[Federal Register Volume 69, Number 53 (Thursday, March 18, 2004)]
[Proposed Rules]
[Pages 12922-12936]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 04-5981]



[[Page 12921]]

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Part III





Securities and Exchange Commission





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17 CFR Part 240



Securities Transactions Settlement; Proposed Rule

  Federal Register / Vol. 69, No. 53 / Thursday, March 18, 2004 / 
Proposed Rules  

[[Page 12922]]


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SECURITIES AND EXCHANGE COMMISSION

17 CFR Part 240

[Release No. 33-8398; 34-49405; IC-26384; File No. S7-13-04]
RIN 3235-AJ19


Securities Transactions Settlement

AGENCY: Securities and Exchange Commission.

ACTION: Concept release; Request for comment.

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SUMMARY: The Securities and Exchange Commission (``Commission'') is 
seeking comment on methods to improve the safety and operational 
efficiency of the U.S. clearance and settlement system and to help the 
U.S. securities industry achieve straight-through processing. First, 
the Commission is seeking comment on whether the Commission should 
adopt a new rule or the self-regulatory organizations should be 
required to amend their existing rules to require the completion of the 
confirmation and affirmation process on trade date (``T+0'') when a 
broker-dealer provides delivery-versus-payment or receive-versus-
payment privileges to a customer. Second, the Commission is seeking 
comment on the benefits and costs associated with implementing a 
settlement cycle for most broker-dealer transactions that is shorter 
than three days (``T+3''). Third, the Commission is seeking comment on 
reducing the use of physical securities.

DATES: Comments should be submitted on or before June 16, 2004.

ADDRESSES: Comments may be submitted electronically or by paper. 
Electronic comments may be submitted by: (1) Electronic form on the SEC 
Web site (http://www.sec.gov) or (2) e-mail to [email protected]. 
Mail paper comments in triplicate to Jonathan G. Katz, Secretary, 
Securities and Exchange Commission, 450 Fifth Street, NW., Washington, 
DC 20549-0609. All submissions should refer to file number S7-13-04; 
this file number should be included on the subject line if e-mail is 
used. To help us process and review your comments more efficiently, 
please use only one method. The Commission will post all comments on 
the Commission's Internet Web site (http://www.sec.gov). Comments are 
also available for public inspection and copying in the Commission's 
Public Reference Room, 450 Fifth Street, NW., Washington, DC 20549. We 
do not edit personal identifying information from submissions. You 
should submit only information that you wish to make available 
publicly.

FOR FURTHER INFORMATION CONTACT: Jerry Carpenter, Assistant Director; 
Jeffrey Mooney, Senior Special Counsel; Susan Petersen, Special 
Counsel; Michael Milone, Special Counsel; or Jennifer Lucier, Special 
Counsel at (202) 942-4187, Office of Trading Practices and Processing, 
Division of Market Regulation, Securities and Exchange Commission, 450 
Fifth Street, NW., Washington, DC 20549-1001.

I. Introduction

    In 1975, Congress enacted section 17A of the Securities Exchange 
Act of 1934 (``Exchange Act''),\1\ which directs the Commission to 
facilitate the establishment of a national clearance and settlement 
system for securities transactions. In providing the Commission with 
this authority, the Congress made the following findings:
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    \1\ 15 U.S.C. 78q-1. For legislative history concerning Section 
17A, see, e.g., Report of Senate Comm. on Housing and Urban Affairs, 
Securities Acts Amendments of 1975: Report to Accompany S. 249, S. 
Rep. No. 75, 94th Cong., 1st Sess. 4 (1975); Conference Comm. Report 
to Accompany S. 249, Joint Explanatory Statement of Comm. of 
Conference, H.R. Rep. No. 229, 94th Cong., 1st Sess., 102 (1975).
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    (1) The prompt and accurate clearance and settlement of securities 
transactions, including the transfer of record ownership and the 
safeguarding of securities and funds related thereto, are necessary for 
the protection of investors and persons facilitating transactions by 
and acting on behalf of investors.
    (2) Inefficient procedures for clearance and settlement impose 
unnecessary costs on investors and persons facilitating transactions by 
and acting on behalf of investors.
    (3) New data processing and communications techniques create the 
opportunity for more efficient, effective, and safe procedures for 
clearance and settlement.
    (4) The linking of all clearance and settlement facilities and the 
development of uniform standards and procedures for clearance and 
settlement will reduce unnecessary costs and increase the protection of 
investors and persons facilitating transactions by and acting on behalf 
of investors.\2\
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    \2\ 15 U.S.C. 78q-1(a)(1)(A)-(D).
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    These findings serve as objectives in the Commission's ongoing 
efforts to enhance efficiency and reduce risk in the operation of the 
U.S. clearance and settlement system. As one means of furthering these 
objectives, the Commission staff supports industry initiatives to 
improve the operation of the clearance and settlement system. One such 
recent industry initiative is to enhance the reliability and efficiency 
of securities transaction processing by emphasizing straight-through 
processing (``STP'')\3\ and to shorten the settlement cycle for 
securities transactions. The Securities Industry Association (``SIA'') 
has taken the lead in this effort, in cooperation with a number of 
other trade organizations, market participants, and regulatory bodies 
representing a cross-section of industry participants domestically and 
internationally.\4\
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    \3\ The Securities Industry Association describes STP ``as the 
seamless integration of systems and processes to automate the trade 
process from end-to-end--trade execution, confirmation, and 
settlement--without manual intervention or the re-keying of data.'' 
``STP Glossary,'' prepared by the SIA and available at http://www.sia.com/stp/other/Glossary_v2.3.xls.
    \4\ The SIA created a steering committee and several 
subcommittees to focus on various aspects of its project. Copies of 
the committees' white papers and reports are available on the SIA's 
Web site www.sia.com/stp/html/industry_reports.html. The Commission 
staff participates on the SIA's STP steering and legal and 
regulatory committees as observers.
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    The SIA identified ten building blocks as essential to realizing 
the goal of improving the speed, safety, and efficiency of the trade 
settlement process: \5\
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    \5\ ``SIA T+1 Business Case Final Report,'' at 18-21 (August 
2000)(``SIA Business Case Report''). The report is available online 
at http://www.sia.com/t_plus_one_issue/pdf/BusinessCaseFinal.pdf.
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    1. Modify internal processes at broker-dealers, asset managers, and 
custodians to ensure compliance with compressed settlement deadlines.
    2. Identify and comply with accelerated deadlines for submission of 
trades to the clearing and settlement systems.
    3. Amend the National Securities Clearing Corporation's (``NSCC'') 
trade guarantee process so that the guarantee is provided on trade 
date.
    4. Report trades to clearing corporations in locked-in format and 
revise clearing corporations' output.
    5. Rewrite Continuous Net Settlement processes at NSCC to enhance 
speed and efficiency.
    6. Reduce reliance on checks and use alternative means of payment, 
such as automatic debits allowed by the National Automated Clearing 
House Association.
    7. Immobilize securities shares prior to conducting transactions.
    8. Revise the prospectus delivery rules and procedures for initial 
public offerings.
    9. Develop industry matching utilities and linkages for all asset 
classes.
    10. Standardize reference data and move to standardized industry 
protocols

