Pushing buttons

A securities salesman sitting at his desk can press buttons on a small desk-top computer terminal and see displayed on a screen a median bid and asked price for any of several thousand over-the-counter securities. If his customer is interested, the salesman can have one of his firm's traders press buttons on a larger computer unit that will display all bid and asked prices of all market makers for that security, so that the trader can know which is offering the best price and call him to execute the order.

Until recently, the exchanges directed their opposition at NASD plans to include listed stock quotes in NASDAQ. They feel it aids the so-called "third market"-off-board trading by non-exchange members in listed stocks-thus "fragmenting" the exchange market to the detriment of buyers and sellers. They also argue that, since the third market isn't as tightly regulated as the exchanges, any such enhancement of that market will dilute overall securities industry regulation. The exchanges, by taking their fight to the SEC late last year, initially blocked inclusion of listed stocks. But the NASD, faced with the threat of a lawsuit from a third-market firm, decided in March to include 33 listed stocks on an experimental basis. That move prompted another exchange plea to the SEC. ". . . The concept of including listed securities in an over-the-counter quotation system is one which is inimical to the interests of public investors and the concept of a central market," Big Board President Robert W. Haack charged in a letter to the commission.

Despite the move, the NASD voted last month to expand the experiment to cover all listed equity securities that have at least two makers and that meet certain other qualifications of price and size. NASD officials estimate that some 100 listed stocks will be tested, after which the NASD will decide whether to include such securities permanently.

Price competition highlighted

One effect of NASDAQ is that it highlights price competition among over-thecounter market makers in a particular listed stock, and between those market makers and the exchanges' specialist in that security. A major beneficiary is the investor who, because the market maker quotes are instantly obtainable on NASDAQ, can feel more confident that his broker has checked all markets and obtained the best price.

What's really worrying the exchanges is NASDAQ's future potential. While it's now only a quotation system, NASDAQ has the built-in capacity to execute trades. The computer terminals could be equipped so that orders could be entered instantaneously by push button, rather than by time-consuming phone calls.

If this potential were utilized, NASDAQ could become a self-contained system capable of handling all aspects of securities transactions, from the customer's inquiry through order placement and execution to clearance, settlement and transfer. And if such an integrated system included listed securities, it would make the exchanges obsolete, some experts say, because NASDAQ would be quicker, more efficient and less costly than the manual system currently offered in the exchange market.

There's little question the exchanges are responding to such a threat. Although both exchanges have had long-standing automation plans, both have recently announced pilot projects that would automate the execution of certain smaller stock transactions on their trading floors. For the American exchange, this represents a complete reorientation of its automation program. "The exchange would be negligent," argues Richard Burdge, executive vice president of the American exchange, "if it saw a system where you push a button and get an execution, then didn't do anything about it. We definitely think we have further opportunities in this area."

One area of agreement

The clearing area, while having less public exposure, is no less important to the public, say both sides in a rare example of agreement. But each faction claims that its respective method for reducing physical handling of securities would exceed the other in saving money for brokers. The result, it's claimed, would be that eventually these savings could be passed on to investors in the form of lower brokerage commissions.

In the stock-clearing process, transactions among brokers are "netted out" so that a broker need deliver to other brokers only the excess securities he has sold or only the excess amount of cash he owes for securities he has bought. Roughly two-thirds of the over-the-counter transactions in the country still are done outside clearing houses. The NASD presently operates a New York clearing

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facility acquired last year from a privately held concern for transactions solely involving New York brokers.

Transactions done outside this clearing house must be settled by mail, a timeconsuming and cumbersome process that materially contributed to the back-office mess of the late 1960s. Despite resistance by the two major exchanges, the NASD says it plans to take a major initial step toward a national clearing network by starting a pilot project on Dec. 1 that would revamp its New York operation using a controversial technique that hasn't been tried before in the nation's financial capital.

The NASD's projected national hookup is founded on the so-called "net-bynet" system, which requires that brokers settle their trades with the clearing house itself. This contrasts with the "daily balance order" system used by the exchanges and the NASD's New York unit, whereby the clearing house merely acts as a conduit for passing securities and cash among brokers.

