The Depository Trust & Clearing Corporation

August 7, 2002

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

Re: Docket No. R-1122

Mr. Jonathan G. Katz
Securities and Exchange Commission
450 Fifth Street, N.W.
Washington, D.C. 20549-0609

Re: File No. S7-15-02

Dear Ms. Johnson and Mr. Katz:

The Depository Trust & Clearing Corporation ("DTCC")1 is pleased to have the opportunity to respond to the Interagency White Paper on Structural Change in the Settlement of Government Securities (the "White Paper"). We believe that discussion of the issues raised in the White Paper is of enormous importance to the financial markets.2

The White Paper may be said to raise two broad matters for discussion - whether there is a need for structural change in the manner in which settlement services for Government securities are provided and, if so, what change is desirable. Our belief with regard to the first matter is that the current structure basically is a sound one. This view is based on the assumption that the two settlement banks - JPMorgan Chase ("Chase") and The Bank of New York ("BNY") - each: (1) make a long-term commitment to continuing to provide an array of operational and financial settlement services in a responsive and innovative manner to the GSCC and private industry participants, and (2) devote the necessary resources to establish appropriate levels of contingency and backup arrangements and recovery capabilities.

Having said that, as discussed below, we believe that there otherwise exist critical vulnerabilities in the settlement process for the Government securities marketplace. DTCC proposes that these vulnerabilities be addressed by: (1) establishing an advisory group to the three senior market regulators - the Federal Reserve (the "Fed"3), the Securities and Exchange Commission ("SEC"), and the Treasury Department - that would recommend standards for the conduct of the clearance and settlement business; and (2) having DTCC provide an additional level of backup protection by acting as a data repository, in a manner that helps ensure that the industry has a failsafe "fallback" mechanism that it can turn to immediately and in a coordinated fashion. With regard to the latter recommendation, we recognize that, so long as Chase and BNY have incompatible systems, DTCC's role as a data repository would be of limited value.

Finally, we wish to express our belief that, should the need arise in the future for a new settlement utility, or should this be deemed desirable by industry participants and regulators, the most logical choice for such a utility is The Depository Trust Company ("DTC") 4. In making this observation, we are aware that any private entity that serves as the new settlement vehicle would need to be able to provide significant financing services to market participants, and that DTC does not have capital or liquidity resources equivalent to those of Chase or BNY; thus, it would need alternate sources of liquidity, which potentially could include the Fed itself.


The Government securities marketplace continues to be the largest and most important financial marketplace in the world, and of vital significance to markets, investors, businesses and economies in the U.S. and around the world. In view of this, there must be assurance that the entire clearance and settlement process for that marketplace will function at the highest level of safety and soundness over the long term and satisfactorily meet ongoing market needs. For this reason, ultimate responsibility for the clearance and settlement process should be viewed as a public trust, one that cannot be dependent upon contractual arrangements with, and the business plans of, commercial entities with diverse and wide-ranging business interests and risks. Instead, there must be more direct accountability to a devoted authority comprised or representative of all the key market segments.

The events that occurred in the post-9/11 period, in addition to uncovering operational risk issues, also demonstrated that we need to enhance our general oversight of the means by which all of the key entities in the settlement process - including GSCC, the Fed, and the settlement banks - interact with one another and coordinate their efforts. Each of these entities is critical to the overall settlement process for Government securities; the process is no stronger than its weakest link. Thus, there must be assurance that the clearing, settlement and depository functions work together in a seamless fashion to best serve the long-term interests of the marketplace.

Focusing on specific vulnerabilities, as is noted in the White Paper, there are various ones that arise from the use of the two settlement banks, including the possibility of interruption in connectivity to Fedwire, customers, and each other, the potential lack of sufficiently robust contingency arrangements by one or both, geographic concentration, and lack of common messaging standards. These operational risks can be addressed through enhanced focus, planning, and devoted resources. As is also pointed out in the White Paper, vulnerabilities arise from the chance that a settlement bank's financial condition may become impaired, perhaps because of losses from activities unrelated to the clearing and settlement business. Moreover, the existence of two settlement banks, as opposed to a single one, raises the potential for market disruption and massive reconciliation issues should one of the two banks be operational and the other not.

