aNote that earlier the clerical cost of stock loans It is estimated that broker-to-broker fails in NYSE issues cost the industry $60 million in clerical and administrative costs at a volume of 20 million shares per day. The broker-to-institution cost is estimated at $29 million for clerical costs and at $65 million for imputed interest for a total of $94 million. Broker-to-cash customer fails cost the industry an estimated $28 million. Conversely, customerto-broker fails cost $17 million in clerical and administrative costs, and there was an imputed interest benefit of $76 million for a net annual benefit of $59 million. In addition, stock loans made to cover segregation requirements and short sales cost an additional $2 million per year. The result is that, given the existing system as defined, fails or incomplete transactions are estimated to cost the securities industry $125 million (net) per year. Alternatives to the existing trade completion system will be examined next to see how they impact on these costs. -24 ALTERNATIVE DELIVERY PRIORITY SCHEMES As stated earlier, different firms have different delivery priority schemes, which change from time to time. This is to be expected because the most important prerequisite, current information on inventories, is generally not available. Further, particularly in the large firms, decisions about deliveries are made by many different people operating independently of each other. To exercise a systematic delivery priority scheme, these individual decisions would have to be coordinated. It appears, however, when one looks at the overall result of these diverse procedures, that the institutional deliveries are usually given top priority followed, in order, by deliveries to other brokers, repayment of stock borrowed, and deliveries to public cash customers. Delivery priorities are important only in those cases where a broker has less than enough stock to make all of his required deliveries. In this circumstance, it would appear that the choice about which deliveries to make would have an impact on the overall performance of the trade completion system. For example, delivering to brokers first might result in the available inventory being distributed in such a way that, for the industry as a whole, there would be fewer fails to deliver. On the other hand, delivering to customers first would undoubtedly result in greater customer satisfaction. Given the disparate costs of fails of different kinds, it is not immediately obvious which delivery priority would result in the least net cost. Two alternatives to the existing system were simulated: delivering to customers first and delivering to brokers first. The results are displayed in Table 2. The benchmark case is shown in the first column, and as noted earlier, the net cost is $125 million per year. The second column shows the results of delivering to public cash customers first, institutional customers second, brokers third, and stock loans last. This approach to reducing customer complaints is obviously very expensive. The cost of fails-to-deliver to public cash customers is cut from $28 million per year to $3 million per year, but this is the only savings. The cost of broker-to-broker fails goes up by a factor of 10 and the cost of broker-to-institution fails by a factor of 2. A fails clearance or continuous netting would substantially reduce the level and cost of broker-to-broker fails. When the cost of the delivery priority scheme is included, the net cost increases from $125 million per year to $739 million per year with the largest part of the difference accounted for by the increase in the cost of brokerto-broker fails. It appears that giving first priority to customers causes stock to be delivered out of the system faster than it comes in. As previously noted, public cash customers bring their stock in 3 days after settlement date, and institutional customers 1 day after settlement date. A policy of delivering to public cash customers first would, therefore, result in a net depletion of available inventory and a major tie-up of deliveries among brokers. The last column shows the results of the opposite approach of giving brokers the precedence. This was done to test the assumption that, if broker deliveries are given top priority followed by institutions, public cash customers, and stock loans, everyone will be served better. Brokers can satisfy customers only when they have themselves been satisfied. The cost of broker-to-broker fails is reduced by a third. The table also points to the validity of the hypothesis that satisfying brokers will in turn satisfy customers, since the cost of broker-to-public cash customer fails goes down slightly. These gains are more than offset, however, by the increased cost of -26 broker-to-institution fails and the cost of implementing the deliverypriority scheme. The net cost increases from $125 million per year to $132 million per year. and From these examples, it is evident that delivering to institutional customers first followed by brokers, stock loan repayment, public cash customers, as in the existing system, is the most efficient, from a cost standpoint, of the alternatives examined so far. Putting customers first ties up the system, and putting brokers first does not have any significant effect. It should be noted, however, that this priority may have significantly different effects when taken in combination with other changes. ALTERNATIVE STOCK LOAN POLICIES When a broker needs more stock than he has in his free box, he may, by putting up 100 percent of the market value of the stock, borrow the stock from another broker. These are typically "call loans" and are possible, of course, only when loanable stock can be located by the prospective borrower. Of the many purposes for which stock may be borrowed, probably the most common is to make delivery of stock sold short. Stock is also borrowed to cover segregation requirements and for use in making deliveries other than those required by short sales. ・・ Although, in the real world, stock loans are made for all three purposes, only the first two have been allowed in the existing system or benchmark case. Further, while stock loans are fairly common in practice, there is no efficient system for bringing prospective borrowers and lenders together. Obviously, the borrower of stock incurs a cost-the cost of the capital he must put up--and there is an equal benefit to the lender. These represent transfer payments from the point of view of the industry as a whole and hence are not treated in this analysis. They should not be ignored, however, as they can be significant from the standpoint of individual firms. Firms with large supplies of loanable stock, usually those with large numbers of margin customers, typically profit from such policies at a cost to the firms that must borrow. -27 In the model, a broker always attempts to borrow stock to cover short sales and segregation requirements whenever his available resources are less than needed. In addition, there is the alternative of borrowing to cover fails-to-deliver to customers or to brokers. Table 3 shows the results of enforcing alternative stock loan policies of covering fails-to-deliver to institutions or to brokers. In both alternatives, stock loans are mandatory when stock is available. Further, a completely efficient stock lending and borrowing system has been assumed, i.e., if stock is available and needed, it will be found and borrowed. The only restriction is that firms are allowed to lend a maximum of 85 percent of the stock held in their free box on any given day. In time, this may result in the lending of over 85 percent of the free box. Borrowing to Prevent Broker-to-Institution Fails Table 3 shows that borrowing stock to prevent failing to deliver to institutional customers results in an annual cost reduction of $8 million, accounted for by reductions of $3 million in broker-to-broker fails, $2 million in broker-to-public cash customer fails, $9 million in broker-to-institution fails, and an offsetting $6 million increase in the cost of making stock loans. The objective of this policy, to effect a significant reduction in the cost of broker-to-institution |