I. BACKGROUND AND SUMMARY OF RESULTS Operational Problems of the Securities Industry In 1968, the volume of trading in securities rose to unforeseen and unprece dented levels. This volume in combination with a rising price level created a period of general prosperity for the securities industry. At the same time, however, the high trading volume caused a flood of paperwork that overwhelmed the bookkeeping offices of many brokers, and associated with this problem was the growing number of failures to complete transactions on settlement day. Some informed observers were seriously concerned that the industry could not handle the paperwork anticipated as a result of even higher volumes of trading. Records were often not updated on time, errors were at an all-time high, and customers complained to brokers, the exchanges, and the Securities and Exchange Commission (SEC) that they were not receiving stock certificates promptly or that their account records were not current. These failures to complete transactions on time caused the brokers to incur substantial costs. The Rand Corporation has estimated that these delays in completing stock transactions between brokers and between brokers and their customers in 1968 cost the 386 reporting members of the New York Stock Exchange around $180 million' for interest and clerical expense. For that year their gross profit from agency commissions on listed and over-thecounter stocks was approximately $300 million.2 There were other problems of concern to the securities industry at that time, such as commission rates, institutional membership in the exchanges and the National Association of Securities Dealers, and public offerings of equities in member firms, but the problem of completing transactions seemed most urgent. Therefore, when members of Rand, the American Stock Exchange (AMEX), the National Association of Securities Dealers (NASD), and the New York Stock Exchange (NYSE) 'It must be kept in mind that this cost is based on the share volumes and stock prices current in 1968 in all markets. The various alternatives discussed later in this summary and listed in Table 1. page 12, involve only one market at a time (NYSE or OTC) and share volumes and prices different from those prevailing in 1968. 2 Data on gross profit from security commissions for all firms in 1968 were not available. Data reported in SEC Forms X-17A-10 may provide this information for 1969 when the tabulations are completed. met in early 1969, the discussion centered on what Rand might do to assist the securities industry in handling its trade completion problems. It became clear that while many solutions had been proposed, the analytical capability needed for testing and evaluating them was not available. This deficiency was one of the difficulties that prevented the securities industry from concentrating its efforts on implementing desirable improvements. Providing the Analytical Capability Actual experimentation with a wide variety of system changes is not possible when the activity is as complex in nature as the trade completion process. To deal with this problem, Rand developed a unique computer simulation model and the related cost-estimating procedures that provide the means for experimentation with and analysis of the trade completion system. Therefore, it is now possible to test quickly, economically, and under near laboratory conditions many proposals that had been put forward by the industry, those that Rand developed as part of its study, and those that will be developed in the future. It is important to note that proposed changes in the trade completion system can now be tested without interfering with the actual operations. THE SIMULATION MODEL Mathematical simulation has been used by Rand and the United States Air Force to solve some difficult aircraft maintenance management problems. Simulation models of this type have been used to study and gain insights into many and varied types of economic problems in the leather industry, university operations, routing studies in the transportation field, and airline maintenance and scheduling problems. It is not a new technique, but this is the first time it has been used in a comprehensive way to study the trade completion problem of the securities industry. The Rand simulation model permits design changes in 52 characteristics of the trade completion process, such as stock delivery priorities, stock borrowing and segregating policies, stock clearing processing rules, etc. All the essential processes in the flow of stock certificates related to the settling of trades on any exchange or in the over-the-counter (OTC) market are included and can be varied at will." The major advantages of this model can be summarized as follows: 3 Trade completion is defined to include all people and processes involved in the handling of stock certificates following the purchase or sale of a security. • For a complete description of the model, the computer program, and the supporting data, see R. L. Petruschell, S. J. Benton, D. J. Dreyfuss, L. E. Knollmeyer, J. Y. Lu, and R. E. Stanton, Reducing Costs of Stock Transactions: A Study of Alternative Trade Completion Systems, Vol. III, The Trade Completion Simulation Model, The Rand Corporation, R-552-ST, December 1970. 1. The real system can continue to function without disruption 2. By eliminating processes of the real system that are extrane- 3. A large number and range of changes can be examined quickly 4. In addition, these changes can be studied singly or in a large A description of the tests Rand conducted will provide some insight into the range of changes that can be examined and the relative costs and benefits involved. BROAD OUTLINE OF THE TESTS An essential step in the development of the model was the definition of incomplete transactions, or fails. The term "fails," as used in the industry, is usually limited to broker-to-broker fails. This definition was found to be too narrow for a full study of the problem because consideration of other kinds of incomplete transactions was essential for evaluating how the trade completion system functioned. Therefore, the definition was broadened to include fails between customers (individuals as well as institutions) and brokers and fails by brokers to repay a stock loan on call date. In order to evaluate the effects of changes in trade completion processes on the level of fails and the related costs, it is necessary to have a standard or benchmark case against which to measure differences caused by the changes. Accordingly, a benchmark case was set up to represent the existing system of trading on the NYSE at a volume of about 20 million shares per day and at an average price of $35 per share. The model