figure 3.4: The Average Value of an
ACH Transaction, 1992-1995                    4S00     Dollars

                                             4400

                                             4300

                                             4200

                                             4100

                                             4000     _   _   _

                                             3900

                                             3800

                                             3700

                                             3600

                                             3500     ^ ^ ^ ^

                                                 1992                            1993                             1994                                1995

                                                 Year



                                             Source: NACHA,




                                             Table 3.8 shows the total dollar amount of ACH transactions for each of the
                                             four ACH providers for the period 1992 through 1996.


                                             "^Fedwire is :m electronic funds Iraiisl'cir network operated by the Federal Heserve fcjr large-dollar
                                             value transfers. CHIPS, the other large-dollar electronic payment system, is owned by NYCHA. For
                                             more discussion on Fedwire and CHIPS, sec the F'cdwirc Funds Transfer and Clearing House
                                             Interbank Payments System subsections in Section I.


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                  "r skiSe ito®^i^»i8jp?i(ai>i&iSCT                                                                                       '-y*:a.-t'Jtt.^je':^.i-
                                      Section 3: Retail Payment Systems • ACH
                                      Automated Clearing House




Table 3.B: Total Amount of Dollars
Processed by Each ACH Provider,      ACH provider                                1992                1996              Percent change
1992-1996                            Federal Reserve:                            $6,5 trillion       $8,7 trillion
                                       commercial                                                                                     34%
                                     Federal Reserve:                            860 billion         1.3 trillion
                                       government                                                                                     51
                                     American                                    76,7 billion        174.7 billion                   128
                                     NYACH                                       2,0 trillion        2.6 trillion                     30
                                     VISA ,                                      N/A                 656.0 billion
                                     N/A: Not available.
                                     Note: Double counting exists in the dollar-value figure's for the private ACH processors. The
                                     dollar-value figures for NYACH, American, and VISA Include some ACH entries that are sent to or
                                     received from the Federal Reserve.
                                     Sources: Federal Reserve Board. American. NYCHA, and VISA.




                                     The ACH operates by a batch processing system in which groups of
Processes                            transactions are transmitted to ACH operators throughout the day. As the
                                     groups of transactions are received, they are edited for conformance with
                                     the operating rules of NACHA, settlement data for the originating and
                                     receiving depository institutions are captured, and individual transactions
                                     are sorted to the receiving depository institutions.

                                     Unlike Fedvdre transfers, which are processed and settled immediately,
                                     ACH transactions are valued-dated, that is, the originator of ACH
                                     transactions includes the settlement date in the payment instructions
                                     when it originates the transaction, ACH credit transactions may be
                                     originated up to 2 business days before the settlement date, and the ACH
                                     debit transactions may be originated 1 business day before the settlement
                                     date. Government entries can be originated up to 4 days before the
                                     settlement date.

                                     Depository institutions that use the Federal Reserve as their provider can
                                     deposit files of ACH transactions at the Federal Reserve Bank anytime
                                     during the day. ACH transactions may be destined for institutions located in
                                     the same Federal Reserve district or in another Federal Reserve district.
                                     The Federal Reserve processes ACH transactions nearly 24 hours a day.'"




                                     '"All Federal Reserve ACH processing is done at the East Rutherford (New Jersey) Operations Center
                                     of the FRBNY.



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                            Section 3: Retail Payment Systems • ACH
                            Automated Clearing House




                           In 1994, NYACH, VISA, and American established the Private ACH Exchjinge
                           (PAX). Since the establishment of PAX, New York, American, and VISA can
                           exchange transactions directly without using the Federal Reserve as an
                           intermedicuy processor, PAX handles about 1 million transactions monthly.
                           Previously, the three ACH private processors had to use the Federal
                           Reserve's ACH service to deliver ACH transactions among themselves. For
                           example, when American sent an ACH file to VISA, American would send the
                           file first to the Federal Reserve, where the transactions were processed
                           and distributed to VISA for its members. Now, using PAX, American can send
                           the ACH file directly to VISA.'^

                           The Federal Reserve provides settlement services to all three
                           processors—net entries are posted for members of VISA and American;
                           gross entries are posted for NYACH. Net settlement allows participants that
                           use private processors to settle their net positions either through Fedwire
                           funds transfers, using special settlement accounts at Reserve Banks, or by
                           accounting entries, which are posted to participants' reserve accounts by
                           Federal Reserve Banks. Currently, VISA is the only one of the three private
                           ACH processors that uses the Fedwire funds transfer service for settlement.

                           Examples of one ACH credit transaction and one ACH debit transaction
                           follow.


Example of an ACH Credit   Figure 3.5 illustrates how a company's payroll is transmitted over the ACH.
Transaction                Example: Company A, headquartered in Washington, D.C, with offices
                           located in Chicago, Los Angeles, and New York, pays all of its employees
                           by direct deposit using the ACH network.

                           Originator of the ACH payment: Company A.
                           Receiver of the ACH payment: Company A's employees.
                           Originating depository institution: Bank A.
                           Receiving depository institutions: Banks in which Company A's employees
                           have their accounts.




                           "Private ACH operators still continue to use the Federal Reserve to deliver a significant number of
                           transactions.



                           Page 121                                   GAO/GGD-97-73 Payments, Clearance, and Settlement
                                                 SecUon 3: Retail Payment Systems • ACH
                                                 Automated Clearing House




Figure 3.5: Typical ACH Credit Transaction—The Direct Deposit of a Payroll



 D.ny 0 (J.-inu.-iry t 3 or   l^)




     Company A (originator) originates
     an ACH credit Iransac Ion for each
                                                       i    Company A
                                                            Pny:   .IDHH I J H "
                                                            A m o u n t : Si I'DH
                                                            Dnie: 1 !•> '.'I.
                                                            Acci. no.: l l T M S f i / H ' i m i 1
                                                            D.ink r^o.: u u o t


            ol Its employees.




O    Company A electronically transmits
      its ACH inansactions lo its bank,
       Bank A (originating institution).
                                                                                                                      Alter EROC receives Bank A's ACH
                                                                                                                   transactions, Fed ACH (operating system)
                                                                                                                       sends a copy ol them to a back-up
                                                                                                                              processor In Dallas.




O     Bank A edits the ACH transactions;
     (hen it balances the total value of the
       individual transactions against the
      total value Company A says It sent
                    to Bank A.




O     Bank A combines Company A's
     ACH transactions witti batches of
  transactions from its other customers:
then it elaclronically transmits tliese to the
 Federal Reserve, which receives them at
      its centralized ACH processing
               center (EROC).




                                                 Page 122                                            OAO/GGD-97-73 Payments, Clearance, and Settlement
 Section 3: Retail Payment Systems < ACH
 Automated Clearing House




                                                   V Fed ACH sorts all transactions: than
                                                      it electronically transmits Ihem to tlie
                                                          banks (receiving Institutions) ol
                                                    Co. A's employees (receivers) in Chicago.
                                                          Los Angeles, Washington, D.C.
                                                     and to NYACH. NYACH will transmit the
                                                        transactions to the New York bank.




                                                   D.iy 2 or 3 (Jnnunry, 15)



                                                   ^ A l 6:30 a.m. (ET), the Federal Reserve
                                                    posts the debit to Bank A's reserve account
                                                     (or Bank A's correspondent account) and
                                                   posts the credits to the racelvino institutions
                                                         ol Co. A's employees in Chicago.
                                                          Los Angeles, Washington. D.C..
                                                                   and New York,
                                                    The payment Is now provisionally settled.
                                                       Sometime during the day. Bank A
                                                          will lund the ACH payment.




                                                        Each ol the employees' banks posts
                                                      the value ol their pay to their accounts.
                                                             making it available at the
                                                               opening o( business.




                                                  bay Sor 4 (January 16)



                                                   Alter the Federal Reserve completes its
                                                      accounting, settlement ol the ACH
                                                              transaction is final.




                                                                  (Figure notes on next page)

Page 123                            GAO/GGD-97-73 Payments, Clearance, and Settlement
 Section 3: Retail Payment Systems • ACH
 Automated Clearing House




Note: The Federal Reserve retains the right to reverse a credit given to a receiver of an ACH
credit transaction until the Federal Reserve's books have been closed, v^rhich generally occurs
during the night of the settlement day. The Federal Reserve could reverse a credit to the receiving
institutions on the night of Jan. 15, but not later than the morning of Jan. 16.

Source: GAO analysis of information provided by the Federal Reserve Board.




Page 124                                 GAO/GGD-97-73 Payments, Clearance, and Settlement
                          Section 3: Retail Payment Systems • ACH
                          Automated Clearing House




Example of an ACH Debit   Figure 3.6 illustrates an example of an ACH debit transaction in which a
Transaction               homeowner sends his or her mortgage payment to a mortgage company
                          through the ACH system. In this example, both the originating depository
                          institution and the receiving depository institution are using private ACH
                          providers to process the ACH transaction.

                          Example: A homeowner in New York authorizes its mortgage company,
                          which is located in California, to make a withdrawal of $2,000 each month
                          from the customer's deposit account for the purpose of paying his or her
                          monthly mortgage.

                          Originator of the ACH transaction: Mortgage Company.
                          Receiver of the ACH transaction: Homeowner.
                          Originating depository institution: Bank A in San Fremcisco.
                          Receiving depository institution: Bank B in New York.




                          Page 125                           GAO/GGD-97-73 Payments, Clearance, and SetUement
                                                   Section 3; Retail Pa>'ment Systems • ACH
                                                   Automated Clearing House




Figure 3.6: Typical ACH Debit Transaction—Bill Payment



Day 0 (January 13)



    '          The mortgage company
        (originator) prepares the withdrawal
             information and submits the
        information to its deposit institution,
              Bank A, in San Francisco.




e           Bank A presents the
         ACH debit entry for $2,000 lo
              VISA, Bank A's
               ACH operator.




O             VISA processes
 ttie information and transmits the ACH
debit entry lor $2.00.0 to NYACH via PAX.
 The homeowner's depository institution
    Bank B (receiving institution), uses
       NYACH as its ACH operator.




                                                  Page 126                             GAO/GGD-97-73 Payments, Clearance, and Settlement
     Section 3: Retail Payment Systems • ACH
     Automated Clearing House




                              John Doe Homeowner
                               Accl.no.-123456789               pay 1 (January 14)
                                Debit     Credit

/
                                                                             Bank B debits
                                                                  the homeowner's account for $2,000
                                                                      and sends that transaction in
                                                                             a file to VISA.




                                                                 Q
                                                                 ^^          VISA receives the file
                                                                       Irom Bank B including the $2,000
                                                                  transaction and sends the file to Bank A
                                                                    including the $2,000 transaction using
                                                                           the Federal Reserve net
                                                                              settlement service.^




                                                                   '               VISA selllement
                                                                         is final when Bank A is credited.
                                                                       Bank A makes funds available lo the
                                                                        mortgage company no later then
                                                                            clbse-ol -businoss that day.




           Bank A .
    originating institution




    =VISA settles its ACH entries through a special settlement account at the Federal Reserve Bank of
    San Francisco. Each VISA participant in a net debit position sends a Fedwire funds transfer lor
    the amount of its net debit position. When all participants in net debit positions have sent
    Fedwires to fund the account. VISA sends Fedwires equal to each of the remaining participants'
    net credit positions.



    Source: NACHA.




    Page 127                                 GAO/GGD-97-73 Payments, Clearance, and Settlement
                        Section 3: Retail Payment Systems • ACH
                        Automated Clearing House




                       The ACH is governed primarily by rules •written by the private sector, NACHA
Regulatory Oversight   Operating Rules and Guidelines, which are supplemented by the rules of
                       local ACH associations. The National Automated Clearing House
                       Association (NACHA) is a nonprofit banking trade association that
                       promulgates the rules and operating guidelines for electronic payments
                       through the ACH. NACHA represents 38 regional ACH associations and their
                       more than 14,000 depository institution members. The Federal Reserve
                       recognizes NACHA as the informal rulemaker for ACH transactions.
                       According to a Federal Reserve official, NACHA, however, has no
                       enforcement authority over depository institutions that use the ACH or over
                       ACH providers to ensure compliance with its rules.

                       Depository institutions using the Federal Reserve's ACH services must
                       comply !vith the Reserve Banks' uniform ACH Operating Circular, which
                       incorporates the operating rules of NACHA by reference and indicates any
                       rule that the Federal Reserve has not determined to incorporate in its
                       uniform circular. In addition, depository institutions that originate and
                       receive consumer ACH transactions must comply with the regulations that
                       the Board of Governors of the Federal Reserve System promulgates in
                       Regulation E, which implements the Electronic Funds Transfer Act.
                       Corporate ACH credit transactions are governed by ucc 4(A). When the
                       federal government is the originator, the transactions are governed by the
                       Treasury Department's regulations, 31 CFR Part 210.




                       Page 128                            GAO/GGD-97-73 Payments, Clearance, and Settlement
                                                               Section 3: Retail Payment Systems • ACH
                                                               Automated Clearing House




                                                              For the purposes of this report, we discuss some of the most important
Risk and Risk                                                 risks and risk mitigations associated with the ACH.
Mitigation
Table 3.9: Risk and Risk l\/iitigation for
ACH                                                           Risk                                                Risk mitigation
                                                              Temporal credit risk                                Credit monitoring
                                                              Return item risk                                    Credit monitoring



Risk 1: Temporal Credit                                      The originating institution of an ACH credit transaction is obligated to pay
                                                             for any ACH credit entry that it initiates. Because the ACH credit
                                                             transactions may be originated up to 2 business days before the settlement
                                                             date cmd a customer may not fund its obligation until late on the
                                                             settlement day, the originating depository institution may be exposed to
                                                             credit risk for nearly 3 business days. This type of risk is called temporal
                                                             risk.

Mitigation                                                   Credit monitoring by financial institutions. According to the Federal
                                                             Reserve's payments system risk policy, depository institutions that
                                                             originate ACH credit transactions should

                                                             perform a credit assessment of all customers originating large-dollar
                                                             volumes of ACH credit transactions;
                                                             establish interday credit limits for originating customers that originate ACH
                                                             credit transactions based on each institution's credit assessment;
                                                             monitor compliance with the credit limit across all processing cycles for a
                                                             given settlement date; and
                                                             require the customer either to prefund its account, provide collateral, or
                                                             deposit the ACH file on the night cycle preceding the settlement day if the
                                                             customer's financial condition is deteriorating.'^


Risk 2: Return Item                                          The major risk facing institutions that originate ACH debit trcmsactions is
                                                             return item risk. Return item risk occurs when institutions receiving ACH
                                                             debit transactions are unable to fund payment requests and the
                                                             transactions must be returned to the originating institutions. Receiving
                                                             institutions may return ACH debit transactions for a number of reasons,
                                                             including insufficient fimds, the existence of a stop payment order, or an
                                                             unauthorized transaction. The risk to depository institutions originating


                                                             '"Guide to the Federal Kescrve's Payments System Risk Policy. Hoard of Governors of the Tederal
                                                             Reserve System, p. 57.



                                                            Page 129                                   GAO/GGD-97-73 Payments, Clearance, and Settlement




                      tjfejilrari^>rf.»<Jy-jKt.tt. .^^^Mi''^^'i•J.., •
              SecUon 3: Retail Payment Systems • ACH
              Automated Clearing House




             debit transactions depends on when they make funds available to their
             customers. Originating depository institutions typically make funds from
             ACH debit transactions available to their customers at the opening of
             business on the settlement date for the transactions. Receiving institutions
             must return ACH debit transactions so that the originating institutions
             receive the returned transactions by the opening of business on the second
             business day following the settlement day.