Recognizing the validity of these issues, we believe, however, that there are other, even more fundamental weaknesses in the current settlement structure. Perhaps the most significant one is that the two settlement banks are not necessarily committed over the long term to this business. In theory, based on considerations such as overall profit, return on equity or assets, efficient usage of capital, and/or risk, either or both of the banks could choose to end certain services or even leave the business entirely.

Also, except for a contract that can be terminated upon relatively short notice5, the two banks are not required, by law or regulation, to provide a full array of services or, indeed, any services to GSCC. In theory, they can refuse to service GSCC at any time, and for any reason, based on business or other considerations. Even though it is the central clearing corporation for the marketplace, GSCC has no legal or other standing beyond that of a "customer", similar to any broker-dealer customer.

Furthermore, while not a monopoly, as a practical matter the two banks have an oligopoly on settlement services that could diminish competitive pressures and their incentive to innovate.

Proposed Oversight Structure

The principal issue for consideration at this time is, thus, how to go about addressing these concerns, and whether there is merit to the utility concept introduced in the White Paper as a means of doing so. We believe that the introduction of a new utility, one that would function in place of the two settlement banks, is impractical and unnecessary, at least in the short term.

We suggest that a better approach to addressing the industry's vulnerabilities would be to create, in a separately established body comprised of industry participants, an oversight authority that would set standards for the conduct of the Government securities clearance and settlement business. We recommend that this involve establishing an advisory group (the "Advisory Group") to the three senior market regulators that would set standards for any bank that is a provider of clearance and settlement services for the marketplace, with regard to matters such as contingency, backup, communications, connectivity, data storage, and redundant facilities. Such an advisory group could be used to oversee and help ensure: (1) the offering of high quality automated operational services; (2) implementation of the highest level of contingency and backup arrangements and connections in and among the clearing, settlement, and depository functions, ensuring immediate recovery capability; (3) standardization of messaging formats and protocols and satisfactory communication and connectivity among all key entities; (4) innovation in providing new services and coordinated implementation of those services; (5) responsiveness to the industry's needs; and (6) the availability of an array of settlement and corollary services to all industry participants.

Of particular importance in this regard is that, while we are confident that the two banks will establish individual backup and recovery capabilities of the highest quality, such an oversight body would ensure that they work closely with each other, the Fed, GSCC, and others to develop and routinely test fallback procedures. This will help to guarantee that there is timely recovery and orderly settlement in the event of a catastrophic event that strikes a particular bank or a large market participant. History has shown that coordinated fallback procedures are easier to achieve with some type of regulatory or quasi-regulatory mandate.

The Advisory Group also could be asked to recommend priorities for the implementation of new settlement services. Moreover, the Advisory Group could act as a forum for discussion by the trading, clearing corporation, settlement bank, depository, and regulatory segments of the marketplace of significant matters and concerns specific to the Government securities settlement process. In this manner, the Advisory Group would help ensure the safety, soundness, responsiveness and reliability of the settlement mechanism for the marketplace.

We believe that such an Advisory Group should involve representation by each of the key segments of the marketplace - industry participants, GSCC (as the central clearing corporation), Chase and BNY (as the settlement banks), and the Fed (in its role as the depository). With regard to industry participants, a process would need to be established to provide for equitable representation by each major market segment, such as broker-dealers, banks, institutional entities, hedge funds, and foreign participants. The Advisory Group should be devoted to oversight of the settlement process for the Government securities marketplace, and be committed over the long term to the best interests of that marketplace.

Moreover, we suggest that an appropriate, formal mechanism be put in place pursuant to which the Advisory Group is able to, on a regular basis, present issues, concerns, and recommendations to the senior market regulators, either individually or together.

We wish to emphasize that such an Advisory Group would not have any authority over the actions of the settlement banks or any other market participants. Ultimate oversight of the marketplace is best left with the senior regulators; this Group would act as an advisor to them.