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for broker-dealers, asset managers, and custodians.
    Initially, the main emphasis of this industry effort was on 
shortening the date of trade settlement from the current three business 
days after trade date (``T+3'') to settlement on the next business day 
after trade date (``T+1''). In July 2002, the SIA shifted the principal 
focus of the initiative from shortening the settlement cycle to 
achieving industry-wide STP.\6\ In refocusing the project, the SIA 
stated that the industry needed to focus on more effective STP before 
it would be in a position to fully evaluate the conversion from T+3 to 
T+1.\7\ The SIA, however, plans to reconsider the need to pursue a 
reduction in the settlement cycle in 2004.\8\
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    \6\ ``SIA Board Endorses Program to Modernize Clearing and 
Settlement Process for Securities,'' STP Connections (Securities 
Industry Association, New York, NY), July 18, 2002, (press release 
from the SIA Board of Directors endorsing straight-through 
processing). See SIA STP Connections, Issue 1, July 22, 2002, 
available at http://www.sia.com/stp/pdf/STP_Newsletter_Issue_1.pdf.
    \7\ Id. at 2.
    \8\ Id. at 2.
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    Reducing risk and increasing efficiency in securities clearance and 
settlement has also been the focus of recent international initiatives. 
For the past several years, Commission staff has participated on a Task 
Force organized by the Committee on Payment and Settlement Systems 
(``CPSS'') of the Group of 10 central banks and the International 
Organization of Securities Commissions (``IOSCO'') \9\ that was charged 
with promoting the implementation of measures that can reduce risks, 
increase efficiency, and provide safeguards for investors in securities 
clearance and settlement systems. In November 2001, the CPSS and IOSCO 
published the Task Force's findings in a report titled, 
``Recommendations for Securities Settlement Systems'' (``CPSS/IOSCO 
Report'').\10\ The CPSS/IOSCO Report set forth 19 recommendations that 
established minimum standards for the operation of a settlement 
system.\11\
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    \9\ The Committee on Payment and Settlement Systems serves as a 
forum for the central banks of the G10 countries to monitor and 
analyze developments in payment and settlement arrangements and to 
consider related policy issues. The International Organization of 
Securities Commissions consists of 164 securities market regulators 
that have agreed to cooperate in order to promote high standards of 
regulation and to maintain efficient and sound domestic and 
international securities markets. The Commission is a member of 
IOSCO.
    \10\ ``Recommendations for Securities Settlement Systems,'' 
CPSS/IOSCO Task Force (November 2001). The Commission actively 
participated in drafting the CPSS/IOSCO Report and supported its 
publication.
    \11\ The 19 recommendations are contained in Appendix 1.
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    In November 2002, the Task Force published an assessment 
methodology for the recommendations.\12\ The assessment methodology is 
primarily intended for use in self-assessments by national authorities 
to determine whether markets in their jurisdiction have implemented the 
recommendations contained in the CPSS/IOSCO Report and to develop 
action plans for implementation where necessary. The Commission and the 
Board of Governors of the Federal Reserve System have begun assessing 
the U.S. clearance and settlement system.
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    \12\ ``Assessment Methodology for Recommendations for Securities 
Settlement Systems,'' CPSS/IOSCO Task Force (November 2002). The 
Commission actively participated in drafting the CPSS/IOSCO 
assessment methodology and supported its publication.
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    On January 30, 2003, the Group of Thirty (``G30'') published a 
report titled, ``Global Clearing and Settlement, A Plan of Action'' 
(``2003 G30 Report'').\13\ The 2003 G30 Report describes best practices 
for clearing entities operating in the major mature markets with the 
goal of improving cross-border clearance and settlement. Commission 
staff participated in the G30's efforts to prepare the report.
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    \13\ The G30, established in 1978, is an independent, non-
partisan, not-for-profit organization composed of international 
financial leaders whose focus is on international economic and 
financial issues. For additional information about the G30, visit 
their Web site at http://www.group30.org.
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    The purpose of this release is to build upon these initiatives and 
continue the exploration of methods to improve the operation of the 
U.S. clearance and settlement system. People who invest in securities 
markets want to know that their product will be delivered on time, at 
the agreed upon terms, and that they will not lose their funds and 
securities because of insolvency, mismanagement, or operational 
difficulties. In particular, the focus of this release is on improving 
the trade confirmation/affirmation process, shortening the settlement 
cycle, and reducing the use of physical securities. Regulators and 
financial supervisors globally are also addressing these areas.\14\ In 
light of these domestic and international efforts, the Commission 
believes that it is timely to request comment on these issues to help 
continue the ongoing dialogue concerning the safety, reliability, and 
efficiency of the U.S. clearance and settlement system.
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    \14\ Several regulatory and oversight bodies are addressing 
confirmation/affirmation processing, the shortening of settlement 
cycles, and reducing the use of physical securities. Many of the 
countries involved in the CPSS/IOSCO Report are currently assessing 
operations in their jurisdictions and have launched efforts to 
improve securities transaction processing. For example, the Canadian 
Capital Markets Association, a federally incorporated, not-for-
profit organization, has been working with the Canadian Depository 
for Securities and provincial regulators to implement straight-
through processing and potentially shorten the settlement cycle in 
Canada to T+1. See, http://www.ccma-acmc.ca. Likewise, in September 
2003, the Hong Kong Securities and Futures Commission (``HKSFC'') 
published its conclusions, based on comments received on its 
consultation paper, supporting a certificate-less securities market 
in Hong Kong. The HKSFC's consultative paper and conclusions are 
available at http://www.hksfc.org.hk. In July 2003, the Governing 
Council of the European System of Central Banks (``ESCB'') and the 
Committee of European Securities Regulators (``CESR'') published for 
comment a set of standards for clearance and settlement in the 
European Union that were based on recommendations made in the CPSS/
IOSCO Report. The ESCB-CESR paper is available at http://www.centralbank.ie/gconsult/consult9b.pdf.
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II. Trade Confirmation and Affirmation

