[Federal Register Volume 63, Number 70 (Monday, April 13, 1998)]
[Rules and Regulations]
[Pages 17943-17947]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 98-9594]
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SECURITIES AND EXCHANGE COMMISSION
17 CFR PART 241
[Release No. 34-39829; File No. S7-10-98]
Confirmation and Affirmation of Securities Trades; Matching
AGENCY: Securities and Exchange Commission.
ACTION: Interpretive release; request for comments.
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SUMMARY: The Securities and Exchange Commission (``Commission'') is
publishing its interpretation that a ``matching'' service that compares
securities trade information from a broker-dealer and the broker-
dealer's customer is a clearing agency function. The Commission also is
soliciting comment on two possible approaches for providing exemptive
relief from full clearing agency regulation for qualified electronic
trade confirmation (``ETC'') vendors that fall within the Commission's
interpretation of clearing agency because they provide a matching
service.
DATES: The interpretation contained in Section III of this release is
effective April 13, 1998.
Comments should be submitted on or before June 12, 1998.
ADDRESSES: Interested persons should submit comments in triplicate to
Jonathan Katz, Secretary, Securities and Exchange Commission, 450 5th
Street, N.W., Washington, DC 20549-6009. Comments can be submitted
electronically at the following E-mail address: [email protected].
All comment letters should refer to File No. S7-10-98; this file number
should be included on the subject line if E-mail is used. All comments
received will be available for public inspection and copying in the
Commission's Public Reference Room, 450 5th Street, NW, Washington, DC
20549. Electronically submitted comment letters will be posted on the
Commission's Internet Web site (http://www.sec.gov).
FOR FURTHER INFORMATION CONTACT: Jerry W. Carpenter, Assistant
Director; Jeffrey Mooney, Special Counsel; or Theodore R. Lazo,
Attorney; at 202/942-4187, Office of Risk Management and Control,
Division of Market Regulation, Securities and Exchange Commission,
Washington, D.C. 20549.
SUPPLEMENTARY INFORMATION:
I. Introduction
Recently, the New York Stock Exchange (``NYSE''), the National
Association of Securities Dealers (``NASD''), and the Municipal
Securities Rulemaking Board (``MSRB'') (collectively ``SROs'') filed
proposed rule changes under Section 19(b) of the Securities Exchange
Act of 1934 (``Exchange Act'') \1\ to amend their rules dealing with
the post-trade processing of trades executed by their members. The
SROs' current rules require their broker-dealer members to use the
facilities of a securities depository \2\ for the electronic
confirmation and affirmation of transactions where the broker-dealer
provides delivery-versus-payment (``DVP'') or receive-versus-payment
(``RVP'') \3\ privileges to its customer (``SRO confirmation
rules'').\4\ As a practical matter, the SRO confirmation rules require
broker-dealers to use The Depository Trust Company's (``DTC'')
Institutional Delivery (``ID'') system because it is the only
confirmation/affirmation service offered by a securities depository.\5\
Under the proposed amendments to the SRO confirmation rules, broker-
dealers will be permitted to use entities that are not registered
clearing agencies for the confirmation and affirmation of RVP/DVP
transactions as long as the entities are qualified ETC vendors as
defined by the SRO rules. A qualified ETC vendor intermediary will only
transmit information between the parties to a trade, and the parties
will confirm and affirm the accuracy of the information.
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\1\ 15 U.S.C. 78s(b)(1).
\2\ A ``securities depository'' is defined in the SRO
confirmation rules as a clearing agency that is registered under
Section 17A of the Exchange Act, 15 U.S.C. 78q-1.
\3\ RVP services allow an institutional seller to require cash
payment before delivering its securities at settlement. DVP services
allow an institutional buyer to pay for its purchased securities
only when the securities are delivered. Generally, bids only extend
RVP/DVP privileges to their institutional customers.
\4\ The confirmation rules are: MSRB Rule G-15(d)(ii); NASD Rule
11860(a)(5); and NYSE Rule 387(a)(5). The SROs and the Commission
have separate rules requiring customer confirmations and specifying
their content. See, e.g., Exchange Act Rule 10b-10, NASD Rule 2230;
NYSE Rule 409. These rules are not the subject of this proceeding.
\5\ Previously, the Philadelphia Depository Trust Company and
the Midwest Securities Trust Company offered confirmation/
affirmation services, but these securities depositories no longer
provide any depository services.
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The Commission understands that the next step in the evolution of
post-trade processing will be the development of matching services.
``Matching'' is the term used to describe the process by which an
intermediary reconciles trade information from the broker-dealer and
its customer to generate an affirmed confirmation which is then used in
effecting settlement of the trade.