Use of DTCC as a Data Repository

It is obviously of the utmost importance that the Government securities marketplace have a "bulletproof" backup and contingency mechanism in place such that, should a "9/11"-type event occur, processing would continue in a seamless fashion. To facilitate this, we suggest the development of an industry-sanctioned "ultimate" level of backup protection and safe storage of data and applications.

Such a data repository would ensure prompt business recovery by maintaining backup position files for each of the settlement banks. In the event that one of the settlement banks is unable to process (meaning that its contingency plans also were compromised), the data repository would have up-to-the-minute copies of the impaired bank's files. This would enable settlement processing for that bank to continue through processing by the remaining settlement bank.

We believe that the DTCC organization is ideally positioned to support the business recovery capabilities for the settlement banks and the Government securities marketplace as a whole. We are already developing a remote third data center far from the New York metropolitan area. Moreover, DTCC is a member-owned and governed entity with whom industry participants are comfortable maintaining their trade data and positions. Furthermore, the cost of establishing such an ultimate backup facility would be minimized by leveraging off of the use of an existing industry utility that supports various securities marketplaces.

Having said this, we recognize that there are many required elements to fashioning a failsafe backup and contingency mechanism, and that the assumption by DTCC of a data repository role would be just one of them. Indeed, so long as Chase and BNY have incompatible systems, DTCC's role as a data repository would represent an incomplete contingency solution. This is because, should one bank fail, DTCC would have retained data only in that bank's format, and may not be able to communicate such data to the remaining bank. Therefore, a vital measure to be taken by the settlement banks is to ensure their ability to take in and process data generated by the other.

Use of DTC as a Settlement Vehicle

Another key benefit of an oversight body is to ensure that there always is available an appropriate settlement mechanism. Again, we believe that the two settlement banks have provided the industry, for many years, with high quality and comprehensive operational and financing services, and we assume that they will continue to do so with enhanced contingency and backup capabilities. However, there always exists the possibility that the banks may choose to leave the business or not perform certain necessary settlement services. In such a case, the Advisory Group could serve as the forum for the industry's determination as to how to shift to an alternate settlement mechanism.

We do not believe that use of the Fed as the settlement utility would be appropriate, for many reasons, including ones that are suggested in the White Paper itself. The Fed essentially is a public entity that does not have the same competitive and profitability concerns as a private one, thus making it potentially less responsive and innovative as a service provider. Also, the Fed's bank supervisory, monetary policy and payments systems responsibilities may conflict with its new settlement responsibilities. For example, any signal from the Fed about intraday credit limits on a specific entity (particularly a bank) could cause problems for an institution because it would telegraph the Fed's supervisory opinion as well.

It also is unclear to us whether the process for adding or modifying services would be sufficiently prompt and flexible to meet market needs. Major changes to Fed services typically require it first to go out for public comment, which can be a time-consuming process.

Moreover, to provide a full array of services, including tri-party repo services, the Fed would have to open up access to an enormous range of entities, including all types of institutional entities (such as insurance companies, pension plans, mutual funds, and hedge funds), which may not be feasible.

With regard to the provision of financing services, there is a potential adverse impact on market discipline through the perception of the Fed as providing unlimited liquidity support. In general, Fed provision of services raises significant moral hazard concerns.

As noted above, in order to provide a full array of settlement services, DTC would need to be able to provide market participants with significant financing services. The intraday and overnight financing provided by Chase and BNY is the critical "grease" for the wheels of the settlement process. DTC on its own would not have sufficient capital or liquidity resources for this purpose. Thus, it would need to arrange for additional sources of liquidity, which could be provided by a consortium of banks. Given the large dollar amounts that may at times be required, the Fed itself may need to act as a backup liquidity source.

