Report on Group of Thirty Recommendations Regarding Clearance and Settlement and Request for Comments

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EXECUTIVE SUMMARY

In a report titled "Clearance and Settlement Systems in the World's Securities Markets," a private-sector group published nine recommendations proposing standards for clearance and settlement of corporate securities to reduce risk and maximize efficiency. Targeted for implementation by 1990 or 1992, the report's nine recommendations address both risk and efficiency. Briefly, the authors suggest containing risk by shortening the time between trade date and settlement, promoting trade guarantees, and assuring the simultaneous exchange of payment and securities. To promote efficiency, they recommend eliminating the physical movement of certificates, encouraging the use of netting systems where appropriate, and standardizing communications methods and settlement schedules.

At a recent meeting of the heads of the various U.S. securities and options markets, the Group of Thirty recommendations were a major agenda item. In light of differing views on the merits of the Group's recommendations, particularly as they relate to individual investors, a determination was made that the proposals should be circulated to members for comment. Since virtually all firms that do a public business are NASD members, the NASD was asked to undertake this task.

BACKGROUND

The Group of Thirty includes high-level international businesspeople, bankers, and others concerned with the workings of the international financial system. The Group met in London to discuss the state of clearance and settlement practices in the principal securities markets of the world as well as the plans of countries for making those practices more compatible. Their conclusion was that while the development of a single global clearing facility was not practical, agreement on a set of practices and standards that could be embraced by the markets that, in essence, constitute the world's securities system was highly desirable. The group found the need for such an agreement especially compelling because present standards of clearance and settlement are not acceptable. They are inefficient and generate undue costs, overt and hidden, and undue risks for participants.

According to the report, the risk and inefficiency associated with the system are apparent in the following areas:

• The current process lacks compatible trade-comparison systems for both domestic and international trades.
• Different settlement periods exist for different markets and range from same-day settlement to several weeks.
• The lack of delivery versus payment (DVP) leaves one party to a transaction unduly exposed.
• Standardized trade guarantees are not available.
• Many markets have not developed book-entry processing for settlement of securities transactions.

Listed below are the specific recommendations. Most of the recommendations would not affect the U.S. since effective clearance and settlement systems exist. However, Recommendations 6 and 7, relating to payment in same-day funds and shrinking the settlement cycle to T+3, would have a significant impact on U.S. broker-dealers. In addition, Recommendation 9 would require introduction of a new numbering standard.

SPECIFIC RECOMMENDATIONS

Recommendation 1: By 1990, all comparisons of trades between direct market participants (i.e., brokers, broker-dealers, and other exchange members) should be accomplished by T+l.

The lack of timely, efficient, and disciplined matching systems creates significant risk for participants in the securities processing cycle. The report recommends that comparison (or trade matching) should occur no later than trade date plus 1 (T+l) and that all markets should accomplish this T+l matching goal by 1990.

This T+l standard gives both sides to a trade a chance to correct any discrepancies or conflicts while reducing risk in the settlement system and helping to ensure timely settlement. To achieve this standard will require an automated system that can report trade detail to counterparties, match trades, resolve trade errors, and "lock in" matching trades.

Present plans are for both the NASD and the NYSE to share systems in operation that meet this goal.

Recommendation 2: Indirect market participants (such as institutional investors or any trading counterparties that are not broker-dealers) should, by 1992, be members of a trade comparison system that achieves positive affirmation of trade details.

Affirmation systems exist for institutional investors that are unwilling or unable to participate in a risk-sharing arrangement, such as that found in a two-sided comparison system. In the former system, the institution (and its agent bank) receives a list of trades to which it is a counterparty. The institution then must affirm or question the trades within a preset time frame.

These systems link indirect members to a central clearing system or securities depository. The most efficient systems are highly automated and provide participants with on-line, real-time access to information, such as clearing and settlement data (to manage positions) and accounts (to manage cash).

The identification system operated by the Depository Trust Company (DTC) provides U.S. conformance with this goal.

Recommendation 3: Each country should have an effective and fully developed central securities depository organized and managed to encourage the broadest possible industry participation (directly and indirectly) in place by 1992.