Mitigation   Credit monitoring by financial institutions. The Federal Reserve's
             payment system risk policy recommends that depository institutions
             originating ACH debit transactions perform a credit assessment and
             monitor the return experience of their customers. Depending upon the
             results of these analyses, depository institutions are expected to take steps
             to protect themselves from losses, such as delaying availability for all or
             some portion of fimds collected or requiring balances or collateral to
             cover the value of potential return items.




             Page 130                           GAO/GGD-97-73 Payments, Clearance, and Settlement
Section 4: New and Emerging Products and Services * Overview

Overview of New and Emerging Financial
Products and Services

                                   In this section we discuss emerging payment technologies. These include
                                   stored-value cards, electronic banking, and financial transactions made
                                   over the Internet. These technologies have the potential to alter the way
                                   many everyday payments are made.


                                   All of these technologies take advantage of advances in computer chips,
Main Characteristics               conununications, and software.
                                   Some have the potential to reduce the cost and increase the converuence
                                   of making payments. Over time, these technologies may displace some
                                   transactions that are currently made by cash and check.


                                   Most technologies are in the testing and implementation stage.
Statistical Information            In October 1996, 2.1 million U.S. households were banking online.
                                   Tests of general purpose stored-value cards have been conducted for
                                   several years, but nowhere in the United States are they available for
                                   general use.
                                   In 1995, an estimated quarter of a billion dollars of credit card purchases
                                   were made over the Internet. The dramatic increase in the number of
                                   Internet users and businesses offering products over the Internet suggests
                                   that this volume will increase rapidly.


                                   Regulators will have to adapt existing regulations, and perhaps adopt new
Regulatory                         regulations, to accommodate these new technologies. For example, they
Information                        must decide to what extent regulations governing electronic funds transfer
                                   (EFT) should be applied to stored-value cards.


                                   Conducting fmancial transactions over the Internet creates new
Risk Information                   opportunities for counterfeiting, money laundering, and tax evasion.
                                   Securing payments over the Internet will involve the implementation of
                                   new and unproven security measures.




                                   Page 131                       GAO/GGD-97-73 Payments, Clearance, and Settlement
                                       Section 4: New and Emerging Products and Services • Overview
                                       Overview of New and Emerging Financial
                                       Products and Services




                                      The Internet is a network of networks connecting millions of desktop
The Internet                          computers in homes, businesses, universities, and governments.

                                      Background

                                      The Internet began in the 1960s as a Department of Defense effort to link a
                                      number of independent computer systems so that researchers around the
         Netscape   AAMMEERRI ICCAA
                                      country could share a few super computers.
                                      The Internet is largely self-goverrung.
                                      The Internet is an open communications system with no built-in means to
                                      protect privacy of information, such as a consumer's credit card number.

                                      Developments

                                      The number of desktop computers cormected to the Internet increased
                                      dramatically in the mid-1990s as several developments made the Internet
                                      increasingly useful and easy for nonexperts to use. These developments
                                      are

                                      availability of simplified e-mail systems;
                                      establishment ofthe World Wide Web (www),' a collection of documents
                                      interlinked by a shared language, and
                                      development of user-friendly www browsers, programs designed to read
                                      documents on the www.




                                      'Many people confuse the World Wide Web and the Internet. As stated earlier, the Internet refers to the
                                      overall network of networks.



                                      Page 132                                   GAO/G6D-97-73 Payments, Clearance, and Settlement
Section 4: New and Emerging Products and Services * Stored-Value Cards

Stored-Value Cards


                                   Recent developments in encryption, microchips, and computer network
Description and Use                technology have enabled consumers to make electronic payments through
                                   the use of a stored-value card, a credit-card-sized device in which money
                                   value is stored digitally.^ Although stored-value cards resemble credit or
                                   debit cards, transactions made with stored-value cards resemble
                                   transactions made with currency or coin. For instance, users of
                                   stored-value cards do not need a deposit account at a fmancial institution
                                   nor do merchants have to verify a cardholder's identity when purchases
                                   are made. Stored-value cards are intended for repetitive, low-value
                                   transactions too small for economical use of a credit or debit card, such as
                                   payments for mass transit or fast food.

                                   Stored-value cards have features that resemble traveler's checks, in that
                                   the card purchaser surrenders cash value in exchange for obligations of an
                                   issuer, which may not be a fmancial institution. However, unlike traveler's
                                   checks, stored-vedue cards are designed for small-dollar value purchases
                                   and can be used only with hardware devices equipped to accept payments.
                                   The maximum dollar value that can be held on a stored-value card is
                                   determined by the issuer. One industry representative predicted that this
                                   amount would be about the same as the maximum withdrawal from an
                                   automated teller machine (ATM).

                                   Two types of multipurpose stored-value cards exist: disposable
                                   stored-value cards, which are loaded with a fixed doUar value and are
                                   discarded once all the stored cash is spent, and reloadable cards—such
                                   as the Mondex card—which can be replenished by inserting the card in a
                                   specially equipped ATM, a specially equipped telephone, or an electronic
                                   wcdlet.^ In the near future, individuals may be able to transfer funds to a
                                   stored-value card using a personal computer connected to a network.




                                   -Ont type of stored-value card is the single-purpose card, e.g., a card used to pay for telephone calls
                                   and transit fares. In this report, we will focus on general purpose cards that can be used to buy Roods
                                   and senices from a variety of vendors.

                                   'A device that looks like a calculator and is designed to transfer value from one card to another.



                                   Page 133                                    GAO/GGD-97-73 Payments, Clearance, and Settlement
                        Section 4: New and Emerging Products and Services • Stored-Value Cards
                        Stored-Value Cards




Key Terms
Q   Debit card          A debit card is a bank card that draws funds directly from a consumer's
                        checking or savings account.

Q   Electronic wallet   An electronic wallet is a small portable device that loads and reads stored-
                        value cards.

    Encryption          Encryption is the process of disguising a message (using mathematical formulas
                        called algorithms) in such a way as to hide its substance.

    Stored-value card   A stored-value card is a credit-card-sized device, implanted with a computer
                        chip, with stored money value. A reloadable stored-value card can be reused
                        by transferring value from an automated teller machine or other device. A
                        disposable card cannot be reloaded.


                        General-purpose stored-value cards are still in the early stage of
Basic Data              development. Tests of disposable and reloadable stored-value cards are
                        being conducted in about two dozen countries, including the United
                        States. Banks, credit card companies, jmd technologically based
                        companies see the automation of small transactions as one ofthe frontiers
                        of payment technology. Table 4.1 describes a few ofthe most extensive
                        tests of stored-value cards.




                        Page 134                            GAO/GGD-97-73 Payments, Clearance, and Settlement
                                      Section 4: New and Emerging Products and Services • Stored-Value Cards
                                      Stored-Value Cards




Table 4.1: Stored-Value Card Tests
                                      Location                  Description
                                      Svi/indon, England        In July 1995, Mondex, a venttJre of \wo British banks, began
                                                                conducting a test of stored-value cards in Swindon, England, a
                                                                city with 190,000 residents. The cards and the merchant
                                                                hook-ups were provided free of charge.

                                                                • Swindon residents were offered reloadable cards to be used at
                                                                  a majority of the city's stores, parking meters,
                                                                  pay phones, and buses.
                                                                • 8.000 residents actually used the cards,

                                                                • 750 merchants out of the 1,000 in Swindon signed up
                                                                  to accept the cards.
                                     1996 Olympics in          At the 1996 Olympics in Atlanta, VISA and the three largest
                                     Atlanta, GA               banks in the southern United States conducted the largest
                                                               experiment with stored-value cards.

                                                               • About 2 million stored-value cards were made available in
                                                                 denominations of $10. $20. $50, and $100.

                                                               • All of ttie 85,000 spectators at the opening ceremonies were to
                                                                 be given $5 cards.

                                                               • In July 1996, 198,000 transactions were made with VISA cash
                                                                  cards.                 .
                                     Manhaittan, NY            Chase Manhattan Bank, Citibank, MasterCard, Mondex, and
                                                               VISA announced an extensive pilot project on the upper west
                                                               side of Manhattan to begin in October of 1997.

                                                               • Between 50,000 and 100,000 bank customers are to be offered
                                                                  reloadable cards that will be subject to
                                                                 predetermined dollar limits.

                                                               • The banks are expected to charge for the cards, although some
                                                                 may be offered at a nominal cost or for free.

                                        '                      * About 500 merchants are expected to accept the cards.
                                     Source: GAO analysis of industry data.


                                     Irutial results of these pilots suggest that consumers will be slow to adopt
                                     stored-value cards. According to press reports, in neither the Mondex nor
                                     the VISA trials did the number of users meet issuers' expectations.




                                     Page 135                                 GAO/GGD-97-73 Payments, Clearance, and Settlement
             Section 4: New and Emerging Products and Services '* Stored-Value Cards
             Stored-Value Cards




            The economic viability of stored-value cards has yet to be proven. Since
            stored-value cards cannot be read by existing ATMS or the card readers
            attached to cash registers, an initial investment in card reader machines
            will be required. These costs should decrease over time as the capacity to
            read stored-value cards is incorporated into POS terminals and other
            devices.

            Figure 4.1 illustrates how Mondex anticipates processing a transaction
Processes   using a Mondex stored-value card.

            Example: A consumer purchases a stored-value card to make purchases.
            After the consumer makes the purchase, using stored value as payment,
            the merchant exchanges the stored value for a bank deposit.




            Page 136                             GAO/GGD-97-73 Payments, Clearance, and Settlement
                                               Section 4: New and Emerging Products and Services • Stored-Volue Cards
                                               Stored-Value Cards




Figure 4.1: A Typical Mondex Card Transaction




                                                                   0   The Mondex originator
                                                                       sells Mondex value to
                                                                        Bank A. an Issuer of
                                                                           Mondex cards.
                                                                      The Mondex originator
                                                                   uses the money from Bank A
                                                                     to purchase government/
                                                                        government backed
                                                                            securities.

                                                                                                                       Bank A sells Mondex value lo
                                                                                                                       consumers by transferring the
                                                                                                                           requested dollar value
                                                                                                                        to a Mondex card/terminal.
                                                                                                                        Consumer A purchases $50
                                                                                                                         in Mondex value, which is
                                                                                                                           loaded onto a Mondex
                                                                                                                             slored-value card.




                            ' ^ Merchant C's bank sends                                                          ^        Consumer A pays for $3.95
                             stored value back to the originator                                                      wonh of purctiases and transferrs
                              in exchange for equivalent credit                                                      that amount of stored Mondex value
                                       10 its account.                                                                 from his/tier card to Merctiani C's
                                                                                                                                     terminal.




                                                                       "               Hilerchant C
                                                                              sends accumulated Mondex
                                                                             value to its bank in exchange
                                                                           for equivalent dollar deposits into
                                                                                 Merchant C's account.




                                   Merchant C's Bank                                                                         Merchant C




                                             Source: GAO analysis of industry data.




                                             Page 137                                          GAO/GGD-97-73 Payments, Clearance, and Settlement
                               Section 4: New and Emerging Products and Services • Stored-Value Cards
                               Stored-Value Cards




                               Nonbanks offering electronic cash, such as stored-value cards, are not
Regulatory Oversight           subject to the bank supervisory regime. Similarly, nonbanks are not
                               subject to any of the statutory and prudential limits that apply to banks.''
                               Banking institutions that issue such cards would be examined by their
                               respective regulators, such as the Federal Reserve or the Comptroller of
                               the Currency. Currently, there are no federal regulatior\s that specifically
                               address the regulatory oversight of stored-value cards. There are, however,
                               regulations that may apply to stored-value transactions, such as the
                               Federal Reserve's Regulation E.

                              Regulation E is intended to protect consumers in electronic funds
                              transfers. In March of 1996, the Federal Reserve Board proposed to amend
                              its Regulation E, "Electronic Funds Transfers," to exempt from coverage
                              stored-value cards meeting specific criteria. Among other things, the
                              regulation requires that consumers be pro'vided with a written record of
                              electronic transactions and generally limits consumer liability for
                              unauthorized electronic funds transfers to $50. The Board proposed to
                              exempt from Regulation E stored-value cards with a maximum value of
                              $100 or less and stored-value cards that are not linked to any central
                              database.''

                              The Economic Growth and Regulatory Paperwork Reduction Act of 1996
                              contained provisions instructing the Federal Reserve not to finalize any
                              amendments to the Electronic Funds Transfer Act (EFTA) for at least 9
                              months from the date of enactment (September 30,1996). It edso
                              instructed the Federal Reserve to conduct a study of electronic
                              stored-value products to determine whether the provisions of EFTA could
                              be applied to such products without adversely affecting the cost,
                              development, and operation of such products.

                              On July 16, 1996, FDIC issued an opinion describing what kinds of
                              stored-value cards could qualify for deposit insurance. Observers believe
                              that most stored-value cards will not be covered, FDIC observed that the
                              principles discussed in the opinion also would apply to stored-value
                              computer network systems that allow consumers to access stored-value
                              using personal computers.

                              ^See. for example, OCC interpretive letters regarding Huntington National Bank (Aug. 19, 1996) and
                              Wells Fargo Bank, etal (Dec. 2, 199G), giving national banks permission to invest in limited liability
                              companies that will operate stored-value card systems.

                              "^^Like debit cards, stored-value cards that require online authorization at the time of transaction would
                              be subject to most Regulation E requirements. Certain off-line stored-value-cards—those with
                              balancijs maintained on a .separate database—would be subject to only the initial disclosure
                              requirements of Regulation E.



                              Page 138                                                        GAO/GGD-97-73 Payments, Clearance, and Settlement




           ^^is'm^B^SSmmm?.                              .   . . .•..•..>ibi'^A<.t.A*ft<>ftti.^>;.VA.-i...-.   ..^..
                                      SecUon 4: New and Emerging Products and Services • Stored-Value Cards
                                      Stored-Value Cards




                                     For purposes of this report, we discuss some of the most important risk
Risk and Risk                        and risk mitigations associated with stored-value cards.
Mitigation
Table 4.2: Risk and Potential Risk
Mitigation for Stored-Value Cards    Risk                                                 Risk mitigation
                                     Credit risk
                                                                                                         Siffi                         £i
                                     Fraud risk                                                          mmm^mmmm
                                              Shaded cells Indicate that mitigations are not in general use since stored-value cards are
                                      m       still in the developmental stage.


Risk 1: Credit                       When people purchase stored-value cards, or when merchants accept
                                     stored-vedue as payment for goods and services, they expose themselves to
                                     the credit risk that the issuer of the stored-vjdue card will be unable to
                                     redeem the value stored on the card.

Mitigation                           Restrictions on issuers. The major stored-value tests in the United
                                     States are being conducted by nonbanks such as VISA, MasterCard, and
                                     Mondex. These issuers' operations are not covered by bank regulation, but
                                     industry representatives believe that they could be covered by applicable
                                     state regulations such as those governing nonbank "money
                                     transinitters"^firms that issue "instruments for the transmission of
                                     money," such as traveler's checks and money orders.*" The state
                                     regulations provide a number of safeguards for users of these nonbank
                                     services. Issuers must generally be licensed and bonded, are required to
                                     hold a minimum level of capital, may be required to hold reserves equal to
                                     100 percent of outstainding Vcdue, and are also subject to periodic
                                     examinations and audits.




                                     'According to the Federal Reserve, 44 states have enacted such laws, which industry representatives
                                     believe would apply, or will be amended to apply, to multipurpose stored-value cards.



                                     Page 139                                  GAO/GGD-97-73 Payments, Clearance, and Settlement
Rr.



