IV. A BROKER MODULE FOR THE NYSE

The bookkeeping entry/depository concept is at the heart of the system we are describing. A primary requirement, therefore, is that the set of services offered by the NYSE Broker Module encourage Clearing Members, and the brokers they serve, to maintain as large a fraction of eligible securities as practical within the depository, and that withdrawals and re-entries be minimized. This process can be encouraged through the pricing schedule or by making it mandatory to maintain a fraction of segregated securities within the system. In general, however, the depository concept will succeed or fail on the basis of the quality and completeness of services offered, and the extent to which it permits participants to reduce their operating costs.

A. PRIMARY SERVICES

The services provided by the NYSE Broker Module must be designed to minimize the number of broker-to-broker Fails on settlement date. A series of defenses is available for this purpose. The first defense is the depository itself. A second line of defense is the provision of stock lending services. A third involves the collection of complete Fails information, the proper employment of Fails clearances and, where necessary, a system for Buy-Ins. These and other primary services are described below.

1. Clearing

We are not proposing any significant changes in clearing procedures; these can continue to employ the daily DBO/RBO system. Consideration might be given to automatically submitting the DBO's that result from compared transactions to the settlement run, except in cases where a Clearing Member takes action to stop such transfers — that is, an exception basis could be employed in moving from the DBO allocation run to the settlement operation. This move would lead to more efficient and less expensive operations. However, it should not be undertaken without the understanding and approval of the Membership. Exception reports do not provide the type of protection that positive instructions do and they lead to far more serious consequences if errors of omission occur.

2. Broker-to-Broker Settlement

Broker-to-Broker settlement should be effected entirely by bookkeeping entries, as is currently the practice with CCS. This operation, however, should incorporate a stock lending service and rigorous Fails control as described below.

3. Stock Lending Service

An essentially compulsory form of stock lending service should be provided within the Broker Module. Acceptance of loans for making settlement could be made a specific requirement, or alternatively, a "price" might be attached to being in a Fails position under circumstances where stock could be borrowed and was not. Various forms of lending services are possible, ranging from simple maintenance of records concerning which firms have stock available to lend (and possibly which other firms they are agreeable to loaning it to) through to an essentially automated system. In the interest of combining automated features with encouragement for firms to make securities available for lending, we would suggest that firms be encouraged to: (1) indicate the number of shares they will make available for loans without restriction concerning to whom the loans can be made and (2) use additional, optional, indicators to show when larger amounts are available. These larger amounts, however, would be restricted to loans to specific firms or would be subject to individual broker-to-broker negotiations.

All stock loans developed by the system should be marked-to-themarket to assure complete protection for the lender.

The stock loan system can work on a basis of establishing specific broker-to-broker loans or all loans can be treated as though they were made to and from the Broker Module. In the latter case, however, the Module would still be acting only as an arranger of loans, and the oldest borrower (or borrowers) would consistently represent the opposite side to a lender who wishes his securities returned.

The choice of which of these procedures to employ depends to a large extent on the Fails control mechanisms being employed. If loans are treated as temporary and of brief duration, with automatic Buy-Ins to be made at their expiration dates, the broker-to-broker lending system is adequate, and

is more in the NYSE tradition than an alternative procedure. If, on the other hand, longer-term loans are to be permitted within the system, the bookkeeping employed for maintaining broker-to-broker records can become unduly complex, so an arrangement that places the Broker Module in the middle may be more satisfactory.

To decide which of these various techniques should be employed will require a “market" study. The objective is to establish an effective stock lending system through encouraging participation by brokers with securities available to loan. Accordingly, their interests and preferences should have major influence on the procedures to be employed. In any case, a considerable amount of careful record keeping on the borrowing status of members of the system will be required to support system integrity.

