SCC estimated at the end of 1970 that approximately 91% of all listed bonds were being cleared through Stock Clearing Corporation.

Direct clearing

SCC also operates a Direct Clearing operation to permit eligible member organizations to use the mails for their clearing operations. At the end of 1970, a total of 64 out-of-town retail brokerage firms, specialists and floor traders were using the service.

In general, purchases and sales for out-of-town member firms are effected on the trading floor of the Exchange by a New York correspondent broker for the out-of-town firm-and clearance and settlement are handled directly between the out-of-town member's office and the Direct Clearing Department of SCC. Prior to the inauguration of Direct Clearing Members' participation in Central Certificate Service, such members typically maintained bank accounts in New York, shipped securities to or received securities by mail from Stock Clearing Corporation. Payment and receipt of funds to and from members' bank accounts were handled by SCC personnel acting under a power of attorney granted by the Direct Clearing Member as part of its membership agreement with SCC. Clearance and settlement are still handled in this manner for most Direct Clearing Members. However, a number of DCM's have now made bulk deposits in SCC's Central Certificate Service, through which delivery and settlement are being handled by computerized bookkeeping entries.

A number of additional services have been initiated for Direct Clearing Members in 1970 and 1971. An odd-lot clearing service was inaugurated at the end of May 1970 and, by year-end, was clearing more than half a million shares per month. In July 1970, a bond clearance service was introduced; at year-end some 30,000 bonds per month were being cleared for Direct Clearing Members.

In July 1971, an important step was taken toward centralizing in one location all receipt and delivery functions for Direct Clearing Members through the start-up of a Securities Transmittal Services by which out-of-town Direct Clearing Members may receive or deliver through the Direct Clearing facilities any over-the-counter stock or bond (except U.S. Treasury obligations).

Also in July, consolidation of the Direct Clearing operation of the NYSE and Amex was completed, with the merged operation headquartered at the NYSE's Direct Clearing facilities. By providing a consolidated service for 65 Direct Clearing firms, the operation is already achieving significant operating economies. (All but one of 33 Amex Direct Mail Clearing Members were also NYSE Direct Clearing Members prior to the consolidation.)

Other stock clearing systems

Essentially, two types of stock clearing systems are in operation in the United States today. One is the "daily balance order" or "daily netting" system which is employed by the New York and American Stock Exchanges and the NOTC (in New York only) described earlier in this statement, operated in conjunction with the Central Certificate Service depository and delivery system. The second system, known as "net-by-net" or "continuous net" is now employed by the Pacific Coast Stock Exchange and is planned to be used by the Midwest Stock Exchange and the National Clearing Corporation.

In a "net-by-net" settlement system, a Clearing Member's open net securities positions and net money balance resulting from its securities transactions are brought forward daily, on a perpetual or "continuous" basis, and the daily transactions are merged, netted and carried forward for securities positions. This leaves in the Clearing Members' accounts within the system all transactions which have failed in delivery or receipt until settlement activity occurs through the delivery to the Clearing Corporation of securities and corresponding money settlements or through offsetting transactions.

The Clearing Member, in the "net-by-net" system carries one net position for each security and one net money position for each daily settlement, with such positions updated by trades settling and by receipts and deliveries. The Clearing Corporation itself, rather than another broker, is the contra-side to the firm's securities and money settlements. Securities delivered by Clearing Members are, in effect, owed to the Clearing Corporation; securities due Clearing Members are, in effect, owed to them by the Clearing Corporation and, in the settlement process, allocated to their accounts by the Clearing Corporation.

7A brief chronology of major developments in the history of the New York Stock Exchange's stock clearing corporation is appended as Exhibit C, p. 1869.

In April 1969, the New York Stock Exchange retained the independent consulting firm of Arthur D. Little, Inc., to conduct a preliminary design study for a Securities Handling System that would meet the needs of the securities industry in the impending decade. ADL's report, presented to the Exchange in November 1969, included a succinct evaluation of the "daily balance order" and "net-bynet" systems and concluded, among other things, that "the disadvantage of having more than one clearing system is more than balanced by the opportunities offered the different markets to develop systems to meet their specific needs, and to express initiative in trying new procedures that can work to the long-term benefit of all markets."

The "daily balance order" system also requires movements of securities and money settlement on each settlement day; however, for the vast majority of NYSE and Amex issues, eligible for CCS, the certificate "movements" are drastically reduced as they are accomplished primarily by computerized bookkeeping entry.

In evaluating the relative merits of the two systems, it is important to bear in mind that the "daily balance order" system is operated in conjunction with a depository and a computerized bookkeeping delivery system. On the other hand, the "net-by-net" system was devised to replace a cumbersome trade-for-trade comparison and settlement system for which no ancillary depository system existed or was immediately feasible.