A. Confirmation/Affirmation Process

    Promptly verifying trade details is essential to identifying 
discrepancies that can lead to, among other things, settlement failures 
and errors in recording trades.\15\ Currently, the self regulatory 
organizations' (``SRO'') confirmation rules require a broker-dealer to 
use the facilities of a registered clearing agency, an entity that has 
received an exemption from clearing agency registration, or a qualified 
vendor for the confirmation/affirmation of securities transactions when 
the broker-dealer allows a customer to pay for the trade when the 
broker-dealer delivers the securities or cash to the customer.\16\ This 
process is generally

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referred to as providing the customer with receive-versus-payment 
(``RVP'') or delivery-versus-payment (``DVP'') privileges. Generally, 
broker-dealers provide RVP or DVP privileges to institutional 
customers. The SRO confirmation rules also require the broker-dealer to 
have obtained an agreement from each customer with RVP/DVP privileges 
that the customer will affirm each trade promptly upon receipt of the 
confirmation.\17\
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    \15\ CPSS has defined a fail as ``a failure to settle a 
securities transaction on the contractual settlement date, usually 
because of technical or temporary difficulties.'' ``A glossary of 
terms used in payments and settlement systems,'' at 18, CPSS (March 
2003).
    \16\ See, e.g., Securities Exchange Act Release No. 19227 
(November 9, 1982), 47 FR 51658 (November 16, 1982) [File No. SR-
NYSE-82-1 etc.] (approving SRO confirmation rules). The SRO 
confirmation rules include: American Stock Exchange (``AMEX'') Rule 
423(5); Chicago Stock Exchange Article XV, Rule 5; New York Stock 
Exchange (``NYSE'') Rule 387(a)(5); Pacific Stock Exchange Rule 
9.12(a)(5); Philadelphia Stock Exchange Rule 274(b); National 
Association of Securities Dealers (``NASD'') Rule 11860(a)(5); and 
Municipal Rulemaking Board Rule G-15(d)(ii). Trades settled outside 
of the United States are excluded from the confirmation rules' 
requirements.
    The Commission's order approving the confirmation rules 
concluded that the confirmation rules were consistent with the 
establishment of a national system of clearance and settlement, 
mandated in Section 17A of the Exchange Act, because the trade 
confirmation service provided by registered clearing agencies 
provided uniform procedures for the confirmation and affirmation of 
institutional trades. The Commission also concluded that automated 
confirmations, affirmations, and settlement would increase the 
quantity and accuracy of trade information regarding customer-side 
settlement and therefore were consistent with the requirements of 
Sections 6 and 15A of the Exchange Act to foster the cooperation and 
coordination of persons engaged in clearing, settling, and 
processing information with respect to securities transactions. 15 
U.S.C. 78f and 78o-3. Finally, the Commission believed that the 
aggregate benefits of the confirmation rules to broker-dealers, 
investment managers, and custodian banks outweighed the costs to 
these parties and did not impose an inappropriate burden on 
competition. 47 FR 51658.
    \17\ E.g., NYSE Rule 387(a)(4). The agreement must provide that 
the customer will affirm the trade by T+2 when the broker-dealer 
provides the customer RVP privileges and by T+1 when the broker-
dealer provides DVP privileges.
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    After a broker-dealer executes a trade for a customer who has RVP/
DVP privileges, the broker-dealer will provide trade details to the 
customer. This step is called the ``notice of execution'' or ``NOE.'' 
If the customer submitted the order on behalf of other parties (e.g., 
an investment manager on behalf of several mutual funds), the customer 
will tell the broker-dealer how to ``allocate'' the transaction among 
the underlying entities. The broker-dealer will reply to the customer 
by sending details of, or ``confirming,'' each allocation. If the 
broker has correctly allocated the trade, the customer will ``affirm'' 
the trade.\18\
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    \18\ The trade confirmation/affirmation process is discussed in 
detail in the SIA paper, ``Institutional Transaction Processing 
Model,'' which is available at http://www.sia.com.
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    In the U.S., the only entity currently offering confirmation/
affirmation services is the Global Joint Venture Matching Services--US, 
LLC (known as ``Omgeo'').\19\ Once a trade has been affirmed, Omgeo 
submits a deliver order (``DO'') to The Depository Trust Company 
(``DTC'') \20\ for book-entry settlement.\21\
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    \19\ Generally, an entity that provides a matching service falls 
within the Exchange Act's definition of a clearing agency and 
therefore must register as such or obtain an exemption from 
registration. 15 U.S.C. 78c(a)(23). The Commission has issued an 
order conditionally exempting Omgeo from clearing agency 
registration with regard to providing matching and confirmation/
affirmation services. Securities Exchange Act Release No. 44188 
(April 17, 2001), 66 FR 20494 (April 23, 2001) [File. No. 600-32].
    \20\ DTC is a clearing agency registered under Section 17A of 
the Exchange Act.
    \21\ A DO is an instruction from a participant directing DTC to 
debit its securities account and to credit the securities account of 
another DTC participant.
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    Broker-dealers generally confirm trades with their institutional 
customers on trade date (``T+0'') while their institutional customers 
affirm the large majority of their trades after T+0. For example, in 
the first half of 2003, of the approximate 700,000 trades that were 
submitted to Omgeo on an average daily basis the confirmation rate on 
T+0 was approximately 85.8%, but affirmation rates were approximately 
23% on T+0, 85% on T+1, and 88.5% on T+2.\22\ Therefore, approximately 
eleven percent of trades either are not affirmed at all or are not 
affirmed using Omgeo's confirmation/affirmation process.\23\
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    \22\ See generally Lee Cutrone, Managing Director, Omgeo, 
remarks at the SIA STP Spring Conference, ``The Path to STP,'' (May 
20, 2003) (presentation available online at http://www.sia.com/stpspring03/pdf/Path_Lee.Cutrone.pdf).
    \23\ These exceptional trades generally are settled by the 
broker-dealer giving DTC a DO through a manual process.
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B. Industry Initiative

