Segregation of Securities Members may deliver fungible securities to the Depository and designate one or more of the eligible accounts: Unclassified Account. Bank Collateral Account___ Stock Loan Account--- Free securities Securities collateralizing bank loans Fully paid customer securities in bulk Securities loaned to the PCSE Clearing The Unclassified, Segregated and Bank Collateral Departments maintain securities in separate subvaults within the main vault. Bank hypothecated securities are stored in individual deposit boxes for each participating bank. The Unclassified and Segregated Departments use a bulk segregation system for storing securities. Our Depository is directly connected to a net-by-net clearing operation which is the most advanced system in the country. Thus, the movement of securities between the four (4) optional depository accounts and the clearing account is accomplished by bookkeeping entries on the records of the Clearing Corporation, and physical securities are virtually immobilized in the Depository. The movement of securities involving cash settlement is exclusively concentrated in the Clearing Corporation, while the movement of securities without cash consideration is confined to our Depository vaults. Features of the PCSE CC Securities Depository—Reports One document to the participant, issued daily, summarizes all his activity in a meaningful report. Only a minimum number of documents are required from the participant: deposit of securities, release and delivery of securities, and allocation of securities into/out of unclassified accounts. Daily Position Report Summarizes activity; indicates closing positions by security. This report reflects each position at current market and also indicates total dollar value for each account. Permits broker to have a total daily update on portion of his stock record at the Depository. Evaluates his compliance with regulatory requirements and segregation of securities. Values stock for him under Depository administration. Pledgeholder Report Allows bank to evaluate collateral status of each customer daily. Stock Loan Advice Report Indicates to the participating firm, securities borrowed and securities returned by the Clearing Corporation. Dividends, Proxies, Exchanges and Reorganizations Are also reported as they are processed by the Depository. The PCSE CC recommends the development of regional depositories rather than a central depository concept. The regional depository concept utilizes the expertise of industry specialists in all geographical areas, and excludes the possibility of concentrating all securities activities in a central area. It involves considerably less security risk than a central depository, provides a minimum disruption to the operation of existing institutions, and recognizes that there is a regional focus to much of the financial activity of this country so that regional financial communities will best be served by a depository located in the region's financial center. We feel that one centralized depository would concentrate all securities and related services in one area and would tend to create a monopoly in the handling of securities. It would be imprudent to house such an enormous resource in one geographical area. So doing would expose its operation to a greater degree of malfunction by reason of power failures, acts of God or war. A series of interconnecting regional depositories is the most secure and acceptable alternative. The success of the PCSE Clearing Corporation's depository is notable in a number of areas: (1) The available inventory of certificates expedites the clearance and settlement of securities transactions. (2) Deliveries and receipts for participating members are dramatically reduced. (3) Operating and insurance costs for participants are reduced. (4) Available capital is increased within the broker-dealer operation. (5) Control over the collection and disbursement of dividends is increased. (6) Availability of concise, daily reports to participants on the status of all security positions. Present Developments The PCSE Clearing Corporation has applied for membership in Central Certificate Service. The New York Stock Exchange has indicated that membership will be available on the same basis as that of members of the Exchange. Interdepository memberships will eliminate the majority of transcontinental shipments of securities and will enhance the operating efficiency of the respective depositories and clearing operations. The Boston, Midwest, Pacific Coast and Philadelphia Stock Clearing Corporations recently reached agreement to provide reciprocal services with respect to securities deliveries and transfers between these regions. As depositories are developed by the other regional exchanges, we anticipate that a network of accounts linking one with the other will further reduce the movement of securities between trading centers. We will cooperate with any of these regional centers in making our expertise and software available to them in the development of their depositories. Eventually, we will expand eligibility for membership in the depository so that all financial institutions engaged in the trading and management of securities may be depository members. Problems in the Development of Depositories One significant problem in the development of depositories is the reluctance of banks to allow securities collateralizing loans to be held in a depository. Where these securities are domiciled outside the depository, the operating efficiency of the depository is dramatically reduced. Five major banks in California-Bank of America, Security Pacific National Bank, United California Bank, Crocker National Bank and Wells Fargo Bank-have all agreed to domicile their collateral loan securities in our depository. The eleven New York clearing house banks, which participated in the development of Central Certificate Service, require that their collateral loan securities or their equivalent be domiciled within the banks' vaults. Another important area requiring resolution in the development and evolution of depositories is a change in state laws which will permit banks and other institutions to deposit securities held under a fiduciary arrangement in a depository. This issue is particularly important since transactions involving fiduciary securities are generally settled on a C.O.D. or cash on delivery basis. Such transactions are traditionally the most difficult and expensive for broker-dealers to settle, and are responsible for a disproportionately high percentage of "DK's" and consequently aggravate the "fail" problem in our industry. Were fiduciary securities controlled by banks and other institutions held in a depository, transactions involving such securities could be automatically settled. The New York State Legislature recently passed a law which will permit fiduciary securities to be held in a depository. Federal