Delta Data Software, Inc.
February 5, 2004
Submitted Electronically to firstname.lastname@example.org
Jonathon G. Katz
Re: Proposed Amendments to Rules Governing Pricing of Mutual Fund Shares. (Release No. IC-26288; File No. S7-27-03)
Dear Mr. Katz:
This letter comments on the proposed amendments to rule 22c-1 under the Investment Company Act of 1940, as amended (the "Investment Company Act"), which governs the pricing of mutual fund shares. The proposed rule amendments would impose a "hard" 4 p.m. cut-off for submitting purchase and sale orders for mutual fund shares to a designated fund transfer agent or registered clearing agency (e.g., Fund/SERV).
Delta Data Software, Inc. is a primary supplier of mutual fund processing systems to the financial industry, with installed systems processing approximately 25% of the dollar volume of all retirement industry fund trades daily through the NSCC. For over six years, we have been intimately involved in improving the control, integrity, and auditability of the trading process while simultaneously improving the efficiencies and reducing the errors and costs involved in the trading, reconciliation and settlement activities. We respectfully submit our comments in an effort to improve the understanding of how current, existing technology can be rapidly and economically deployed to prevent illicit late trading activities or to discover any such illicit trades in a timely manner.
We will not address the reasons for avoiding a 4:00 PM hard close, as other industry organizations with far more direct knowledge regarding the impact of implementing the several currently proposed 4:00 PM cut-off alternatives are presenting their views on the difficulties and cost to be incurred should one of those alternatives be mandated. We will confine our comments to addressing how a 4:00 PM hard close can be avoided while concurrently ensuring the integrity of the trading process and retaining all of the efficiencies gained by the technological advance largely adopted by the financial industry over the past seven years.
Highlights of A Proposed Approach to Ensure Integrity and to Reestablish Credibility in The Mutual Fund Trading Operations of Financial Institutions
The process proposed in this document, which was discussed in overview with Director Paul Roye and his staff at the SEC as part of the SPARK preliminary presentation to the SEC Investment Management Division in October, is an approach that can be used to ensure that, (a) any unauthorized late trades cannot be placed by an unauthorized person or by an authorized person acting alone; and, (b) all trades originated or modified after the daily cut-off time will be prominently displayed in daily reports to the compliance officer; and, (c) will be fully traceable and auditable by outside auditors and examiners in a list of all trades originated after the daily cut-off for mutual fund order, all orders cancelled after the daily cut-off, and all orders changed in any manner after the daily cut-off.
Virtually all bank and trust companies which trade mutual funds have one or more primary customer account systems where the daily trade activity is posted to the customer accounts. These primary systems are typically under tight security and are operated with proper division of responsibilities and supervision. Mutual fund trade orders may be originated in these systems under good control processes. In addition, there are typically other systems that interface electronically to these primary systems, such as internet trading systems, Voice response trading systems and other customer order systems for use by internal bank customer service personnel, trust officers, and other authorized personnel. These additional systems also have good security to preclude unauthorized personnel from entering trades.
All of these systems, that is, the primary systems and all the additional customer order originating systems that update the primary systems, apply date-time stamps to the orders that are electronically originated at the time the order is entered into the system. Since the date-time placed on the order is controlled by the application software, the only way a dishonest operator can tamper with the date-time stamp on an electronically-originated order is to tamper with the electronic clock that feeds the date-time information to the application software. In most large institutions, the systems clocks are unavailable to anyone except authorized information technology personnel, and the system clock integrity should be reliable. However, we have proposed that if the integrity of the clock is at question, the use of special clocks with encrypted date-time information to supply the date-time information to all applications that are used in the mutual fund trading process.
However, the weakest point today in the mutual fund trading process is the preprocessing and transmitting of mutual fund trade orders. It is during this processing that manual trade orders may be prepared (legitimately) to correct mistakes discovered in the validation processing. Also, many organizations do not have straight-through- processing of mutual fund trade orders from point of origin to submission to the fund company. Without straight-through processing, there is are opportunities for unscrupulous operators to manipulate the actual trade information sent to the fund companies. We believe that the current methods of after-hours processing of trades and transmission of trades need significant improvement, and we are certain that the deficiencies in the current methods can be readily corrected within a reasonable time period and at affordable expense.
The minimum controls necessary to assure compliance with the laws relating to late trading of mutual funds securities through internal controls and audits and examinations must include controls in the areas listed below.
Valid Customer Account.
The first line of defense in the ability to trace any potential inappropriate activity is to have proper controls over the establishment and maintenance of customer accounts and fund company accounts.
Date-Timestamps Of All Transactions, Applied With Integrity.
Virtually all commercial recordkeeping systems place an electronic date-time stamp on each transaction record that is originated by the system. These systems retain the originating date-time stamps throughout the entire processing cycle of the system, so that it is easy to investigate the trading activity of an individual going back through the whole history of the account on the system. These systems also place a unique transaction ID on the transaction record. These are useful for audit and examination purposes when looking at the recordkeeping system by itself.