                       Section 4: New and Emerging Products and Services • Stored-Value Cards
                       Stored-Value Cords




      Risk 2: Fraud   Recognizing that stored-value cards could be attractive targets for
                      computer criminals, vendors have made security a high priority. Some
                      researchers assert that aflawmay make it possible to counterfeit certain
                      kinds of stored-value cards currently used in Europe and being tested in
                      the United States.

      Mitigation      Issuer security measures. Stored-value cards are constructed in such a
                      way that their chips are likely to be destroyed if an attempt is made to
                      tamper with them. Card issuers are studying sophisticated cryptographic
                      techniques to prevent fraud. Card issuers may also periodically replace
                      cards with new cards that offer alternative safeguards against fraud.




                      Page 140                            GAO/GGD-97-73 Payments, Clearance, and Settlement
 Section 4: New and Emerging Products and Services • Electronic Banking

 Electronic Banking


                                      Advances in data communications and computer technology have enabled
Description and Use                   depository institutions as well as securities brokerage firms cind other
                                      nonbankfinancialservice providers—including corrunercial online
                                      services—to offer electronic banking services.^ Electronic banking
                                      services may be delivered by means of automated teller machines (ATM);
                                      specially equipped telephones, such as screen telephones;^ and personal
                                      computers equipped with modems and communication software.

                                      Many consumers may choose one or more of these means to pay bills,
                                      access information about account balances, transfer funds between
                                      checking and savings accounts, and purchase mutual fund shares, among
                                      other banking-related activities. Specific options available to consumers
                                      vary by depository institution. Table 4.3 lists banking services accessible
                                      through electronic means.

Table 4.3: Consumer Financial
Activities Accessible by Electronic
                                                                                                                                   ^^mm
                                                                                                Method of payment
Means, 1996                                                                                      Screen
                                      Type of transaction                        ATM         telephones       Telephones              Computers
                                      Pay bills                                   Yes                 Yes=              Yes"                            Yes"
                                      Transfer funds between                      Yes                 Yes               Yes                             Yes
                                      personal accounts
                                      Inquire about account                       Yes                 Yes               Yes                             Yes
                                      balances
                                      Purchase Certificate of                      No<=                No               Yes                             Yes
                                      Deposit (CD)
                                      Purchase mutual fund shares                  No                 Yes               Yes                            Yes
                                      Apply for loan                               No                 Yes              Yes                             Yes
                                      Obtain currency                             Yes                  No               No                               No
                                      "Capability to make payments is generally limited lo certain preidentified businesses, such as
                                      telephone companies.

                                      ''Payment of bills through home computers is generally accomplished using the services of a
                                      third-party service provider,

                                      'Some, but not most. ATMs offer opportunities to purchase CDs.

                                      Source: GAO analysis of industry data.




                                      'Electronic banking Is the use of electronic means lo access banking services. Examples of oleclronlc
                                      banking include accessing an account balance via an ATM, transfer of funds between personal
                                      accounts using the telephone, and payment of bills using a computer

                                      "Screen telephones are telephones that have a small viewing screen att.ached and that may have a
                                      keyboard. Some home banking services use these devices.



                                      Page 141                                  GAO/GGD-97-73 Payments, Clearance, and Settlement




                                                                                                                       u^t   . A M m <L'.rtultfy.U''|)?tR.'.
                                   SecUon 4: New and Emerging Products and Services • Electronic Danking
                                   Electronic Banking;




                                  Depository institutions and other financial service providers (e.g.,
                                  nonbanks^) compete in offering many electronic banking
                                  services—including services for paying bills, purchasing CDs and mutual
                                  funds, and processing loan applications. In addition, some foreign banks
                                  are using the Internet to pro'vide various services, including the sale of
                                  securities.



Key Terms
    Commercial online service      A commercial online service is typically an integrated package of services
                                   providing news, e-mail, special-interest forums, information resources,
                                   shopping, and other services accessed by consumer and business computer
                                   users with proprietary software and a modem (e.g., America Online,
                                   Microsoft Network, CompuServe, etc.).

Q   Electronic banking             Electronic banking is banking activity accessed by electronic means.

    Electronic funds transfer     Electronic funds transfer refers to any transfer of funds between accounts
                                  through an electronic terminal, telephone, computer, or magnetic tape,
                                  without the use of checks or other paper.

    Internet                      The Internet is an open, worldwide communication infrastructure consisting
                                  of interconnected computer networks that allows access to remote information
                                  and the exchange of information between computers.




                                  Accurate data on electronic banking are difficult to obtain and interpret
Basic Data                        because of both the rapidly evolving means of delivery and the varied
                                  ways in which electronic banking can be done. One study suggests that
                                  banks plan to reduce the number of traditional "bricks and mortar"
                                  branches and replace them, at least in part, with alternative electronic
                                  delivery means, including increasingly sophisticated ATMS that offer many
                                  new services and products, such as the sale of mutual funds and
                                  insurance.'" The study also estimates that telephone banking transactions
                                  •will grow by 50 percent by 1998. Finally, the study predicts continued
                                  explosive growth in PC-based banking for the foreseeable future.



                                  "For purposes of this report we u.se the tcnii "nonbank" to refer to any nondepository flnnnclal .service
                                  provider, including providers such as CheckFrce.

                                  '"Creating the Value Network: 19%, American Bankers Association and Ernest & Young, 199G, p. 11.



                                  Page 142                                    GAO/GGD-97-73 Payments, Clearance, and Settlement




                ww?mm^siwf^^pwWtr-m    iMS^skaittiiU.^c^                . 'ffiiraaiHCTxrB^EH                   jMj'l.«.K'>4l>/<l«.Mr<:<l.'Vv.)£»'i'>>idt'y#.r'
             Section 4: New and Emerging Products and Services • Electronic Banking
             Electronic Banking




            Electronic bill payment is a service offered by banks and nonbanks. For a
Processes   fee, electronic bill payment services pay designated bills, after
            authorization, on a consumer's behalf. Bill payments may be made
            electroniccilly or by printed paper check. If the payee does not accept
            electronic payment, the bill-paying service would print and mail a check
            on behalf of the consumer. This type of payment system is not very
            different from a customer writing checks. The orUy difference is that a
            centralized computer systern is involved in delivering the check to the
            payee. A representative of Intuit, one of the electronic bill payment
            services, told us that about 40 percent of merchants are equipped to
            receive payment electronically, and only a fraction of those
            merchants—about 20 percent—will accept payment without a guarantee
            ofthe payment from the electronic payor. As a result, at least 60 percent of
            all bills paid by this service are paid by paper check.

            There are almost I million users of electronic bill payment services
            provided by the two market leaders—CheckFree and Intuit. As of June 30,
            1996, CheckFree had 729,000 users, and Intuit had approximately 200,000.
            Both CheckFree and Intuit are nonbank financial service providers.

            A bank may provide bill payment services in-house to its customers, or it
            may contract with jm outside electronic bill payment service to provide
            the service for the bank's customers. In addition, consumers may contract
            independently with an electronic bill payment service; in such case, no
            contractual relationship exists between the bank and the service.

            The electronic bill payment process illustrated in figure 4.2 is that of a
            nonbank providing the service to a consumer without a contractual
            relationship with the consumer's bank. The merchant in this case can
            accept electronic payments. To commurucate with tlie bill payment
            system, the consumer uses a home computer equipped with a modem and
            appropriate software. Messages are transmitted over a private
            communication network (not the Internet).




            Page 143                             GAO/GGD-97-73 Payments, Clearance, and Settlement
                                                   Section 4: New and Emerging Products and Services • Electronic Banking
                                                   Electronic Banking




Figure 4.2: Illustration of an Electronic Bill Payment Process




      Consumer A enters into an agreement
  with ABC Billing Systems. Then. Consumer A
      sends an electronic message by home
    computer/modem to ABC Billing Systems
  idontilying Itie merchant, timing, ana amount
      of the payment. Additional information
     affecting the liming of the payment (e.g..
      merchant's ability to accept electronic
        payments) will be handled with ifie
       idenlilicatioh information at Itiis lime.




                                                                                                                 •(Figure notes on next page)



                                                   Page 144                            GAO/GGD-97-73 Payments, Clearance, and Settlement
                        Section 4: New and Emerging Products and Services • Electronic Banking
                        Electronic Banking




                        Note: Electronic bill payment providers recommend that consumers schedule payments 3 to 4
                        days before they are due in case the payment has to be sent through the mail instead of
                        electronically and also to allow for settlement time for ACH.

                       Source: GAO analysis of industry data.



                       Financial institutions that offer electronic banking services are regulated
Regulatory Oversight   by their respective regulators. Banks are regulated by occ and the Federal
                       Reserve. Brokerage firms are regulated by their self-regulatory
                       organization. Businesses other than banks and brokerage firms that offer
                       electronic banking services are subject to investigation by the Federal
                       Trade Commission (FTC), which operates under a broad mandate to
                       regulate interstate commerce, FTC conducts investigations in response to
                       complaints, but it does not regularly and routinely conduct examinations
                       of entities under its jurisdiction because it is not concerned with the
                       financial soundness of those it oversees.

                       The specific electronic banking transactions are governed by the
                       Electronic Fund Transfer Act of 1978, and the Federal Reserve Board's
                       corresponding Regulation E, which is intended to protect consumers
                       against losses due to unauthorized electronic funds transfers. A
                       consumer's liability for unauthorized transactions involving an electronic
                       fund transfer generally is limited to $50 but can be as much as $500 if the
                       consumer fails to timely notify the institution that an access device was
                       lost or stolen. Regulation E also requires financial service providers to
                       inform customers of their rights in the event an unauthorized transaction
                       occurs. That disclosure must be made when an account is opened or
                       before the first electronic transfer is made. Additional disclosure must be
                       made periodically during the life of the account. Also, the customer must
                       receive a written receipt when an electronic trzmsfer is initiated and
                       periodic statements describing each transfer.''




                       "The receipt requirement applies to transfers at electronic terminals but not to transfers initiated by
                       consumers over the telephone, such as home banking transactions.



                       Page 145                                    GAO/GGD-97-73 Payments, Clearance, and Settlement




                        i5;it*f;*»U!J- '-.-"iilWP'f'.',!                                    .i..>..i.,».. ..^^iiJ tfy.tx«Jif.fijtJji^'<ifta<n*-t--m.
                                           Section 4: New and Emerging Products and Services • Electronic Banking
                                           Electronic Blinking .




                                          For purposes of this report, we discuss some of the most important risk
Risk and Risk                             and risk mitigations associated with electronic banking.
Mitigation

Table 4.4: Risk and Risk Mitigation for
                                          Risk                                               Risk mitigation
Electronic Banking
                                          Fraud risk                                         ysi6(^Qf/!pechanlsm8;,to;p^^^^^^                   ^'•;;;.,..:: >• :rxt<, ;'^
                                                                                             atiitlj'e'otic|rtipn;^^\^^^^^^
                                                                                             Intorm'Jitfc^i'jisysteiinl^^^                                 • > r-
                                                                                            tlansl:nls>sipns;;:,;>,;:Jjj))i^i;:y^;^;;^;jj,^,:j:,;;^: .'i .::...•...
                                          Security risk                                      Regulatory reviev\/ of computer security
                                                                                             Use of firewalls and other security
                                                                                             mechanisms
                                                 Shaded cells indicate that mitigations are not in general use. Unshaded cells indicate
                                                 mitigations in general use.




Risk 1: FYaud                             Electronic banking poses risks of financial loss due to unauthorized
                                          transfers by electronic intruders. Both financial service providers and
                                          consumers engaged in EI=TS are exposed to this risk.

Mitigation                                Use of mechanisms to provide authentication, verification, and
                                          security of information in electronic banking activity. Passwords,
                                          PIN numbers, encryption, and other methods are commonly used to help
                                          ensure secure management of financial information in electronic banking
                                          activities.

                                          In addition, several efforts are under way to legislate the legality and use
                                          of digital signatures. Digital signatures are the electronic counterpart of
                                          requiring a driver's license or passport. They enable a person to verify his
                                          or her identity for the electronic transfer of funds or some other
                                          transaction.


Risk 2: Security                          Banking regulators have recognized that systems delivering financial
                                          products and services face risks posed by individuals witha desire to
                                          disrupt systems rather than to realize any financial gain. The damage from
                                          viruses or other forms of attack could be significant. If a virus caused the
                                          system of a bank to malfunction, for example, customers could lose access
                                          to their accounts. Consumers' computer systems are also at risk of viruses
                                          and other forms of attack communicated through use of the Internet.




                                          Page 146                                GAO/GGD-97-73 Payments, Clearance, and Settlement
                                      Section 4: New and Emerging Products and Services • Electronic Banking
                                      Electronic Banking




Mitigation                            Regulatory review of computer security. The U.S. bank regulators are
                                      required to perform extensive reviews of banks' computer facilities as part
                                      of their routine bank examinations.

Mitigation                           Use of firewalls and other security mechanisms in a security
                                     strategy. Some financial institutions use firewalls and other methods of
                                     filtering information coming from the Internet to computers to prevent
                                     viruses and other malicious programs from damaging computer systems. A
                                     firewall is a set of security procedures designed to block off intruders by
                                     limiting the information that can pass to the server. Most firewalls involve
                                     either looking at the "packets" of data individually or resending all data
                                     destined for an organization through a single "gateway" or checkpoint.




                                     Page 14"                                       GAO/GGD-97-73 Payments, Clearance, and Settlement




             ffSl ^JrifM^fl^>>^i*iy.'^'i'^^f^i^'*ffil^^^^^S^f^^l^K^^^^l^!lh^' ••y^RiV^vFiSwff*?!
Section 4: New and Emerging Products and Services * the Internet

Financial Services Over the Internet


                                    An increasing number of merchants and financial service providers are
Description and Use                 using the Internet as a communications infrastructure for financial
                                    a'ctivities. In this section, we discuss purchases over the Internet with
                                    payment by credit card and electronic money, and the use of the Internet
                                    as an avenue for information jmd communication to facilitate trading of
                                    government and coiporate securities.

                                    Many retail merchants have established World Wide Web (www) sites to
                                    enable consumers to make online purchases using credit cards. In 1996, a
                                    private research firm estimated that by 2000, the value of online purchases
                                    by credit card will likely be more than $6 billion. The m^jor difference
                                    between a more traditional credit card transaction—whether by
                                    telephone, fax, or at a sales counter—and a credit card transaction over
                                    the Internet is in how the customer provides credit card information to the
                                    merchant, including specicd procedures used to secure corifidential
                                    information.

                                    For purposes of our discussion, the term "electronic money" includes a
                                    wide variety of emerging strategies and mechanisms—mzuiy of them still
                                    in a developmental stage—to enable a consumer to make online payments
                                    on a cash basis without the use of physical cash, credit cards, or a
                                    standard checking account.'- In Internet transactions, online merchants
                                    would redeem electronic money for the appropriate value from the issuer.
                                    Electronic money was not widely used in Internet transactions as of
                                    October 1996. An attorney we interviewed, who has a practice dealing with
                                    issues concerning electronic commerce and payment systems, told us that
                                    over 20 electronic money systems were under development or operating as
                                    of October 1996. A few of the versions of electronic money offered or
                                    under development'^' include the following:

                                    E-Cash: DigiCash was the first company to license the technology of
                                    electronic money, which it calls e-cash. Its creators claim that e-cash
                                    combines the speed of the present bank-based wire system with the
                                    anonymity of cash. As of October 1996, e-cash was offered by one U.S.
                                    bank, the Mark Twain Bank in St. Louis, MO. E-cash is a string of digits
                                    that has been given the value of a digital coin by the issuing bank. These
                                    digits are stored on the customer's hard drive. The customer uses these
                                    digits to pay for the transactions that he or she makes. In an e-cash

                                    '•This is referred to us online .scrip in the .June 1996 Congressional Budget Office study. Emerging
                                    Electronic Methods fur Making Retail Payments.

