[Federal Register Volume 63, Number 70 (Monday, April 13, 1998)]
[Notices]
[Pages 18057-18060]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 98-9591]


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SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-39831; File No. SR-NASD-98-20]


Self-Regulatory Organizations; National Association of Securities 
Dealers, Inc.; Notice of Filing of Proposed Rule Change Relating to 
Permitting Qualified Vendors to Provide Confirmation and Affirmation 
Services to Institutional Customers

April 6, 1998.
    Pursuant to Section 19(b)(1) of the Securities Exchange Act of 1934 
(``Act''),\1\ notice is hereby given that on March 5, 1998, the 
National Association of Securities Dealers, Inc. (``NASD'' or 
``Association'') filed with the Securities and Exchange Commission 
(``Commission'') the proposed rule change as described in Items I, II, 
and III below, which items have been prepared primarily by the NASD. 
The Commission is publishing this notice to solicit comments from 
interested persons on the proposed rule change.
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    \1\ 15 U.S.C. 78s(b)(1).
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I. Self-Regulatory Organization's Statement of the Terms of 
Substance of the Proposed Rule Change

    The NASD Regulation, Inc. (``NASD Regulation'') is proposing to 
amend Rule 11860 of the NASD's Uniform Practice Code to permit members 
to use the facilities of a Qualified Electronic Vendor for electronic 
confirmation and affirmation of depository eligible transactions. Below 
is the text of the proposed rule change (proposed new language is in 
italics; proposed deletions are in brackets):
11860. Acceptance and Settlement of COD Orders
    (a) No member shall accept an order from a customer pursuant to an 
arrangement whereby payment for securities purchased or delivery of

[[Page 18058]]

securities sold is to be made to or by an agent of the customer unless 
all of the following procedures are followed:
    (5) The facilities of a [securities depository] Clearing Agency 
shall be utilized for the [confirmation, acknowledgment and] book-entry 
settlement of all depository eligible transactions [covered by this 
Rule] except transactions that are to be settled outside the United 
States. The facilities of either a Clearing Agency or a Qualified 
Vendor shall be utilized for the electronic confirmation and 
affirmation of all depository eligible transactions.
    (b) Definitions.
    (1) ``Clearing Agency'' shall mean a clearing agency as defined in 
Section 3(a)(23) of the Act that is registered with the Commission 
pursuant to Section 17A(b)(2) of the Act or has obtained from the 
Commission an exemption from registration granted specifically to allow 
the clearing agency to provide confirmation and affirmation services.
    (2) ``Depository eligible transactions'' shall mean transactions in 
those securities for which confirmation, affirmation, [and] or book 
entry settlement can be performed through the facilities of a 
[securities depository] Clearing Agency.
    [(2) ``Securities depository'' shall mean a clearing agency as 
defined in Section 3(a)(23) of the Act, that is registered with the 
Commission pursuant to Section 17A(b)(2).]
    (3) ``Qualified Vendor'' shall mean a vendor or electronic 
confirmation and affirmation service that:
    (A) Shall, for each transaction subject to this rule: (i) deliver a 
trade record to a Clearing Agency in the Clearing Agency's format; (ii) 
obtain a control number for the trade record from the Clearing Agency; 
(iii) cross-reference the control number to the confirmation and 
subsequent affirmation of the trade; and (iv) include the control 
number when delivering the affirmation of the trade to the Clearing 
Agency.
    (B) Certifies (i) with respect to its electronic trade 
confirmation/affirmation system, that it has a capacity requirements 
evaluation and monitoring process that allows the vendor to formulate 
current and anticipated estimated capacity requirements; (ii) that its 
electronic trade confirmation/affirmation system has sufficient 
capacity to process the volume of data that it reasonably anticipates 
to be entered into its electronic trade confirmation/affirmation system 
during the upcoming year; (iii) that its electronic trade confirmation/
affirmation system has formal contingency procedures, that the entity 
has followed a formal process of reviewing the likelihood of 
contingency occurrences, and that the contingency protocols are 
reviewed, tested and updated on a regular basis; (iv) that its 
electronic trade confirmation/affirmation system has a process for 
preventing, detecting, and controlling any potential or actual systems 
or computer operations failures, and its procedures designed to protect 
against security breaches are followed; and (v) that its current assets 
exceed its current liabilities by at least $500,000;
    (C) When it begins providing such services, annually thereafter, 
and whenever it makes material changes to the services it provides, 
submits an Auditor's report to the Association and the Commission \2\ 
which is not deemed unacceptable by the Commission staff (for purposes 
of this subparagraph (C) ``material change'' means any changes to its 
systems that significantly affect or have the potential to 
significantly affect its electronic trade confirmation/affirmation 
systems, including: changes that: (i) affect or potentially affect the 
capacity or security of its electronic trade confirmation/affirmation 
system; (ii) rely on new or substantially different technology; or 
(iii) provide a new service to the Qualified Vendor's electronic trade 
confirmation/affirmation system); and
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    \2\ With respect to the determination of whether a vendor is a 
``Qualified Vendor,'' the Commission interprets NASD Regulation's 
use of the word ``Commission'' in the proposed rule change to mean 
Commission staff.
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    (D) Immediately notifies the Association and the Commission in 
writing if it intends to cease providing services, and supplies 
supplemental information regarding their electronic trade confirmation/
affirmation services as requested by the Association or the Commission.
    (E) A vendor may cease to be qualified if the Commission staff: (i) 
deems the Auditor's report unacceptable either because it contains any 
findings of material weaknesses, or for other identified reasons; or 
(ii) notifies the vendor in writing that it is no longer qualified. If 
the vendor ceases to be qualified, the member using that vendor shall 
not be deemed in violation of this Rule if it ceases using such vendor 
promptly upon receiving notice that the vendor is no longer qualified.
    (4) ``Auditor's report'' shall mean a written report that is 
prepared by competent, independent, external audit personnel in 
accordance with the standards of the American Institute of Certified 
Public Accountants and the Information Systems Audit and Control 
Association and that (i) verifies the certifications contained in 
subsection (b)(3)(B) above; (ii) contains a risk analysis of all 
aspects of the entity's information technology systems, including 
computer operations, telecommunications, data security, systems 
development, capacity planning and testing, and contingency planning 
and testing; and (iii) contains the written response of the entity's 
management to the information provided pursuant to (A) and (B).