1. SIA ITPC White Papers
    As part of its effort to improve the clearance and settlement 
process, the SIA formed the Institutional Transaction Processing 
Committee (``ITPC'') to evaluate the settlement process for 
institutional trades. The SIA's ITPC published several white papers 
that describe what it believes are shortcomings in the processing of 
RVP/DVP transactions and has recommended the use of matching utilities 
as the way to improve the process.\24\ As described in the ITPC 2002 
White Paper, current methods of institutional transaction processing 
involve a series of sequential steps by the broker-dealer and its 
customer with only one participant reviewing and entering trade data at 
a time. The result is that the processing swings back and forth between 
the customer and broker-dealer, and with each pass, one party will 
provide additional trade data. ``The process is reactive in that each 
participant waits for a trigger before executing the next step in the 
process.''\25\ The result is delay and redundant flows of non-essential 
data.
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    \24\ The ITPC published its first white paper in December 1999 
with a subsequent version released in February 2001. The final ITPC 
white paper, ``Institutional Transaction Processing Model,'' was 
published in May 2002 (``ITPC 2002 White Paper'').
    \25\ ITPC 2002 White Paper at 3.
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    According to the ITPC, another major cause for delay in 
institutional transaction processing is the fact that many industry 
participants have to manually re-key trade data into several systems. 
Broker-dealers and their customers tend to have internal systems that 
lack both automation and common message standards. This lack of 
synchronized automated data causes errors and discrepancies.
    The ITPC 2002 White Paper states that redesigning the institutional 
transactional settlement model to achieve STP would allow the industry 
to streamline today's operating process, increase capacity 
significantly, decrease the number of exception items, and reduce costs 
over time by eliminating many redundant and manual steps. To address 
the perceived deficiencies in the existing institutional transaction 
process, the ITPC envisioned an institutional transaction processing 
model in which trade data is matched by a matching utility (``MU''). 
The MU would seamlessly match the data submitted by the broker-dealer 
and its institutional customer and would submit the matched transaction 
information to the depository in real time.\26\ The ITPC model ``treats 
the trade cycle as a unit from post-execution to settlement rather than 
a group of loosely related messages and processes'' where, 
``communications between trade participants and the matching utility 
are assumed to be automated, with virtually simultaneous processes 
comprising the `steps' of each phase.''\27\
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    \26\ See supra note 19.
    \27\ ITPC 2002 White Paper at 6.
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2. Industry Proposals for Rulemaking
    One of the principal goals of the SIA's STP initiative is for all 
transactions to be confirmed and affirmed or matched on T+0.\28\ In 
order to achieve STP, either to accommodate a standard settlement cycle 
or as a needed improvement to institutional transaction processing, the 
SIA has suggested two Commission or