The Commission is of the view that matching constitutes a clearing
agency function within the meaning of the clearing agency definition
under Section 3(a)(23) of the Exchange Act.\6\ Specifically, matching
constitutes ``comparison of data respecting the terms of settlement of
securities transactions.'' The Commission concludes that matching is so
closely tied to the clearance and settlement process that it is
different not only in degree but also different in kind from the
current confirmation and affirmation process. The purpose of this
release is to seek comment on the concept of providing exemptive relief
either through registration as clearing agencies subject to reduced
requirements or through the grant of a conditional exemption from
registration to qualified ETC vendors that provide a matching service.
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\6\ 15 U.S.C. 78c(a)(23).
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II. Background
A. Confirmation and Affirmation Process
The confirmation/affirmation process refers to the transmission of
messages among broker-dealers, institutional investors, and custodian
banks regarding the terms of a trade executed for the institutional
investor. Because the trades of institutional investors involve larger
sums of money, larger amounts of securities, more parties, and more
steps between order entry and final settlement, institutional trades
are usually more complex than retail transactions.
[[Page 17944]]
1. Confirmation Using the ID System
The typical components of the ``customer-side'' settlement of an
institutional trade under the current SRO confirmation rules are
illustrated in Figure 1.\7\
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[GRAPHIC] [TIFF OMITTED] TR13AP98.005
Figure 1
Typically, an institutional trade will begin with the institution's
investment manager placing an order with the broker-dealer. After the
broker-dealer executes the trade, the broker-dealer will advise the
institution of the execution details. This is commonly referred to as
giving notice of execution (step 1 of Figure 1). The institution then
advises the broker-dealer as to how the trade should be allocated among
its accounts (step 2 of Figure 1).\8\ The broker-dealer then submits
the trade data to DTC (step 3 of Figure 1).
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\7\ This is a separate process from the ``street-side''
settlement of the trade which is carried out between the buying and
selling broker-dealers involved in the trade.
\8\ The current confirmation rules do not require use of any
system or type of system for notice of execution or allocation
instructions.
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Next, DTC adds the transaction to the ID system's trade database,
assigns an ID control number, and forwards an electronic confirmation
to the institution, the broker-dealer, the institution's settlement
agent, and other interested parties (e.g., trustees, plan
administrators, or correspondent banks) (step 4 of Figure 1). The
institution reviews the confirmation for accuracy. If accurate, the
institution or its designated affirming agent affirms the trade through
the ID system (step 5 of Figure 1). DTC then generates an affirmed
confirmation and sends it to the broker-dealer and to the institution's
settlement agent (step 6 of Figure 1).\9\ At this point, the trade is
sent into DTC's settlement system (i.e., the ID system is not a
settlement system in that no money or securities move through it) and
must be authorized by the party obligated to deliver the securities
(i.e., the selling party) institution or the settlement agent before
settlement occurs (steps 7 and 8 of Figure 1). ``Quality Control''
involves DTC's monitoring and production of various reports for
regulators and ID system users which show such things as when a
confirmation was sent and the affirmation was received (step 9 of
Figure 1).
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\9\ In the ID system, the affirming party may be the
institution, the institution's agent, or another party designated by
the institution (i.e., an ``interested party'').
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2. Confirmation Using a Qualified ETC Vendor
Under the proposed SRO rule changes, a qualified ETC vendor may be
used for the confirmation/affirmation process. The broker-dealer
submits trade data to the qualified ETC vendor which generates and
sends a confirmation to the institution (steps 3 and 4 of Figure
[[Page 17945]]
1). After reviewing the confirmation, the institution sends an
affirmation to the broker-dealer through the facilities of the
qualified ETC vendor (step 5 of Figure 1). At some point in this
process, the qualified ETC vendor forwards the confirmation to DTC in
an ID system format in order that DTC can assign an ID control number
to the trade. DTC sends the confirmation with the control number back
to the qualified ETC vendor, and the qualified ETC vendor provides the
control number to the broker-dealer and the institution. After receipt
of the affirmation from the institution, the qualified ETC vendor sends
the affirmed confirmation with the ID control number to DTC in ID
system format. In this process, a qualified ETC vendor only transmits
information between the parties to the trade and the parties verify the
accuracy of the information.
B. Matching Services
The components of customer-side settlement of an institutional
trade through a ``matching'' system are illustrated in Figure 2.