                                    'The examples were selected for pun)oscs of illustration only, without any intention to endorse any of
                                    the featured products.



                                    Page 148                                    GAO/GGD-97-73 Payments, Clearance, and Settlement
 Section 4: New and Emerging Products and Service* • the Internet
 Financial Services Over the Internet




transaction, when a customer pays for e-cash, the bank's deposit liability
to the customer is reduced, and in its place is a new, e-cash liability for
that amount. After the customer transfers the e-cash to a merchant, when
the merchant deposits e-cash, the deposit reduces the e-cash liability and
increases the deposit liability. This means that there is a conversion from
e-cash to funds available for the merchant to withdraw.
Electronic Money System: Citibank's Electronic Money System (EMS) is
designed to provide secure, real-time transactions over any network,
including the Internet, EMS offers a blend of anonymity and disclosure.
According to a Citibank official, each electronic transaction would have an
audit trail that could be traced, but the identity ofthe parties would
remain anonymous.

In recent years, the Internet has also been used to provide information to
potential investors about exchange-traded government and corporate
securities. It has also been used by investors for communication of buy
and sell orders and even to create electroruc bulletin-board-based trading
mechanisms for shareholders of off-exchange corporate securities, SEC has
also allowed a brokerage firm to use the Internet to estabbsh a market for
qualified investors in private placement investments. As of October 1996,
securities transactions payments were not made over the Internet; such
payments were cleared zmd settled conventionally.




Page 149                             GAO/GGD-97-73 Payments, Clearance, and Settlement
                               Section 4: New and Emerging Products and Services • the Internet
                               Financial Services Over the Internet




Key Terms
Q   Authentication             Authentication is the process of verifying the identification of the true sender
                               of a message and also that the text of the message itself has not been altered.

    Encryption/decryption      Encryption is the process of disguising a message (using mathematical
                               formulas called algorithms) in such a way as to hide its substance. Decryption
                               is the restoration of encrypted data to its original text.

Q   Payment processor or       A payment processor or credit card association is an association dedicated
    credit card association    to the settlement and clearance of transactions using credit cards. Examples
                               of such associations are VISA and f^/lasterCard.

Q   Verification              Verification is the ability to positively identify and authenticate a particular
                              encrypted communication.




                              Page 150                             GAO/GGD-97-73 Payments, CIcnrnnce, and Settlement
                                      Section 4: New and Emerging Products and Services • the Internet
                                      Financial Services Over tlie Internet




                                     While statistics on the total value of Internet transactions are not available,
Basic Data                           many vendors offer merchandise that can be purchased online with a
                                     credit card. With increased use and sophistication of home computer
                                     technology and www services, Internet-assisted financial services are
                                     expected to increase.

                                     In 1995 about a quarter of a billion dollars of credit card purchases were
                                     made via the Internet.
                                     In 1995, one bank (The Mark Twain Bank of St. Louis, MO) offered
                                     electronic cash that could be used to make purchases from a few vendors
                                     equipped to take electronic payments.
                                     In 1996, more than 20 electronic money systems were available or under
                                     development.


                                     Example: A consumer is planning to purchase an outdoor chair.
Processes                            He or she decides to shop online by connecting to L.L. Brian's www site.




                                    Page 161                              GAO/GGD-97-73 Payments, Clearance, and SetUement




        RTfMin H'/»;';fe*3/SKVi(i'HS^®**m#«^^
                                                 Section 4: New and Emerging Products and Services • Uie Internet
                                                 Financial Services Over the Internet




Figure 4.3: Credit Card Payments Over the Internet




 O        Ttie consumer dials up his/her
       Internet service provider and using
      Iheir browser software connects with
               the World Wide Web.




 &      Using the browser, the consumer
     enters the Internet address ot L.L.Brian
             to call up its home page.




                                                Page 152                             GAO/GGD-97-73 Payments, Clearance, and Settlement




                                                                                                               .t^j,^.^..^nivyjitkj::>t.-rr'. f-r>v\*t\ •oiA'* 'Wvi.'/i'
 Section 4: New and Emerging Products and Services • the Internet.
 Financial Services 0\'er the Internet




                                                              By clicking on pictures and
                                                       highlighted text, the consumer collects
                                                        inlormation and decides to buy some
                                                          outdoor furnishings, which he/she
                                                             will pay lor with a credit card.




                                                  Qt      LL. Brian's computer rnslnjcis the
                                                            consumer's browser software to
                                                           switch into "secure" mode. In this
                                                       secure mode, the consumer's personal
                                                         inlormation and credit card number
                                                         are encrypted before transmission,
                                                          lo ensure the privacy and security
                                                                   ol the transaction.




Source: GAO analysis of industry data.




Page 153                                 GAO/GGD-97-73 Payments, Clearance, and Settlement
                        Section 4: New and Emerging Products and Services • the Internet
                        Financial Services Over the Internet




                        Regulatory oversight forfinancialservices on the Internet is determined
Regulatory Oversight    largely by the type of entity providing the service. Depository institutions,
                        brokerage furms, stock markets, and nonbank financial service providers
                        are subject to varying degrees of oversight by a variety of federal and state
                        agencies. The Internet itself is generally not regulated by the states or the
                        federal government."

                       Depository institutions are subject to oversight by federal and state
                       banking agencies. They are regularly and routinely examined to help
                       ensure safety and soundness and compliance with consumer protection
                       and civil rights laws and regulations, including the Federal Reserve
                       Board's Regulation E, "Electronic Funds Transfers," which, among other
                       things, limit the amount of consumer liability for an unauthorized
                       electronic transfer of funds. Internet-transmitted activities in which
                       depository institutions are involved would not be exempt from the
                       scrutiny of federal examiners. Depository institutions issue credit cards,
                       distribute electronic money, and sell securities. Under certain conditions,
                       banks may also underwrite initial public offerings and assist in private
                       placement investments.'^




                       '•"Domain names, the Internet addresses that are used to mark the network space of an institution, arc
                       assigned by an organization known as the Internet Network Information Center (InterNIC). IntcrNIC is
                       a nonprofit organization. It currently subcontracts the actual business of domain registration to a
                       private contractor A number of consortia, such as the World Wide Web Consortium, promote
                       uniformity in communication standards used on the Internet

                       ""Banks are allowed to conduct certain securities activities, such as brokerage services, within any
                       licensed bank. However, if a bank wishes to engage in securities underwriting, it may do so only
                       through what is known as a Section 20 affiliate. This institution is a subsidiary of the bank's holding
                       company rather than the bank itself.



                       Page 154                                                   GAO/GGD-97-73 Payments, Clearance, and Settlement




                       iLjt'3)EifAii.ii,.aj7if!crjr3p:OTnOTfffl«!ws3M5i: ^V' '.sii*.-aKX..-,ji.^'<..';uij. .^^ .'-. Mitii'-a'jtiMttiirntiniiL'.Jltll.i^St-.nfA^^^liii.'-ti
                                           Section 4: New and Emerging Products and Services • the Internet
                                           Financial Services Over the Internet




                                          For purposes of this report, we discuss some of the most important risk
Risk and Risk                             and risk mitigations associated with financial services on the internet.
Mitigation
Table 4.5: Risk and Risk Mitigation for
Financial Services on the Internet        Risk                                                     Risk mitigation

                                          Security risk
                                                                                                                     ^•>iS|^
                                                                                                  mm^mmmmmm
                                                                                                  mmmmm^smmm!m^
                                                   Shaded cells indicate that mitigations are not In general use.




Risk: Security                            Intruders using advanced programming techniques may be able to break
                                          into a computer system over the Internet and obtain information they are
                                          not authorized to have. The security of the systems is of particular concern
                                          because a break-in could result in an immense amount of
                                          information—such as credit card numbers^etting into unauthorized
                                          hands. Further, if information is not secured before transmission over the
                                          Internet, an intruder could obtain a copy of the information being
                                          transmitted or change the message. A report published by the Bank for
                                          International Settlements (BIS) on the security of electronic money has
                                          recognized security concerns and noted that"... no single security
                                          measure or set of measures . . . can be said to be sufficient for a particular
                                          product. It is a combination of measures, together with the rigor with
                                          which they are implemented, that will serve to reduce the risk most
                                          effectively.""^

Mitigation                                Use of strong encryption systems. Systems that trzmsmit credit card
                                          information and electronic cash generally use encryption systems to
                                          prevent electronic intruders from obtaining information—such as credit
                                          card numbers—that could be used to make an unauthorized transfer of
                                          funds. Two major secure-communication protocols have been used in the
                                          Internet/www commerce market: Secure Sockets Layer (SSL) and Secure
                                          HyperText Transfer Protocol (S-HTTP). Information Law Alert describes the
                                          difference between SSL and S-HTTP as similar to the difference between an
                                          armored car, which protects the channel, and an envelope, which secures
                                          the specific data being transmitted.




                                          '"Ul.S is an organization of central banks based in Basle, Switzerland. It is the principal fonim for
                                          consultation, cooperation, and information exchange among central bankers.



                                          Page 155                                     GAO/GGD-97-73 Payments, Clearance, and Settlement
              Section 4: New and Emerging Products and Services • the Internet
              Financial Services Over the Internet




             On February 1,1996, VISA and MasterCard armounced their support for a
             new set of technical standards—to be known as Secure Electronic
             Transaction (SET)—for making secure credit card purchases over open
             networks such as the Internet, SET is to include universally accepted
             standcirds for encrypting credit card numbers and verifying their use; the
             standards are to be incorporated into Internet-related software—most
             notably software browsers widely used to access the www. Among other
             things, SET would help prevent merchant misuse of credit card numbers.
             Instead of receiving an encrypted credit card number to be decrypted by
             the merchant, the merchant would receive and pass the encrypted credit
             card number to the credit card association, which would then decrypt the
             number and transmit an authorization code to the merchant. This standard
             was not expected to be operational until early 1997.

Mitigation   Avoidance ofthe Internet for transmitting credit card numbers.
             Some fums allow shoppers to make credit card purchases over the
             Internet without transmitting their credit card irtformation. One firm, for
             example, will take a shopper's credit card information over the telephone
             and then act as an intermediary between the shopper and the Internet
             seller.

Mitigation   Use of firewalls and other security mechanisms in a security
             strategy. Some fmancial institutions use furewalls and other methods of
             filtering information coming from the Internet to computers to prevent
             viruses and other such malicious programs from damaging computer
             systems. The furewall attempts to block off intruders by limiting the
             information that can pass to the server. Mostfirewallsinvolve either
             looking at the packets of data individually or resending everything
             destined for em organization through a single gateway or checkpoint.




             Page 156                             GAO/GGD-97-73 Payments, Clearance, and Settlement
Section 5: Issues

Issues Related to Payments, Clearance, and
Settlement Systems

                                                                In this section, we highlight issues we identified in doing our work on
                                                                payments, clearance, and settlement systems. As discussed in the scope
                                                                and methodology section of this report, many of these issues were raised
                                                                by payments system users, providers, and regulators. In addition, we
                                                                identified some issues from our review of documents, data, and other
                                                                materials. Some of the issues relate to specific payments systems; others
                                                                are broader in nature. We did not seek to evaluate or resolve any of these
                                                                issues in this report.


                                                                Retail payment transactions are generally small-value, large-volume
Issue: the Safety of                                            payments, such as paper checks for consumer purchases, paychecks,
Traditional Retail                                              Social Security fund trzinsfers, and other payments made via an automated
Payment Transactions                                            clearing house (ACH). Individually, these types of payments represent a
                                                                fairly low level of risk. However, to the individual expecting to receive an
                                                                electronic payment, the failure to receive the payment could become a
                                                                potentially serious problem. In addition, when retail payment mechanisms
                                                                are used for large-dollar transactions, risk can escalate. Thus, proposals
                                                                have been made to enhance the safety of retail payment systems.


The Use of ACH to                                               In general, use of an ACH network involves considerably more risk than the
Transmit Large-Dollar                                           use of more secure payments systems such as Fedwire. Unlike Fedwire,
Payments                                                        ACH payments are provisional in nature until final settlerhent, which can
                                                                occur as many as 2 days after payment instructions are received.

                                                               As previously mentioned, ACH networks have largely been used for
                                                               small-dollar payments in which the dollar-value risk if a payment were to
                                                               be returned unpaid would be correspondingly small. Also, the price for an
                                                               ACH transaction is much lower than that for a Fedwire transaction. The
                                                               price differential can be as great as $0.01 for an ACH transaction versus
                                                               $0.45 for a Fedwire transaction. Thus, there is a price incentive to use ACH
                                                               for increasingly larger dollar-value transactions. Currently, the ACH format
                                                               does not allow any ACH transaction greater than $100 million. However,
                                                               some industry officials told us that this dollar cap has been circumvented
                                                               in cases when the originator of the ACH transaction cuts a large value ACH
                                                               payrnent into several smaller ACH payments to remain under the
                                                               $100 million cap for each individual payment.

                                                                Some industry officials have expressed concerns about ACH being used for
                                                                any large-dollar transactions, even those substantially below the
                                                                $100-million cap. One industry official has suggested that the ACH dollar



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                        cap should be as low as $100,000. Moreover, these officials told us that the
                        failure of severed large-dollar transactions could expose counterparties to
                        risks that go beyond those borne by the individual originating institution.
                        However, other industry officials we spoke to said they did not believe in
                        the necessity of imposing such dollar limits. They argued that the risk is
                        borne by the individual financial institution that chooses to use an ACH for
                        large-dollar transfers.


Same-Day Settlement     Risks in using £m ACH arise from the time lag between payment instructions
Finality of ACH         being issued and final settlement being made. For example, if a customer
Transactions            making an ACH payment through his or her bank fails to fund the payment
                        on the settlement day, the originating institution could suffer a financial
                        loss.

                        Some industry officials .say that the period of risk could be shortened if the
                        Federal Reserve adopted same-day settlement finality for its ACH
                        processing. The Federal Reserve reserves the right to reverse credits to
                        banks until some time in the night following provision of these credits to
                        banks. A Federal Reserve official told us that there are several obstacles
                        that would need to be overcome before same-day settlement fmality could
                        be achieved. For example, ACH transactions are provisional payments with
                        the presumption, but no guarantee, that the originator of the transaction
                        •will fund its ACH obligations. If same-day finality were established for ACH
                        transactions, then some sort of guju-antee—such as collateral
                        requirements—would need to be established to ensure that the depository
                        institutions had sufficient funds to settle their ACH transactions.


                        New and emerging financial products and services present many legal and
Issue: New and          regulatory challenges. Some areas of regulatory oversight, such as the
Emerging Financial      Community Reinvestment Act (CRA) and credit access, are currently
Products and Services   directed toward the geographical location of the bank, market, or product
                        being supervised. And consumer protection laws and regulations have
                        generally been written with the current, predominantly paper-based,
                        processes in mind. With the growth of electronic commerce, such as
                        electronic banking, electronic cash, and use of the Internet to purchase
                        securities, regulators are likely to face increasing complications in
                        applying existing laws and regulations to these new products and services.
                        Several task forces are already under way to look at some of the consumer
                        protection and compliance issues. In addition, the current regulatory
                        structure is likely to be tested further as nonbanks increasingly offer these



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                       new services and products. Such developments, already under way, are
                       likely to raise anew issues related to the extent to which there is a "level
                       playing field" between banks and nonbanks.


