Securities and Exchange Commission:

Oversight of U.S. Equities Market Clearing Agencies

GAO-09-318R: Published: Feb 26, 2009. Publicly Released: Mar 26, 2009.

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An effective clearance and settlement process is vital to the functioning of equities markets. When investors agree to trade an equity security, the purchaser promises to deliver cash to the seller and the seller promises to deliver the security to the purchaser. The process by which the seller receives payment and the buyer, the securities, is known as clearance and settlement. In the United States equities market, a centralized clearance and settlement system was established to reduce risks and increase efficiency in the market. As part of this system, trades in equities and other securities are typically cleared and settled through clearing agencies--self-regulatory organizations (SRO) that are required to register with and are subject to oversight by the Securities and Exchange Commission (SEC). Virtually all equities securities trades in the United States are cleared and settled through the National Securities Clearing Corporation (NSCC) and the Depository Trust Company (DTC), clearing agency subsidiaries of the Depository Trust and Clearing Corporation (DTCC). According to DTCC, 99.9 percent of daily transactions by dollar value clear and settle within the standard 3-day settlement period. In the remaining transactions, the seller failed to deliver the securities on time, resulting in a fails to deliver (FTD). On December 31, 2007, the value of aggregated FTDs was $7.5 billion. According to SEC, many FTDs are caused by processing delays or mechanical errors, and are typically resolved within a few days. FTD can also result from naked short selling. While not defined in the federal securities laws or SRO rules, according to SEC, naked short selling generally refers to selling short without having borrowed the securities to make delivery; potentially resulting in a FTD. When FTDs persist for days or months, they can accumulate to a level that may affect the market for that security. In recent years, investors, publicly traded companies, and others have expressed concerns regarding the intentional failures to deliver by some investors. For example, FTDs may be indicative of an illegal trading strategy known as manipulative naked short selling, in which short sellers attempt to profit by using naked short selling to inundate the market with sales of a security and manipulate its price downward. FTDs may also deprive shareholders of the benefits of ownership, such as voting and lending. To facilitate and monitor industry compliance with these rules and emergency orders, NSCC electronically submits FTD data daily to SEC and the stock exchanges. Because the prompt and accurate settlement of trades is essential to the smooth functioning of the United States' equities markets, Congress asked us to provide a background briefing on: (1) NSCC and DTC processes for clearing and settling equities trades, including their process for identifying and addressing FTD; and (2) SEC's efforts to ensure the reliability and efficiency of the clearance and settlement system through its examination program for clearing agencies.

Trade clearance and settlement in the United States operates on a standard 3-day settlement cycle. Due to the volume and value of trading in today's markets, NSCC nets trades and payments among its participants, using its Continuous Net Settlement System. This is a book entry accounting system, whereby each NSCC participant's daily purchases and sales of securities, based on trade date, are automatically netted into one long position (right to receive) or one short position (obligation to deliver) for each securities issue purchased or sold. The participant's corresponding payment obligations are, similarly, netted into one obligation to pay or one obligation to receive money. For each participant with a short position on settlement date, NSCC instructs the securities depository designated by the participant--typically DTC--to deliver securities from the participant's account at the depository to the NSCC's account. NSCC then instructs the depository to deliver those securities from NSCC's account to participants with net long positions in the security. If a participant fails to deliver the total number of securities that they owe NSCC on a particular settlement date, NSCC may be unable to meet its delivery obligations, resulting in a fails to receive (FTR) for participants who have net long positions. NSCC uses the automated Stock Borrow Program to borrow shares to meet as many of its delivery obligations as possible. This program allows participants to instruct NSCC on the specific securities from their DTC account that are available for borrowing to cover NSCC's Continuous Net Settlement System delivery shortfalls. Any shares that NSCC borrows are debited from the lending participant's DTC account, delivered to NSCC, and, subsequently, delivered to a NSCC participant with a net short position. NSCC creates a right to receive (net long) position for the lender in the Continuous Net Settlement System to show that it is owed securities. Until the securities are returned, the lending participant no longer has ownership rights in them and, therefore, cannot re-lend them. Additionally, any delivery made using the Stock Borrow Program does not relieve the participant who fails to deliver from its delivery obligation to NSCC. OCIE oversees the clearing agency examination program and conducts both regular cycle and special examinations of clearing agencies. The largest clearing agencies (including NSCC and DTC), which provide centralized clearing services, are examined every other year. The smaller clearing agencies are examined on a two- or three-year cycle, depending on resources. In addition to regular cycle examinations, OCIE conducts special examinations targeting clearing activities of more than one clearing agency.

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