Speech by SEC Staff:
The Securities and Exchange Commission, as a matter of policy, disclaims responsibility for any private publications or statements by any of its employees. The views expressed herein are mine and do not necessarily reflect the views of the Commission or my colleagues on the staff of the Commission.
Good morning and thank you for inviting me to participate in the 11th Annual International Securities Settlement Conference. It is a pleasure to be here today to consider the important topics on the program agenda. I will offer my perspective on the U.S. experience in promoting efficiency in the clearance and settlement process that I hope will be relevant at this conference about the current situation in Europe. I emphasize that this is my overview, and does not necessarily reflect the views of the SEC or other members of its staff.
When we think of the phrase "market efficiency," we think of markets where securities can be traded, cleared, and settled, easily, quickly, and at a relatively low cost. While that concept may be easily understood, the more complex question is how do markets achieve this efficiency? Technological innovation? Competition? Regulation? Or a combination of all three? I believe that where technology, competitive forces, and industry practice fail to improve market inefficiencies, we must consider whether regulatory intervention is appropriate.
In free market economies, the strong preference is to rely whenever possible on competitive forces as a means to maximize efficiency. Despite this strong preference, all countries with the most developed free market economies have adopted regulatory regimes in a wide variety of contexts. One of the most common of these contexts is the financial markets, particularly the equity markets. These regulatory regimes have typically been adopted as a pragmatic response to what were perceived at the time as severe market failures that required regulatory action for the public interest.
Over the last century, economists have devoted a great deal of thought to articulating basic principles for when regulatory action is warranted. Economists have also studied the relative strengths and weaknesses of governmental action in general, as well as different kinds of regulatory approaches. This economic analysis can often be helpful, if for no other reason that it reminds us that regulatory action is rarely a straightforward solution to a discrete problem. Instead, enlightened regulation requires one to consider how firms and individuals will respond to new regulation. Failure to consider unintended consequences can lead to regulatory cures that are worse than the apparent inefficiencies.
In recent years, the securities markets have experienced great changes as technology has advanced and trading volumes have exploded. For example, in the U.S. in the past 10 years technology has facilitated shortening the settlement cycle from five days to three; the implementation of decimals trading; and improved order execution and order routing.
Our markets have also benefited from increased competition between market participants. The conditions of perfect competition include the existence of many buyers and sellers, the absence of externalities, full information about price and quantity by market participants, and no transaction costs. Clearly, the conditions for perfect competition have never existed in the real world. Even under less than perfect conditions, however, competition generates greater efficiency and social welfare than non-competitive economic models. Regulation, however can sometimes address the less than perfect conditions for market competition and thereby promote more vigorous and beneficial competition.
Today, I would like to share our experiences in the United States in dealing with the role of regulation in achieving market efficiency. I will focus my discussion on the impact of regulation on the U.S. clearance and settlement system.
Regulatory Impact on Efficiency on the U.S. Clearance and Settlement System
From 1934 through 1975, state law governed clearance and settlement processes in the United States. It was not until the late 1960s that the Commission began focusing on how securities transactions were cleared and settled.
In the late 1960s and early 1970s, the U.S. securities markets experienced a back-office crisis caused by increasing volumes and back-office inefficiencies in processing securities transactions. During this "paperwork crisis," a brokerage firm used approximately 33 different documents to execute and record a single securities transaction. As a result, these paper-based transactions slowed processing to the point where exchanges and the National Association of Securities Dealers ("NASD") shortened the trading day to alleviate back-office build up. Clerical personnel at firms were working day and night to process transactions. As the piles of paper grew, so did the number of errors in handling and recording transactions.
The confusion and delays in the back offices of brokers and dealers were magnified by inadequate clearance and settlement facilities, particularly in the over-the-counter area, and clogged transfer agent and registrar facilities. Systems designed for the three million share days of 1960 proved incapable of dealing with the astonishing volume of thirteen million share days around the end of the decade.
