For Everything You Invest In

  Mary M. Fenoglio
Executive Vice President
State Street Bank and Trust Company
1776 Heritage Drive
North Quincy, MA 02171
Telephone: (617) 985-5277
Facsimile: (617) 537-2541


August 12, 2002

Ms. Jennifer J. Johnson, Secretary
Board of Governors of Federal Reserve System
20th Street and Constitution Avenue, N.W.
Washington, DC 20551

Mr. Jonathan G. Katz, Secretary
Securities and Exchange Commission
450 5th Street, NW
Washington, DC 20549-0609

Re: File No. S7-15-02/Docket No. R-1122

Dear Ms. Johnson and Mr. Katz,

We would like to thank the Board of Governors of the Federal Reserve System (Board) and the Securities and Exchange Commission (SEC) for the opportunity to comment on the Interagency White Paper on Structural Change in the Settlement of Government Securities: Issues and Options. Like many others in our industry, the events of September 11, 2001 prompted a comprehensive review of our crisis management and business continuity plans, with the goal to ensure continuous availability of operations by anticipating and mitigating potentially disruptive events

We appreciate that the Board and the SEC are seeking ways to strengthen the resiliency of our market infrastructure, an effort that logically complements similar work being done at financial institutions and vendor firms industry wide. It is evident that considerable thought has been given to the approaches outlined in the White Paper and their potential impact. As the current infrastructure supports the world's largest and most liquid government securities market, we agree that any review or proposed change must be examined from every conceivable angle. We endorse the paper's goal of providing a framework where a full industry discussion of all the relevant issues and questions points the way forward. In support of that objective we offer the following comments.

Old Euroclear Model

We agree that this model raises a number of issues. The paper highlights the potential for less robust operational resiliency and an increased risk if the service-provider bank exits the business, perhaps because of financial difficulties in an unrelated part of its business. We would also note that with the establishment of the Euroclear Bank in 2000, the industry made a conscious decision to move away from the Old Euroclear Model. There are additional issues to consider with this model:

The paper proposes that a single provider would be inherently more efficient than multiple providers. While we may agree at a certain level, the question of how a single provider would ultimately be selected could prove most vexing. Further, if there is a concern today in an environment supported by two major service providers, would that concern not increase if the field was narrowed to a single provider?
Fifteen years ago, there were probably 4-5 times the number of clearing banks that there are today. As a result of mergers, acquisitions, and decisions by banks to exit the business, two major clearers remain. Both clearing banks, however, have demonstrated a strong commitment to this business over an extended period of time, and continue to do so, notwithstanding the difficulties encountered in the aftermath of the September 11 attacks. One might question whether the industry would be more comfortable with a "new" service provider which could potentially win the business with an aggressive bid, but which would have no proven track record in this area? If the wrong service provider were selected, a transition to another provider would be a costly undertaking both in terms of expense and market reputation.
The Old Euroclear Model adds an extra layer of administrative and communication overhead, which does not exist in today's process. Participants will need to go through an intermediary to deal with the contracted service provider. The issue of whether this model is the most efficient use of industry resources would need to be carefully examined.

A private limited-purpose bank

We agree with the White Paper's assessment that a limited purpose bank functioning as a utility could (i) provide robust back-up facilities, (ii) be unlikely to exit the clearing business, and (iii) create triparty services to support the required security financing needs. With regards to the paper's concern on innovation of triparty services, utilities such as DTC have often been responsive to their participants' needs by developing new products and services. Also, banks providing triparty services via the utility are likely to continually innovate their products for competitive reasons.

The paper suggests that providing a back-up credit facility to the utility may be less risky than the Federal Reserve's current arrangement with the clearing banks. We agree for the reasons stated in the White Paper, e.g. greater transparency and more intense supervision. In addition, a utility would also have the commitment and financial backing of a large number of participants, which would seem to be a less risky proposition than the current arrangement.

This alternative may also provide efficiency gains for both the industry and the Federal Reserve. The Federal Reserve would no longer require its book-entry clearance system, back-up sites, hardware/software maintenance, and all the staffing and other ancillary costs involved with this service. The industry would benefit from a single settlement location, as it would allow consolidation of multiple systems, and all their related costs to one platform. Fewer operational staff would be needed to service a single service provider. Other benefits would include receiving and reconciling a single source, versus today's multiple sources, on processes such as position reconciliation, securities entitlements, and reference database information. This is a model under which other market utilities operate, including the United Kingdom (CREST) and Canada (CDS).