legislation which would make this possible in all states should be considered as a next step in the evolution of a depository system. The development of software to account for the depository operation, the development of a physical plant to provide adequate security for certificates and the processing and maintenance of records, as well as the education of participants in the use of the depository facility represent other areas which must be considered in the development of a regional depository system. A further problem in connection with this development is posed by the New York State Transfer Tax. This tax prevents the development of depositories to their fullest potential. For example, if PCSE CC maintained an account with CCS, settlement of accounts between the two depositories which required us to ship securities to New York would require payment of the New York Transfer Tax. This tax would have to be paid even though the underlying securities transactions may have occurred essentially outside the State of New York. Recent Changes and Recommended Changes in State Laws Section 8-320 of the Uniform Commercial Code (Section 8320 of the California Commercial Code) was added to provide that securities may be transferred or pledged by the making of appropriate entries in the books of a Clearing Cor poration if the securities are in the custody of a Clearing Corporation or of a custodian bank that is subject to the instructions of the Clearing Corporation. Presently, trust and estate laws in most states require that a trustee have physical possession of stock held in trust. This is a major obstacle to the full development of depositories. If these laws are changed by amendment to state law as has occurred in New York, or by Federal law pre-empting the field, banks will be able to participate more extensively in depositories. Regulatory Problems The development of our depository has been discussed in detail with the Comptroller of the Currency and, consequently, no problems should be posed by the development of a depository in this area. The operation of the Federal Deposit Insurance Corporation should be enhanced by having the majority of securities housed in a series of depositories by reason of centralized record keeping, the elimination of duplicate reporting from several sources, a centralized fund of information providing accurate and timely reports, as well as the fact that losses are minimized. Our depository has made provision for the segregation of customer fully paid securities within the depository pursuant to the requirements of Regulation T and U of the Federal Reserve System. We feel that the public customer is better protected when his securities are domiciled in the vaults of a depository. Regulatory authorities may verify the segregation requirements of customer stock pursuant to Federal Reserve requirements by interrogating the records of a depository, rather than having to assess the records of individual broker-dealers. Further, we have made provision that the depository is in a position to deliver daily reports to regulatory agencies on the status of every participant's security position with the depository. Most or all of the self-regulating authorities in the securities industry support the concept of depositories. We understand that a number of such agencies are actively engaged in the development of their own depositories, which would support the development of the regional concept of interlocking depositories. Again we are willing to cooperate in the development of such a system of depositories and will donate our experience to this effort. Federal Law With Respect to Depositories Any Federal law pre-empting the field of regulation of depositories should not require one central depository. To a considerable degree, the financial activities of the country still have a regional focus, and a system of compatible regional depositories would be more convenient for regional financial communities. The administration of depositories is a new concept. Accordingly, Federal legislation may be desirable to provide some means of uniform control over the establishment, administration and regulation of depositories in the following areas: (1) Depositories should be under the direction of regional clearing corporations' association with national securities exchanges or the NASD. (2) All securities should be eligible for inclusion in a depository, O.T.C., listed, etc. (3) Standards for vaults, etc. used to house securities should be sufficient to meet with the approval of insurance companies and S.I.P.C. (4) Minimum record keeping standards should be established. (5) Also needed are uniform standards for retention and protection of records, uniform system of communications between depositories, uniform documentation designed with a view toward the machine-readable certificate. (6) A Federal law which would address itself to the legal problems involved in allowing trust securities to be held in a depository might well be desirable. Development of a Machine-Readable Certificate and Accompanying Documents The desirability of a machine-readable stock certificate and accompanying documents is dramatically reduced when a majority of securities are immobilized in depositories. Accounting for the movement of securities in a depository environment involves minimal physical handling of securities. We believe that the development of regional depositories is a priority matter for the securities industry, not only to advance immobilization of the stock certificate but to facilitate the clearance and settlement of securities transactions. The adoption of machine-readable certificates prior to the development of such depositories appears to be imprudent and premature. 67-228-72-pt. 3-4 Documents used to effect clearance, transfer, and other operations in a depository environment will necessarily be different from those presently required. A change at this time would involve the industry in unnecessary and unreasonable expense, which it can ill afford. When most securities are immobilized in depositories and general agreement has been reached as to the documentation necessary to effect transfer, settlement, and other operations, machine-readable documents will most likely represent the most efficient means of achieving further savings in time and costs. At that time we will support the development of machine-readable certificates and other documents. Form of a Machine-readable Stock Certificate If a machine-readable certificate is to be developed, we feel that the significant information on the face of the certificate should appear in optical character readable form on an 81⁄2" x 11" document similar to that presently used. Significant OCR information should include CUSIP number, certificate number, share quantity and registration. Securities should be issued in fixed denominations of 1, 5, 10, 20, 100, 500, 1000, etc., as