study of Arthur D. Little and Company concerning solutions to these problems, recommended the formation of the National Clearing Corporation to implement clearing for over-the-counter transactions using the continuous net settlement system. These studies indicates that operational problems, in particular failures to complete transactions, were primarily caused by the lack of any national over-the-counter clearing facility. The selection of the continuous net system, pioneered by and in successful operation by the Pacific Coast Stock Exchange for many years was, among other things, based upon considerations of geographical distribution of broker/dealers and the nature of the securities to be traded. That is, both the largest and smallest broker/dealers wherever located were to be served on a comprehensive basis. Likewise, all issues of securities both large and small, were to be included to the extent feasible to permit the effective operation of the national system. A survey of trading volume in all sections of the nation was commenced. This survey, a copy of which is provided for your files, indicates the nature and extent of trading patterns within the various geographic sections of the country, as well as between them. It is obvious that the trading patterns indicated call for the most carefully drawn and executed system which can be devised. This is our goal.

Simultaneously with the institution of the clearing survey, work was commenced on financing, system design and operating procedures. With the cooperation offered by the Pacific Coast Stock Exchange, system design and implementation have progressed to the extent that we currently plan to implement a pilot operation in the New York area in November of this year. Physical premises have been readied, a computer installed, software design and planning completed, and operational and administrative personnel have been hired. Eleven large firms, both over-the-counter market makers and large integrated exchange members, doing a cross section of securities transactions, have volunteered to process their over-the-counter transactions on a pilot basis using the continuous net system. Numerous others have volunteered to enter the pilot phase and will be added as we progress.

Presenly, there is no national system for clearing over-the-counter securities transactions although some are presently cleared through organized clearing facilities. The Pacific Coast Stock Exchange clears over-the-counter transactions for its members using a continuous net system. For the most part, dealers throughout the nation, with the exception of New York, clear in a variety of fashions, including the use of the mails, banks, and private and public carriers. The result is a lack of uniformity both in manner, form and substance. The over-the-counter clearing problem is further complicated and enlarged because of the diverse nature and locations of the issuing companies, with many acting under varied transfer requirements and circumstances.

In New York many over-the-counter securities transactions are processed through the daily balance order system (referred to hereafter as DBÓ), which consists of netting the trades of all members of the clearing facility on a daily basis, with instructions issued daily to firms to deliver net amounts of securities to other clearing members in order to satisfy the net results of the matching of the orders for the day's business. This system lends itself to operation in a limited geographical area and has been used by the New York and American Stock Exchanges for many years and has been conducted for over-the-counter securities by the National OTC Clearing Corporation since 1962. This corporation was founded at the instigation of the NASD and was merged with the National Clearing Corporation on September 30, 1971. The NOTC clearing operations under the DBO are continuing, data processing being performed by the clearing facility of the American Stock Exchange. We estimate that approximately 30% of all overthe-counter transactions are presently being cleared in this manner in New York. By the end of this year DBO clearing will be accomplished through the physical facilities of NCC. Preparation is being made for conversion of all such transactions to the continuous net settlement system, after satisfactory operation of the pilot project. This conversion in the New York area is planned for February 1972. An important factor reinforcing our determination to elect to implement a continuous net clearance system, as opposed to the continuation of the balance order system or any other which might be devised, was contained in the recommendations of the Rand Corporation, a copy of which we will supply for your records. The Rand Corporation, retained by the New York Stock Exchange, American Stock Exchange and NASD in 1969, to study and make recommendations relating to up-dating and modernizing clearing procedures for the securities

industry. recommended as superior, the continuous net settlement system for securities clearance. Industry savings through reduced bank draft and interest charges, together with operational savings derived from simplifications made available through continuous net settlement, has been estimated, based upon figures supplied by the Rand Corporation, to approximate some $52 million annually.