However, not all systems verify that the date-time stamp on a record is compliant with the 4:00 PM ET cut-off when processing the updates to the system for the end of the trading day. The integrity for this process is normally controlled by enforcing the policies and procedures established by the institution for such activity. This enforcement is auditable, since most systems also affix the date-time stamp of the posting process that updated the system following the trade order generation. A report showing all transactions with an origination date-time stamp after 4:00 PM for trades posted to account on or before that same posting date would show potential late trading activity.
Additionally, the date-time stamp applied by the recordkeeping is ultimately derived by the computer clock on the hosting computer. It is possible to manipulate the applied date-time stamp by manipulating the computer clock. In large institutions, this is not practical because the main computers are under the control of major IT organizations and their clocks are not easily manipulated. However, in a small shop, there is nothing other than the employee integrity to control this manipulation of the computer clock. For this reason, less a priori reliance can be place on the integrity of the date-timestamp as it is applied today.
However, a number of different technologies exist today for applying tamper-proof, verified accurate date-timestamps. Some of these will be briefly described later in this paper.
Control Over The Timely Cut-off Of Investor Instructions
All commercial Voice Response Units and Web-based application for participant financial instructions have date-timestamp of participant activity. In addition, these systems all update separate transaction databases that are used to update the primary recordkeeping database at 4:00 PM ET each day.
The control over the 4:00 PM ET cut-off is normally the result of a process initiated either automatically by a controlling computer routine or it is initiated by an established administrative process that is applied consistently within the organization. It is important that internal control and audit programs assure that these daily cut-offs are made in a timely manner each day. Clearly, a better approach would be for these cut-offs to be systematically controlled by the computer systems used to process the transactions, using tamper-proof timestamps to initiate and document the cut-off activity.
Traceability And Auditability Of Every Transaction From Point Of Origination Through Receipt By Fund Company.
The ability to aggregate trade orders has been an important part of the advances made in efficiency and economics during the past five years. However, one instance of the late trading abuses recently discovered involved aggregating manual trades for hedge fund accounts with electronic trades from pension plan accounts, with all the aggregated trades placed in the same omnibus account at the fund company.
Many large financial firms maintain `super-omnibus' accounts at the fund companies, where trades for retail accounts are aggregated with trades for pension plan accounts, endowment accounts, personal trust accounts, etc. Without prejudice as to whether such `super-omnibus' accounts should be discouraged, it is essential for proper control and examination purposes that these aggregated trades and their resultant single trade be fully traceable in both directions; that the history of these transactions be maintained indefinitely; and, that the audit program include a testing of this integrity.
There are a number of institutions which act as intermediaries for trading for smaller firms. These intermediaries include trust companies, securities firms and clearing firms. Many of these intermediaries may not have transactional traceability either within their own institution or across their clients' systems. This represents a break in the audit chain which needs to be corrected.
Control Over Exception Trades, Correcting Trades, Trade Cancellations, Etc.
Control and Verification of Control Of Trade Database Records.
For the compliance review, audit and regulatory review processes to be reliable, it is essential that the integrity of all of the original trade data be controlled and that the control be verifiable. The control process over the original trade records must ensure that no records can be altered after trades are submitted, that no records can be added to the database after the daily processing cycle, and that no trade records can be removed from the database. In addition, there must be a means for verifying that these controls are working and for readily and easily detecting any tampering in a timely manner.
Effective Daily Share Position and Cash Reconciliation Processes.
The daily share and cash reconciliation process is an integral part of the control program. This is the process where the positions at the fund companies on a specific date are reconciled to the corresponding positions on the primary recordkeeping systems. It would be very easy to camouflage short-term late day trading by showing a reconciling item on an unauthorized purchase and then clearing the item with the sale of the position, without ever posting the item to the recordkeeping system. The primary systems that create the trade orders post those orders to the customer accounts at the end of the daily processing cycle. The trade orders are forwarded to the fund companies and are executed and confirmed back to the institution. The fund company's transfer agent then posts these trades to the institution's accounts at the fund company and forwards a file of the resultant fund account positions to the institution. This file from the fund company is usually received on the second day following the trading.
On a day-to-day basis, the position reported by the fund company and the related position(s) recorded on the institution's recordkeeping system are frequently different. These differences result from a number of reasons, including:
Many firms match cleared trades one-for-one with trades placed and reconcile their positions trade-by-trade on a daily basis. Many other firms simply keep a rolling list of unmatched trades and reconcile these differences in detail only once or twice a month. It is important to assure that each share position reconciliation is backed up by a detailed trade-for-trade matching for reconciling items, and that this reconciliation be explained and be reviewed by appropriate supervisory or compliance personnel. As stated at the beginning of this section, without proper daily position reconciliation reviews, it would be very easy to camouflage short-term late day trading by showing a reconciling item on an unauthorized purchase and then clearing the item with the sale of the position, without ever posting the item to the recordkeeping system.
