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we feel that at the present stage of development, what is really needed, and what should be considered as the first order of business, in order to provide a lasting solution to the operations problems of the securities industry, is to establish a mechanism for guiding and implementing new systems in a coordinated and efficient manner.
This function of coordinating and directing system improvements is partially accomplished for the banking system by the Federal Reserve. Perhaps as an alternative in this case the Securities and Exchange Commission should be designated as the responsible agency for instigating and regulating changes in the security clearance and settlement process.
We would recommend the following program: Establishment of a new agency or commission to succeed the present BASIC committee. This new agency should be a national organization, with a permanent staff, to guide and, if necessary, direct development of improved customer transaction systems for the financial industry.
The new organization should be self-sustaining and should have a source of financing, perhaps by means of a minimum charge levied on all security transactions.
The benefits to the investor of the charge, which is somewhat analagous to the highway use tax, would be better, more reliable security processing systems.
The new organization should set uniform standards for information exchange regardless of systems used or physical characteristics of the media of communication. And these standards should include as a minimum: a security numbering system, financial institution numbering system, and customer identification system.
A major responsibility of this new agency or commission should be to decide on the quickest, most effective route to automation of the security trading and settlement process. In order to accomplish this, the new commission should be directed to consider all of the related interests of stock trading and settlement which includes shareholders, issuing corporation, transfer agents, registrars, the over-the-counter brokers, regional brokers, New York brokers, various clearinghouses, as well as NASD and regional and New York Stock Exchanges.
Having considered all of these interrelated groups, the agency or commission should then recommend appropriate changes to the present system. The Commission should supervise the implementation and subsequent operation of these new and improved systems.
This proposed commission should not actually operate the new system. Their roles should be limited to defining the operations and clearing problems of the industry, preparing a comprehensive program to resolve these problems within a time schedule compatible with expected growth of the industry, setting standards for information exchange, supervising adoption of the new standards and procedures and installation of new systems, monitoring continuing operation of the industry's trading and clearing system.
We recognize this subcommittee is already working to achieve some of these same objectives. Any investigation which sheds further light on the magnitude of the problem, and details that cause it is useful and will provide foundation for future work in this complicated area. We are concerned, though, that at the point when this committee begins to draft legislation, the approach chosen be broad enough to allow for the sort of detailed systems analysis which is still required and the legislation be flexible enough to accommodate and support whatever improvements and new systems are needed. Legislation which would create the commission we describe above would provide needed freedom of action together with strong mandate to move the financial industry to install improved and integrated systems.
We would not want the committee to support a bill which would create a national clearing system or national depository. In our view, the evidence is not at all conclusive that this particular approach would provide the answer to the financial industry operations problem.
Thank you, Mr. Chairman, for the opportunity to present our views on this subject. If you have no objection, I would defer reading the rest of the testimony and be glad to answer any questions that may come up. Mr. Moss. Thank you very much. (The prepared statement submitted by Mr. Weinberg follows:)
PRESENTATION BEFORE THE SUBCOMMITTEE ON COMMERCE AND FINANCE OF THE
COMMITTEE ON INTERSTATE AND FOREIGN COMMERCE OCTOBER 26, 1971, BY ELI WEINBERG, PARTNER, LYBRAND, Ross Bros. & MONTGOMERY
When addressing ourselves to the question of the feasibility of developing a fully automated system for stock transactions as outlined in the Subcommittee letter of 9–27–71, it appears that a positive assumption has been made concern. ing the desirability of a particular automated system. It seems to us, that it may be premature, in trying to help solve the problems in securities operations, to decide on a particular system at this time.
What is needed, and what should be considered as the first order of business to provide a lasting solution for the operations problems of the securities industry, is to establish a mechanism for guiding and implementing new systems in a coordinated and efficient manner. This function is partially accomplished for the banking system by the Federal Reserve. As one alternative, the SEC could be designated as the responsible agency for instigating and regulating changes in the securities clearance and settlement process.
We at Lybrand would like to recommend the following program:
Establish a new agency to succeed the present BASIC Committee. This new agency should represent an expansion of the present BASIC Committee in terms of membership, scope and objectives. This should be a national organization, with a permanent staff to guide and if necessary direct the development of improved customer transaction systems for the financial industry. This organization should have a source of financing, preferably by means of a minimal charge levied on all security transactions. The benefit of the charge, much like the highway use tax, will be better, more reliable security processing systems.