4. Fails Control

The first requirement for effective Fails control is the maintenance of good records. The record keeping must start with the DBO's resulting from compared transactions – any such DBO that does not lead to a settlement transfer should be considered a Fail, unless the Clearing Member involved specifically claims it as a delayed DK. Partial settlements must be recorded, and later transfers to complete these partials must be related to the original DBO's. Stock loans incurred to avoid Fails must be tracked. Finally, cases of "True Fails,” where stock simply cannot be borrowed to fulfill a DBO requirement, must also be recorded.

With information this complete the NYSE will be able to keep rigorous track of the settlement performance and Fails status of its Clearing Members. Overall trends in individual securities, or by individual Clearing Members, can be spotted early so corrective action can be taken where poor performance is detected. In addition, the information necessary for an effective Fails clearance will be available. Fails clearances have not been particularly useful in the past because the input records have not been accurate, and because the process of replacing old contracts with new ones has awkward aspects. While the former deficiency can be cured by maintenance of good records, the latter difficulty will still apply. We do not, therefore, recommend that Fails clearance computer programs be developed at this time. We do urge, however, that the records and file structure for the Fails control system be constructed to permit later rapid development of such programs should they

prove necessary. A possibility of particular interest is the use of Fails clearing for only a limited number of securities that the control records show as being in difficulty; such a process would be far simpler than a full clearing run and might be highly effective in reducing Fails.

The final defense against Fails is a system for Buy-Ins. Unfortunately, use of Buy-Ins can have a disruptive effect on the market, especially when conditions are such that they are necessary despite the defense mechanisms discussed above. As a result, this procedure must be used with caution. However, we believe that current procedures for implementing Buy-Ins, which require one Member to take action against another, are not satisfactory. We consider that the Exchange should be the source of action rather than an individual Member. The procedures should, in this sense, be automatic, although considerable selectivity will be desirable in specifying the conditions under which the automatic rules are brought into effect.

We believe the above set of services should be adequate to eliminate a very large fraction of all Fails that now arise. However, since the Fails level is related to trading activity, high bursts of volume in the future may still cause difficulties. If these occur, the NYSE will have far superior sources of data than in the past for handling such situations and for developing additional defenses, as needed, to keep Fails at an acceptable level.

In connection with the Securities Movement System to effect customer deliveries, the Broker Module will have to process various types of broker authorizations and perform suitable checks of broker cash and securities positions. These are discussed briefly in Section V.

B. OTHER SERVICES

The primary services described above have been largely concerned with reducing the vulnerability of the NYSE system to broker-to-broker Fails. Although this is certainly a vital consideration, a variety of other services will also have to be provided to the Membership. Some of these services are discussed below.

1. Collateral Loans

Various means are available for handling collateral loans. The current CCS approach could be employed, wherein pledged shares are moved to the internal account of the lending bank, which then has the same rights of control over pledged shares as if it had physical possession of such collateral. Alternatively, the Custodian Module, on receipt of appropriate instructions, could segregate shares of securities that are in Broker Module nominee name. These shares would no longer be available for transfer within the system, or out of the system, and the records would indicate the pledgee Clearing Member and the bank making the loan. The bank would again have all the rights normally accruing to a holder of collateral.

2. Dividends, Proxies, etc., Distribution

Dividends, proxies, and other company related information must be distributed, and lists of Clearing Members and their security positions in the system provided to corporations, as is now done with CCS.

3. Record Keeping Services

Basic records should include complete activity reports and frequent position reports. The basic file structure should permit securities to be listed as available for loan (as described earlier) in addition to the current categories which include general and interim pledged and unpledged and investment identification data.

The basic files might also permit securities to be listed as being in segregated status if this is considered to be a desirable service to brokers. However, it should be noted that the NYSE will not be in a position to verify such data as they are entered; at best it can only accept and process the inputs that brokers present. Furthermore, the data input requirements may be very large for the value of the records being maintained. Consequently, we do not believe a firm decision should be made on this question at the present time, but the possibility should be considered during the detailed design process.