According to David H. Morgan, head of the NASD's National Clearing Corp. subsidiary, the chief advantages of the net-by-net system are that it reduces delivery failures among brokers, cuts down physical movements of securities by some 60% compared to 30% under the other method and generally simplifies brokers' bookkeeping because a broker has to settle trades only with the clearing house and not with dozens of other brokers. Annual savings over present methods would be at least $50 million, Mr. Morgan estimates.

Two recent failures

In recent months, the NASD has unsuccessfully tried to open clearing outposts for its national system on the West Coast and in Chicago. Talks with the Pacific Coast Stock Exchange for a joint use of facilities fell through because of a number of procedural questions, while a joint program with the Midwest Stock Exchange ran into programming problems and had to be scrapped.

The embarrassing result for the NASD is that today the association isn't much closer toward creation of a national clearing network than it was more than three years ago, when it first began work on the project.

Despite those setbacks, the NASD is pushing ahead with the conversion of its New York operation to the net-by-net system. Participating at the outset will be 11 firms, including Merrill Lynch, Pierce, Fenner & Smith Inc., the nation's largest. The 11 houses will use a parallel system, employing net-by-net to clear trades with one another while still maintaining the daily balance order method to clear trades with the same 250 other firms in the clearing operation.

Plans call for the project to be expanded to include the entire New York operation by the end of next year, says Mr. Morgan.

Beyond being a monumental black eye for the NASD as a self-regulatory organization, failure in this venture could. in the view of industry sources. trigger the SEC and Congress to seek greater federal regulation of the securities markets. And the fallout from such a federal outburst, it's suggested, might very well affect the exchanges as well as the over-the-counter market.

To some in the exchange community, the NASD's moves therefore are an attempt to push a self-interest position that could explode to the detriment of the entire securities industry. But the NASD, its partisans say, is solidly convinced of is technical prowess in the NASDAQ and stock-clearing areas and belieres that these programs will offer real advantages to investors, brokers and corporations whose stock is publicly traded.

Bitter opposition

The NASD's plans have also evoked bitter opposition from the Big Board and Amex, who are attacking on three fronts.

First, they are asserting that because about 70% of the NASD's clearing-house members are also members of the exchanges' clearing facilities, a switch to the net-by-net system would unnecessarily create duplicate costs and programs for those overlapping members.

"What worries me and some of the members." says Richard B. Howland, the Big Board's executive vice president and head of its Stock Clearing Corp. subsidiary, "is that we have the possibility arising of an economic waste. The NASD has spent a lot of money in New York to get net-by-net going. But it duplicates existing facilities."

Secondly, the two exchanges are charging that the net-by-net system has certain structural deficiencies, is more expensive for brokers than the daily balance order method and never has been tested under high-volume conditions such as exist in New York,

For example, the Big Board's Mr. Howland estimates that it would cost Big Board member firms a total of $3.5 million annually more in processing charges paid to the clearinghouse to switch to a net-by-net system. The NASD's Mr. Morgan concedes this may be true, but says the net-by-net method will allow brokers to realize other savings elsewhere.

National depository

Finally, the exchanges assert that the work they have been doing the past three years to cut down certificate movements and paperwork shortly will make any sort of clearing system obsolete for most if not all brokerage houses.

Essentially, the objective here is to end almost all stock-certificate movement through use of a national depository sponsored by all stock exchanges, the NASD and such large institutional investors as banks and mutual funds. Under this concept, brokers and investors place stock in the depository, and change of ownership after a trade occurs is made by computerized bookkeeping entry.

The NASD has endorsed this concept and has pledged to participate in it. But only after it has built a national clearing system that eventually would be hooked into the depository in an as yet undefined way.

Meantime, the Big Board has expanded its central certificate service depository to include not only most Big Board issues but almost all American exchange stocks held by members. Moreover, it already has taken in about 115 over-thecounter stocks and plans to add about 900 more. It also plans to offer associate memberships in the depository to some 40 large over-the-counter firms, which would deposit large amounts of their stock too.

And last month it was announced that the depository would one day be spun off by the Big Board and turned over to the joint management of the two major exchanges, the NASD and 11 major New York City commercial banks, which also would become depositors. The participants said such a move could point the way to a national depository system.