It is generally acknowledged that an important advantage of the "net-by-net" system is its capacity for minimizing fails because, as the contra-side to each participant in each trade, the Clearing Corporation must be involved in every settlement and thus has better control of false information and can "net down" the trades. At the same time, as ADL pointed out, the system "accepts the existence of fails, within controlled limits, for the sake of decreasing delivery requirements, and decreasing the impact which original fails can have in producing secondary fails."

In the context of the serious impact of fails on securities industry operations during the high-share-volume periods of 1967 and 1968, it is obviously pertinent to determine whether the opportunity for minimizing fails, in itself, would justify the adoption of a continuous netting system by the NYSE and Amex. The ADL report discusses the question in some detail, concluding that the expansion of existing services-i.e., incorporation of an automated stock loan feature in CCS, combined with more sophisticated computerized recordskeeping with respect to identifying and netting fails, "marketing to the market" and calculating dividends, all of which can probably be accomplished through modifications of existing technological capabilities-would achieve the same objective without sacrificing the particular advantages of the daily balance order system for the NYSE and Amex markets:

As a result of past work, ADL has recommended that the NASD adopt a continuous netting approach. We consider this procedure highly desirable for a situation where the geographical and size distributions of participants vary widely, where supplies of liquid stock in the securities traded are limited, and were a significant fraction of securities handled is not fungible and thus limits the effectiveness of bookkeeping entry systems. Under these conditions, we consider continuous netting as the most desirable technique to employ.

In the case of the NYSE, we do not recommend the adoption of continuous netting because:

(1) We consider the establishment of an effective depository as a superior approach for the NYSE, with its centralized operations. more equal sizes of Clearing Members, large liquid supplies of securities, and a high degree of fungibility in its listed stocks. We believe the stock lending and fails control procedures we are recommending will be greater and more effective if the NYSE retains traditional procedures than if it were to adopt a new set of relationships.

(2) Accepting the contra-side position for each trade, as opposed to merely acting as a bookkeeping and monitoring agency, entails a considerable increase in NYSE liability. While the NYSE's liability will increase in any case, since its data sources will be improved and thereby its ability to act on its responsibilities for regulating its membership, this is a different and less direct form of liability. (3) If the NYSE were on the contra-side of each trade, it would become more difficult for it to equitably police its membership, be67-228-72-pt. 3- -3

cause it would be an active participant in each operation as well as a judge and arbitrator. We believe equitable policing can be done more effectively under present procedures. It should be noted, however, that if effective stock lending and fails controls are not adopted, continuous netting may become a necessity.

Having accepted these ADL recommendations as both desirable and feasibleand, indeed, preferable to the costly, time-consuming and disruptive alternative of converting to a continuous netting system-the Exchange has been working on the development of an Automated Delivery System. The PDQ program described in Part I of this statement will be the initial element to undergo pilot testing and is now scheduled to begin before the end of the year.

On instructions from the delivering broker, the Automatic Delivery System will permit automatic matching by computer of balance orders due for settlement against the broker's deliverable CCS positions-thereby eliminating movement of CCS-delivery paperwork and providing the basis for closer monitoring of Clearing Members' fails. The Exchange is also exploring the possibilities of incorporating "fails controls" and an automated stock loan feature into the system-possibly with a complementary system of automatic buy-ins to be made, if necessary, for any remaining fails.

Thus, at present, the NYSE does not contemplate adoption of a system in which the Stock Clearing Corporation would be the contra-side to Clearing Members' trades. The Exchange believes that in building the additional capabilities described above into the existing "daily balance order" system, coupled with the Central Certificate Service, it will be possible to achieve, within approximately one year, the essential goal of bringing present clearance, settlement and delivery procedures to a state of near-maximum efficiency. Future developments

There remains the question of whether, in the absence of complete standardization of existing systems-i.e., the anticipated continued use of both the daily balance order system and the continuous netting system to serve the varied needs of the various securities markets-it may be possible "to interface the two systems so as to develop an integrated national system."

The question is not so much one of possibility-since there is no inherent incompatibility-as one of determining what may and may not be desirable and useful. For example, as noted earlier, plans are going forward for the Pacific Coast and Midwest Stock Exchange clearing corporations to become members of CCS. The National Clearing Corporation has indicated an interest in developing an interface between its own clearing functions and the CCS depository, and both organizations are continuing to explore, on a preliminary basis, the possibility of integrating the two clearing systems through the depository.

In this connection, it is worth noting that the NCC has recognized that "time may prove that a nationwide clearing network will await a national depository, or depositories may await clearing." Based on the existence of the fully functioning Central Certificate Service and current industry-wide efforts to develop the Comprehensive Securities Depository System, the NYSE believes that preliminary discussions now can serve a useful purpose in the effort to establish an effective interface once the nationwide depository becomes an operating entity. For the longer run, the Exchange has under development the total automation concept of the "locked-in trade”—whereby the trading floor of the Exchange would become, in effect, an electronic bridge between brokerage firms entering transaction orders for their customers, and the clearance, settlement and delivery operations. Essentially, the locked-in trade concept envisions a series of automatic operations, triggered by the transmission of an order to the trading floor, and following through all the subsequent steps--including execution of the order, reporting and confirmation of trade data, clearance and settlement of the transaction, delivery (whether by computerized bookkeeping entry or physical delivery of a certificate to a customer at his request)—to complete the transaction.