Operational deficiencies caused fail rates and customer complaints to soar. Losses in 1967-1968 caused an unprecedented number of broker-dealer firm failures. For example, roughly 160 New York Stock Exchange ("NYSE") member firms went out of business while others either merged or liquidated.
Because the problems confronting the industry were industry-wide and could not be tackled in isolation, few immediate solutions were available.
The Commission responded to the paperwork crisis by restructuring the regulatory framework governing the back office operations of brokers and dealers. The Commission established new record-keeping standards for broker-dealers, imposed new custody requirements for customer funds and securities, and tightened net capital requirements. The Commission also reviewed rule changes concerning operations at the clearing corporations of the exchanges and the NASD intended to ensure that funds and securities were adequately safeguarded.1
By the early 1970s, the U.S. Congress also had begun its inquiry into the back office crisis and asked the Commission to (1) compile a list of unsafe and unsound practices employed by brokers and dealers in conducting their business, (2) report to Congress on steps being taken to eliminate these practices, and (3) recommend additional legislation that might be needed to eliminate these unsafe and unsound practices. In its study, the Commission found, "There is no area of the securities business which offers more opportunity for reducing costs as well as exposure to the kind of disruption which resulted in loss to customers during the 1969-1970 period than the improvement and modernization of the systems for clearing, settlement, delivery, and transfer of securities. It was an archaic method of achieving this simple objective which nearly drowned the financial community in a tidal wave of uncontrolled paper."2
After extensive studies and hearings, Congress agreed that a fundamental weakness in the U.S. clearance and settlement system was the absence of a mechanism to give direction to, and ensure cooperation and coordination among, the entities engaged in securities processing - clearing corporations, securities depositories, transfer agents, and issuers. Industry practice combined with a lack of uniformity had failed to effectively support transaction processing in the U.S., and legislation soon followed.3
In 1975, the U.S. Congress enacted amendments to the Securities Exchange Act of 1934 ("Exchange Act") finding that:
Two basic themes recur throughout the legislative history underlying the securities processing provisions of the 1975 Amendments: prevent another paperwork crisis in the securities industry; and establish a safe, efficient, and modern national clearing and settlement system. Under Section 17A of the Exchange Act, the Commission was given the authority to facilitate:
A key component of the Commission's supervision of the securities clearance and settlement system is its authority to regulate clearing agencies. Before performing clearing agency functions, including trade comparison, netting, matching, and settlement activities, intermediaries must either register with the Commission or apply for an exemption from registration. Developing a national system of linked clearing facilities meant an overhaul of the system existing during the early 1970s. A prime example of the Commission's use of its authority to develop a safe, sound, and efficient system was the registration of the National Securities Clearing Corporation ("NSCC").
During the 1970s, the U.S. clearance and settlement system was fragmented - the NYSE, American Stock Exchange ("AMEX"), the NASD (the over-the-counter ("OTC") market), and the regional exchanges each owned subsidiary clearing agencies and depositories to clear and settle trades initiated on their exchange or market. The three clearing agencies for the NYSE, AMEX, and OTC market operated virtually identical facilities located within a few blocks of each other in downtown New York City. Brokers and dealers transacting business in several markets were required to participate in multiple clearing corporations, which resulted in increased costs for firms and investors.6
An ambitious effort to establish a national system began when the NYSE, AMEX, and OTC market merged their subsidiary clearing corporations into a new corporation called the National Securities Clearing Corporation. Essentially, NSCC would allow member brokers and dealers both in and outside New York City to submit NYSE, AMEX, and OTC transaction data to one clearing corporation for comparison and settlement. Combining the operations of the former subsidiary clearing corporations would eliminate duplicative personnel, operations, and equipment while reducing costs and fees for brokers and dealers.7
From 1975 to 1983, the Commission pursued an extraordinary process in determining whether to register NSCC, including multiple refinements to NSCC's application, solicitation of written public comments, public hearings, and conditional temporary registration.8 In its approval order, the Commission subjected NSCC's registration to several conditions, including a requirement that NSCC establish full interfaces or appropriate links with the clearing agencies of designated regional exchanges.9
To accomplish the statutory goals of Section 17A, the Commission must, among other things, not impose undue burdens on competition, protect the public interest and investors, and promote the safeguarding of funds and securities. In adopting the 1975 Amendments, Congress recognized that competition is itself an effective regulator and that the Commission's pattern of regulation should give appropriate attention to ways of maintaining competition among brokers and dealers. However, Congress did not require the Commission to follow the least anticompetitive standard in making rules and regulations in the securities processing area.10
Registering NSCC was a pivotal development in our industry's history. The effective operation of a national clearance and settlement system was dependent on the existence of a mechanism capable of receiving transmissions from multiple market centers, identifying data from individual participants, and generating settlement instructions, which net offsetting securities and money settlement obligations. Registering NSCC facilitated the development of the U.S. system and encouraged further efficiency in our markets.