Consumer Regulations   The Federal Reserve's Regulation E governs electronic funds transfers
                       (EFT), among other things. Currently, Regulation E provides that
                       consumers must be given a paper receipt at the conclusion of any
                       electronic transaction conducted at an electronic terminal. For this
                       reason, an ATM is to issue a receipt each time a customer uses it. This
                       provision may be a problem for new fmancial products such as
                       stored-value cards.

                       Geographical jurisdictional issues may arise in a number of areas, ciu
                       requires a bcink to delineate the territory it serves and take steps to meet
                       the credit needs of that territory. Electronic access to banks and banking
                       services, which provides consumers with opportunities to bank far from
                       the coiTununities in which they live, clearly complicates the task of
                       delineating a corrmiunity by geographical boundaries. Banks offering
                       services over the Internet as one alternative to those offered at their
                       traditional "bricks and mortar" branches may be able to continue to satisfy
                       CRA requirements using these traditional branches. However, at least one
                       bank is now offering its services exclusively over the Internet, soliciting
                       customers nationwide. As Internet banks increase in number, regulators
                       are likely to face a difficult challenge in defining the territory of service for
                       these banks for CRA purposes. Another jurisdictional concern related to
                       investor protection is raised by offerings of securities over the Internet.

                       The use of stored-value cards will likely raise additional issues related to
                       legal and regulatory oversight. Currently, stored-value cards.are being
                       issued by banks and nonbanks. Questions have arisen about the
                       applicability of deposit insurance to amounts contained on the cards
                       issued by banks. Recently, FDIC issued an opinion having the effect that,
                       with the types of cards cmticipated to be most widely used, the funds paid
                       for them will riot be covered by deposit insurance. Only in cases in which
                       the value is actually held in the cardholder's account at the financial
                       institution until payment is authorized would deposit insurance for the
                       cardholder be available. Consumers may not be aware of this and also may
                       not be aware that, unlike similar-looking credit cards, stored-value cards
                       generally offer no dollar limit against theft or loss.




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                           When fully implemented, stored-value czu-ds may be issued from a provider
                           in any location to a cpnsumer who uses the card in a completely different
                           location. Because of these issues, some bankers have suggested that only
                           banks be permitted to issue stored-value cards. However, these cards are
                           already being issued by nonbanks.


Consumer Rights and        At a U.S. Department of the Treasury conference on the role of
Access Protection Versus   government with regard to electronic money and banking,' several federal
Financial Innovation       policymakers arid representatives of the fmancial services industry
                           emphasized that governments wishing to foster financial innovation must
                           be careful not to impose rules that inhibit it. However, these conference
                           speakers also acknowledged that governments should seek to ensure that
                           effective risk management systems are in place in the private sector.
                           Recognizing that transactions over the Internet ultimately create demands
                           for universally accepted standards for protection of customers, one federal
                           legislator suggested that private-sector interests may wish to join forces in
                           developing an electronic commercial code of conduct and standards for
                           such protection.


Escheatment                Most states have laws that allow them to "escheat," or take custody of
                           abandoned property, such as bank accounts that have been inactive for
                           some period. Given the potentially large sums involved, states with
                           escheatment laws might not allow issuers of stored-value cards and
                           electronic money to keep abandoned funds for their own accounts. But
                           several issues must be resolved. For example, there is an issue of which
                           state would have escheat jurisdiction, particularly if issuers of stored-value
                           cards and. electronic money do not keep records of purchases and
                           customers' addresses.


Banks Versus Nonbanks      A broader question likely to receive increased attention because of the
                           emergence of these new products and services is whether or not banks
                           and nonbanks are operating, or should be made to operate, on a "level
                           playing field"—that is, that they receive equal regulatory treatment. This
                           question has been debated by bankers and other providers of financial
                           services for some time; however, the entry into the market of so many new
                           nonbank providers of such services as electronic banking, stored-value



                           'Toward Electronic Money & Banking: The Role of GbvemmcnI., U.S. Department ofthe Treasury
                           Conference, Sept. 19, 199G.



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                      cards, and Internet-supplied fmancial transactions will likely serve to
                      increase and sharpen the debate.

                      Brokerage houses provide deposit accounts similar to those of commercial
                      banks. But they do not receive the same regulatory oversight as
                      commercial banks do. Nor are they required to hold norunterest bearing
                      reserve accounts at the Federal Reserve. In addition, bankers feel that
                      other regulatory requirements imposed on depository institutions, such as
                      CRA requirements, impose additional regulatory burdens on their
                      institutions, which place them at a competitive disadvantage when
                      competing against nonbanks.

                      On the other hand, banks have certain advantages that are derived from
                      their bank charters. For example, the ability to offer deposit insurance to
                      customers may give banks a competitive advantage over nonbank financial
                      service providers. Furthermore, reserves enable banks to clear and settle
                      obligations. And although undergoing safety-and-soundness examinations
                      may impose regulatory burden on banks, it £dso allows banks to provide a
                      measure of assuremce to customers that their deposits are being
                      well-handled.

                      However, industry observers believe that nonbanks could fall under
                      applicable state regulations, for instance, those governing nonbank
                      "money transmitters"—firms that issue "instruments for the transmission
                      of money," such as traveler's checks or money orders.^ The state laws
                      generally provide a number of safeguards for users. Issuers typically must
                      be licensed and bonded, are required to hold a minimum level of capital,
                      may be required to hold reserves equal to 100 percent of outstanding
                      value, £ind are also subject to periodic examinations and audits.


                      Electronic technologies now in place or under development, such as the
Issue: Security and   use of the Internet for financial transactions, electronic cash, and
Protection for New    stored-value cards, hold great promise for increasing consumer choice in
and Emerging          payment methods. However, such technologies also provide additional
                      means for abuse and illegal activity. Law enforcement officials have
Financial Products    expressed concerns about the possibility of individuals using these new
and Services          products and services for illegal purposes such as money laundering.
                      Some fraudulent schemes involving securities transactions over the
                      Internet have already been uncovered. Because ofthe newness of these


                      -According to the Federal Reserve, 44 states have enacted such laws, which industry representatives
                      believe would apply, or will be amended to apply, to general-purpose stored-value cards.



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                           products and services, approaches to making such products and services
                           more secure and less vulnerable to illegal use £ire still under development.


The Security of Internet   Through the Internet, customers now have access to credit card payment
Transactions               systems, electronic banking, and other financial services in a way that was
                           never before possible. Such services bring to the consumer an array of
                           new, convenient methods for doing financial transactions. However,
                           because of the nature of the Internet—the fact that it is basically an
                           unsecured means of transmitting information—customers, merchants, and
                           other service providers have increasing concerns about the safety and
                           security of their transactions. For example, if an intruder could
                           successfully attack a credit card association, customers could lose access
                           to their accounts, or in the worst case, the credit card payment system
                           would grind to a halt.

                           Firewalls and other methods of filtering inforination coming from the
                           Internet to computers can be used, in part, to increase the security of
                           Internet transactions. A firewall is a method that attempts to block
                           intruders by limiting the information that can pass to the merchant's or the
                           fiinancial institution's internal network. Use of encryption is another
                           means by which the security of Internet transactions could be increased.
                           However, neither firewalls nor encryption provides a guarantee of safety
                           for Internet transactions. To the extent that financial transactions over the
                           Internet remain vulnerable to intrusion or capture by unauthorized parties,
                           consumers may be reluctant to dramatically increase their usage ofthe
                           Internet for their financial business, and any mjyor successful attacks
                           would likely affect the public confidence in electronic commerce in
                           general.

                           In addition to the issue of the basic security of the Internet, the Internet
                           also provides a new means for criminal elements to perpetuate fraudulent
                           schemes against consumers. Such schemes pose risks to consumers
                           because the Internet provides relatively easy and cost-effective access to
                           milliorvs of individuals. Pennsylvania securities regulators we interviewed
                           described several illegal schemes conducted over the Internet, including
                           sales of nonexistent bonds. Law enforcement agencies are stepping up
                           their efforts to identify and stop such schemes, but it remains to be seen
                           whether these efforts can keep pace with the rapid growth of the use of
                           electronic commerce and the Internet for such illicit purposes.




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                          In addition, new technologies, such as the use of the Internet for financial
                          transactions or stored-value cards, are likely to provide additional avenues
                          for money laundering.^ Law enforcement officials are especially concerned
                          with systems that allow person-to-person transfers, which would include
                          stored-value cards and Internet transfers. Financial institutions offering
                          accounts over the Internet are not limited to domestic U.S. institutions.
                          Foreign, off-shore banks, which may not be regulated by U.S. bank
                          supervisory agencies, are now offering U.S. customers accounts and
                          financial services. In at least one case, an off-shore bank is advertising its
                          services over the Internet as a tax haven for U.S. investors. Stored-value
                          cards may enable individuals to move illegal money from a bank account
                          onto a stored-value card, where it will be untraceable when used.
                          However, because stored-value cards generally are designed for
                          small-value purchases and many have low limits, such as $500, for the
                          amounts that can be stored on them, they may not be very efficient
                          vehicles for laundering large amounts of cash.


Legal Status of Digital   To deter forgery, a person wishing to cash a check is usually required to
Signatures                provide a signature and some type of identification—such as a driver's
                          license or passport—to verity that the signature is actually his or hers. A
                          digital identification, or digital certificate, is the electronic counterpart of
                          requiring a driver's license or passport. It enables a person to verify liis or
                          her identity for the electronic transfer of funds or some other transaction.

                          A digital identification allows individuals to sign, or "authenticate," digital
                          transactions. For example, a person wishing to make an electronic money
                          payment over the Internet could verify that the party requesting the
                          payment was actually the generator of the request and not an
                          impersonator.

                          If digital signatures are to substitute for handwritten signatures, they must
                          have the same legal status as handwritten signatures—i.e., they must be
                          legally binding. The legal status of digital signatures is not well defined.
                          For example, banks are required to acquire a signature card for every
                          customer, but none of the banking regulators has ruled on the validity of
                          digital signatures.

                          Several efforts are under way to legislate the legality and use of digital
                          signatures. In 1995, Utali became the first government entity to adopt a

                          'Mdncy liuitidi'rinK i.s the disguising or concealing of illicit income to make it .ippcar legitimate.
                          All.huugli precise Figures arc not available, federal law enforcement officials estimate that between
                          $\00 billion and $:HW billion in U.S. currency is laun<lered each year



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                            comprehensive statute allowing electronic commerce using digital
                            signatures. Similar legislation is under consideration in some other states.


                            The emergence ofthe global marketplace has rapidly increased the .speed
Issue: Mitigation of        £ind volume of wholesale financial transactions. With this growth has come
Settlement Risks in         the potential for increased risk and the call for new mitigation strategies.
Wholesale and               As explained in the section on foreign exchange transactions, Herstatt risk
                            exists because the two sides of a contract are not settled simultaneously;
Foreign Exchange            therefore, if a participant defaulted after receiving its side of a contract but
Transactions                before making the payments due to the other party, all the payors could
                            lose up to the full value of the contracts, which might be sizeable.'
                            Participants in the foreign exchange market might seek to diminish this
                            gap between payment and receipt by delaying payments, but this could
                            create gridlock; that is, if payments were delayed, the intended
                            recipients—even though solvent—might be unable to make their own
                            payments to others, thus spreading the same problems to still other
                            participants. In addition, within the United States, the growth in wholesale
                            transactions could place the Federal Reserve and the taxpayers at
                            increased risk, in part because ofthe provision of daylight overdrafts.

                            A variety of proposals have been made for mitigating veirious risks in
                            wholesale payments. Some of these address Herstatt and gridlock risks in
                            foreign exchange transactions. These proposals include establishing
                            simultaneous payment arrangements, known as payment-vs.-payment
                            (pvp), and creating a clearing house as a coimterparty. Other proposals are
                            concerned with domestic wholesale payments in the United States. Some
                            of these proposals include (1) increasing the fees banks are charged for
                            incurring daylight overdrafts and (2) fully funding each Clearing House
                            Interbank Payment System (CHIPS) transaction rather than allowing debit
                            and credit positions to accumulate until end-of-day settlement.


Timing of Payment Release   A committee of major banks involved in foreign exchange trading has
                            opposed delaying payments until late in the settlement day. Its "best-case"
                            settlement assumption is for payments to be made at opening time on
                            settlement day to ensure adequate liquidity for counterparties.'' We are not
                            aware of any regulatory proposals for standards for payment release.

                            'Herstatt risk can exist within the same lime zone. :LS long ;is suttlenient of one currency occurs before
                            settlement ofthe other. Time /.one differences obviously can increiusc the length of the time gap
                            between the two .settlements.

                            'The New York Foreign Exchange Committee, Reducing Fnn.'ign Exchange Si.-ttlenurnt Risk, Oct. 1994.



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Simultaneous Payment     Herstatt risk in foreign exchange transactions could be eliminated by
Process or PVP           procedures to make payment of each currency leg dependent on payment
                         ofthe other; as mentioned earlier, the process lor allowing simultaneous
                         payment is called PVP. TO enhance the potential for PVP in foreign exchange
                         transactions, the Federal Reserve has announced plans to extend the
                         opening hours of Fedwire in 1997. By the end of this year, Fedwire is to be
                         open from Monday through Friday 12:30 a.m. to 6:30 p.m. KT, thus ensuring
                         that it will be possible to process dollar final settlements during hours
                         when payment system.s in major foreign countries are also open.
                         Expanded Fedwire hours should make simultaneous payments possible.

                         PVP does not automatically follow from overlapping payment system hours:
                         expanded Fedwire hours should make simultaneous payments possible,
                         but realization will depend on private-sector actions. In that regard, a
                         group of major banks in the industrial countries, calling themselves the
                         Group of Twenty, have an objective of bringing about a private-sector PVP
                         system by 1999.

                         A concern of market participants is that any risk-mitigation measures
                         should not be so costly or cumbersome as to interfere with the ability of
                         the markets to function effectively. To that end, proposals for clearing
                         houses and pvp are being examined in terms of the amount of liquidity that
                         may need to be tied up as collateral. The central banks' G-10 committee
                         raises the question as to whether some proposed pvp schemes might
                         heighten the potential for transmission of problems from one countiy to
                         zmother by increasing links between them. Yet another consideration is the
                         degree to which a proposed measure would allocate costs to those
                         institutions that bring risk to the system, thus retciining incentives on each
                         institution to manage risks prudently.


Clearing House Becomes   One approach to reducing Herstatt risk in foreign exchange contracts
Counterparty             involves the creation of a clearing house, which would become the
                         counterparty—and thus guarantor—of all the trades among members. If
                         such an institution had sufficient collateral or other backing available to
                         be used in case of potential payment failures by one or more of its
                         members, a clearing house could reduce credit risk. With reduced
                         concerns over credit risk, there might be less incentive to withhold or
                         delay payments, thus lessening the risk of gridlock. Exchange Clearing
                         House (ECHO) is a clearing house based in London, which had 13 member
                         banks as of May 1996. Multinet International Bank, once in operation, is to




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                           be a clearing house tiiat becomes counteipaity to trades initially in U.S.
                           and Canadian dollars among its members.