The key element here is automation of the trading floor. Following a period of intensive study and planning, the Exchange last month authorized pilot testing of a new Automatic Trading System designed to serve as the base upon which a comprehensive floor automation structure can be developed as a means of achieving the objective of the locked-in trade. The Automated Trading System

would provide for a computer, interacting with Exchange specialists, to receive and execute 100-share market orders and produce trade reports.

The eventual goal of this and other current projects is to link the trading floor with, on the one hand, the brokerage offices which generate transaction orders and, on the other hand, with the clearance, settlement and delivery operation-to complete the fully automated transaction loop which has come to be known as the "locked-in trade."

Mr. Moss. Mr. Phillips M. Montross.

STATEMENT OF PHILLIPS M. MONTROSS, PRESIDENT, MIDWEST STOCK EXCHANGE CLEARING CORPORATION

Mr. MONTROss. Mr. Chairman and members of the subcommittee, I am Phillips M. Montross, president of the Midwest Stock Exchange Clearing Corporation, a subsidiary of the Midwest Stock Exchange. In our testimony, as requested, we shall devote our attention to operational functions with particular emphasis on the movement of securities and money.

It is not our intention to speak to historical problems, such as the so-called 1968 crunch, because so much has already been said. about them. Rather, we shall address ourselves to industry needs and problems, and possible solutions.

We are hopeful that the exposure of industry problems and possible solutions during this subcommittee's investigation will result in an increased awareness within the securities and banking industries of the need for improved effort in developing appropriate solutions to the problems inherent in moving securities and money on a nationwide basis.

Certainly, there is the talent, knowledge, and financial wherewithal within the industry to get the job done if we focus on the proper objective.

In the more detailed testimony we shall address our comments to a variety of problems and proposed solutions. The purpose of this oral summary is to highlight what we consider to be key recommendations for problem solution. We do this in expectation that the subcommittee is primarily concerned with solutions rather than an extensive detailing of problems.

SECURITIES CLEARANCE

We recommend adoption by the industry of the continuous netting concept, as embodied in the continuous net settlement system (CNS). The adoption of a single-or common-clearing system would simplify the clearing process for broker-dealers and allow simple interfacing between clearing facilities in different regions of the country.

CERTIFICATE DEPOSITORIES

We recommend the formation of a national depository organization to oversee the development of a national system within which the eastern, midwestern, western-and perhaps other regional depositories will be integral and interfaced parts.

8 Additional details on the automated trading system were contained in a letter from the exchange chairman and president to the exchange membership, dated Sept. 20, 1971. A copy of this letter is appended as exhibit D, p. 1888.

The depository organization should be controlled initially by the three major financial centers-that is, Chicago, New York, and San Francisco-Los Angeles-and the National Association of Securities Dealers as the national representative. As development and implementation progresses, participation should be opened to additional financial centers.

I would like to expand on this point to state that it is not our purpose to exclude any financial centers of the country that wish to be involved. As Mr. Bevis mentioned during his testimony, during discussions over the past year other financial centers have had an opportunity to indicate their receptivity toward initial involvement, and with the possible exception of Philadelphia have indicated that they would prefer to delay such involvement.

The national depository system, as well as the regional systems, should be concerned with maintaining security account balances for participants in the systems. They should not be concerned with the security clearance function in which money and securities are moved in settlement of trades, except in their capability to interface with the clearance system.

The national depository system should be viewed as a superbookkeeper which would maintain the ledger accounts for security holdings of its members, which would be the regional depositories. The regional depositories would maintain the ledger accounts for security holdings of their members, which would for the most part be brokers, dealers, banks, and other institutions.

The national and regional depository systems should not be involved in the disbursement of corporate-issuer dividends, and distribution of notices or proxy material. The role of the depository should be one of providing the corporation-issuer or its agent with the names of the depository members who have holdings in that issue. Disbursements and distributions would thus be made directly to the depository members.

Ultimately, through improved mechanization and control, it would be possible although not necessarily desirable--for depository members to provide the corporate-issuer or its agent with the names of the ultimate shareowner for which the member acts as nominee.

The national and regional depository systems should be so designed as to lend themselves readily to conversion to a certificateless system by 1975, if such a system is found to be a logical next step toward greater efficiency, service, and protection.

TRANSFER AND REGISTRATION

We recommend a concerted effort by the banking and securities industries to secure the appointment of additional transfer agents in financial centers around the country.

As a national clearing system and a national depository system move closer to realization, there will be an increased need for agents in all major financial centers to provide rapid transfer processing of all issues moving through those systems. It would be illogical to effect a significant increase in the processing speed of clearance and depository systems without facilitating the transfer process.