with currency. Information on the machine-readable certificate should be visible in order that small firms are not immediately forced to undertake large costs of conversion to machine handling of certificates. Problems in the Development of Machine-readable Certificates Some of the problems which will be encountered in the development of a machine-readable certificate include: (1) Addition of a uniform security identification number for all securities. (2) Substantial costs to brokers, corporate issuers, transfer agents, banks and other fiduciaries during the period of transition, approximately two years. (3) Federal law would be needed to require issuers to conform to the new requirements. (4) The development and perfection of machinery to interpret the machinereadable certificates. (5) The hardship of increased capital expenditures required on small brokers, transfer agents, and banks. (6) The increased cost of stock certificates. Regulatory Agencies Positions The majority of securities exchanges, as well as the NASD, agree with the recommendation of the BASIC Committee that an 81⁄2" x 11" document with optical character reading codes is the best design for a machine-readable certificate, and apparently the Federal regulatory authorities endorse this recommendation. The Need for Federal Legislation We believe the necessity for a machine-readable certificate in its current form will be virtually eliminated by the development of depositories. Should the consensus of interested parties as well as regulatory authorities endorse a move to a machine-readable certificate prior to the development of the depository system or, at some later time, a Federal law requiring corporate issuers to issue their stock certificates in machine-readable form would be desirable. The Federal law should be specific as to dimensions, quality of paper and method of positioning and coding critical information on the certificate to include the CUSIP number, certificate number, quantity of shares and registration. The resultant savings will depend on a uniform conversion to this form. If only a few states required their corporate issuers to use machine-readable certificates, and if the design of machine-readable certificates differed from state to state or from issuer to issuer, the industry would be burdened with a dual system and any cost savings which could otherwise accrue would be lost. Special Problem of Fiduciaries Problems in converting to machine-readable stock certificates for bank trust departments and other fiduciaries would be minimized if the conversion is accomplished by affixing an adhesive strip containing optical characters necessary for machine reading on the front or back of the certificate. A procedure requiring that stock certificates presently domiciled with fiduciaries be returned to corporate issuers for reissuance in machine-readable form would be impractical and extremely expensive. Consequently, we recommend that this conversion be accomplished by the institutions themselves. Problems of Transfer Agents The machine-readable certificate would present some immediate problems for transfer agents. It will be necessary to acquire machinery to produce documents coded for processing through optical character readers. It will also be necessary to retrain their staff. Security Measures for Machine-Readable Certificates Machine-readable certificates should be developed giving consideration to the preventative measures against counterfeiting which are used to safeguard securities in their present form against reproduction and, therefore, should not be a problem. Problems of Transition The transition to a machine-readable certificate would involve considerable adjustment in the operating departments of broker-dealers, banks, clearing operations and depositories, and would involve corporate issuers with extra expense in reproduction of new certificates. The period of transition would be expensive for both issuers and processors of securities. Problems Associated With Machine-readable Accompanying Documents The problems involved in the development of uniform machine-readable documents are even greater than those encountered with the machine-readable certificate. Documents related to processing securities are generally multipart forms, and coding information in a machine-readable form on such documents is more difficult than coding similar information on a one-part document. Documents related to processing securities exceed in number the actual certificates in circulation. Technology which is presently available and which could be applied to a machine-readable multipart form would require coding of critical information on each copy of the document in magnetic ink characters. The development of such technology in the present environment, which is paper-intensive, would involve the industry in enormous expenditures which would very likely be obsolete when securities settlement is accomplished through depositories. Problems in the Development of a Uniform Numbering System The PCSE CC and PC Service Corporation, subsidiary of the Pacific Coast Stock Exchange (which performs complete accounting and record keeping services for 40 broker-dealers), adopted the CUSIP numbering system for securities on August 1, 1971. Other major securities exchanges have indicated dates in 1972 when their operations will incorporate the CUSIP number in the description of securities. While the National Association of Securities Dealers has endorsed the CUSIP numbering system, it has not yet adopted the system and has not indicated a date on which its members would be required to convert to the system. We feel that the CUSIP numbering system should be mandatory for all institutions dealing directly or indirectly in the securities markets. When a common, universally accepted identification system for securities is mandatory, then only can the clearance, settlement and transfer of securities transactions be expeditiously and efficiently handled. Development of such concepts as depository systems, interlocking clearing operations of a central marketplace and machinereadable documents without first having a universally acceptable system of security identification in operation is incongruous. We feel that the CUSIP system will be fully effective only when its adoption is mandatory. Long-Term Benefits of Conversion The BASIC Committee analyzed benefits against costs involved in the development of machine-readable certificates for the securities industry, and indicated that such development would involve start-up costs which would be offset by substantial savings subsequent to the installation of the necessary machinery and the training of personnel in handling machine-readable documents.1 We concur wholeheartedly with this conclusion. Furthermore, we feel that the industry must be forced to undertake the expense of this conversion. 1 BASIC Study of October 30, 1970. |