U.S. Treasury OFAC         Under the Emergency Economic Powers Act, the President can prohibit or
Powers Over Assets of      regulate transactions relating to the interests and assets of any foreign
Non-U. S. Companies        country or foreign national. Using this authority, the President can, among
                           other things, prohibit (1) any. transactions in foreign exchange;
                           (2) transfers of credit or payrnents between, by, through, or to any banking
                           institution, to the extent that the transfer or payment involves any interest
                           of a foreign country or national thereof; and (3) the importing or exporting
                           of currency or securities." Regulations implementing Presidential Orders
                           under the act are promulgated by the Office of Foreign Assets Control
                           (OFAC) within the Department ofthe Treasury, OFAC powers are exercised
                           under laws intended to thwart terrorism or crime, OFAC powers are to be
                           exercised on payments flowing across Fedwire or CHIPS, even if the
                           payments are legal in the payor's country. Presently, all mzyor players in
                           global finance are heavily dependent on these two payments systems.
                           Foreign financial institutions might want to divert their payments outside
                           the United States. Some officials raise the concern that if international
                           payments flows are pulled out of the U.S. payments systems, this action
                           might affect the ability ofthe Federal Reserve to monitor financial flows
                           and risks.


Pricing and Provision of   Some private-sector officials believe that the Federal Reserve is
Daylight Overdrafts        significantly underpricing daylight overdrafts. They argue that the rate
                           charged for daylight overdrafts should be equal to the costs of providing
                           those Scune funds to banks at the federal funds rate, which recently has
                           been around 600 basis points. The Federal Reserve told us that they
                           strongly disagree that daylight overdrafts are underpriced. Federal
                           Reserve officials do not believe that daylight overdrafts fall within the
                           meaning of a "new priced sei-vice" being offered under Monetary Control
                           Act and, thus. Federal Reserve officials believe that cost recovery is not
                           required. Instead, officials told us that the Federal Reserve's position is
                           that charging fees for daylight overdrafts is a risk control mechanism as
                           opposed to a charge for a priced service. Further, they argued that to raise

                           ":")0 U.S.C. §S 1701-1700. The act authorizes .such action in cases in which the I*rcsident has declared a
                           national emergency because of aTi "unusual anil extraordinary threat" to the U.S. national .security,
                           foreign policy, or cconon\y. "which luus iis source in whole or substantial part outside the United
                           Stal(!S." The President has used this power lo issue "freeze" orders against the a.s.scLs of Iraq (1090),
                           Panama (IU«8), Libya (lUSd). Iran (l!J7!J), South Vietnani (107?;); and other countries. See Rachel R.
                           Gcrstcnhaber, Conuiicnt, (•'rce/cr Ihmv. (jnil.ed States Extraterritorial (•Veezc Orcfers and the Case for
                           Efficient Risk Allocation, MO U. I'a. 1,. Kcv. a i : t (I<jil2). See :3I CFR. tjij 575.101-075.901.



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                     daylight overdraft fees precipitously would likely cause disruptions, e.g.,
                     causing a substantial volume of large-value payments to be shifted to less
                     secure payments systems, thereby increasing payment system risk.

                    Regardless ofthe level of pricing of daylight overdrafts at the Federal
                    Reserve, it is recognized that they pose credit risks to the Federal Reserve.
                    If the bank receiving an overdraft fails before it repays the overdraft, there
                    could potentially be a loss experienced by the Federal Reserve. However,
                    the institutions at the highest risk of failure are not permitted to incur
                    daylight overdrafts. In addition, virtually all daylight overdrafts that are
                    attributable to Fedwire securities transfers, and by extension the mjgority
                    of daylight overdrafts, are collateralized. In this regard, it is noteworthy
                    that some mgjor European central banks either do not provide
                    uncoUateralized daylight overdrafts or plan to require full collateralization
                    for central bank, real-time gross settlement systems in the future. A
                    Federal Reserve official said that provision of Federal Reserve intraday
                    credit in the Federal Reserve's payment system was indispensable in
                    maintaining the liquidity of the Treasury market, which underpinned the
                    smooth functioning of other financial markets in this country and abroad
                    as well.


CfflPS End-of-Day   On an average day, over $1.2 trillion of large-dollar payments are made
Settlement          among CHIPS' participants. These payments are netted among the members
                    during the day, but the participants' net credit^debit positions are not
                    settled until the end of the day. Individual participants could fail, at cost to
                    their creditors; hypothetically, if enough participants were to fail, then
                    end-of-day settlement would not occur; in the latter case, there would be
                    systemic disruption to payments in this country and elsewhere.

                    Regulators and industry officials pointed out that the ciiiPi", system had
                    rigorous controls over payments and debit positions and had access to
                    collateral that would cover the largest failures. They added that the netting
                    system helps maintain liquidity in the markets since the huge amount of
                    daily payments that are sent over the system only require an average
                    settlement amount of $5 to $10 billion each night.




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                              Several issues concern the role of the Federal Reserve in the payments
Issue: Appropriate            system. Currently, the Federal Reserve serves as both a regulator and
Role of the Federal           provider of certain payment system services and, as such, is in
Reserve in the                competition with private payment-service providers. The Monetary
                              Control Act of 1980^ (MCA) required the Federal Reserve to price, on a
Payments System               basis comparable with private business firms, all the payment services it
                              offered at the time the law was enacted and any other services it
                              developed after that date. Private-sector providers and others have raised
                              questions about the Federal Reserve's ability to fully adhere to this law;
                              others see an inherent conflict in the Federal Reserve's dual role as
                              regulator and service provider.


Potentisil Conflict Between   The Federal Reserve is currently the largest single provider of priced
Federal Reserve's Role as     payments services—e.g., check clearing, ACH services, and wire funds
Both Service Provider and     transfer services—in the nation. Yet, the growth of private check clearing
                              houses, such as the Chicago Clearing House Association (CCH), and the
System Regulator              California Bankers Clearing House (CBCH), all of which directly compete
                              with the Federal Reserve, has been a principal reason that the Federal
                              Reserve's volume of checks cleared has declined in recent years, MCA
                              placed the Federal Reserve in a unique position—competing actively with
                              private-sector institutions in providing services, such as check clearing, on
                              the basis of price and quality of service, even though it has supervisory
                              authority over these competing institutions and has respor\sibility for
                              ensuring that the nation's payment system functions properly.

                              Some private-sector service providers have expressed the concern that the
                              Federzd Reserve faces a potential conflict of interest in being both a
                              provider of services and a regulator of payment systems. These private
                              sector providers fear that the Federal Reserve could be unfairly competing
                              with them in two ways: first, by writing the regulatory rules so as to favor
                              its own services; and second, by underpricing its services so as to retain a
                              larger market share.

                              Federal Reserve officials told us that they have taken steps to ensure they
                              are competing fairly with the private sector in providing payment services.
                              For example, any proposed change in the Federal Reserve's operations
                              must undergo an impact analysis to assess the impact of the proposed
                              change on private-sector competition.


                              "Monetary Control Act of 1980, Pub. L. No. 96-221, Title I, 94 Stat 132 (codified as amended in
                              scattered sections of 12 US.C).


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Potential Conflict Between     The Federal Reserve, in providing its check clearing services, operates
MCA and Federal Reserve's      under two potentially conflicting requirements. First, under MCA, the
Future Check Clearing          Federal Reserve is required to recover all the costs of doing business that
                               it would incur if it were a private business. The second requirement is that
Role                           the Federal Reserve be the "clearer of last resort." This means that the
                               Federal Reserve is required to provide check clearing services, regardless
                               ofthe costs it incurs, to anyfinancialinstitution that needs to use its
                               services for this purpose.

                               The large private clearing houses have an advantage in that they, unlike
                               the Federal Reserve, need not provide check clearing services to small and
                               unprofitable depository institutions. For example, private check clearing
                               houses often only cover certain geographical areas or handle only certain
                               types of payments, such as those for large-dollar amounts. If the private
                               clearing houses increasingly attract the most profitable business, leaving
                               the most costly business for the Federal Reserve, the Federal Reserve may
                               eventually be unable to meet its legal requirement to recover its costs of
                               doing business. In addition, with thefinancialindustry's move toward
                               interstate banking, larger banks will be clearing checks within their own •
                               banks, and possibly exchanging checks among their organizations.


Possible Inefficiency in the   There are many estimates ofthe shju-e of gross domestic product devoted
U.S. Payment System            to the U.S. payment system. For example, the Federal Reserve estimates
                               this share to be below 0.5 percent of gross domestic product. One
                               economist has estimated this share to be higher—between 1 percent and
                               1.5 percent, or in dollar terms, between $72 billion and $109 billion in 1995.
                               Because electronic payments, such as ACH, credit cards, or stored- value
                               cards, are estimated to cost only one-third to one-half that of payments by
                               check, a shift from paper checks to these electronic systems could lower
                               fijiancial costs in the economy. In that regard, the usage of paper check
                               payments in the United States is considerably higher than that in other
                               industrial countries.^ The federal government should be making fewer
                               check payments by 1999 under the Debt Collection Improvement Act of
                               1996. Nonetheless,'because federal government checks only account for
                               about 1.3 percent of all U.S. checks written, this decrease in check
                               payments should have little impact on the total U.S. volume of check
                               payments.



                               'In 1993,80.4 percent of the volume of noncash payments in the United States was checks; among 9
                               other industrial countries, the share of checks in noncash payments averaged 2G.6 percent, ranging
                               from a low of 3.3 percent to high of 68.7 percent



                               Page 169                                  GAO/GGD-97-73 Payments, Clearance, and Settlement




                                                                                                              >i»»i>Hffi!»Hu.'wai.»c-»ftr:*»,*?;--
 Appendix I

Comments From the Board of Governors of
the Federal Reserve System

Note: GAG comments
supplementing those in the
report text appear at the
end of this appendix.
                                                             BOARD or aovcRNans
                                                                         OP THI
                                                        FCOCRAL RESERVE SYSTEM
                                                               WHSHINSTDN, 0 . C. Z O S I I




                                                                                                  otnccron
                                                                                                  oiviaiOM of




                                                                                                   April 16, 1997


                             Ms. Jean Gleason Stromborg
                             Director, Financial Institutions
                              and Market Issues
                             General Government Division
                             United States General Accounting Office
                             Washington, D.C. 20548

                             Dear Ms. Stromberg:

See comment 1.                             We appreciate this opportunitv to comment on th« General Accountir>g
                             Offices (GAO) draft report on Payments. Clearance, itnrf Sattlamunt Systems: An
                             Information Guide to the Systems. Risks, and iaitiiini. While the GAO has
                             incorporated a number of the comments we hed provided on earlier versions of the
                             draft report, we are disappointed that many of our substantive comments have not
                             been addressed and that technical and more substantive problems remain
                             throughout the draft report. In particular, we do not believe that the GAO has
                             developed a consistent framework for discussing the risks, legal environment, and
                             characteristics of the various payment mechanisms. In addition, the draft report
                             does not provide a balanced discussion of the differing perspectives on a number
                             of the issues included in the report. Finally, the draft report contains a number of
                             incorrect or misleading statements.

                                            The draft GAO report does not categorize the risks associated wKh
                             the various payments, clearance, and settlement mechanisms in a consistent or
                             thorough manner, but rattier uses a variety of approaches to discus8ir>g risk.
                             Although the report's introduction purports to categorize risk into four general
                             categories - counterparty/credit risk, operational risk, risk of fraud, and security
                             risk -- the draft report does not conisistentiy follow this approach. Moreover, an
                             important category of risk, liquklity risk, is not included in these categories, and
                             two of these risk categories - fraud risk and security risk - describe substantially
                             the same risks and are generally considered components of operatk>nal risk. More
                             generally, the draft report describes selected risk controls witfiotit provkling an
                             overall context of how these controls work together in a complementary manner to
                             mitigate key risks.




                                   Pa«e 170                                     GAO/GGD-97-73 Payments, Clearance, and Settlement
                     Appendix I
                     Comments From the Board of Governors of
                     the Federal Reserve System




                                VVe also found the mannijr in which the draft report attempts to
                 describe the legal environment in which the various payment mechanisms operate
                 to be confusing. While the discussion with respect to some payment mechanisms
                 focuses on the laws and regulations governing the various types of payment
                 transactions (as in the discussion of Fedwire funds transfers and retail payments),
                 the discussion of other mechanisms also addresses the supervisory regime for
                 institutions that are parties to the fcnsactions (as in the discussion of CHIPS) or
                 for the market in which the transaction is made (as in the discussion of the various
                 securities, futures, and options systems). We believe that greater consistency in
                 the treatment of the legal environment would improve the clarity of the report.

                                 Moreover, as a 'primer" on payment and settlement systems, the
                  draft GAO report does not discuss similar payment systems in a manner that
See comment 2.    provides for easy comparisons or assessment of differences. In other places,
                  statistics are presented in a manner that makes comparison difficult. In other
                  instances, the discussions are not placed in an appropriate context for the reader,
                  For example, the discussion of clearance and settlement in the U.S. government
                 securities market focuses on a portion of the market, namely the GSCC members
                 and the securities clearing banks, which leaves the reader with the erroneous
                 impression that these organizations represent the universe of clearance and
                 settlement activity occurring over Fedwire. The discussion of emerging payment
                 products fails to note that many of the issues mentioned are not unique to those
                 types of payments and have been addressed in other contexts. Finally, some
                 payment mechanisms, such as point-of-sale debit card systems, are not addressed
                 in the report.

                               In addition, we believe that the discussion of many of the issues
                 raised in the draft report is superficial and fails to give the reader an appreciation of
                 the differing perspectives and associated considerations. The following illustrates
                 our concerns with the draft report's discussion of payment issues in Section 5.

                                 Uae of ACH to Transmit Laroe-Dollar Pavmnnt*. The draft report
                 raises the issue of the use of the ACH to make large-dollar payments. The Federal
                 Reserve believes that, as a general matter, it is preferable for large-dollar payments
                 to be sent over systems, such as Fedwire or CHIPS, that permit the sending bank
                 to control the risks associated with these payments more effectively. It is not
                 clear, however, that large-dollar ACH transactions should be prohibited'. For
                 example, it is likely that if large-dollar ACH payments were prohibited, a portion of
                 these payments would be made by check, which has risk characteristics similar to
                 ACH transactions, and others may continue to flow through the ACH by splitting
                 them Into multiple smaller payments. It would also be useful for the GAO to note
                 in Its final report that rh? risk to a bank is based on the total value of transactions
                 originated by a particular customer, not ih« value of any particular transaction.




                     Page 171                                 GAO/GGD-97-73 Payments, Clearance, and Settlement
                        Appendix I
                        Comments From the Board of Governors of
                        the Federal Reserve System




                               The draft report notes that the difference in the fees assessed for
                 ACH transactions and Fedwire funds transfers provides an incentive for banks and
                 their corporate customers to use the ACH for large-value transactions. The report,
                 however, does not mention that differences in the time at which ACH and Fedwire
                 transfers are posted to banks' accounts, which affects the amount of daylight
                 credit incurred, may often offset the price incentive. A bank's marginal cost for
                 intraday credit is $0.42 per $1 million for each hour the overdraft is incurred. While
                 a bank is debited for ACH credit transactions at 8:30 a.m. Eastern Time on the
                 settlement day, it Is able to control the time at which Fedwire transfers are sent
                 (and hence the time at which its account is debited) and, therefore, is able to
                 manage its use of daylight credit more effectively.

                                Same Day Settlement Finality of ACH Transactinn^. Over the past
                  several years. Federal Reserve and industry representatives have analyzed the
                  costs and benefits of same-day settlement finality for ACH transactions. The final
                  report would provide greater balance if it discussed the trade-off between credit
                 risk and operational risk associated with the Federal Reserva'a provision of same-
                 day settlement finality for ACH credit transactions. If the Federal Reserve were to
                 provide same-day finality for these transactions without the risk that transactions
                 sent to a bank would be subsequently reversed, it would need to ensure that the
                 originating bank had sufficient funds in its Federal Reserve account or that it was
                 willing to extend credit to cover the payments at the time they were processed.
                 Thus, the Federal Reserve would need to implement procedures similar to the
                 procedures used to process Fedwire funds transfers. Such procedures would not
                 be practical if the ACH service remained a value-dated systsm. If ACH value
                 dating were eliminated, all ACH credit transactions would have to be processed
                 within a fairly small time frame, which may pose operational risks that could lead
                 to delayed payments.