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SRO rulemaking alternatives.\29\ The first would require broker-dealers 
to obtain an agreement from their customers at the outset of the 
relationship or at the time of the trade to participate in and to 
comply with the operational requirements of interoperable trade-match 
systems as a condition to settling trades on an RVP/DVP basis. The 
second would require investment managers to participate in a trade-
match system, similar to the way broker-dealers and institutions are 
required by the SRO confirmation/affirmation rules to participate in a 
confirmation/affirmation system. Either alternative would result in the 
completion of the confirmation/affirmation process within minutes of 
trade execution. They also would provide time to resolve any 
discrepancies before settlement date, thereby reducing fails.\30\
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    \28\ The SIA formed an Institutional Oversight Committee 
(``IOC'') to oversee the implementation of STP to institutional 
trade processing. The IOC's goal is that on T+0 all parties to a 
transaction should have the information required for automated 
settlement. The IOC believes this implies that:
    (1) 100% of trades would be matched or affirmed on trade date. 
Ultimately, the goal will be to replace the confirm/affirm process 
with matching;
    (2) all communications between participants would be 
asynchronous (non-sequential) and electronic, including: (a) Notice 
of executions; (b) allocations; (c) match status/affirmations; (d) 
settlement instructions;
    (3) an industry standard electronic format for message 
communication would be adopted; and
    (4) manual processing should be exception-based. ``Institutional 
Oversight Committee Project Charter,'' Institutional Oversight 
Committee (December 16, 2002).
    \29\ Letter from Arthur Thomas, Chairman, T+1 Steering 
Committee, to Laura S. Unger, Acting Chairman, Commission (February 
16, 2001).
    \30\ In June 2003, the IOC's Business Practices & Matching 
Implementation Working Group published Institutional Matching User 
Requirements (``User Requirements''). The User Requirements set 
forth a method for using a matching utility for post trade 
processing of institutional trades. The User Requirements also 
provide guidance on the following areas: (1) Connectivity; (2) 
process flows; (3) participant profiles; (4) interfaces; (5) new 
account set-up; (6) exception processing; and (7) variations to the 
ITPC Model. The task of this working group is to identify and 
analyze issues related to pre-allocated trades, prime brokerage, 
correspondent clearing, when-issued trading, and other unresolved 
institutional trade processing issues. The User Requirements are 
available on the SIA's Web site at http://www.sia.com/stp/pdf/MatchingUtilityUserReq.pdf.
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C. CPSS/IOSCO and G30 Recommendations

    Consistent with the SIA project, the CPSS/IOSCO Report recommended 
that confirmation and affirmation of institutional investors' trades 
should occur as soon as possible after trade execution, preferably on 
T+0, but no later than T+1.\31\ The CPSS/IOSCO Report recommended these 
timeframes because early agreement on trade details will allow early 
detection of errors and discrepancies in trade data. This should help 
market participants avoid errors in recording trades, which could 
result in inaccurate books and records, increased and mismanaged market 
risk and credit risk, and increased costs. The CPSS/IOSCO Report also 
stated that STP initiatives should be encouraged.\32\ Many 
practitioners believe that market-wide achievement of STP is essential 
to maintaining high settlement rates as volumes increase and for 
achieving timely settlement of cross-border trades.\33\
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    \31\ CPSS/IOSCO Report at 9.
    \32\ Id. at 9.
    \33\ Id. at 10.
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    The 2003 G30 Report endorsed the CPSS/IOSCO recommendations \34\ 
and recommended that trade confirmation be further automated and 
standardized and that matching utilities be used industry-wide.\35\ 
Specifically, the 2003 G30 Report urged market participants to develop 
compatible, industry-accepted technical and market-practice standards 
to automate the confirmation/affirmation process for institutional 
trades. Like CPSS/IOSCO, the G30 recommended matching institutional 
transaction data on trade date.\36\ The 2003 G30 Report stressed that 
in order to achieve matching on trade date without introducing risk to 
the system, current post-trade processing models must be improved.\37\
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    \34\ 2003 G30 Report at 4.
    \35\ Id. at 31.
    \36\ Id.
    \37\ Id. at 80.
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D. Discussion

    The Commission preliminarily is of the view that the goal of 
industry-wide trade matching is the best method to improve the 
confirmation/affirmation process and to achieve STP. Nevertheless, the 
imposition of a requirement that all broker-dealers and their 
institutional customers use a matching service raises some significant 
issues.
    For example, mandating the use of a matching service for the 
confirmation/affirmation process for institutional trades may stifle 
innovation and competition. While matching is the leading technology 
today, future developments may provide greater efficiency and improved 
service. Mandating that the industry use matching may make it virtually 
impossible for a service provider with a new technology to compete. 
Requiring all entities to use a matching service also may impose an 
unnecessary burden on small and medium broker-dealers and asset 
managers.\38\
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    \38\ As the speaker at one industry conference stated, ``It is 
difficult to argue that an investment manager/investment adviser 
with only 2-3 block executions per week should be compelled to 
interface electronically with a MU.'' John P. Davidson III, Managing 
Director, Morgan Stanley, remarks at the SIA STP Spring Conference, 
Institutional Oversight Subcommittee Update (May 19, 
2003)(presentation available at http://www.sia.com/stpspring03/html/presentations.html).
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    The Commission believes that even an investment manager/investment 
adviser who executes only a small number of trades should be able to 
affirm its trades with its brokers on T+0. Accordingly, the Commission 
seeks comment on how best to have the confirmation/affirmation process 
completed on T+0 for all institutional trades. The following two 
approaches, among others, could be considered.
    First, the SROs could amend their confirmation rules to prohibit 
broker-dealers from extending RVP/DVP privileges to any customer unless 
all trades with that customer are confirmed and affirmed on T+0. 
Because the SROs currently have virtually identical versions of the 
confirmation rules, this may be the most straightforward way to reach 
this goal. The difficulty with this approach is that it would require 
brokers to take actions to assist in achieving compliance.\39\ Broker-
dealers may be reluctant to exert pressure on customers that fail to 
affirm on time because those customers may take their business 
elsewhere.
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    \39\ To facilitate compliance with the SRO confirmation rules, 
Omgeo (as did its predecessor The Depository Trust Company through 
the Institutional Delivery and TradeSuite systems) provides the SROs 
with reports on confirmation and affirmation activity.
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    Another option would be for the Commission to adopt a rule that 
would require broker-dealers to confirm and affirm trades on trade 
date.\40\
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    \40\ For example, under Section 15(c)(6) of the Exchange Act, 15 
U.S.C. 78(c)(6), the Commission has the authority to issue rules and 
regulations with respect to brokers or dealers ``necessary or 
appropriate in the public interest and for the protection of 
investors or to perfect or remove impediments to a national system 
for the prompt and accurate clearance and settlement of securities 
transactions, with respect to the time and method of, and the form 
and format of documents used in connection with making settlements 
of and payments for transactions in securities, making transfers and 
deliveries of securities and closing accounts.''
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    We believe that these alternatives would preserve competition and 
innovation because they do not require the use of a particular service 
or technology. Further, the Commission rule could complement rather 
than replace the existing SRO confirmation rules. For example, the SRO 
confirmation rules could continue to require that the facilities of a 
clearing agency be used for the book-entry settlement of all depository 
eligible transactions, while the Commission rule could require that the 
confirmation and affirmation occur on T+0. In addition, the SRO 
confirmation rules could continue to provide the procedures for a 
qualified vendor to provide electronic confirmation and affirmation 
services.
    The Commission seeks comment on the following issues.
    1. What are the benefits and costs of same-day trade confirmation/
affirmation?