Under the continuous net settlement system, trades are reported daily to the clearing corporation by all members. All trades remain in the system until settlement activity occurs. This positive control of "failed" transactions is an integral part of the system, and an important feature considering the character and widespread trading and clearing activity in the over-the-counter market, since it can afford the NASD valuable information for regulatory purposes. Each clearing member carries only one open position for each security, netted down on a daily basis to give effect to offsetting trades and receipts and deliveries. Experience shows that the netting effect of runs about 60 percent as compared to the netting achieved through the DBO system, which runs about 25-30 percent, or a 100 percent increase. This is a savings in time and effort, and a firstlevel contributor to the immobilization of the certificate. Daily, money amounts whether owing or due to it from the clearing corporations are calculated by NCC. On each day every clearing member receives one statement setting forth its total position in all securities and related money balances for settlement. In the event it or any other member fails to complete transactions called for by the statement there is automatically charged against his account the difference in any change in the market price of the security resulting from market fluctuation. In this manner, on a continuous daily basis, the system accounts for market risk. No such controls are found in other kinds of systems now in existence. All money settlements, receipts and deliveries are made directly with the clearing center, rather than between the myriad number of brokers which may have executed transactions with each other. Savings will result because of this feature as well as because of the production by the system of one daily statement. The convenience is obvious, as is the simplification of accounting, cashiering and related operational functions. In addition, this system incorporates provisions for dividend collection and payment and provides for transfer of securities, upon members' instructions.

Although our plans call for implementation of clearing initially in New York commencing in February, 1972, we are planning also to implement clearing for firms not located in New York but trading with New York firms, as well as in other geographic areas, in the fall of 1972. A pilot operation with the Pacific Coast Stock Exchange is now in existence for West Coast firms dealing with New York firms and significant cost savings and economies have resulted. Obviously, as time permits, the national system will be developed to include all areas of the country. Installation of one national system for clearing over-the-counter transactions will not only assure servicing the entire membership of the NASD, but also will be the most logical way to optimize cost savings to help further better industry self-regulation. Important to note, charges to members for NCC's clearing services will be based upon costs incurred in the operation of clearing facilities.

The necessity for NCC to interface with the depository system being evolved by BASIC is well understood. It is our opinion that the solution to this interface is largely mechanical and therefore possible, since all concerned are desirous of effecting the interfacing of the NCC clearing facility with the BASIC comprehensive depository. Because of the scope of the continuous net settlement system, depository record-keeping need be concerned essentially with the debiting and crediting of securities positions and the maintenance of securities position records and the control thereof. Since the continuous net settlement method includes full accountability over open securities positions, deliveries, and money settlement for all cleared transactions, it is of no direct consequence whether a nationwide depository takes the form of a "transfer agent depository," or an expanded version of the Central Certificate Service.

The NASD and BASIC both believe that the depository, linked to clearing systems-even as those systems vary-will be the platform for the emergence of total systems uniformity.

Recently released volume figures for securities traded through the NASDAQ system indicates that over 6 million shares are traded per day, exclusive of trading in securities not in NASDAQ. This share volume on most days exceeds

the combined total volume of all stock exchanges in the country with the exception of the New York Stock Exchange, whose share volume tends to run twice that of NASDAQ. NASDAQ, an acronym for National Association of Securities Dealers Automated Quotations, is a nationwide system for disseminating quotations for over-the-counter securities by all market makers regulated by the system under NASD rules. Currently, some 2800 securities are included. Instantaneous quotes are obtainable nationwide through this facility which is operated under contract with NASD by Bunker-Ramo Corporation. We have and are continuing to study methods by which NASDAQ can be used as an interface with NCC so that actual transactions may be uniformly reported, compared and cleared. Currently trade executions by dealers throughout the country are recorded in their books and are not centralized in one location except as they are reported to a clearing organization. Confirmations for many over-thecounter transactions are not timely made. For transactions not cleared through organized facilities, several days often are required. Through the interface of NASDAQ and NCC transactions can be reported and compared at one central location and be transmitted directly for clearing processing. The resulting benefits, both regulatory as well as operational for the firms involved, will be enormous. Firm dates have not as yet been established; however, this project is proceeding on a priority basis. We look to a 1973-74 time frame for the accomplishment of this "locked in" type of reporting feature.