[GRAPHIC] [TIFF OMITTED] TR13AP98.006
Figure 2
``Matching'' is the term that is used to describe the process
whereby an intermediary compares the broker-dealer's trade data
submission (step 2 of Figure 2) with the institution's allocation
instructions (step 1 of Figure 2) to determine whether the two
descriptions of the trade agree.\10\ If the trade data and
institution's allocation instructions match, an affirmed confirmation
is produced (step 3 of Figure 2). This would eliminate the separate
steps of producing a confirmation (step 4 of Figure 1) for the
institution to review and affirm (step 5 of Figure 1). At this point,
the trade goes into DTC's settlement process but must be authorized by
the delivering party agent before settlement occurs (steps 4 and 5 of
Figure 2).\11\
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\10\ Figure 2 illustrates a ``matching intermediary'' other than
DTC matching the Institution's allocation instructions with the
Executing Broker's trade data. The Commission has approved a
proposed rule change filed by DTC that will allow DTC to provide
matching services. Securities Exchange Act Release No. 39832 (April
6, 1998), File No. SR-DTC-95-23. Currently, no one provides the type
of services described in DTC's matching proposal.
\11\ This authorization and settlement process is the same
process for the authorization and settlement of institutional trades
where a matching service is not used (steps 7 and 8 of Figure 1).
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III. Matching as a Clearing Agency Function
Section 3(a)(23)(A) of the Exchange Act defines a clearing agency
broadly as ``any person who acts as an intermediary in making payments
or deliveries or both in connection with transactions in securities or
who provides facilities for comparison of data respecting the terms of
settlement of securities transactions, to reduce the number of
settlements of securities transactions, or for the allocation of
[[Page 17946]]
securities settlement responsibilities.''\12\ Section 17A of the
Exchange Act and Rule 17Ab2-1 thereunder require any person who engages
in any of these functions to register with the Commission as a clearing
agency or obtain an exemption from registration.\13\
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\12\ 15 U.S.C. 78c(a)(23)(A).
\13\ 15 U.S.C. 78q-1; 17 CFR 240.17Ab2-1.
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Based on the language, purposes, and policies of Section 3(a)(23)
and 17A, the Commission concludes that an intermediary that captures
trade information from a buyer and a seller of securities and performs
an independent reconciliation or matching of that information is
providing facilities for the comparison of data within the scope of
Exchange Act Section 3(a)(23).\14\ As a result, the intermediary is
performing a clearing agency function. Accordingly, under this
interpretation, only an entity that is registered as a clearing agency
or is exempt from such registration may provide a matching service.
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\14\ A matching service conducted by an intermediary falls
within the literal terms of the definition of clearing agency. A
matching service conducted by an intermediary clearly provides a
facility in which the terms of transactions between broker-dealers
and their institutional customers are compared to each other to
assure that both parties agree to the terms of the trades before
they are submitted for settlement.
Other portions of the statute also support this interpretation.
Section 3(a)(23)(B) of the Exchange Act, 15 U.S.C. 78c(a)(23)(B),
specifically excludes broker-dealers (and other entities) from the
definition of clearing agency if they would fall within the
definition solely because they perform clearing agency functions as
a part of their customary activities, such as brokerage. Therefore,
in connection with its customary business as a broker-dealer, a
broker-dealer may match trades among its own customers without
triggering clearing agency registration. Furthermore, Section
3(a)(23)(A) of the Exchange Act, 15 U.S.C. 78c(a)(23)(A), also
contains another definition that includes an entity that ``otherwise
permits or facilitates the settlement of securities transactions * *
*.''
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The legislative history of the Securities Acts Amendments of 1975
(``1975 Amendments'') supports this statutory interpretation,\15\
including the purposes of establishing a national clearance and
settlement system and the scope of authority granted to the Commission.
Moreover, considering a matching service to be a clearing agency
function is consistent with the purposes of the Exchange Act regulation
of the clearance and settlement system. Congress viewed the clearance
and settlement system in the early 1970s as inadequate and in the 1975
Amendments directed the Commission to facilitate the development of an
improved national clearance and settlement system. Congress articulated
the goals of this national system in Section 17A of the Exchange
Act,\16\ and gave the Commission the authority and responsibility to
regulate, coordinate, and direct the operations of all persons involved
in processing securities transactions toward the goal of a national
system for the prompt and accurate clearance and settlement of
securities transactions.\17\ Congress specifically declined to address
the merits of any particular system or to dictate the shape a national
clearance and settlement system should take.\18\ Instead, Congress
recognized that ``data processing and communications techniques''
involved in clearance and settlement processes would continue to
evolve.\19\ As a result, the Commission was given broad authority over
the clearance and settlement system and wide discretion in determining
what activities fall within the clearing agency function triggering the
requirement to register as a clearing agency.