[[Page 12926]]

    2. What are the relative burdens of trade date confirmation/
affirmation on the different market participants involved?
    3. What effect would trade date confirmation/affirmation have on 
the relationship between a broker-dealer and its customer?
    4. Do the benefits of trade date confirmation/affirmation accrue to 
all participants--brokers, institutional customers, custodians, or 
matching utilities? Do they accrue to large, medium, and small 
entities?
    5. Does trade date confirmation/affirmation introduce any new 
risks? If so, can they be quantified?
    6. Would the modification of the existing SRO confirmation rules or 
the adoption of a new Commission rule be feasible approaches to having 
trades confirmed/affirmed by T+0? Are there alternative rule changes?
    7. If rules mandating trade date confirmation/affirmation are 
adopted, what should be the time frame for implementing them? What 
factors should the Commission consider in determining the 
implementation period?
    8. Would same-day confirmation/affirmation affect cross-border 
trading? If so, how would it do so?
    9. Should any confirmation/affirmation rule apply to all types of 
non-exempt securities?
    10. Should all participants in institutional trades be required to 
use a matching service if the Commission were to require confirmation/
affirmation on T+0?
    11. What, if anything, should the Commission do to facilitate the 
standardization of reference data and use of standardized industry 
protocols by broker-dealers, asset managers, and custodians?

III. Securities Settlement Cycles

A. Introduction

    It is generally accepted that a substantial portion of the risks in 
a clearance and settlement system is directly related to the length of 
time it takes for trades to settle. In other words, ``time equals 
risk.'' \41\ In the context of the Commission's proposal in 1993 to 
move to T+3, the Federal Reserve Board (``Board'') noted that 
settlement systems for securities and other financial instruments were 
a potential source of systemic disturbance to financial markets and to 
the economy.\42\ In the Board's view, the key features of an ideal 
settlement system were the settlement of trades immediately after 
execution and payment in same-day funds.\43\ Similarly, the Federal 
Reserve Bank of New York stated at that time that shortening the 
settlement cycle decreased the likelihood for adverse developments to 
occur between the execution and settlement of each trade, thus lowering 
the credit and market risks that could arise when settling individual 
transactions.\44\ More recently, the CPSS/IOSCO Report noted that the 
longer the period from trade execution to settlement, the greater the 
risk that one of the parties may become insolvent or default on the 
trade, the larger the number of unsettled trades, and the greater the 
opportunity for the prices of the securities to move away from the 
contract prices, thereby increasing the risk that the non-defaulting 
parties will incur a loss when replacing unsettled contracts.\45\
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    \41\ Prompted by the Group of Thirty's 1989 recommendations, in 
1991 the Commission requested that U.S. industry participants form a 
Task Force to evaluate whether and what changes to the clearance and 
settlement system should be pursued, and to determine a timetable 
for the implementation of the changes. The Bachmann Task Force, 
chaired by John Bachmann, presented its findings to the Commission 
in May 1992. The Task Force concluded that ``time equals risk'' and 
that the safety and soundness of the U.S. securities market would be 
substantially improved by shortening the settlement cycle for 
corporate securities to T+3 by mid-1994. The Bachmann Task Force on 
Clearance and Settlement in the U.S. Securities Markets, Report 
Submitted to the Chairman of the U.S. Securities and Exchange 
Commission (May 1992)(``Bachmann Report''). See also Securities 
Exchange Act Release No. 31904 (February 23, 1993), 58 FR 11806 
(March 1, 1993) [File No. SR-5-93].
    \42\ Letter from William W. Wiles, Secretary to the Federal 
Reserve Board, to Jonathan G. Katz, Secretary, Commission (September 
1, 1993) (commenting on the proposal to adopt Rule 15c6-1 
standardizing the settlement cycle for most securities transactions 
to three business days after trade date). Infra note 48.
    \43\ Id.
    \44\ Letter from William J. McDonough, President, Federal 
Reserve Bank of New York, to Jonathan G. Katz, Secretary, Commission 
(August 27, 1993) (commenting on the proposal to adopt Rule 15c6-1 
standardizing the settlement cycle for most securities transactions 
to three business days after trade date). Infra note 48.
    \45\ CPSS/IOSCO Report at 10.
---------------------------------------------------------------------------

    Arguably, the most significant risk that must be addressed by any 
clearance and settlement system is systemic risk. Systemic risk is the 
risk that the inability of one market participant to meet its 
obligations when due will cause others to fail to meet their 
obligations.\46\ Systemic risk can result from other risks inherent in 
clearance and settlement systems, such as credit, liquidity and 
operational risks. A severe problem in one or more of these areas can 
cause securities firms to fail and increase the likelihood of systemic 
disruptions in the financial markets. While the Commission believes 
that the threat of a serious systemic disruption to the U.S. financial 
markets from a settlement failure is small because of the risk 
management controls that are in place, it is nevertheless a serious 
concern. Thus, it is important that the U.S. securities industry 
continue to improve its risk management procedures in order to maintain 
safe and reliable clearance and settlement.
---------------------------------------------------------------------------