The Commission's determination to register NSCC, however, did not come without challenge. Opponents to NSCC's registration included the regional exchanges outside New York City and their affiliated clearing agencies as well as the Antitrust Division of the U.S. Department of Justice. These parties perceived NSCC's registration to have anticompetitive effects and feared NSCC would become a "natural monopoly." Though the Commission conditioned NSCC's registration to ameliorate its competitive edge, legal challenges ensued after the approval was granted in 1977.
An entity called Bradford National Clearing Corporation ("BNCC") sued the Commission, claiming that NSCC's operation had anticompetitive effects and that the Commission misinterpreted the statute by underemphasizing the importance of maintaining a competitive clearing environment. Prior to the creation of NSCC, BNCC had been providing facilities management services for clearing agencies associated with some regional exchanges. BNCC claimed that even though NSCC was required to establish links with regional clearing agencies, regional clearing agencies would still be at a disadvantage. The U.S. Department of Justice shared similar concerns.
The court ultimately upheld the Commission's action to register NSCC. The court's decision states that enhancing competition within the securities industry was one factor for the Commission to consider, but was not the paramount objective in implementing Section 17A. The Commission argued, and the court agreed, that the establishment of a national clearing framework was virtually certain to be more dependable, stable, efficient, and more rapidly achievable than any other alternative.12
I think we can view NSCC as a success. Over the years, NSCC has developed a variety of post-trade automated services designed to increase efficiency, minimize risk, and reduce costs, such as: real time trade submission to NSCC by the exchanges; real time capture of trade reports; and the evolving Continuous Net Settlement System. Today, NSCC functions as the world's largest central counterparty.13 Because I know that people at this conference love numbers, I've brought a few with me. In 2002, NSCC processed a daily average of 16.2 million transactions (an increase of 17% over the record level in 2001); with a peak day surge to 24.7 million transactions on July 24, 2002. The value of the transactions processed in 2002 was $81 trillion, down slightly from the record of $89 trillion in 2001. On the efficiency side, NSCC's netting of securities and money delivery obligations reduces the value of the obligations requiring financial settlement by up to 97%.14
I believe that the registration of NSCC provides us with a significant example of how regulatory action can greatly and positively foster efficiency in a market. The Bradford case supported the Commission's analysis in weighing the need for a national system for clearance and settlement against potential anticompetitive consequences. At the time, there was no clear indication that the fragmentation in our system would be resolved by technology and competition. However, the Commission's obligation to consider competition and efficiency is clearer than ever. In 1996, Congress added Section 3(f) to the Exchange Act, which provides that when the Commission is engaged in rulemaking or reviewing a rule proposed by a self-regulatory organization (such as a clearing agency) for approval, and is required to consider or determine whether an action is necessary or appropriate in the public interest, the Commission must also consider, in addition to the protection of investors, whether the action "will promote efficiency, competition, and capital formation."15
The U.S. clearance and settlement system operates in a utility-based structure that has developed substantially since the Commission approved the full registration of NSCC in 1983.16 In recent years, we have experienced further consolidation in clearing organizations. For example, in 1999, the Depository Trust & Clearing Corporation ("DTCC") was created as a holding company for NSCC and The Depository Trust Company ("DTC"). DTCC has grown to include the Government Securities Clearing Corporation ("GSCC"), the Mortgage-Backed Securities Clearing Corporation ("MBSCC"), and the Emerging Markets Clearing Corporation. Then, in January 2003, GSCC and MBSCC merged to create the Fixed Income Clearing Corporation, continuing as a DTCC subsidiary. By consolidating operations under one parent, the DTCC subsidiaries have experienced increased efficiencies by leveraging their resources, resulting in reduced costs to participants.