This new organization should set uniform standards for information interchange regardless of system used or physical characteristics of the media of communication. These should include:
(a) security numbering system (CUSIP)
(c) customer numbering (Taxpayer I.D.) A major responsibility of this new agency will be to decide on the quickest and most effective route to automation of the security trading and settlement process. In order to accomplish this, the new agency or commission should be directed to consider the interests of all the related elements of a Stock Trading and Settlement System. These interests include:
NASD, and Regional and N.Y. exchanges Having considered all of these interlated groups, the agency or Commission should then recommend appropriate changes to the present system. The Commission should then supervise the implementation and subsequent operation of these new and improved systems. This proposed Commission should actually operate the proposed system. Their role should be limited to:
1. Defining the operations and clearing problems of the industry. 2. Preparing a comprehensive program to resolve these problems within a time schedule that is compatible with the expected volume growth of the industry.
3. Setting standards for information exchange between different systems and different companies. These standards should include coding and identification numbers, file formats and uniform methods of processing similar transactions.
4. Supervising the adoption of the new standards and procedures, and the installation of new systems.
5. Monitoring the continuing operation of the industry's trading and clearing system.
We recognize that this Committee is already working to achieve some of these same objectives. An investigation which sheds further light on the magnitude of the problem, and the details which cause it, is useful and will provide a foundation for future work in this complicated area. We are concerned though, that at the point when this committee begins to draft legislation, that the approach chosen be broad enough to allow for the sort of detailed systems analysis which is still required, and flexible enough to accommodate and support whatever improvements and new systems are required.
Legislation which would create the Commission we described above would provide the needed freedom of action together with a strong mandate to move the industry to install improved, integrated systems.
We would not want the Committee to support a bill which would create a national clearing system, or a national depository. In our view the evidence is not at all conclusive that this particular approach would provide the answer to the financial industry's operations problems.
A specific area that we believe this Committee can make significant and posi. tire changes involves the stock certificates themselves.
The single system change which could have a major impact upon the problems of the industry would be to achieve the transfer and registration of stock certificate via book entry system. This can most effectively be done by enacting Federal legislation to minimize or eliminate the role of the stock certificate. This conclusion is based on the results of the Lybrand Study on the role of the stock certificate which was issued in December, 1969. Since that time, we have sponsored sereral seminars to explore the impact of eliminating stock certificates on the banking industry, the legal profession, and on financial communities outside of New York, specifically Boston.
The result of this work is reflected in our most recent article, in the May 1971 issue of Bank Administration magazine. The article describes the proposed certificateless system which I refer to.
I would like to restate briefly the reasons why my firm, Lybrand, Ross Bros. & Montgomery, has come to the conclusion that the stock certificate should be eliminated
The securities industry is by its nature cyclical, and only by eliminating the stock certificate from the stock trading operation can there be assurance of a system adequate to meet the extreme volume fluctuations of the industry. It is a result of the inelastic nature of present manual operations, that as volume of trading, and especially the number of transactions, increases rapidly, the number of incomplete transactions, fails, and errors, rises. The increase in fails and errors and the resulting inefficiencies has a direct impact on the flow of funds of brokerage firms, on the number of clerical people required and on the total costs of executing a trade.
In our view, present systems are incapable of processing the transaction volumes which have been projected for the next five to ten years. Unless dramatic steps towards improvements are taken, we can only anticipate a recurrence of the problems of 1967 and 1968.
Our concern with existing security clearance systems is most acute in the OTC trading area. We believe the N.Y. depository (CCS) has made a great contribution towards improving the clearance of listed business. We believe, however, that the NASDAQ system, with its very successful introduction, may create the seeds for even more severe operations problems.
A survey of OTC trading made by the National Clearing Corporation, indicates that in 1969, the majority of OTC trading was concentrated within local and regional areas. In fact, with the exception of the Eastern region-each of the other three geographic areas did between 85% to 92% of their trading within their own borders. This pattern may become seriously disrupted in the future as NASDAQ encourages broader markets, and wider inter-regional trading activity. This development would seriously complicate the settlement process due to problems of geography, time difference, mail schedules, etc. We are concerned that the present clearance system cannot handle the transaction volume which may develop in the near future. Central Certificate Service
The depository has been a great step forward and has made a notable contribution to the solution of the operations problem. However, past experience shows it too is vulnerable to sharp volume fluctuations, and there are strong indications it will never, even under the best of circumstances, encompass much more than 50% of all security transactions. Elimination of Stock Certificates
As a result of these and other related considerations, Lybrand has come to the conclusion that the most significant, long-term improvement in the security settlement process can come about through the elimination of stock certificates. Furthermore, we believe the present depository concepts will not achieve their stated objectives of elimination of certificate movement.
The development of certificateless systems should not involve any suddenwholesale conversion to a new system. Through the evolution of several compatible programs we can provide ample opportunity for competition among the various trading markets within the framework of a coordinated development program.
The movement to a certificateless system should be done through several routes to encourage rather than discourage existing competition between various types of financial institutions and the different securities markets. Outlines have been developed for certificateless systems which can easily be adopted by regional exchanges, by NASDAQ and by NYSE and AMEX listed companies.