was used to generate fails for the benchmark case and the cost incurred by brokers due to the fails was calculated. Then a number of alternatives were tested by introducing one or more changes and the costs of the resulting fails combined with the costs of introducing the changes were compared with the benchmark case. In the analysis of alternative clearing systems for over-the-counter stocks, a similar procedure was followed; the cost of the existing system of clearing was compared with the costs of two alternative clearing systems. Results Rand experimented with the simulation model and the related cost-estimating procedure not only to demonstrate the way in which they could be used, but also to show the relative value of a number of system changes. The analyses of these changes identify modifications to the current trade completion system that could result in significant improvements in the industry's performance and in substantial benefit to brokerage firms' net operating income. It is important to note that some of the improvements examined can be implemented only with the cooperation of customers and the banks. Some improvements can be put into effect with minimum structural change in the stock brokers' current arrangements for doing business, or they can be implemented as part of the operating procedures of a certificate depository such as the NYSE Central Certificate Service (CCS) or of a Continuous Net Settlement (CNS) system such as that now being developed by the National Clearing Corporation (NCC). When such changes are incorporated in a depository or a CNS system, additional benefits will be achieved. The test results covered in the discussion to follow show the costs and savings for changes in the trade completion system for only one market at a time—NYSE or OTC. The relative advantages of the various alternatives may be judged by comparing the results for each set of changes with the benchmark case. To provide an additional measure of the benefits achievable by altering existing trade completion processes, a rough estimate was made of the savings that could have been achieved in 1968 by 386 NYSE member firms. These were the firms that dealt with the public and submitted income and expense reports for 1968. As previously stated, their gross profit from security commissions on stocks in all markets was about $300 million and the clerical and interest cost incurred by these firms because of fails of all types was estimated as $180 million. Based on the model results, it is estimated that these firms could have saved almost $100 million by making the improvements specified for the banks' and brokers' minimum structural change case (see page 8 and item 10 in Table 1 on page 12). The changes included in this alternative are (1) taking full advantage of the partial delivery rules, (2) reducing transfer time, and (3) reducing the fail rates for DKs, uncompares, and wrong denominations. These changes alone could have saved an amount of about one-third of the 1968 gross profits of the 386 member firms. THE TEST CASES Benchmark Case The benchmark, or base, case represents the existing system operating under stress-about 20 million shares per day. Under these circumstances, it has been * For a detailed description of these test cases and the supporting cost methods, see R. L. Petruschell, D. J. Dreyfuss, L. E. Knollmeyer, and J. Y. Lu, Reducing Costs of Stock Transactions: A Study of Alternative Trade Completion Systems, Vol. II, Evaluation of Selected Alternatives, The Rand Corporation, R-552-ST, December 1970. ⚫ A DK occurs when stock is presented for delivery and the intended receiver refuses to accept, claiming no knowledge of the transaction. The receiver states, "I don't know the trade." In this study, the term DK was applied only to banks refusing to accept delivery from brokers. estimated that fails of all types in NYSE-listed stocks cost the industry $125 million per year. This comprises $136 million in clerical expense and a net imputed interest benefit of $11 million. For each of the various alternatives examined, the cost of fails after allowing for the cost of introducing the changes was compared with the cost for the benchmark case and the difference represented the savings resulting from the change. The reader should focus on the relative changes in costs and savings for the various cases rather than the absolute value of the estimates. The primary value of these estimates is that they indicate the relative costs and benefits of the system changes. Delivery Priorities When a broker does not have enough stock on hand to make all required deliveries, a decision on delivery priorities must be made. In order to operate a delivery priority system, brokers need current information on the stock certificates in their possession, expected receipts, and required deliveries. Firms with automated cages have the capability of providing themselves with the information needed. Other firms could obtain the required information through service bureaus. The cost of operating such a delivery priority system was estimated at $8 million based on service bureau fees. The simulation model was used to compare the effect on the cost of fails of several delivery priority systems. In the benchmark case, deliveries to institutions were given first priority, brokers second, stock loan repayment third, and cash customers last. When the delivery priority was changed so that cash customers and institutions both preceded brokers, an intolerable level of broker-to-broker fails resulted, and the cost of fails increased sixfold. If, instead, the priority ordering is brokers, institutions, cash customers, and stock loan repayments, then broker-to-broker fails decrease significantly, but the overall cost of fails increases from the $125 million benchmark case to $132 million (including the cost of introducing the change). If no other system changes are introduced, the least-cost combination for delivery priorities results when deliveries are made as in the benchmark case (institutions first, etc.). Transfer Time During the time stock certificates are in the process of having title changed, they are not available for delivery. It follows that any reduction in transfer time will increase the inventory available for brokers to use in completing deliveries to other brokers and to customers. Transfer agents can reduce the time required to complete the transfer operation by using computer-stored stock record information displayed on cathode ray tube terminals. The most tedious and time-consuming step in transfer is the retrieval of stock record data on the buyer and seller. This step can be greatly shortened (and with a concomitant improvement in accuracy) by using |