Most intermediaries in the U.S. clearance and settlement system operate as registered clearing agencies. Given the economies of scale enjoyed by participants of the DTCC subsidiaries, few entities have sought to enter the clearing agency business. An exception is entities seeking to perform matching services.
In 1998, the Commission issued an interpretation that "matching" of trade and allocation details constitutes a clearing agency function, and entities seeking to perform this intermediary function between broker-dealers and institutional customers are required to either register or apply for an exemption.17 A registered clearing agency is subject to a number of regulatory requirements.18 The Commission issued an interpretation of the Exchange Act that stated that a clearing agency that only provided a matching service did not need to be subject to the full scope of clearing agency requirements.19 Instead, a matching service provider could apply for an exemption from registration. The Commission reached this conclusion, in part, because a matching provider would not:
The Commission recognized that a matching service could speed up the affirmation process by eliminating steps and the redundancies of the current affirmation process. The Commission believed that these benefits would bring further efficiencies to institutional transaction settlement.
The Commission also recognized the central role that matching services would play in our clearance and settlement system. Therefore, a matching service may be exempted from registration, but not from regulation.21 In particular, it would be subject to several operational conditions, including:
In 2001, the Commission granted an exemption from clearing agency registration to the Global Joint Venture Matching Service (GJVMS), the DTCC-Thomson joint venture known as Omgeo.23
When the Commission published the application for comment, a number of letters expressed support because they believed the exemption would help the industry achieve shorter settlement cycles. There were also a number of comment letters that expressed concerns that Omgeo would impede competition because of the substantial existing market shares of DTC and Thomson in providing electronic trade confirmation services. The Commission was very sensitive to these concerns and conditioned the exemption in three key areas. First, the Commission required Omgeo to develop fair and reasonable linkages with other matching services (also known as interoperability) to allow customers of other matching services to communicate trade and allocation data with customers of Omgeo. Next, the Commission required Omgeo and any future matching provider to share the costs for linkages and services. And, finally, Omgeo was required to support industry communication protocols; message and file transfer protocols; message format standards; and message language protocols.24
In developing the Omgeo approval Order, the Commission adapted the Exchange Act requirements to the evolving clearance and settlement industry. The Commission was of the view that this framework of operational and interoperability conditions should provide sufficient flexibility to facilitate competition in the operation of matching services that are appropriately regulated.25
Through the exemption process, the Commission seeks to permit private commercial ventures while fulfilling its statutory objectives regarding investor protection, safeguarding securities and funds, and maintaining fair competition among the clearing agencies and others.