The Securities and Exchange Commission under the 1934 Act, now regulates the activities and functions of both NASD and NCC. Rules for operating the NCC's continuous net settlement system have been approved by NCC and NASD's Board of Governors. They have been developed with the advice, guidance and cooperation of all segments of the securities industry and with the cooperation of the staff of the Securities and Exchange Commission. They provide for mandatory clearing of qualified securities by those members qualified under the rules. This is necessary in order to achieve systems operational efficiency. The rules will become operational when they have been reviewed by and not disapproved by the Securities and Exchange Commission. A copy of the rules will be provided for your records.

We appreciate this opportunity to appear on the panel.

Mr. Moss. Mr. Kaestner, of the Manufacturers Hanover Trust Company.

STATEMENT OF FRANK W. KAESTNER, SENIOR VICE PRESIDENT, MANUFACTURERS HANOVER TRUST COMPANY

Mr. KAESTNER. Mr. Chairman, members of the subcommittee, my name is Frank W. Kaestner, and I am chairman of the Corporate Trust Activities Committee of the Trust Division of the American Bankers Association.

Accompanying and assisting me today are Mr. Joseph Bensler, chairman of the CUSIP, banking advisory group, and Mr. Eugene Tangney, a member of the Corporate Trust Activities Committee.

The American Bankers Association appreciates the opportunity to appear on this panel and to comment on some of the problems of the securities industry and on needed steps to help solve these problems.

As bankers representing the American Bankers Association, we share the belief of a majority of people associated with the industry that the complexity and labor intensiveness of security operations were and still are the crux of the problems confronting the industry today.

These operations are cumbersome. time consuming, and terribly expensive. Unfortunately, the magnitude of the paperwork problem is entirely dependent upon the completely unpredictable swings in the trading volume.

We agree completely that the depository concept, regional transfer agent or otherwise, for the purpose of immobilizing the stock certificate is a major step in the right direction toward the ultimate goal, elimination of the stock certificate itself.

What has been accomplished to date in this respect has been significantly constructive. What is yet to be accomplished when the banking community and other financial institutions are permitted. to participate on a full depository basis, will be even more meaningful.

The paperwork problem is much broader than the issue of what to do with the stock certificate. Whether we have a "certificateless" society or not, we are still going to have a paperwork problem of no small magnitude.

It is for this reason we feel much more should be done to standardize the various documents associated with securities transactions.

Furthermore, we would hope that the industry would look at the punchcard machine-readable certificate as a backup for a full depository system and support the change if it appears that the depositories cannot absorb certificates faster than volume is creating

them.

The ABA has devoted a great deal of time and energy to help solve some of the paperwork problems. We stand ready to cooperate with other elements of the securities industry in efforts directed to resolving these problems.

Thank you, Mr. Chairman.

(The prepared statement follows:)

STATEMENT BY FRANK W. KAESTNER ON BEHALF OF THE AMERICAN
BANKERS ASSOCIATION

Mr. Chairman, members of the Subcommittee, my name is Frank W. Kaestner, Senior Vice President, Manufacturers Hanover Trust Company and Chairman of the Corporate Trust Activities Committee of the Trust Division of The American Bankers Association. Accompanying me today are Joseph Bensler, Vice President, First National City Bank, Chairman of the CUSIP Banking Advisory Group and Eugene M. Tangney, Senior Vice President of the First National Bank of Boston. The Association appreciates the opportunity to join with the other witnesses in commenting on some of the problems of the securities industry and on needed steps to help solve these problems.

Trust Departments of insured banks administer over 1 million individual fiduciary accounts almost all of which contain assets in the form of securities. Many Trust Departments serve as transfer agent and/or registrar for some of our nation's largest corporations. Also billions of dollars worth of securities are pledged as collateral for bank loans. So banking is vitally concerned for the future of securities markets and the securities industry.