II. Self-Regulatory Organization's Statement of the Purpose of, and 
Statutory Basis for, the Proposed Rule Change

    In its filing with the Commission, NASD Regulation included 
statements concerning the purpose of and basis for the proposed rule 
change and discussed any comments it received on the proposed rule 
change. The text of these statements may be examined at the places 
specified in Item IV below. NASD Regulation has prepared summaries, set 
forth in sections (A), (B), and (C) below, of the most significant 
aspects of such statements.

(A) Self-Regulatory Organization's Statement of the Purpose of, and 
Statutory Basis for, the Proposed Rule Change

(1) Background
    NASD Uniform Practice Code (UPC) Rule 11860 was adopted in 1982 to 
resolve problems relating to the financial exposure to broker/dealers 
resulting from inaccurate and failed institutional transactions.\3\ The 
financial exposure results from institutional customers that insist on 
``COD/DVP'' transaction terms that permit them to delay payment for 
securities until the securities are delivered to the institution's 
custodian (the ``Cash-on-Delivery'') and to delay delivery of 
securities until payment is received (the ``Delivery-Versus-Payment'') 
(``customer-side'' settlement). Thus, unlike the terms of a retail 
transaction where payment and delivery to the clearinghouse are 
required within three days, the settlement occurs at the institution's 
custodian bank which does not make payment or release securities except 
in exchange for securities or payment.
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    \3\ Other SROs have adopted similar rules requiring 
confirmations/acknowledgments for institutional transactions to be 
processed through a registered clearing agency.
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    Additional financial exposure occurs because the broker/dealer will 
usually sell or purchase securities on behalf of the institutional 
customer from another member (``street-side'' settlement). In

[[Page 18059]]