    \46\ Id. at 41.
---------------------------------------------------------------------------

    In part as a response to the 1987 Market Break and the 1990 
bankruptcy of Drexel Burnham Lambert Group,\47\ the Commission adopted 
Rule 15c6-1, which shortened the settlement time frame for most broker-
dealer securities transactions from T+5 to T+3.\48\ Rule 15c6-1 was 
adopted in connection with other measures taken by the securities 
industry, SROs, and the Commission to improve the operation of the U.S. 
clearance and settlement system and reduce risk. The other measures 
included improving the confirmation/affirmation process for 
institutional trades, expanding cross-margining and guarantee 
arrangements amongst clearing agencies, and implementing same-day funds 
settlement. These steps helped facilitate a smooth transition from T+5 
to T+3.
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    \47\ For a description of the bankruptcy of the Drexel Lambert 
Group, see, ``The Issues Surrounding the Collapse of Drexel Burnham 
Lambert,'' Hearings before the United States Congress, Senate 
Banking, Housing, and Urban Affairs, 101st Congress, 2d Sess. 5 
(1990) (testimony of Richard C. Breeden, Chairman, Commission).
    \48\ 17 CFR 240.15c6-1. Securities Exchange Act Release No. 
33023 (October 6, 1993), 58 FR 52891 (October 13, 1993) [File No. 
S7-5-93] (``Adopting Release''). Rule 15c6-1 became effective on 
June 7, 1995.
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    The implementation of a T+3 settlement cycle is widely viewed as a 
success, and the U.S. clearance and settlement system continues to be 
one of the safest and most reliable in the world.\49\ Nevertheless, we 
believe that we should consider the necessity and appropriateness of 
mitigating systemic disruptions and facilitate a more efficient 
clearance and settlement system. Three principal factors underlie our 
thinking in reviewing options

[[Page 12927]]

relating to shortening the settlement cycle.
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    \49\ The U.S. clearance and settlement system settles more 
trades today with a lower failure rate than before Rule 15c6-1's 
adoption. ``In May 1995, before T+3, and with an average daily 
volume running at 726 million shares in NYSE, Amex and Nasdaq 
securities, NSCC `failures to deliver' were an average of 8.43% of 
all deliveries. In November 1995, after the T+3 conversion, with 
average daily volume running at 830 million shares in the same 
securities, NSCC `failures to deliver' declined to 7.67%.'' 
``Speeding up Settlement: The Next Frontier,'' Arthur Levitt, 
Chairman, Commission, remarks at the Symposium on Risk Reduction in 
Payments, Clearance and Settlement Systems (January 26, 1996)(full 
text available at http://www.sec.gov/news/speech/speecharchive/1996/spch071.txt). According to NSCC, for the first seven months of 2003, 
the average daily failure rate has been 6.80%.
---------------------------------------------------------------------------

    1. Size and growth of the markets: In 1995, the year Rule 15c6-1 
became effective, the combined average daily volume on the New York 
Stock Exchange (NYSE), American Stock Exchange (``AMEX''), and National 
Association of Securities Dealers Automated Quotation System 
(``Nasdaq'') was 726 million shares. By the end of 2003, the combined 
average daily volume for the NYSE and Nasdaq was approximately 3.0 
billion shares.
    2. Tighter linkages: Currently, many financial firms participate in 
multiple markets in multiple jurisdictions and clearing agencies are 
increasing their cross-border activities. Therefore, the failure of one 
system participant could cause a wide circle of participants to fail.
    3. Possible wide-scale regional disruption: In the aftermath of the 
events of September 11, 2001, financial market participants must 
anticipate significant operational disruptions.\50\
---------------------------------------------------------------------------

    \50\ On April 7, 2003, the Commission published a joint report 
with the Board of Governors of the Federal Reserve System and the 
Office of the Comptroller of the Currency that focused on 
infrastructure resiliency titled, ``Interagency Paper on Sound 
Practices to Strengthen the Resilience of the U.S. Financial 
System.'' Securities Exchange Act Release No. 47638 (April 7, 2003), 
68 FR 17809 (April 11, 2003)[File No. S7-32-02].
---------------------------------------------------------------------------

    The Commission continues to agree with the underlying conclusions 
that led to shortening the settlement cycle from T+5 to T+3. First, at 
any given point during the settlement cycle, fewer unsettled trades 
would be subject to credit and market risk, and there would be less 
time between trade execution and settlement for the value of those 
trades to deteriorate.\51\ Second, a shorter settlement cycle would 
reduce the liquidity risk among derivative and cash markets and reduce 
financing costs by allowing investors that participate in both markets 
to obtain the proceeds of securities transactions sooner. Third, 
shortening the settlement cycle would encourage greater efficiency in 
clearing and settlement. However, before taking further action, the 
Commission believes that it is appropriate to seek comment on the 
benefits and costs of implementing a settlement cycle shorter than T+3 
as a potential method of further reducing risk and improving 
efficiency. In deciding whether or not to shorten the settlement cycle 
beyond T+3, the Commission must determine whether benefits of 
establishing a shorter settlement justify the costs of implementing it. 
The Commission believes that an evaluation of the current operation of 
Rule 15c6-1 is an appropriate starting point for such an analysis.\52\
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    \51\ The longer the time period from trade execution to 
settlement, the greater the risk that one of the parties may become 
insolvent or default on the trade (``credit or counter party risk'') 
and the greater the risk the price of the securities may move away 
from the contract price (``market or replacement cost risk'').
    \52\ As with the move from T+5 to T+3, the appropriate building 
blocks must be in place. Without these building blocks in place, a 
move to a shorter settlement cycle could reduce efficiency by 
producing more failed trades and ultimately increase risk rather 
than reduce it.
---------------------------------------------------------------------------