Both the Big Board's Mr. Howland Paul Kolton, Amex president, assert that in the face of these developments, the NASD's clearing role has been overtaken by events and that the association has only a relatively minor role to play in future programs.

Mr. Kolton contends that the NASD should drop its plans to change its New York operation. "It's a tough management decision," he says. "But do you know what a pro does? He cuts his losses. We've scrapped programs in the past. They should scrape this one."

However, the exchange officials say they are concerned about two recent alternative proposals, both of which would effectively remove the exchanges and other New York institutions as the dominant forces in a national depository.

The first, a legislative proposal by Senator William V. Roth, Jr., Republican of Delaware, would create an independently owned and funded depository. It's known that the SEC is intensely interested in this proposal.

The other was suggested in testimony before the Senate's banking subcommittee by a Big Board broker, Junius W. Peake, operations partner of Shields & Co., who is regarded as a back-office expert along Wall Street. Mr. Peake recommended a quasi-governmental organization that would supervise all operations facets of the entire industry.

Mr. PAINTER. Mr. Morgan, I would like to address this question to you. You state on page 6 of your statement that the National Clearing Corporation plans to implement a pilot operation in the New York area next month.

Your move into New York has apparently not been welcomed by either the New York or American Stock Exchanges.

In another article appearing in the July 13, 1971, edition of the Wall Street Journal, entitled, "NASD's Plan to Expand Clearing Facility Assailed by New York, American Boards," it was reported that the New York Stock Exchange has told you in effect, and I hope this is accurate, to stop poaching on their territory. The National Clearing Corporation appears to be a good first step to a national uniform system of clearing, settlement, and so forth, and I do not understand the basis of the New York Stock Exchange's opposition.

First of all, would you care to shed any light on this matter, Mr. Morgan, and I am sure that Mr. Howland will have some comments to make on this.

Mr. MORGAN. Mr. Painter, I would like to make one observation, which is that I had tended personally to discount to some degree the article that was in the Wall Street Journal, especially after having read Mr. Howland's testimony which was submitted to this group, which did not make reference to such things.

It appeared, and I am sure Dick can amplify on this from his point, that certainly in terms of the presented testimony, there appears to be no objection or growing confrontation between the two.

Mr. PAINTER. Mr. Morgan, may I ask you to supply for the record a letter which Mr. Robert Haack wrote to Mr. Gordon Macklin, dated July 8, 1971?

Mr. MORGAN. I will do so.

Mr. Moss. Without objection, the record will be held at this point to receive the letter.

(The letter referred to follows:)

Mr. GORDON S. MACKLIN, Jr..

NEW YORK STOCK EXCHANGE, INC.,

New York, July 8, 1971.

President, National Association of Securities Dealers, Inc.,
Washington, D.C.

DEAR GORDON: After our recent meeting I wanted to send on to you some of our thoughts on the forthcoming introduction of a Continuous Net Settlement System in New York.

The problems of clearance in the over-the-counter market have troubled this industry for many years. Fails of over-the-counter securities have been the most aggrevated sector of this problem for as long as we have statistics. The Ad Hoc Committee on Office Operations has considered the problem of OTC clearance and has urged members of this Exchange and others to participate in the NOTC clearance. This Exchange has now adopted a rule which requires that its members participate in the present NOTC clearing operation.

We have tried through a number of vehicles in the past three years to create uniform practices in the industry. We feel this is constructive-the lack of uniformity in rules, forms, and procedures between the brokers, and between brokers and the banks, has been unnecessarily troublesome. You have been working with us on the Joint Industry Project, through the Ad Hoc Committee and through BASIC.

With a focus on uniformity, we want to make some constructive comments on your forthcoming clearance system and the rules which have been designed to implement it.

Approximately 35 percent of the naton's OTC trading is cleared by the NOTC Clearing Corporation. NOTC operates on the Daily Balance Order (DBO) system using AMEX facilities and staff to process its business. The DBO system is also used by the New York and American Stock Exchanges and thus represents a standard clearance system for the New York brokerage community. Quoting from the National Clearing Corporation's (NCC) Survey of OTC Trading Volume: -66.5% of OTC trading occurs in the eastern quadrant of the country; ---57.5% of OTC trading emanates from New York City:

-Approximately 42% of OTC trading involves New York City brokers on both

sides.

