COMMENT The National Coordinating Group for Comprehensive Securities Depositories has endorsed this report by the Funds and Settlement Subcommittee of its Working Committee on the "Standardization of Funds Settlement for (Depository-Eligible) Securities Transactions". The National Coordinating Group recommends implementation of the concept of standardizing funds settlement of depository-eligible securities transactions in funds valued tomorrow throughout the United States and suggests that banking and securities industry leaders analyze the findings and conclusions of this report. We appreciate the efforts of the Funds and Settlement Subcommittee in preparing this report. The Subcommittee has representatives of the banking and securities industries from the West, Midwest and East as follows: I. INTRODUCTION Because of the different methods of settling securities transactions throughout the United States, the Working Committee of the National Coordinating Group for Comprehensive Securities Depositories organized a Funds And Settlement Subcommittee. The purpose of the Subcommittee was to consider standardization of the settlement media for securities transactions involving depository-eligible issues, and report its findings, conclusions and recommendations. This report has been discussed with representatives of the Securities and Exchange Commission, Federal Reserve System and several Federal Reserve banks, Nationai Association of Securities Dealers, Securities Industry Association and its Securities Operations Division, Banking and Securities Industry Committee (BASIC) and the BASIC Steering Committee, bank clearing houses, stock exchanges' clearing corporations and knowledgeable brokerage, bank and depository personnel. II. SCOPE The Funds and Settlement Subcommittee initially was to concern itself with matters relating to the money settlement vehicle for depository-eligible securities issues among securities depositories throughout the United States. However, because of the difficulty in separating the settlement of all securities transactions from those affecting only the certificate depositories, the scope of this study became broader than just transactions among depositories. The implementation of the recommendations of this Subcommittee will, therefore, require a broader sponsorship than that of the National Coordinating Group for Comprehensive Securities Depositories, which is primarily concerned with the interface among depositories. Sponsorship would be expected to include the Securities Industry Association, ail registered stock exchanges, The National Association of Securities Dealers, American Bankers Association, Bank Administration Institute, and concurrence in recommendations by governmental agencies, such as the Securities and Exchange Commission and the Federal Reserve System. Other securities instruments have funds settlements specified in a different manner from securities issues discussed in this report (e.g., Treasury Instruments, money market instruments and some municipal debt issues are settled in funds valued today or cash equivalent; other municipal instruments are paid for with funds valued tomorrow). These other types of issues were excluded from this analysis. III. MANAGEMENT SUMMARY The Funds and Settlement Subcommittee of the Working Committee of the National Coordinating Group for Comprehensive Securities Depositories reached the following conclusions on the settlement of common stock securities transactions: Securities payments must be standardized throughout the United States. The primary issue is equity for all parties involved in securities transactions. Standardization of settlement in funds valued tomorrow appears to be the best basis to provide equity to all participants. Operations of the settlement system that give one party to a transaction use of funds for an extra day are not equitable (e.g., buyer pays in funds valued today, but as seller, he receives funds valued tomorrow, losing earning power for one day) and will continue until funds settlement is standardized. Payments in funds valued today or cash equivalent conceivably could be accomplished provided time was permitted for money market transactions to take place afterwards. However, because of peak volume of transactions, this method places severe operational demand on the payment system. In addition, settlement in funds valued today could increase the capital requirements of small brokerage firms, since payment or cash could not be transmitted until cash payments were received unless a high enough balance were maintained in the account to cover such situations. These payments or receipts from customers would most probably be in funds valued tomorrow. Errors in a funds valued tomorrow system can be readily corrected by the transmission on the next day of funds valued today (Federal Funds or cash equivalent) through the Federal Reserve System. Thus, errors or questionable transactions can be "unbundled" or corrected on a funds valued tomorrow basis. The corrections may be impossible on a funds valued today or cash basis if funds physically leave the banking system such as with currency withdrawals. It appears that international payments will continue to be settled on a funds valued tomorrow basis, although recent discussions had proposed settling on a cash basis. The same problems cited above, such as peak operational requirements and credit problems in addition to requiring a large computer capability, are the reasons these large international payments will probably continue to be settled in funds valued tomorrow for at least 1973. Further changes in the Federal Reserve System's Wire Network schedule and development of regional certificate depositories could change funds settlement procedures in the future, but are not sufficient factors at this time to warrant conversion to funds valued today or Federal Funds settlement. The Subcommittee recommends that all depository-eligible transactions be settled on a funds valued tomorrow basis. This would require that all securities clearing corporations and the National Association of Securities Dealers specify their funds settlement procedures to be funds valued tomorrow. IV. FINDINGS The Findings portion of this report deals with the following subjects: A. Funds Settlement Terms B. Methods of Settling Securities Transactions C. Federal Reserve System's Wire Network D. Bank Wire E. Status of Federal Reserve System Plans to Modify Funds Settlement System F. Status of New York Clearing House Association Plans to Settle International Transactions A. FUNDS SETTLEMENT TERMS There appears to be considerable misunderstanding about the settlement process for corporate securities issues, some of which may arise from lack of common understanding of terms used. Terms such as good funds, same day money, Federal Funds, Fed Funds, Clearing House Funds, next day funds, etc., are used with many different connotations. Two funds settlement terms will be used in this report, based on when the funds are available to the depositor: Funds valued today or cash equivalent. Funds valued tomorrow. 