this situation, the member is subject to financial exposure for the 
institutional transaction until the institution's custodian bank 
forwards securities or payment that will cover the street-side 
transaction. The institution's custodian bank will only act on 
instructions in the form of an acknowledged confirmation.
    Institutional transactions are large dollar transactions that 
require accurate communications among multiple parties to achieve 
settlement in numbers of accounts that the institution represents. If 
there is any delay in settlement with the institution or the 
transaction is a ``fail'' because the institution refuses to recognize 
the trade, the broker/dealer is subject to financial exposure for a 
large dollar, institutional transaction and subject to financing 
charges and additional net capital requirements during the time until 
settlement with the custodian bank or the member otherwise takes steps 
to clear the ``fail'' from its books.
    The rules of the SROs were adopted jointly in 1982 to address the 
securities industry's inability at that time to process institutional 
securities transactions efficiently during periods of high-volume 
trading. Traditional manual methods of confirming, affirming, and 
settling such trades were costly, time-consuming, and prone to error, 
all of which led to an unacceptable number of failed transactions. The 
SROs sought to address these problems by requiring depository 
participants to use their depositories' automated systems for 
confirmation, acknowledgment, and settlement of depository-eligible 
trades. At that time the principal (and currently the only) 
confirmation/affirmation system operated by a depository was the 
Institutional Delivery (ID) system operated by the Depository Trust 
Company (DTC).
    One vendor of institutional confirmation and acknowledgment 
services has expressed a desire to provide to DTC on behalf of their 
customers, confirmations and acknowledgments. Rule 11860, however, 
requires such providers to be registered clearing agencies. The vendor 
inquired about changing the rule to permit unregistered vendors to 
provide such services.
    After discussions with various participants, users and regulators, 
NASD Regulation has developed a proposed rule change that will address 
the regulatory concerns involved in opening the clearance and 
settlement system to unregistered outside vendors, while at the same 
time exposing the process to the innovation and cost-cutting that 
competition from outside vendors can produce.\4\
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    \4\ The Commission notes that the proposed rule change addresses 
the concerns raised by the Petition for Rulemaking filed by Thomson 
Financial Services (``Thomson'') with the Commission in December 
1996. Thus, the Commission will respond to Thomson's petition after 
the final disposition of the proposed rule change.
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(2) Proposed Rule Change
    NASD Regulation is proposing to amend Subsection (a)(5) of Rule 
11860 to permit either a Clearing Agency or a Qualified Vendor to 
provide electronic confirmation and affirmation of all depository 
eligible transactions. The principal provision of the proposed rule 
change is the definition of ``Qualified Vendor'' in proposed new 
subparagraph 10860(b)(3). The definition provisions address information 
formatting, vendor qualifications, vendor capability, and notice from 
the vendor of any changes to its services or systems. The provisions 
are designed to prevent and minimize disruptions in the clearance and 
settlement system that could result from participation by less-than-
Qualified Vendors.
    Under paragraph (b)(3)(A) of the proposed rule change a Qualified 
Vendor must be able to: (1) deliver a trade record to a Clearing Agency 
in the Clearing Agency's format; (2) obtain a control number for the 
trade record from the Clearing Agency; (3) cross-reference the control 
number to the confirmation and subsequent affirmation of the trade; and 
(4) include the control number when delivering the affirmation of the 
trade to the Clearing Agency. These requirements will ensure that the 
clearing agency's functions in completing the clearance and settlement 
of a transaction will not be disrupted by submissions from vendors that 
are incompatible with the clearing agency's systems.
    Paragraph (b)(3)(B) of the proposed rule change requires a 
Qualified Vendor to certify that its electronic trade confirmation/
affirmation system has a process for evaluating and monitoring capacity 
requirements. This process must permit the vendor to establish current 
and anticipated estimated capacity requirements. In addition the 
Qualified Vendor must certify that its system has sufficient capacity 
to process the data volume that it expects to handle. The Qualified 
Vendor also must certify that its system has formal contingency 
procedures that are regularly reviewed, tested and updated and that it 
can prevent, detect, and control systems or computer operations 
failures. The Qualified Vendor also must certify that it has followed a 
formal process of reviewing the likelihood of contingency occurrences. 
The Qualified Vendor also must certify that its procedures are designed 
to protect against security breaches and that the procedures are 
followed. Finally, a Qualified Vendor must certify that its current 
assets exceed its current liabilities by at least $500,000.
    Paragraph (b)(3)(C) of the proposed rule change requires Qualified 
Vendors, when they begin to provide services, annually thereafter, and 
whenever they make ``material changes'' to their services to submit an 
``Auditor's report'' to the Association and the Commission which the 
Commission staff does not deem unacceptable.\5\
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    \5\ At this time, the Commission staff intends to indicate that 
a vendor's initial Auditor's report is not unacceptable and that the 
vendor therefore is a qualified vendor for purposes of Rule 11860 by 
issuing a letter to the vendor stating that it will not recommend 
enforcement action against any of the Association's member 
organizations that elect to use the confirmation/affirmation 
services of the vendor.
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    In addition, for purposes of this subparagraph (b)(3)(C), the term 
``material change'' means any change to its systems that significantly 
affect or have the potential to significantly affect its systems. Such 
changes include those that, affect or potentially affect the capacity 
or security of its electronic trade confirmation/affirmation system, 
rely on new or substantially different technology, or provide a new 
service to the Qualified Vendor's electronic trade confirmation/
affirmation system. This notice provision is intended to prevent 
vendors from unilaterally and without notice upsetting the clearance 
and settlement system. Such advance notice will permit customers and 
regulators to evaluate the effect of the changes and take such steps as 
may be necessary to prevent disruptions in clearing and settling 
transactions.
    Paragraph (b)(4) of the proposed rule change specifies that the 
Auditor's report is a written report prepared by competent, 
independent, external audit personnel in accordance with the standards 
of the American Institute of Certified Public Accountants and the 
Information Systems Audit and Control Association. The report must 
verify the vendor's certifications required under paragraph (b)(3)(B) 
of the proposed rule above. The report also must include a risk 
analysis of all aspects of the vendor's information technology systems, 
including computer operations, telecommunications, data security, 
systems development, capacity planning and testing, and contingency 
planning and testing. Finally, the report must include the vendor 
management's