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\15\ Pub. L. No. 94-29, 89 Stat. 97 (1975). The definition of
clearing agency in Section 3(a)(23) of the Exchange Act was adopted
as part of the 1975 Amendments.
\16\ 15 U.S.C. 78q-1. Section 17A(a)(2) of the Exchange Act, 15
U.S.C. 78q-1(a)(2), states that the Commission is directed: (i) to
facilitate the establishment of a national system for the prompt and
accurate clearance and settlement of transactions in securities, and
(ii) to facilitate the establishment of linked or coordinated
facilities for clearance and settlement of transactions in
securities, securities options, contracts of sale for future
delivery and options thereon, and commodity options.
\17\ Id. at 232.
\18\ Id. at 184.
\19\ See Section 17A(a)(1)(C) of the Exchange Act, 15 U.S.C.
78q-1(a)(1)(C); S. Rep. 75, 94th Cong., 1st Sess. 54 (1975); H. Rep.
123, 94th Cong., 1st Sess. 44 (1975).
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In fact, the clearance and settlement process for institutional
trades has evolved dramatically. When the 1975 Amendments were enacted,
the processing of institutional trades was carried out directly between
the broker-dealer and the institution with little or no automation. The
SROs' rules requiring the use of electronic confirmation and
affirmation of institutional trades were adopted in response to the
increased complexity of institutional trades and the need to automate
the process. Today, the volume of institutional trades has grown to an
extent that they now account for a large portion of the trading
activity in the U.S. securities markets.\20\ Because of the increased
volume and complexity of institutional trades, virtually all of them
are now processed through electronic systems.
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\20\ Using block trades (i.e., 10,000 shares or more) as a proxy
for institutional trades, in 1996 institutional trading accounted
for 55.9% of NYSE volume and 34.1% of Nasdaq National Market volume.
NYSE, Fact Book for the Year 1996, p. 16 (1997); The Nasdaq Stock
Market, Inc., 1997 Fact Book & Company Directory, p. 27 (1997).
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Matching is inextricably intertwined with the clearance and
settlement process. A vendor that provides a matching service will
actively compare trade and allocation information and will issue the
affirmed confirmation that will be used in settling the
transaction.\21\ In addition, matching addresses two areas that the
Commission and the securities industry view as critical to maintaining
a sound clearance and settlement system: reducing errors and reducing
the amount of settlement time.
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\21\ In contrast, a vendor that provides confirmation/
affirmation services only will exchange messages between a broker-
dealer and its institutional customer. The broker-dealer and its
institutional customer will compare the trade information contained
in those messages, and the institution itself will issue the
affirmed confirmation.
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As noted above, matching combines certain steps in the confirmation
and affirmation process and therefore can help to reduce errors.
Effective matching also will be critical in any effort to shorten the
settlement cycle.\22\ At the same time, matching concentrates
processing risk in the entity that performs matching instead of
dispersing that risk more broadly to broker-dealers and their
institutional customers. In particular, matching eliminates a separate
affirmation step that would allow the detection of errors that could
delay settlement or cause the trade to fail.\23\
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\22\ The vast majority of the comment letters that the
Commission received regarding DTC's matching proposal supported the
proposal. Twenty-two of the commenters specifically noted matching's
effect on shortening the settlement cycle as a reason for their
support.
\23\ This is in contrast to a Qualified ETC Vendor which would
transmit confirmations and affirmations between broker-dealers and
their customers for their review and therefore would involve less
concentration of risk.
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Accordingly, the Commission believes that an entity providing
matching would have a significant impact on the national clearance and
settlement system. The breakdown of a matching system's ability to
accurately compare the trade information from hundreds of institutions
and broker-dealers involving thousands of transactions and millions of
dollars worth of securities could result in a widespread systemic
failure of the national clearance and settlement system.\24\ Without
any regulatory authority over matching vendors, the Commission would
have only limited ability to guard against
[[Page 17947]]
such failure. Congress granted the Commission broad power to establish
a centralized system of regulation over the national clearance and
settlement system in order to prevent such a situation from
occurring.\25\ Given the significant role played by matching services
and the scope of the definition, the Commission believes that some form
of regulation is appropriate to assure the prompt and accurate
clearance and settlement of securities.\26\
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\24\ Based on conversations between Commission staff and DTC,
the Commission understands that over the last five months of 1997
the ID system received an average of 165,000 trade inputs per day.
On the highest volume day during that period, the ID system received
approximately 310,000 trade inputs.