                                The discussion in this section regerding the risk that ACH debit
See comment 3.   transactions will be returned should be deleted because this risk relates to the
                 finality of the underiying payment, and not to the finality of the settlement of the
                 transaction.

                              Issues Surrounding the Regulation of New and Emerging Finaneifyl
                 Producta and SflryJCflS. The draft report suggests that the Federel Reserve's
                 Regulation E receipt requirement may pose problems for new products, such as
                 stored-value cards, due to privacy concern*. The Federal Reserve agrees that it
                 may not be appropriate to require receipt* (or these transactions. Consequently,
                 the Board proposed not to apply the receipt requirement to most types of stored-
                 value cards in its April 1996 proposed amendments to Regulation E. (In
                 Congressional testimony about emerging payment methods in 1995, former Vice
                 Chairman Blinder also noted that it would rn»k» little sense to require receipts at




                       Page 172                                GAO/GGD-97-73 Payments, Clearance, and Settlement
                        Appendix I
                        Comments From the Board of Governors of
                        the Federal Reserve System




                                                           -4-
See comment 4.
                 vending machines, for example.) In addition, in March 1997 the Board issued a
                  report to Congress on the application of the Electronic Fund Transfer Act to
                 electronic stored-value products. This report provides a comprehensive analysis of
                 the costs of applying Regulation E provisions to stored-value cards and discusses
                 the considerable costs of applying the terminal receipt requirement to these
                 transactions. It is not clear, however, why the draft report describes the problems
                 associated with providing receipts for stored-value cards in the context of privacy
                 concerns, when such concerns have not been raised with respect to debit or credit
                 card transactions.

                               More generally, the discussion of issues related to emerging electronic
                 payment products fails to note that many of the issues mentioned are not unique to
                 these types of payments and have been addressed in other contexts. For example,
                 the draft report notes that seignorage could decline if some U.S. currency is
                 replaced by stored-value cards. It would be useful if the GAO put this issue in
                 context by explaining that, to the extent that any noncash payment mechanism
                 replaces cash transactions, seignorage may decline. The amount of currency in
                 circulation today, and the associated seignorage, would certainly be higher if check
                 payments, credit cards, and other electronic payments were not widely used. Any
                 material affect of electronic money on seignorage would be very unlikely in the
                 near to intermediate term. In addition, the draft report should recognize that the
                 Federal Reserve Board has stated in Congressional testimony that it is highly
                 unlikely that the introduction of stored-value cards will raise significant concerns
                 with respect to the Federal Reserve's ability to formulate and implement monetary
                 policy.


See comment 5.                Finally, the draft report is Incorrect in its statement that brokerage
                 firms and other nonbanks that provide accounts similar to demand deposits are
                 subject to Federal Reserve reserve requirements. Reserve requirements are limited
                 to transaction accounts held at depository institutions.

See comment 6.                 Issues Surrounding Mitioatlon of Sattlemant Risks in Wholnsaln and
                 Foreign Exchange Transactions. The draft report, which explains that Herstatt risk
                 exists because the two sides of a foreign exchange contract settle in different
                 countries, is misleading as it implies that Herstatt risk is only an intraday risk and
                 results primarily from the different time zones of the settling currencies. This Is
                 not the case. Studies by the G-10 central banks and the New 'Vork Foreign
                 Exchange Committee, e private-sector group, have shown that a bank's exposure
                 may amount to the total value of its foreign exchange transactions over several
                 days. The fact that foreign exchange settlement exposures span several days and
                 not just one day was a key finding of the March 1996 BIS report entitled
                 "Settlement Risk in Foreign Exchenge Transactions."




                       Page 173                                  GAO/GGD-97-73 Payments, Clearance, and Settlement
                        Appendix I
                        Comments From the Board of Governors of
                        the Federal Reserve System




                               Simultaneous Payment (Davment-vs-oavment PVP). If the GAO
See comment 7,   Includes a discussion of the G-20 Initiative In its final report, it should do so as part
                 of its discussion of PVP, rather than in the "clearinghouse becomes counterparty'
                 section, where it is referenced in the draft report. The objective of the G-20
                 continuous linked settlement initiative Is to establish a mechanism to facilitate the
                 simultaneous irrevocable final settlement of foreign exchange transactions.

                               Pricing and Provision of Davlipht Overdrafts The Federal Reserve's
                 provision of daylight credit, like its overnight discount window lending, is not a
                 priced service under the Monetary Control Act. In addition, the arguments cited in
                 the report for pricing daylight overdrafts at the overnight federal funds rate are
                 fundamentally flawed, in that they fail to distinguish between the cost of overnight
                 funds and the cost of intraday funds. That is, the overnight interbank rate is not
                 the appropriate benchmark for the cost of intraday credit, either for the Federal
                 Reserve or privete financial institutions.

                               Nevertheless, the Federal Reserve is not, as the draft report suggests,
                 unwilling to consider appropriate adjustments to the daylight overdraft foe. In fact,
                 in 1995 when It last increesod the level of the fee, the Board stated its intention to
                 evaluate the desirability of any further increases in the daylight overdraft fee in two
                 years, based on the objectives of the payment system risk program.

                               The Potential Conflict Batwaon the Federal Reserve's Role as Sarviea
See comment 8.
                  Provider and System Regulator. According to the draft report, some private-sector
                 service providers fear that the Federal Reserve could be competing unfairly with
                 them by writing regulations so as to favoi- its own services and by underpricing its
                 services so that it retains market share. The report would bo more balanced if the
                 GAO discussed whether there has been any evidence of unfair competition by the
                 Federal Reserve. We believe that the Board's regulatory actions as well as the
                 Federal Reserve's priced-services cost recovery performance demonstrate that the
                 Federal Reserve does not act as an unfair competitor. For example, the Board
                 adopted Regulation CC's same-day settlement rule, which improved the legal
                 presentment rights of banks that compete with the Reserve Banks in the collection
                 of checks, even though it projected that the rule would result in significant Reserve
                 Bank check volume declines. The Federal Reserve has also fully recovered the
                 costs of providing its priced services over the long run, as required by the
                 Monetary Control Act. During the past ten years, the Federal Reserve has
                 recovered 100.7 percent of its total costs (including imputed costs and targeted
                 return on equity); 1996 priced-services cost recovery was 103.5 percent.

See comment 9.                Possible Inefficiency In the United States Payments Systan^. The draft
                 report states that the share of GDP devoted to the payments system is estimated
                 at 1.0 to 1.5 percent. This estimate overstates the payment system's component




                       Page 174                                 GAO/GGD-97-73 Payments, Clearance, and Settlement
       Appendix I
       Comments From the Board of Governors of
       the Federal Reserve System




of GDP to the extent that costs included in total payment system costs (such as
estimates of the time spent by consumers writing checks and maintaining their
bank account records) are not costs reflected in the GDP. Wo estimate that the
payment system's share of GDP is well below 0.5 percent.

                As noted in the draft report, checks are the dominant form of noncash
 payments in the United States, although the total cost of a check transaction far
 exceeds that of most electronic payments. We believe it would be useful for the
 final report to describe some of the barriers to the widespread replacement of
 checks by electronic payments in this country. First, checks are familiar,, very
convenient to use, and accepted for most types of payments. Electronic
payments, on the other hand, are not always easy to use and are not accepted for
many typos of payments. Second, many consumers do not wish to give up control
of the payment process and, thus, have not embraced automated debit services
through the ACH for bill payments. Third, no electronic payment products are
currently widely available that permit individuals to pay other individuals. Fourth,
businesses that shift from checks'to electronic forms of payment often require
investments in new accounts payable and receivable systems, which are costly to
implement. While cost savings can be realized by tHJsinesses whan they use
electronic payments, tfte transition costs are high, which slows the rate-of -
acceptance. Finally, electronic payment systems are more capital intensive than
paper check processing systems, resulting in high unit processing costs until
significant transaction volumes are realized. As a result, higfier fees are often
charged to users of electronic payment services than to users of checks, which
negatively affect demend for electronic payments.

           We hope that these comments, along wKh the additional technical
comments we have provided under separate cover, are useful in the GAO's
development of its final report.

                                     Sincerely,




      Page 175                               OAO/GGD-97-73 Payments, Clearance, and Settlement
                Appendix I
                Comments From the Board of Governors of
                the Federal Reserve System




                The following are GAG'S comments on the Board of Governors of the
                Federal Reserve System's letter dated April 16,1997.


               1. The Federal Reserve acknowledged that we had incorporated a number
GAO Comments   of the comments they provided on earlier versions of the draft report.
               However, they expressed disappointment that many of their substantive
               comments were not addressed.

               While the Federal Reserve was reviewing our draft, we were in frequent
               contact vdth staff regarding technical comments. We incorporated their
               suggested changes where appropriate. In addition, officials responsible for
               operating many of these payment systems or developing new products,
               such as CHIPS, GSCC, and Mondex, reviewed sections ofthe report and
               commented on its accuracy. We made a number of changes to these
               sections based on their comments. Because our presentation of the issues
               did not include evaluation or conclusions, we did not incorporate the
               Federal Reserve's detailed comments on the issues if, in our judgment,
               their comments were evaluative in nature. However, their corrunents on
               the issues are presented in their entirety in the Board of Governors' letter.

               2. The Federal Reserve stated that our discussion ofthe clearance and
               settlement in the U.S. goverrmient securities market only focuses on a
               portion ofthe market, the cscc members and the securities clearing banks.
               The Federal Reserve believes this leaves the reader vyith the erroneous
               impression that these organizations represent all of the clearance and
               settlement activity that occurs over Fedwire.

               We have added a footnote to our discussion of Treasuries stating that we
               focused only on oscc's process, which is one mechanism for clearing and
               settling U.S. government securities. See page 58.

               3. The Federal Reserve commented that our discussion regarding the risk
               that ACH debit transactions will be returned should be deleted because this
               risk relates to the finality ofthe underlying payment, not to the finality of
               the settlement of the transaction.

               We have deleted our example ofthe ACH debit transaction in our
               discussion of same-day settlement finality of ACH transactions. See page
               158.




               Page 176                          GAO/GGD-97-73 Payments, Clearance, and Settlement
 Appendix I
 Comments From the Board of Governors of
 the Federal Beserve System




4. The Federal Reserve commented that it is not clear why the report
discusses the problems associated with providing receipts for stored-value
cards in the context of privacy concerns, when such concerns have not
been raised with respect to debit or credit card transactions.

We deleted our discussion describing the problems associated with
providing receipts for stored-value cards in the context of privacy. See
page 159.

5. The Federal Reserve commented that our report was incorrect in stating
that brokerage firms and other nonbanks that provide accounts similar to
demand deposits are subject to Federal Reserve reserve requirements.

We have clarified our discussion of banks versus nonbanks to remove the
mistaken impression that brokerage firms and other nonbanks that
provide accounts similar to demand deposits are subject to Federal
Reserve reserve requirements. See page 160.

6. The Federal Reserve stated that our report was misleading in that it
implied Herstatt risk is orJy an intraday risk and results primarily from the
different time zones of the settling currencies.

We state in the report that intraday risk could accumulate to the sum of 2
or 3 days' trading volume. See page 44. We have added language to the
report recognizing that Herstatt risk can exist within the same time zone.
See page 164.

7. The Federal Reserve commented that if GAO includes a discussion ofthe
Gr-20 initiative, it should do so as part of its discussion of pvp, rather than
in the "clearing house becomes counterparty" section.

We have moved the discussion of the G-20 initiative in foreign exchange
transactions to the section discussing simultaneous PVP. See page 165.

8. The Federal Reserve believes that our discussion of the issues in the
report fails to give the reader an appreciation of the diflfering perspectives
and associated considerations. For example, with regard to the potential
conflict between the Federal Reserve's role as service provider and system
regulator, the Federal Reserve believes the report would be more balanced
if it included a discussion of any actual evidence of unfair competition by
the Federal Reserve. In addition, the Board provided information in its




Page 177                           GAO/GGD-97-73 Payments, Clearance, and SetUement
 Appendix I
 Conuaenta Prom the Board of Governors of
 the Federal Beaerve System




 letter and in its discussion of other issues on efforts it has made to
 minimize the potential conflict between its two roles.

We raise the issues of the potential conflict in the Federal Reserve's dual
role because many private-sector individuals and organizations expressed
such concerns. We do not present any evidence that would either
substantiate or refute the contention that the Federal Reserve is actually
competing unfairly with its private-sector competitors. We have, however,
incorporated where appropriate additional information the Board has
given us about its efforts to minimize the potential conflict between its two
roles. For example, we acknowledge that the Federal Reserve said that
when it is considering any proposed change in its payment system
operations, it conducts an analysis to assess the impact ofthe proposed
change on private-sector competition. See page 168.

9. The Federal Reserve stated that our report overestimated the share of
gross domestic product devoted to the payments system and oflfered an
alternative estimate.

Recognizing that there are many different ways to measure possible
inefficiencies in the U.S. pajrment system, we have included the Federal
Reserve's estimate. See page 169.




Pa«e 178                           GAO/GGD-S7-73 Payments, Clearance, and Settlement
Appendix II

Major Contributors to This Report


                        Nolani T. Traylor, Evaluator-in-Charge
General Government      Tamara E. Cross, Senior Evaluator
Division, Washington,   Nancy Eibeck, Evaluator
D.C.                    Robert Pollard, Economist
                        Charles Kilian, Advisor
                        John Treanor, Banking Advisor
                        Desiree W. Whipple, Reports Analyst
                        Kim Wheeler, Publishing Advisor
                        Hazel Bailey, Evaluator (Communications Analyst)


                        Abuid Amaro, Evaluator
San Francisco           Linda Chu, Evaluator
Regional Office
Office of General       Paul Thompson, Senior Attorney
Counsel, Washington,
D.C.




                        Page 179                     GAO/GGD-97-73 Payments, Clearance, and Settlement
 Glossary


ACH Operator/Processor   An ACH operator/processor is a central clearing facility that receives
                         batches of ACH credit and debit transactions from originating depository
                         institutions; edits, sorts, and distributes the transactions to receiving
                         depository institutions; and facilitates the settlement among participants.

Authentication           Authentication is the process of verifying the identification ofthe true
                         sender of a message and also that the text of the message itself has not
                         been altered.

Back Office              The back office of a financial institution is made up of employees
                         responsible for (1) recording and maintaining the official records ofthe
                         financial institutions and (2) processing transactions entered into by the
                         financial institutions or its customers.

Batch Processing         Batch processing is the transmission or processing of a group of payment
                         orders and/or securities transfer instructions.

Bond                     A bond is a debt security representing a loan by the buyer to the
                         corporation or goverrunent issuing the bond; it may pay interest, or it may
                         be discounted in price from the value at maturity.

Book-Entry System        A book-entry system is an accounting system that permits the transfer of
                         assets (e.g., securities) without the physical movement of paper
                         documents or certificates.

Browser                  A browser is a computer program that facilitates locating and displa3dng
                         information on the World Wide Web (e.g., Netscape Navigator or Microsoft
                         Explorer). The browser could work on the Internet or through internal
                         information management systems called Intranets.

Call Option              A call option is a contract that gives one the right, but not the obligation,
                         to buy a specified amount of an underlying asset, such as stocks or
                         currency, at a specified price by a certain date.