A central securities depository's (CSD) main function is to immobilize stock certificates to facilitate "book entry" processing of securities transactions. With the book-entry method in place, securities can be transferred from one account to another by a simple debit or credit on the books of the CSD. The CSD can include the capability for trade clearance, safe custody, and settlement/postsettlement processing of securities and information, such as corporate actions and dividend/interest processing. In addition, it may include a payments system that could credit or debit the cash account of the member financial institution at the same time it processes the securities side of the transaction. The DTC fulfills this function for the United States.

Recommendation 4: Each country should study its market volumes and participation to determine whether a trade netting system would be beneficial in terms of reducing risk and promoting efficiency. If a netting system would be appropriate, it should be implemented by 1992.

Trade-netting systems work best in high-volume markets. Three basic options exist for netting transactions. These are bilateral netting with all trades in the same security between the same counterparties netting to one final delivery versus payment; multilateral netting with all trades in the same security netting to a final long or short position for each participant; and continuous net settlement with all trades in a particular security plus failed trades continuously netting to a final long or short position and the clearing corporation standing in as the counterparty to the trade.

The National Securities Clearing Corporation (NSCC) currently operates a continuous net settlement system that meets this objective.

Recommendation 5: Delivery versus payment (DVP) should be employed as the method for settling all securities transactions. A DVP system should be in place by 1992.

Simultaneous exchange of value is important to eliminate the risks of price change and failure to perform according to contract. DVP effectively removes any exposure resulting from delivery delay by a counterparty. Although CSDs are useful, DVP can be accomplished through linkage to a final payment system, a system of bank guarantees, or a clearance or depository agency's financial guarantees. The NSCC and DTC do provide DVP settlement.

Recommendation 6: Payments associated with the settlement of securities transactions and the servicing of securities portfolios should be made consistent across all instruments and markets by adopting the " same day" funds convention.

Same-day funds refers to the availability of funds on the same day as they are deposited. Adoption of this convention should help increase the efficiency of the accounting and payment systems. As noted above, this is not the current practice in the United States.

Recommendation 7: A "rolling settlement" system should be adopted by all markets. Final settlement should occur on T+3 by 1992. As an interim target, final settlement should occur on T+5 by 1990 at the latest, except where it hinders the achievement of T+3 by 1992.

In a rolling settlement environment, trades settle on all business days of the week. This process limits the number of outstanding trades, thereby reducing market exposure. The primary objective of this proposal is to reduce the delay between trade date and settlement date. The secondary objective is to standardize settlement time frames throughout international markets.

T+3 settlement would require that the NSCC change its settlement cycle from T+5.

Recommendation 8: Securities lending and borrowing should be encouraged as a method of expediting the settlement of securities transactions. Existing regulatory and taxation barriers that inhibit the practice of lending securities should be removed by 1990.

In many countries, restrictions and taxation apply that make it impossible or excessively expensive for market participants to lend or borrow securities to achieve timely settlement of transactions. These impediments to the lending and borrowing of securities should be removed in order to allow the maximum possible number of transactions to settle in the recommended time frame.

Securities lending and borrowing is common practice in this country.

Recommendation 9: Each country should adopt the standard for securities messages developed by the International Organization of Standardization [ISO Standard 7775]. In particular, countries should adopt the ISIN numbering system for securities issues as defined in the ISO Standard 6166, at least for cross-border transactions. These standards should be universally applied by 1992.

No worldwide securities numbering system exists. Many countries with highly developed securities businesses identify issues by code numbers, but these numbers have little significance outside the country concerned. Securities of the same issue are identified by different numbers in different countries where they may be physically held and/or booked. As a result, the national numbers are not satisfactory for cross-border transactions. The rapid expansion of the international securities business has created an urgent need for a universally applicable international securities identification number (ISIN).

Various standards for numbering securities exist today, including CUSIP, SEDOL, and others. For trade information to be communicated in a consistent format and handled by computers, a single numbering standard and message system would be ideal. Such a system is provided by the international ISO Standards 6166 and 7775. The ISIN consists of a country code, a security's domestic code number, and a check digit to validate the code.

This would require some change but should be feasible if applied only to cross-border transactions.

REQUEST FOR COMMENTS

Member comments on the Group of Thirty recommendations are earnestly solicited to guide us in our discussions on these recommendations. They should be directed to Mr. Lynn Nellius, Secretary, National Association of Securities Dealers, Inc., 1735 K Street, NW, Washington, DC 20006. All comments received will be shared with other interested U.S. markets