\25\ S. Rep. 75, 94th Cong., 1st Sess. 55 (1975); H. Rep. 123,
94th Cong., 1st Sess. 78-79 (1975).
\26\ Letter regarding Bradford National Corporation (June 1,
1981), CCH Transfer Binder, para. 76,853.
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IV. Possible Regulatory Approaches
Even though matching services fall within the definition of
clearing agency, the Commission preliminarily is of the view that an
entity that limits its clearing agency functions to providing matching
services need not be subject to the full panoply of clearing agency
regulation. The Commission has broad exemptive authority under Section
17A. Section 17A(b)(1) authorizes the Commission to exempt
(conditionally or unconditionally) any clearing agency from any
provision of Section 17A if the Commission finds that such exemption is
consistent with the public interest, the protection of investors, and
the purposes of Section 17A.
Two alternative approaches may provide an appropriate regulatory
structure for entities providing matching facilities: limited
registration or conditional exemption. Under either approach only those
regulatory requirements that the Commission views as necessary and
appropriate to achieve the goals of Section 17A would be applicable to
an entity providing a matching facility.\27\ The limited registration
alternative is a ``scaled back'' approach, which would register the
matching service provider as a clearing agency while providing
exemptions from individual clearing agency requirements. The
conditional exemption alternative is a ``building block'' approach,
which would exempt the entity from clearing agency registration subject
to appropriate conditions.\28\ Under either approach, the Commission
would publish for comment a notice of the qualified ETC vendor's
application for limited registration or conditional exemption,
including the proposed terms of the registration or exemption, before
approving the application.\29\
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\27\ Under either approach, an entity would have to meet the
requirements to become qualified as an ETC vendor under the SRO
rules. The requirements needed to become a qualified ETC vendor are
necessary elements but in themselves are not sufficient for an
entity that provides a matching function.
\28\ Under the exemptive approach, the Commission anticipates
that an entity seeking an exemption for matching would be required
to: (1) provide the Commission with information on its matching
services and notice of material changes to its matching services;
(2) establish an electronic link to a registered clearing agency
that provides for the settlement of its matched trades; (3) allow
the Commission to inspect its facilities and records; and (4) make
periodic disclosures to the Commission regarding its operations.
Applicants requesting exemption from clearing agency
registration are required to meet standards substantially similar to
those required of registrants under Section 17A in order to assure
that the fundamental goals of that section are furthered (i.e.,
safety and soundness of the national clearance and settlement
system). See, e.g., Securities Exchange Act Release Nos. 36573
(December 12, 1995), 60 FR 65076 (order approving application for
exemption from clearing agency registration for the Clearing
Corporation for Options and Securities); 38328 (February 24, 1997),
62 FR 9225 (order approving application for exemption from clearing
agency registration for Cedel Bank, societe anonyme; and 38589 (May
9, 1997), 62 FR 26833 (notice of application for exemption from
clearing agency registration by Morgan Guaranty Trust Company of New
York, Brussels Office, as operator of the Euroclear System).
\29\ See Section 19(a) of the Exchange Act, 15 U.S.C. 78s(a),
and Exchange Act Rule 17Ab2-1, 17 CFR 240.17Ab2-1.
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The Commission requests commenters' views on whether limited
clearing agency registration or conditional exemption from clearing
agency registration is the best alternative for regulating qualified
ETC vendors that provide matching services. Does either or both of
these proposed alternatives provide a prudent method to ensure the
safety and soundness of the national system for clearance and
settlement of securities transactions and the continued development of
linked and coordinated clearance mechanisms subject to uniform
standards? Generally speaking, what clearing agency requirements under
Section 17A(b) would be necessary and appropriate for matching
services, and which would not? Are there other alternatives by which
the Commission could maintain oversight of matching by qualified ETC
vendors that would ensure the safety and soundness of the national
clearance and settlement system?
List of Subjects in 17 CFR Part 241
Securities.
Amendment of the Code of Federal Regulations
For the reasons set out in the preamble, Title 17 Chapter II of the
Code of Federal Regulations is amended as set forth below:
PART 241--INTERPRETATIVE RELEASES RELATING TO THE SECURITIES
EXCHANGE ACT OF 1934 AND GENERAL RULES AND REGULATIONS THEREUNDER
Part 241 is amended by adding Release No. 34-39829 and the release
date of April 6, 1998 to the list of interpretive releases.
By the Commission.
Dated: April 6, 1998.
Margaret H. McFarland,
Deputy Secretary.
[FR Doc. 98-9594 Filed 4-10-98; 8:45 am]
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