[[Page 18060]]

written response to the information provided under paragraph (b)(3)(A) 
and (B), above.
    Paragaph (b)(3)(D) of the proposed rule requires Qualified Vendors 
to immediately notify the Association and the Commission in writing if 
they intend to cease providing services and supply supplemental 
information about their services upon the request of the Association or 
the Commission. This provision will provide the Association and the 
Commission notice of circumstances when vendors, in ceasing to provide 
services, may create disruptions to the clearance settlement system and 
to take such steps as may be necessary to minimize disruptions. In 
addition, this provision will permit the Association and the Commission 
to obtain information from vendors even though the vendors are not 
members of the Association or registered as clearing agencies. Such 
information is important to regulators in overseeing the clearance and 
settlement system.
    Under paragraph (b)(3)(E) a vendor may cease to be qualified if the 
Commission staff deems the Auditor's report to be unacceptable either 
because it contains any findings of material weaknesses, or for other 
identified reasons, or notifies the vendor in writing that the 
Commission staff has determined that the vendor is no longer qualified. 
This provision will permit the Commission staff to evaluate whether a 
vendor is qualified at any time. The principal opportunities for the 
Commission staff to make such evaluations will be when the vendor 
submits its certifications and Auditor's report. In addition, the 
Commission will be afforded other opportunities to evaluate a vendor's 
qualifications through information obtained in connection with a 
vendor's notices under paragraph (b)(3)(D) or as a result of 
supplemental information supplied by a vendor under paragraph 
(b)(3)(E), or through information obtained from any other source 
available to the Commission. Finally, if a vendor ceases to be 
qualified, the member using the vendor must cease using the vendor 
promptly upon receiving notice that the vendor is no longer qualified. 
NASD Regulation is requesting that the proposed rule change be 
effective within 45 days of Commission approval.
    NASD Regulation believes that the proposed rule change is 
consistent with the provisions of Section 15A(b)(6) of the Act \6\ in 
that the proposed rule change will permit Qualified Vendors to offer 
confirmation, affirmation and related services in connection with the 
clearance and settlement of institutional securities transactions 
thereby increasing the options available to participants in 
institutional securities transactions and enhancing the clearance and 
settlement system.
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    \6\ 15 U.S.C. 78o-3.
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(B) Self-Regulatory Organization's Statement on Burden on Competition

    NASD Regulation does not believe that the proposed rule change will 
result in any burden on competition that is not necessary or 
appropriate in furtherance of the purposes of the Act, as amended.

(C) Self-Regulatory Organization's Statement on Comments on the 
Proposed Rule Change Received from Members, Participants or Others

    Written comments were neither solicited nor received.

III. Date of Effectiveness of the Proposed Rule Change and Timing 
for Commission Action

    Within thirty-five days of the date of publication of this notice 
in the Federal Register or within such longer period (i) as the 
Commission may designate up to ninety days of such date if it finds 
such longer period to be appropriate and publishes its reasons for so 
finding or (ii) as to which the self-regulatory organization consents, 
the Commission will:
    (A) by order approve such proposed rule change or
    (B) institute proceedings to determine whether the proposed rule 
change should be disapproved.

IV. Solicitation of Comments

    Interested persons are invited to submit written data, views, and 
arguments concerning the foregoing, including whether the proposed rule 
change is consistent with the Act. Persons making written submissions 
should file six copies thereof with the Secretary, Securities and 
Exchange Commission, 450 Fifth Street, N.W., Washington, D.C. 20549. 
Copies of the submission, all subsequent amendments, all written 
statements with respect to the proposed rule change that are filed with 
the Commission, and all written communications relating to the proposed 
rule change between the Commission and any person, other than those 
that may be withheld from the public in accordance with the provisions 
of 5 U.S.C. 552, will be available for inspection and copying in the 
Commission's Public Reference Section, 450 Fifth Street, N.W., 
Washington, D.C. 20549. Copies of such filing also will be available 
for inspection and copying at the principal office of NASD. All 
submissions should refer to File No. SR-NASD-98-20 and should be 
submitted by May 4, 1998.

    By the Commission.
Margaret H. McFarland,
Deputy Secretary.
[FR Doc. 98-9591 Filed 4-10-98; 8:45 am]
BILLING CODE 8010-01-M