With 35 percent of the nation's OTC business cleared by the NOTC, and the vast majority of all listed business cleared by the New York and American Exchanges, upwards of 75 percent of all security transactions can be estimated to be compared and settled through existing clearing facilities in New York City. Member firms are staffed to clear and settle their listed and NOTC volume. using essentially the same processing system. The present NYSE, AMEX and NOTC clearing systems are all based on a daily balance order concept and thus represent a standard clearance system for the New York brokerage community.

The development of a different system will move in a contrary direction, ignoring the need for conformity in operating systems and procedures. This need has been stressed by the North American Rockwell, Ernst & Ernst, Lybrand studies and by knowledgeable operations experts throughout the industry.

Your plan as it relates to New York City clearing facilities appears to conflict with the industry objective of consolidating Exchange service operations, establishing a single clearing entity in New York and obtaining the efficiencies of scale inherent in computer operations. As recent outgrowths of this trend, the Exchanges recently agreed to consolidate their direct clearing operations, studies looking to consolidating the clearing corporations have progressed and the Exchanges and the ASEF have agreed to pursue a single unified approach in obtaining bulk communications facilities. The NASD plan on the other hand, would increase the number of separate facilities and systems.

A paradox growing out of your current plans is that substantial financial resources are being allocated to the eastern section of the country, which presently contains sophisticated OTC clearing facilities, whereas the essential OTC problem lies in the lack of clearing facilities in other parts of the country. The New York OTC problem was essentially solved when the Exchanges required that NOTC membership become mandatory. The out-of-town problem, however, remains since there is no way to capture trades by distant market-makers in the absence of out-of-town clearing facilities. Out-of-town trades equal about one-third of member firm OTC volume and the proposed system is not addressed to this.

From the member firm point of view, the key features of the net-by-net system will require separate departments, controls and computer programs of considerable magnitude depending upon their mix of business. Further fragmentation of the "back office" will, therefore, result when the objective should be to standardize and consolidate systems. Member firms will find it necessary to conduct extensive employee training and other systems development and start-up chores at a time when "back office" capacity is again a challenging issue. Start-up and development costs for getting your proposed system on line are simply duplicative of present budgets and facilities. While this consideration should not alone inhibit the introduction of improvements, it s a concern to be weighed in the present New York climate.

Thus far I have been really saying again the things that you and I have already discussed about the idea of creating a new and duplicate facility here in New York. You have also circulated and asked for comments on the operating rules of the National Clearing Corporation. Most of these are involved substantially with internal operations or the relation of NCC with its clearing member. However, there are some of these rules which touch our clearing members and about which we would like to comment.

NCC Rule 1 defines a block trade as "a transaction reported to a clearing center involving the same cleared security at the same market price in which the aggregate value, at contract price, of the securities traded is $250,000 or more with optional recognition as a block trade for transactions of over $75,000." NCC Rule 13 provides that block trades shall be cleared and settled on a tradefor-trade basis and will not be cleared through the Continuous Net Settlement System. NCC Rules 6(h) states that "the Clearing Fund shall not be used for any liabilities or losses incurred by the Clearing Members for trades cleared as block trades as provided in Rule 13." In the case of the failure of a broker who is the opposite side of a block trade in over-the-counter securites, the solvent broker has no recourse to the NCC Clearing Fund and is, therefore, placed in the unenviable position of having to close out a block trade in an over-the-counter security.

The inability of the NCC Clearing Fund to back these trades seems to impair the utility of the proposed facility for large transactions at a time when large transactions are becoming more a part of the market. Such a procedure in practice will require member firms to create still additional procedures for handling large trades in NCC eligible issues but which cannot be treated as regular clearance of NCC eligible issues.

NCC Rule 5(a) requires clearing members of the NCC to "report, clear and settle through the Clearing Corporation directly every contract and transaction to which it may be a party and which the rules of the Clearing Corporation may require to be reported, cleared and settled through the Clearing Corporation with only such exceptions as may be previously agreed to by the Clearing Corpora