Comprehensive Pricing Controls, Including The Application Of Prices To Pending Trades.
Sometimes, errors are not discovered until two or more days after the trading has occurred for a particular account. Correction of such errors always involves a correcting set of trades with resultant gains or losses. Typically, the gains are attributable to the customer account, but the losses are borne by the recordkeeper. While we are unaware of any illicit activity exploiting this area of activity, it would be possible for an insider to deliberately misprice a series of trades in an account owned by a collaborator and subsequently place a correcting trade order to either close out a loss position with the loss attributed to the recordkeeper institution or capture the gain for the collaborator account. Systematic controls should be applied to disclose any irregular pricing actions.
Use Of Technology To Improve Mutual Fund Trade Processing.
We believe that a combination of technology; proper internal controls, procedures, supervision, internal compliance oversight and security; and, independent outside audit and compliance review will ensure a the integrity of the processing and trading environment that exists today and will preserve the economic efficiencies and service levels that the customers of the U.S. financial industry. The proposals below are all essential to the proposed approach. There are additional features we will propose, but these are more detailed than appropriate for this document.
Trading and Trade Processing Systems (Includes Mutual Fund Company Transfer Agent Systems)
The first and most important area for the proper application of technology is the series of computer applications used to originate and process trades. These systems must have comprehensive user security, input and change controls, exception handling procedures, archival capabilities, audit trails, separation of duties, supervisory controls and compliance reporting designed into the core system. And, equally importantly, departmental procedures must be in place to properly utilize the system-based controls. In most large institutions, this combination of good systems and procedures and compliance review should be adequate to ensure the integrity of the trade processing.
However, there are additional economical technologies that can be incorporated to further ensure the integrity of the process. These include the use of tamper-proof date-timestamps, and the use of hashing algorithms and digital signatures to verify that the content of the transaction data has not been altered in any illegitimate manner.
There are a number of commercially available tamperproof date-timestamp products that can be economically incorporated into the trading and trade processing systems. There are also a number of commercial vendors of economical products that use various encryption and digital signature approaches to verify that the content of the data has not been altered and to identify any data that has been altered. Incorporation of such technology into the trading and trade processing systems should also be also economically modest.
We propose that all mutual fund trade orders be originated electronically in one or more controlled systems. In addition, we propose that all mutual funds trades be transmitted electronically, using straight-through-processing technology whenever possible, and we further propose that, without exception, all mutual funds trades submitted to the fund company after the daily cut-off period must have been originated in a controlled straight-through-processing environment and must be submitted electronically to the fund company from the controlled environment. Any mutual fund orders not originated and transmitted from such a controlled electronic environment must be received at the fund company or its authorized, registered clearing firm prior to the daily cut-off time. We further propose that the systems used to accomplish this processing have the following basic control features regardless of whether encryption techniques are also incorporated.
Internal Controls and Procedures and Oversight..
There should be sufficient internals controls, supervision, security, and compliance oversight to preclude any individual from subverting the late-day trading regulations. In addition, there should be sufficient separation of duties to routinely protect against collusion among individuals within the organization. There should also be sufficient and daily oversight and substantial review by the compliance department to assure that the controls are working as planned.
Outside Audit and Compliance Review.
The audit programs and the compliance review programs should be expanded to examine and validate that the entire process contains necessary and sufficient controls and processes to ensure integrity in the mutual funds trading process. Independent auditors knowledgeable about the mutual fund processing environment should examine the processes and audit the historical data to validate that the controls are working in a manner to prevent abuse and to discover abuse when present.
There should be a requirement that all individuals involved in the trading process sign an affidavit periodically that they understand the regulations and that they have complied fully with the regulations, and they should be required to disclose each incident that may have been nonconforming. Each supervisor with approval authority for trade order changes or corrections should be required to report periodically on the frequency of changes and corrections, and these reports and the underlying trade information should be reviewed and critiqued by both internal compliance and audit personnel and by outside auditors and compliance examiners. Each compliance officer should prepare a report periodically evidencing that the exception trading process has been properly reviewed for compliance purposes and the exceptions should be reviewed independently by the compliance department for patterns that may suggest inappropriate activity.
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In conclusion, we know that the technology exists today to ensure the integrity of the mutual fund trading process with verifiable 4:00 PM cut-off of trade origination without resorting to a hard 4:00 PM ET cut-off for trade processing and submission, for those firms which adopt the approach proposed in this letter or an equivalent approach. In addition, we are prepared to demonstrate that this technology is available, and is effective, and can be readily deployed.
We appreciate your taking the time to study our position. We hope that these comments are helpful. We will be glad to answer your additional questions and provide any additional information that may be helpful to you. Please feel free to call me (303-680-7006) or Burton Keller (706-323-1497, ext 145) if you have questions or comments.
Very truly yours,
J. David Hayes