Banking has modernized its handling of an ever increasing volume of checks and believes that similar action is necessary to handle the paper work involved in stock transfers. Banking recognized the need for change a decade ago and in 1962 the New York Clearing House Association established a Securities Procedure Committee to study the problem. In 1964, The American Bankers Association, after discussion with the New York Clearing House Association, established the Committee on Uniform Security Indentification Procedures. The Committee better known by the acronym CUSIP was charged with the responsibility of developing a uniform security identification system. The Committee met this charge. and in 1968 The American Bankers Association contracted with Standard Statistics Company, Inc. to implement the CUSIP system. This is the current Directory and it contains CUSIP numbers for approximately 1,000,000 issues. The CUSIP number identification system forms the basis for all future standardization in the securities field.

The CUSIP Committee also developed a standard description system to expedite further the handling of securities and accompanying documents. The Committee recognized the need for a technical group to develop plans for the various pieces of paper themselves, so it established the Securities Imprinting and Processing Task Force (SIP).

This task force included representatives from all sectors of the securities industry including government regulators. The task force for two and a half years studied the stock certificate and accompanying documents. In June of 1969, it published an interim report in which it recommended that the present stock certificate be replaced by a man-machine readable card certificate. The recommended certificate could be processed both by punch card equipment and OCR equipment. It urged that preliminary steps be taken immediately to implement its recommendation.

Subsequently, the New York Clearing House Association, the exchanges and National Association of Securities Dealers established the Banking and Securities Industry Committee (BASIC) to develop plans to solve the paper work problems. As a consequence, the SIP task force decided to publish a final report and to become inactive. In its final report, SIP re-emphasized its support of a man-machine readable card certificate. It proposed and recommended a Standard Man-Machine Processable Transfer Instruction Form, Batch Control Ticket, Broker Comparison Form, and Security Transaction Record. It also recommended the development of a Financial Industry Number System (FINS).

The New York Stock Exchange and BASIC have announced that the CUSIP numbering system will become mandatory on April 1, 1972.

With this as background let me summarize for you our general thoughts on the direction efforts to improve securities processing should take. I'll be talking about securities processing in the broadcast of terms including transfer and custodial activities of banks and brokerage firms. I would first like to describe to you, our understanding of the fundamental problems we are facing and then spend a moment discussing what we see as the ideal solution and then finish with a description of how we believe this solution must evolve over time.

Our observations of the securities industry and our experience in attempting to assist in resolving some of these problems lead us to the conclusion that there are four unique characteristics of this business that make it particularly prone to the difficulties incurred during the much publicized paper work crunch. The most fundamental of these characteristics is the labor-intensiveness of operations. Like most service industries, securities processing has historically turned to the labor market to handle increased volume as opposed to machine processing. In the past this solution was highly desirable to the brokerage industry because it allowed it to keep costs a constant percentage of revenue and thus ensure a reasonable profit margin. This labor-intensiveness, in effect, set the scene for the variety of problems faced by the industry in the last several years.

A second characteristic of the business is the sheer complexity of the processing steps required. One consultant who recently reviewed securities processing systems pointed out that there are over 100 tasks that have to be completed in carrying out a security transaction. The special terminology used by the industry— such as, DK's, RECS, Window Tickets and Fanfolds further increase the complexity. Some of this complexity developed because of the legal foundations of securities and some because of a desire to be completely flexible in meeting issuer and customer needs. We are not suggesting that this complexity is unnecessary but are simply pointing out that each additional processing requirement makes it that much more difficult to bring in untrained people and get them up to full productivity in a short period of time.

A third characteristic is the high dollar value of the paper being processed. It is not unusual for a major bank to process a billion dollars worth of securities every day. No organization can accept this kind of liability without building in a comprehensive set of controls and audits. In fact, some banks have estimated that one-half of the cost of each transaction is spent on controls of one form or another. This exposure and the attendant controls place a further restriction on the availability of labor and the speed at which personnel can be hired, trained and put into sensitive positions. For example, most banks require several years of experience with the bank before a person becomes eligible to work in the vault. This means that a bank should be forecasting its vault labor requirements three or more years in advance if it hopes to meet increases in volume without loss of control.