While Omgeo is not a registered clearing agency, it is still a regulated entity. I'd like to take a few moments and share my views on clearing agencies engaging in unregulated activities. For example, in the U.S., DTCC may engage in activities that are not regulated by the Commission. It is natural for its users and owners to want to leverage the complex's resources to achieve greater efficiencies. When these activities are conducted within the regulated entity, the regulator can gain important insights into their potential impact on the clearing agency. Creating a separate affiliate is another method to engage in unregulated activities, but the creation of a separate legal entity is not a panacea for the risks to the clearing agencies that may be presented. This is because separate legal entities may nevertheless share resources, management, staff, and other assets. I believe that the business relationships of legally separate entities must be structured so that their operational and commercial activities do not undermine the objective of insulating the financial resources and operations of the clearing agency. There also can be negative aspects to legal separation. In my view, the regulator may have difficulty obtaining a clear picture of interrelationships that may exist between the clearing agency and affiliated entities. This may require the regulator to develop methods to obtain sufficient information about these relationships in order to adequately assess the clearing agency's risk management.
While I believe that regulation and competition can be effective ways to enhance market efficiency, information and communications technologies are equally critical to healthy and efficient markets. Under our federal securities laws, disclosure and dissemination requirements are crucial elements of the Commission's approach to protecting investors and promoting fair and orderly markets. The Commission has long recognized the benefits of information and communication technologies in furthering its goals.26
Developments in the securities markets designed to reduce systemic risk have been possible because of advances in technology. One example is shorter settlement cycles. As markets and market participants implement straight-through processing, it may be possible to reduce settlement cycles even further. Similarly, enhanced automation in securities payment systems made possible the industry's conversion from a next-day funds settlement system for securities transactions and principal and interest payments to a same-day funds settlement system (i.e., payment must now be made in funds that are immediately available and final at the time of payment). The same-day funds system reduces systemic risk by eliminating overnight credit risk and by achieving closer conformity with the payment methods used in the derivatives markets, government securities markets, and other markets.27
The Commission actively monitors the state of technology in the markets and the effect of technological advances on both the industry and the Commission's regulatory program. In its oversight of the securities markets, the Commission weighs the industry's need to develop more efficient methods of doing business, the desire of market professionals and investors for guidance and regulatory certainty, and the Commission's mandate to protect investors and maintain fair and orderly markets. Overall, recent advances in technology have brought greater transparency, provided unprecedented opportunities for innovation and competition, facilitated tremendous increases in trading volume, and made possible the development of methods to reduce risk. At the same time, the rapid pace of technology-driven changes has challenged, and will continue to challenge, the Commission to reevaluate the manner in which it oversees the nation's securities markets. The staff will continue to work with the industry to reduce tensions caused by technological changes and regulatory obligations.28
In this connection, the Commission staff is currently drafting a consultation document focusing on STP in terms of same day matching of trades, shorter settlement cycles, and security dematerialization.
In conclusion, I note that financial regulators around the world and the global financial industry are focused on enhancing efficiency in their systems. For example, the Committee on Payment and Settlement Systems ("CPSS") and the Technical Committee of the International Organization of Securities Commissions ("IOSCO") issued 19 recommendations for securities settlement systems in 2001.29 Recommendation 15 is "Efficiency" and states, "While maintaining safe and secure operations, securities settlement systems should be cost-effective in meeting the requirements of users."30 Securities settlement systems around the world are currently being assessed on this and the other recommendations.31 Wisely, I think, the report acknowledges that "it is difficult to assess the efficiency of a particular settlement system in a definitive manner. Accordingly, the focus of any assessment should largely be on whether the system operator or other relevant party has in place the mechanisms to review periodically the service levels, costs, pricing, and operational reliability of the system."32
As others have noted, about a year ago, the Group of 30 ("G30") issued a report entitled, "Global Clearing and Settlement: A Plan of Action."33 The prime aim of the report is "to contribute to a sounder and more efficient international financial system, with particular emphasis on improving the global system of clearance and settlement of securities."34 From some comments at this conference, I perceive that no one quibbles with that goal, but may have different perspectives on how to get there.
The challenge for the SEC and for all regulators of clearance and settlement systems is to continue to respond to, and also where possible to anticipate, changes arising from competitive forces and technological advances in ways that enhance efficiency and investor protection. And I hope that I speak for all regulators that, with your cooperation, we look forward to meeting that challenge.
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