(a) NASDAQ should be required to implement, before completing the extension of their present test phase, a certificateless settlement system to complement their trading system.
(b) The Boston Stock Clearing Corporation and the First National Bank of Boston should be encouraged to implement the certificateless systems which they have proposed.
(c) A select group of companies listed on the NYSE and AMEX should be encouraged to extend their present dividend reinvestment programs (which virtually eliminate certificates) to new issues of shares to stockholders on a contractual basis. The advantage to the corporation is a new and consistent source of relatively inexpensive capital, and to the shareholder, a means of purchasing shares at reduced or perhaps with no service
charge or commission. As these systems develop-on Regional exchanges, OTC, and in the New York area, the advantages of the certificateless system will be tested and further improved, yet because all systems fit the same basic standards for information interchange, they are compatible and can develop and co-exist with each other.
We do not foresee or even encourage the development of a single, overall securities processing system. This is not compatible with the diverse nature of our securities industry. We should more likely end up with a number of input systems-coordinated where necessary with transfer agents but otherwise inde pendent. This would be somewhat similar to the present bank checking account systems. Each bank has its own internal system, but with common input and output requirements where they interface with other banking institutions.
The timetable to develop and implement these systems will vary depending or the degree of support and manpower devoted to the project. After the proposed
agency or Commission has been formed, presumably the Boston area could begin implementing a system within 12 to 18 months. Extensions of existing dividend reinvestment systems to new securities issues could be done on a similar 12 to 18 month timetable. Development of settlement systems for NASDAQ would take longer, perhaps two to three years. Pressure of competition, by prohibiting extension of the NASDAQ testing phase until the settlement system is implemented, will encourage adherence to a minimum time schedule. The major point we would like to convey is that any systems change is major and requires time the objective is to be sure the expenditure is justified terms th benefits to be realized.
The cost to implement these systems can only be guessed at. The principal though, of how these costs should be met, can be established. The transaction charge previously mentioned, perhaps an extension of the present SEC charge on security sales, should cover the cost of central planning and development group. Development of individual systems should be paid for directly by the members of the industry involved. These costs, especially to banks, will be recouped in transfer fees from more profitable operations. It is not necessary for the Federal Government to finance any of these systems changes.
Implementation of certificateless systems such as those proposed would provide for a diversity of industry processes, compatible with our concepts of free competition between capital markets. What would be standardized is the coding systems and formats for information interchange. In this area, legal changes could be helpful to improve the flexibility allowed in format of legal documents. For example, substituting reels of magnetic tape for individual transfer instructions, or delivery instructions.
Elimination of stock certificates, and the related improvement of communications in the settlement process between brokers and transfer agents could conceivably provide for next day settlement of all security trades. Without the need for manual intervention after the trading process there will be fewer problems of manpower shortages and clerical errors as volume increases. Without the need to physically present certificates, problems of mail delivery and physical movement and security thefts will be eliminated.
We estimate that a certificateless system of settlement and its related benefits could reduce payroll costs for clearing brokers by as much as 40-50%. The work of the cage, dividend, proxy, and stock record departments would be virtually eliminated. Margin and customer accounting operations would be simplified. One medium sized firm has estimated their annual expenses would be reduced by 2 million dollars. This amount is equal to half of their pre-tax net income.
Equally important would be the savings to out-of-town brokers if certificates were eliminated. It is conceivable that they no longer would be required to have a New York correspondent, and could thereby reduce clearing costs which now amount to as much as 20–25% of gross commissions. This would be an important competitive advantage for local brokers, outside of New York in competing with the large wire houses and New York based firms.
We believe the elimination of the certificate is vital and inevitable. The question is whether it can be done quickly enough to help the financial community before the next crisis. With prompt action, and strong support from this Committee we believe this goal can be achieved within the very near future.
At this point, we would like to respond to the specific questions outlined in the Committee letter of September 29, 1971.
(a) We believe it is entirely feasible to develop a fully automated stock transaction system. There are a number of examples of systems in other industries which have characteristics similar to that of the proposed automated stock transaction system. In addition, there are important elenients of the proposed system which are in fact already implemented within the securities industry.
Lybrand, for example, has conducted a study for several of its clients to crimpare the relative performance of automated security clearance systems. There are no less than a dozen different such systems available or proposed for is by individual brokerage firms. These security clearance systems control all movement of stock and transactions from the point of agreement of the trade with the other broker to the ultimate settlement with the customer. Examples of these systems include those in use by brokerage firms such as CBWL-Hayden Stone. Goldman Sachs & Co., Smith Barney, and several others. The study, which the Lybrand Data Processing consultants prepared, indicated such a system