Gash Letter              A cash letter is a group of checks, accompanied by a listing of the checks,
                         which is sent to a clearing house, a correspondent bank, or the Federal
                         Reserve for collection.

Check                    A check is a written order from one party (the payor) to another party (the
                         payee) requiring the payor to pay a specified sum on demand to the payee
                         or to a third party specified by the payee.




                         Page 180                         GAO/GGD-97-73 Payments, Clearance, and Settlement
                              Glossary




Check Clearing               Check clearing is the movementof a check from the depository institution
                             at which it was deposited back to the institution on which it was written.
                             The funds move in the opposite direction, with a corresponding credit and
                             debit to the involved accounts.

Check Truncation             Check truncation is the practice of holding a paper check at the bank at
                             which it was deposited (or at an intermediary bank) and electronically
                             forwarding the essential information on the check to the bank on which it
                             was vmtten. A truncated check is not returned to the writer.

Class of Options             A class of options consists of options that are of the same type and style
                             and cover the same underlying asset.

Clearance                    Clearance is the process of transmitting, reconciling, and in soifie cases,
                             confirming payment orders or security transfer instructions prior to
                             settlement, possibly including the netting of instructions and the
                             establishment of final positions for settlement. In the context of securities
                             markets, this process is often referred to as clearance.

Clearing Agent Banks         Clearing agent banks are Fedwire participants that are regularly engaged
                             in the business of providing clearing services in eligible securities for
                             members and oscc.

Clearing House               A clearing house is a voluntary association of depository institutions that
                             facilitates the exchange of payment transactions such as checks,
                             automated clearing house transactions, and large-value funds transfers
                             and the settlement of participants' net debit or credit positions.

Clearing Members             Clearing members are firms that are determined by occ to be qualified to
                             interact with occ on behalf of market participants.

Commercial/Merchant Server   A commercial/merchant server is a computer and/or computer program
                             that provides information in response to requests by other computer
                             programs. Some servers are capable of sending and receiving secure
                             messages.

Commercial Online Service    A commercial online service is an integrated package of services providing
                             news, e-mail, a special-interest forum, information resources, shopping,
                             and other services accessed by consumer and business computer users
                             using proprietary software and a modem (examples include America
                             Online, Microsoft Network, CompuServe, etc.).




                             Page 181                        GAO/GGD-97-73 Payments, Clearance, and SetUement
                       Glossau-y




Comparison Members    Comparison members are primarily government securities broker-dealers
                      and clearing agent banks that are capable of interacting with GSCC
                      operations.

Corporate Payments    Corporate payments are payments that are used by businesses to pay
                      other businesses for goods or services.

Correspondent Bank    A correspondent bank is a bank that—by arrangement—holds the deposits
                      of another bank and provides payments and other services for that bank.

Credit Card Company   A credit card company is a company that owns the trademark of a
                      particular credit card and may also provide a number of marketing,
                      processing, or other services to the members using the card services.

Credit Line           A credit line is the maximum amount of credit available in an open-ended
                      credit arrangement, such as a bank credit card, which the lender may
                      change at any time. The credit line is disclosed in the credit card
                      agreement.

Currency Option       Currency options are options that represent the right to buy or sell foreign
                      currency at a particular price within a specified period.

CUSIP                 CUSIP stands for the Committee on Uniform Securities Identification
                      Procedures. Each type and issue of security will have its own unique cusiP
                      number.

Daylight Overdraft    A daylight overdraft is an intraday loan that occurs when a bank transfers
                      funds in excess of its reserve account.

Depositary Bank       A depositary bank is the bank at which a check is first deposited.

Direct Participants   Direct participants are financial institutions that are permitted to transact
                      with the clearing organization, and all customers come to the clearing
                      organization through them. The term usually refers to. institutions that
                      interact with NSCC.

Dual Trading          Dual trading occurs when an individual (or representative of a firm) trades
                      on behalf of customers and also trades for his or her own or the firm's
                      proprietary account.

Decryption            Decryption is the restoration of encrypted data to their original text.




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                                 Glossary




DVP System                      A delivery vs. payment (DVP) system is a system that ensures that the final
                                transfer of one asset will occur if, and only if, the final transfer of another
                                asset (or other assets) occurs.

Electronic Banking              Electronic banking is a banking activity accessed by electronic means.

Electronic Funds Transfer       EFT is any transfer of funds between accounts using an electronic terminal,
(EFT)                           telephone, computer, or magnetic tape and that does not use checks or
                                other paper.

Electronic Data Capture (EDC)   EDC is a point-of-sale terminal that reads the information encoded in the
                                magnetic stripe of bank cards. These terminals electronically authorize
                                and capture transaction data, eliminating the need for a paper deposit.

Encryption                      Encryption is the process of disguising a message (using mathematical
                                formulas called algorithms) in such a way as to hide its substance, a
                                process of creating secret writing.

Equity Index Option             An equity index option is an options contract that covers the price of a
                                diversified stock portfolio that matches a designated stock-index (a
                                statistical indicator used to measure changes in stock groupings).

Equity/Stock                    Equity or stock is a financial instrument that represents ownership in a
                                company.

Exchange                        An exchange is an orgaruzed market -with transactions concentrated in a
                                physical facility with participants entering two-sided quotatiorvs (bid and
                                ask) on a continuous basis.

Exercise                        Exercise means to make use of the "rights" in a contract. For instance, a
                                buyer of a call option may exercise the right to buy the imderlying asset at
                                a particular price agreed upon when the contract was purchased.

Federal Funds Rate              The federal funds rate is the rate charged by a depository institution on an
                                overnight sale of federal funds to another depository institution. The rate
                                may vary from day to day and firom bank to bank.

Federal Reserve Account         A federal reserve account is a noninterest-eaming account that a
                                depository institution maintains with a Federal Reserve Bank. The balance
                                in this accoimt is maintained for purposes of (1) satisfying the Federal
                                Reserve's reserve requirements and/or (2) settling payments cleared




                                Pa«el83                         GAO/GGD-97-73 Payments, Clearance, and Settlement
                               Glossary




                              through the Federal Reserve. The balances in these accounts play a central
                              role in the exchange of funds between depository institutiorvs.

FUe                           A file is a group of entries transmitted by originating institutions or to
                              receiving institutiorvs by ACH operators. Afilemay contain one or more
                              batches of entries.

Finality                      Finality is an irrevocable and unconditional transfer of payment.

Float                         Float is checkbook money that appears on the books of both the check
                              writer (the payor) and the check receiver (the payee) while a check is
                              being processed.

Floor Broker                  Afloorbroker executes trades for customers and may also execute trades
                              for their personal or employer accounts.

FIoorTrader                   Afloortrader executes trades orUy for their personal accounts. A floor
                              trader is also referred to as a "local."

Futures Commission Merchant   An FCM is afirmthat buys or sells futures contracts and accepts payment
(FCM)                         from or extends credit to those whose orders it accepts.

Hedging                       Hedging is engaging infinancialtransactiorvs to protect against potential
                              adverse changes in the values of assets, liabilities, or off-balance-sheet
                              activities.

The Internet                  The Internet is an open, worldwide corrununication infirastructure
                              cor\sisting of intercormected computer networks that allow access to
                              remote information and the exchange of irrformation between computers.
Liquidity                     Liquidity is a quality that makes an asset easily convertible into cash with
                              relatively little loss of value in the conversion process.
Locked-in Trades              Locked-in trades are transactions that are matched by a computer, usually
                              at the place of the trade, before being sent to a clearing organization.
Market Maker                  Market maker is a dealer that makes bids and offers at which he/she will
                              trade.
MICR-line Information         MiCR-line information refers to the data characters at the bottom of a
                              check. The magnetic ink character recognition (MICR) line at the bottom of




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                              Glossary




                             a check includes the routing number of the payor bank, the amount of the
                             check, the number ofthe check, and the account number ofthe customer.

Mortgage-Backed Securities   MBS are securities that are backed by mortgages in which investors
                             receive payments out of the interest and principal payments made on the
                             underlying mortgages.

Multilateral Netting         Multilateral netting is an arrangement among three or more parties to net
                             their obligations, which may arise from financial contracts, transfers of
                             funds, or both. This type of netting normally takes place in the context of a
                             multilateral net settlement system.

Net Debit Cap                A net debit cap is the quantitative limit placed on the debit position that
                             participants in a funds or securities transfer system can incur during the
                             business day. Under the Federal Reserve's policy, institutions are subject
                             to two caps—a daily cap and a 2-week cap.

Net Settlement               Net settlement is the settlement of a number of obligations or transfers
                             between or among counterparties on a net basis.

Netting                      Netting is an agreed upon offsetting of positions or obligations by trading
                             partners that can reduce a large number of individual obligations or
                             positions to a smaller number.

Netting Members              Netting members are primarily goverrunent securities broker-dealers and
                             banks that are capable of participating in the netting services through
                             GSCC


Novation                     Novation is an agreement to replace one party to a contract vvlth a new
                             party. The novation transfers both rights and duties and requires the
                             consent of both the original and the new party.

Offsetting                   Offsetting is liquidating a purchase of contracts (e.g., futures contracts) by
                             the sale of an equal number of contracts with the same delivery month,
                             thus closing out a position.

On-Us Check                  An "on-us check" is a check payable from funds on deposit at the same
                             bank where it is presented for collection.
Open Outcry                  Open outcry is a form of trading whereby buyers and sellers trade by
                             shouting their orders and using hand signals.




                             Page 185                        GAO/GGD-97-73 Payments, Clearance, and Settlement
                               Glossary




Opportunity Costs             Opportunity costs refer to the present value of income that could be
                              earned (or saved) by investing in the most attractive alternative to the one
                              being considered.

Options on Futures            An option on a futures contract gives an investor the right but not the
                              obligation, in exchange for a price (called a premium), to buy or sell a
                              specified futures contract at a specific price (called the exercise price)
                              within a specified period.

Order-Book OfiBcial           An order-book official is an exchange official who accepts and executes
                              limit orders from customers—orders to buy or sell when the market
                              reaches a certain price.

Originating Depository        An originating depository institution is a depository institution that
Institution                   initiates and warrants electronic payments processed through the ACH
                              network on behalf of its customers.

Originator                    An originator is the person or organization that initiates an ACH entry.

Paying Bank                   A paying bank is the bank at which a check is payable and to which it is
                              sent for payment or collection.

Payment Processor or Credit   A payment processor is an association dedicated to the settlement and
Card Association              clearance of transactions using credit cards. Examples of such
                              associations are VISA and MasterCard.

Payments System               Payments system is a collective term for mechanisms (both paper-backed
                              and electroruc) for moving funds, payments, and money among financial
                              institutions throughout the nation. The Federal Reserve plays a mjyor role
                              in the nation's payments system through distribution of currency and coin,
                              processing of checks, electronic transfer of funds, and the operation of
                              automated clearing houses that transfer funds electronically among
                              depository institutions; various private organizations also perform
                              payments system functions.

Premium                       A premium is the amount that the buyer of an option pays the writer or
                              seller of the option.

Presentment Fee               A presentment fee is a fee that a bank receiving a check may impose on
                              the bank that presents the check for payment.




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                                Glossary




Proprietary Trading             Proprietaiy trading is the buying and selling for the trading institution's
                                own account, in contrast to the trading the institution does on behalf of its
                                customers.

Put Option                      A put option is a contract that gives one the right, but not the obligation, to
                                sell a specified amount of an underlying asset, such as stocks or currency,
                                at a specified price by a certain date.

Real-Time Gross Settlement      Real-time gross settlement is a system that processes each transaction as
                                it is initiated rather than processing it in a batch. Gross settlement means
                                that the system settles each transaction individually.

Receiver                        A receiver is the individual or organization that has authorized an
                                originator to initiate an ACH credit or debit transaction entry to the
                                receiver's account with the receiving depository institution.

Registered Options Trader       A trader that trades on the exchange floor but has em obligation to make
                                markets similar to that of specialists.

Repurchase Agreement            A repurchase agreement is an agreement between a buyer and seller
                                (usually) of U.S. government securities, whereby the seller agrees to
                                repurchase the securities at an agreed-upon price and, usually, at a stated
                                time.

Respondent Bank                 A respondent bank is a bank that regularly buys check processing and
                                other services from a correspondent bank.

Return Item                     A return item is a transaction that has been returned by a receiving
                                depository institution because it Ccinnot be posted.

Securities                      Securities refer to a financial instrument that represents a share of
                                ownership in a corporation—a stock; a loan to a corporation, government,
                                or governmental body—a bond; or conditional rights to ownership, e.g., an
                                option.

Self-Regulatory Organizations   Self-regulatory organizations are industry organizations and associations
                                responsible for enforcement and practices in their market.

Series of Options               Series of options are all options ofthe same class that also have the same
                                unit of trade, strike price, and expiration date.




                                Page 187                        GAO/GGD-97-73 Payments, Clearance, and Settlement
                       Glossary




Server                A server is a computer that stores information that is retrieved by other
                      computers.

Settlement            In banking, settlement refers to the process of recording the debit and
                      credit positions of two parties in a transfer of funds. Also, it is the delivery
                      of securities by a seller and the payment by the buyer.

Settlement Banks      Settlement banks are banks that maintain the settlement accounts for
                      clearing members whereby payments and deposits are made.

Specialist            A specialist is a member designated by an exchange to be the sole market
                      maker for a particular stock.

Speculation           Speculation is the assumption of risk in anticipation of gain but
                      recognizing a higher than average possibility of loss. The term speculation
                      implies that a business or investment risk can be analyzed and measured,
                      and its distinction from the term investment is one of degree of risk.

Stock/Equity Option   A stock option gives one the right to purchase or sell a certain number of
                      shares of stock at a particular price within a specified period.

Stored-Value Card     A stored-value card is a credit-card-sized device, implanted with a
                      computer chip, with stored money value. A reloadable stored-value card
                      can be reused by transferring value to it from an automated teller machine
                      or other device. A disposable card cannot be reloaded.

SW.l.F.T.             The Society for Worldwide Interbank Financial Telecommunication is an
                      international financial payment cooperative organization that operates a
                      network that facilitates the exchange of payment and other financial
                      messages between financial institutions throughout the world.

Systemic Risk         Systemic risk refers to the risk that the failure of one participant in a
                      transfer system (or financial mcU"kets generally) to meet its required
                      obligations will cause other participants or financial institutions to be
                      unable to meet their obligations when due.

Trade Comparison      Trade comparison is the receipt, validation, and matching of data on the
                      long (buy) and short (sell) side of a transaction and the report.ing of such
                      match.

Treasury Security     A Trocusuiy security is a negotiable debt obligation ofthe U.S. government,
                      backed by Us full faith and credit, and issued with various maturities.



                      Page 188                                            GAO/GGD-97-73 Payments, Clearance, and Settlement




                                         .   ^t ..^- ^\t ..t±J^'9:   t-
                                       Glossary




UCC                                   The Uniform Commercial Code (ucc) is a set of model laws governing
                                      commercial and financial transactions.

Value Added Networks                  Value added networks refer to a third-party service provider that manages
                                      data conmiunications networks for businesses that exchange electroruc
                                      data with other businesses.

Verification                          Verification is the ability to positively identify and authenticate a
                                      particular encrypted communication.

Writer (Option)                       An options seller is called a writer of options, a "covered" vmter if ovming
                                      the underlying asset and a "naked" writer if not. The writer of an option is
                                      obligated lo sell, in the case of a call option, or buy, in the case of a put
                                      option, a specified amount of the underlying asset at a predetermined
                                      price when the buyer or holder exercises the option. The writer earns a
                                      premium paid by the buyer.




(233483)                              Page 189                        GAO/GGD-97-73 Payments, Clearance, and Settlement




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