In addition to the credit facility issues the paper discusses, this option raises other questions:

The Fedwire book-entry system is true delivery-versus-payment and is recognized as a real-time-gross-settlement (RTGS) system. If this option were selected would the utility need to provide a similar RTGS capability?
In 1997, the industry was planning to migrate settlement of Fannie Mae and Freddie Mac mortgage-backed securities from the Federal Reserve to Participants Trust Company (which subsequently merged with DTC). This plan was subsequently aborted. One of the primary reasons why was that dealers discovered they would lose their ability to net Fed repo transactions backed by different security types. This had tremendous balance sheet implications. Therefore, any proposed change should be preceded by a thorough examination of all regulatory requirements.

Enhancement of Federal Reserve services

We agree that the Fedwire system has proven more reliable than those of private sector firms, and to a lesser extent, those of market utilities. The enhanced Federal Reserve service contemplates providing account and credit services directly to dealers, which, as noted, is a marked departure from today's service. The question is whether it makes sense for the Federal Reserve to be in the business of servicing thousands of accounts and providing billions of dollars in intraday credit. Downstream effects of such a service would need to be reviewed (i.e. whether such a service would impact the evolution of the intraday funds market).

The paper expressed a concern that, without direct competition or participant owners to prioritize its activities, this service might have difficulty in promoting innovation and efficiency on an ongoing basis. If the past is a guide, this is one area where there is opportunity for improvement. For example, in Q1 2002, Ginnie Mae securities converted from clearing at DTC to clearing through Fedwire's book-entry system (a move some questioned given the normal reluctance of the government to take on a service that is being adequately handled in the private sector). Before this conversion could take place, however, the Federal Reserve had to replicate functionality that supported these securities on their prior platform - functionality such as repo tracking, interim accounting, fail tracking, etc.

Further Comments

The first question posed in the White Paper asks whether the Board and the SEC have correctly identified the vulnerabilities that should be considered in evaluating the government securities market. From a business-continuity perspective, we believe that the paper has identified the known vulnerabilities. The recent extreme volatility in the markets, however, has underscored another vulnerability: that is, the importance of investor confidence in the market and its infrastructure. One current business practice that we believe undermines the markets' integrity and reputational risk is a Bond Market Association guideline known as dealer-time. This issue has been formally raised with the BMA and the SEC,1 and with staff members of the Federal Reserve, but the industry has manifestly been unable to resolve this issue. Accordingly, we would respectfully request the Board's assistance in bringing this important issue to formal closure.

The fourth question posed asks whether concerns about efficiency, innovation and competition can be addressed through governance and, if so, how? Efficiency, innovation, and competition are usually driven by market forces and user demands, rather than mandated or facilitated through governance. Proper governance, however, can be critical to ensure that the proper forces, as well as checks and balances, are in place to realize these goals. Direct head-to-head competition between service providers certainly promotes these goals. As previously noted, however, we have also seen these objectives promoted within participant-owned utilities where participants often prod the utility forward on new initiatives. As utilities extend their reaches beyond their local markets, we would expect those single market utilities, which once may have had the luxury of no competition, to find that is no longer the case.

The fifth question asks whether it is feasible to separate the provision of core clearing from the provision of triparty repo services, and whether such separation would enable other banks to compete more effectively in the provision of triparty services. This question raises a host of issues, which are perhaps best answered by members of the broker-dealer community. There are a number of broker-dealers currently which, through mergers or acquisitions, have a banking affiliate that has full Fedwire book-entry capability. Yet these broker-dealers continue to process their business through the clearing banks. This would indicate a particularly strong linkage between the triparty and clearance functions. To facilitate increased competition under one of the new approaches, it might be necessary for the new model to include a base-line triparty service.

Finally, the ninth question posed asks what the next steps should be, what type of decision-making framework should be created, and which groups should be represented in that process. We believe that the next steps should be for the Board and the SEC, after analyzing the responses to the White Paper, convene a working group of senior industry representatives (with equal representation from all constituencies, including the Federal Reserve and DTCC) to review and discuss the findings and make recommendations to the Board and SEC on how to proceed. The SEC and the Board would incorporate their findings into a concept release for further public comment, with such action or rulemaking as is determined to be appropriate to be taken thereafter.

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We thank the Board and the SEC for their efforts, and look forward to participating in the discussions and decision-making process on this important industry issue.



Mary M. Fenoglio



1 SEC release No.34-46166; File No.SR-DTC-2001-14.