Nonetheless, we believe that any new settlement utility should be a private one, and that the most logical choice for this is DTC. Among the reasons for this are that DTC: (1) is an industry utility owned and governed by its members; (2) is closely regulated by the Fed, SEC, and New York State Banking Department; (3) is not a commercial bank with a wide array of services; rather, it is focused on providing post-trade custodial, depository and settlement services; (4) with the backing of the entire industry, would be able to make a long-term commitment to the highest level of contingency and backup capabilities; (5) as a registered clearing agency subject to fair representation standards, is open on an equitable basis to all market participants; (6) is experienced in controlling and managing market and credit risk, including intra-day risk; (7) given its more limited business focus, operation on a not-for-profit basis, and carefully managed risk profile, is not vulnerable to other financial risks; (8) already has a large membership base and links with virtually all significant market participants; and (9) would be able to provide a single pipeline for receiving and sending data on clearing and settlement activity for all market participants.

We further recognize that this offer for DTC to act as the settlement vehicle for the Government securities marketplace will be more useful to consider at a later date, after sufficient coordination and standardization has been brought to the settlement process.


Again, we appreciate the opportunity to provide comments on these highly significant matters. If you have any questions regarding this letter, or would like additional information, please contact Jeffrey Ingber, General Counsel of GSCC, at (212) 855-7630 or, or myself.


Dennis Dirks

cc: Members of the DTCC and GSCC Boards of Directors
Members of the DTCC Fixed-Income Operations and Planning Committee
Mr. Thomas Costa --- GSCC
Mr. Larry Bergmann - Securities and Exchange Commission
Mr. Jerry Carpenter - Securities and Exchange Commission
Mr. Norman Carleton - Treasury Department
Mr. Robert Colby - Securities and Exchange Commission
Mr. Vincent Conlon - New York State Banking Department
Ms. Joyce Hansen - Federal Reserve Bank of New York
Mr. Darryll Hendricks - Federal Reserve Bank of New York
Mr. Patrick Parkinson - Board of Governors of the Federal Reserve System
Mr. Paul Saltzman - The Bond Market Association
Ms. Lori Santamorena --- Bureau of Public Debt
Mr. Jeffrey Stehm - Board of Governors of the Federal Reserve System
Ms. Patricia White - Board of Governors of the Federal Reserve System

1 DTCC is the largest financial services post-trade infrastructure organization in the world. It owns and supports six operating subsidiaries: The Depository Trust Company, Emerging Markets Clearing Corporation, European Central Counterparty Limited, Government Securities Clearing Corporation, MBS Clearing Corporation, and National Securities Clearing Corporation. DTCC also is joint owner, along with The Thomson Corporation, of Omgeo LLC, which provides various global trade management services.
2 This response represents the views of both the Government Securities Clearing Corporation ("GSCC"), reflecting its unique role as the central clearing corporation for the Government securities marketplace, and DTCC generally, reflecting its involvement in ensuring the safety, soundness, and efficiency of post-trade clearance and settlement for various securities marketplaces (each of which is potentially adversely affected by disruption in the settlement process for the Government securities marketplace). With regard to GSCC, we note that its volumes continue to grow. On average each day during the first half of 2002, GSCC: (1) compared $1.6 trillion in transactions, up from a daily average of $1.4 trillion in the fourth quarter of last year, and (2) due in part to the continuing increase in GCF Repo activity, put $1.9 trillion in activity on average each day into its net and fully guaranteed settlement of that activity. Moreover, GSCC's average daily term repo book was $3.1 trillion.
3 Depending upon the context, the "Fed" may be used to refer to the Federal Reserve Bank of New York, the Federal Reserve Banks generally, or the Board of Governors of the Federal Reserve System.
4 DTC is a registered clearing agency with the SEC, a member of the Federal Reserve System, and a limited-purpose trust company under New York State banking law. DTC also is a securities depository and a clearinghouse for the settlement of securities trading activity. It retains custody of approximately 2 million securities issues worth $23 trillion, and records changes in ownership via book-entry movements including some $1.5 trillion in securities from 84 countries. DTC provides a range of ancillary services, including deliver order and collateral loan services for securities in custody. DTC has received a AAA rating from Standard & Poor's.
5 Both Chase and BNY can terminate their clearance agreements with GSCC after 90 calendar days written notice.