1. Funds Valued Today The term funds valued today indicates that the recipient of the money has funds placed today in his bank account, which are available for immediate withdrawal in cash or can be considered the equivalent of cash. These transactions are the same as those referred to as payments in: cash, good funds, available funds, Federal or Fed Funds (designating funds credited to the depositor's bank in the Federal Reserve System). 2. Funds Valued Tomorrow The term funds valued tomorrow means that the depositor does not have funds or cash equivalent available for withdrawal until the day after deposit or the next business day. Similarly, the payor realizes a one day delay until the next business day before funds are debited. These types of funds are also referred to as Clearing House Funds, New York Clearing House Funds, one day delay, valued the next day, or "Custom of Wall Street". An analogy can be drawn between the settlement of funds and that of securities transactions. A securities transaction that takes place on trade date, or "day zero", does not settle with the delivery of the securities until "business day five". This allows time to confirm the transaction for accuracy and issue the proper instructions to deliver securities to the purchaser. In earlier trade practices, securities traded on exchanges were delivered on the trade day until 1933 when the time was extended to two days. Subsequent changes were made to three and then four days. In February, 1968, the time allowed for delivery was extended to five days. In much the same way, the delay of funds for value the next business day has developed as a trade practice to allow for time zone differences, the exchange of data, usually in the form of a large volume of checks, etc. B. METHODS OF SETTLING SECURITIES TRANSACTIONS Corporate securities transactions funds settlement procedures have developed differently in various parts of the country. In some cases, various banks in the same city have different procedures for handling the funds aspect of the securities transaction for the debit party and credit party. Not much attention was centered on the importance of managing money by those in the securities industry until the late 1960's. Most securities transactions were generally concentrated in one geographical area, and different funds settlement procedures did not cause appreciable trouble. In the 1960's, more settlements began to be made locally rather than in New York City. With the development of regional exchanges, plans for regional depositories, and the requirement by more institutions to settle locally, differences in funds settlement procedures began to cause some parties of a securities transaction to have a possible advantage or disadvantage in the use of funds. In the case of large new underwritings or block trades, the sums of money involved in the use of funds for one day can be significant. Many securities and banking leaders have commented on the need to have a standard funds settlement procedure on a national basis. One of the major positions of the Securities Operations Division of the Securities Industry Association is to standardize funds settlement procedures. The Subcommittee found that many knowledgeable securities industry people failed to realize that the use of funds valued today requires that cash or available funds be in an account before funds can be transferred. This could cause some brokerage firms to maintain higher balances than might be necessary with a funds valued tomorrow basis in which debits and credits are netted, and it could conceivably require greater capitalization. For example, paying off a loan in funds valued today could be delayed awaiting the receipt of funds valued today. Also with a funds valued today basis, it is possible that some transactions could not be completed prior to transfer deadlines and surplus funds would have to be maintained for these situations. Or, customers could be paying by checks with funds valued tomorrow for transactions that a brokerage firm would have to settle in funds valued today. The information obtained by this Funds And Settlement Subcommittee on various settlement procedures, which are summarized below, indicates problems for the national brokerage firm dealing in transactions throughout the United States because of the lack of funds settlement standards. 1. Stock Exchange Clearing Corporations At least two different settlement procedures exist among the various clearing corporations. For example, on one hand, the stock clearing corporations of the Midwest and PBW (Philadelphia – Baltimore - Washington) stock exchanges require funds settlement in funds valued today or cash. On the other hand, the stock clearing corporations of the New York and American stock exchanges require funds settlement in funds valued tomorrow. The Pacific Stock Exchange typifies another variant settlement procedure that includes some transactions settled in funds valued today and others in funds valued tomorrow. 2. Banking Practices in Certain Areas The basic methods of settling securities transactions in several money market areas are mentioned here to illustrate the variations that presently exist among different cities. Appendix I describes the basic check processing system with which many persons reading this report are familiar. |