B. Rule 15c6-1

    The Commission adopted Rule 15c6-1 to ``facilitate the 
establishment of a national system for the prompt and accurate 
clearance and settlement of transactions in securities.'' \53\ The rule 
was adopted in 1993 and became effective in 1995.\54\ Rule 15c6-1 
provides, ``a broker or dealer shall not effect or enter into a 
contract for the purchase or sale of a security (other than an exempted 
security, government security, municipal security, commercial paper, 
bankers' acceptances, or commercial bills) that provides for payment of 
funds and delivery of securities later than the third business day 
after the date of the contract unless otherwise expressly agreed to by 
the parties at the time of the transaction.'' \55\
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    \53\ 15 U.S.C. 78q-1(a)(2)(A)(i).
    \54\ 17 CFR 240.15c6-1. Rule 15c6-1 became effective on June 7, 
1995. Prior to 1995, the standard practice for settling securities 
transactions was five business days after trade date (``T+5'').
    \55\ 17 CFR 240.15c6-1(a).
---------------------------------------------------------------------------

    The Commission's adoption of Rule 15c6-1 followed the 1989 G30 
Report \56\ and the Bachmann Report.\57\ The 1989 G30 Report 
recommended that markets around the world shorten settlement cycles to 
T+3 by 1992 ``[i]n order to minimize counterparty risk and exposure 
with securities transactions, same day settlement is the final goal.'' 
\58\ The Bachmann Report echoed this view and concluded that a shorter 
settlement period would reduce market risk to the clearing 
corporations, their members, and the markets as a whole and proposed 
T+3 as the standard settlement period.\59\
---------------------------------------------------------------------------

    \56\ ``Clearance and Settlement Systems in the World's 
Securities Markets,'' Group of Thirty (March 1989) (``1989 G30 
Report''). Recommendation 7 of the G30's 1989 Report states, ``[a] 
`[r]olling [s]ettlement' system should be adopted by all markets. 
Final settlement should occur on T+3 by 1992.'' Copies of the 1989 
G30 Report can be requested from the G30 at http://www.group30.org.
    \57\ See supra note 41.
    \58\ 1989 G30 Report at 14.
    \59\ Bachmann Report at 6.
---------------------------------------------------------------------------

    In the next sections, we discuss specific issues related to the 
current operation of Rule 15c6-1 and risk considerations in shortening 
the settlement cycle beyond T+3.

C. Current Operation of Rule 15c6-1

1. Coverage
    Rule 15c6-1 covers all securities, except for exempted securities 
(including government securities and municipal securities,\60\ 
commercial paper, bankers' acceptances, or commercial bills).\61\ In 
addition, the rule specifically exempts sales of unlisted partnership 
interests.\62\ The Commission has granted an exemption for securities 
that do not generally trade in the U.S.\63\ The Commission also 
exempted from Rule 15c6-1 a contract for the purchase or sale of any 
security issued by an insurance company that is funded by or 
participates in a separate account, including a variable annuity 
contract or a variable life insurance contract or any other insurance 
contract registered as a security under the Securities Act of 1933 
(``Securities Act'').\64\
---------------------------------------------------------------------------

    \60\ Although not covered by Rule 15c6-1, the Commission 
approved a proposed rule change by the Municipal Securities 
Rulemaking Board that required transactions in municipal securities 
to settle by T+3. Securities Exchange Act Release No. 35427 
(February 28, 1995), 60 FR 12798 (March 8, 1995) [File No. SR-MSRB-
94-10].
    \61\ 17 CFR 240.15c6-1(a).
    \62\ 17 CFR 240.15c6-1(b)(1).
    \63\ Securities Exchange Act Release No. 35750 (May 22, 1995), 
60 FR 27994 (May 26, 1995). Under this exemptive order, all 
transactions in securities that do not have transfer or delivery 
facilities in the U.S. are exempt from the scope of Rule 15c6-1. 
Furthermore, if less than 10% of the annual trading volume in a 
security that has U.S. transfer or delivery facilities occurs in the 
U.S., transactions in such security will be exempted from Rule 15c6-
1 unless the parties clearly intend T+3 settlement to apply. In 
addition, a depositary receipt is considered a separate security 
from the underlying security. Thus, if there are no transfer 
facilities in the U.S. for a foreign security but there are transfer 
facilities for a depository receipt based on such foreign security, 
only the foreign security will be exempt from Rule 15c6-1.
    \64\ Securities Exchange Act Release No. 35815 (June 6, 1995), 
60 FR 30906 (June 12, 1995).
---------------------------------------------------------------------------

2. Offerings
    Rule 15c6-1 provides a T+4 settlement cycle in firm commitment 
underwritings for securities that are priced after 4:30 p.m. Eastern 
time,\65\ which enables market participants to satisfy prospectus 
delivery requirements of the Securities Act.\66\ Subsection

[[Page 12928]]

5(b)(2) of the Securities Act prohibits the sending of securities 
through interstate commerce ``for the purpose of sale or for delivery 
after sale, unless accompanied or preceded by a prospectus that meets 
the requirements of subsection (a) of section 10.'' \67\ Subsection 
5(b)(1) of the Securities Act requires that a prospectus used after a 
registration statement has been filed must meet the disclosure 
requirements of section 10 of the Securities Act.\68\ The term 
``prospectus'' is defined broadly to include any written communication 
that ``offers a security for sale or confirms the sale of any 
security.'' \69\
---------------------------------------------------------------------------

    \65\ 17 CFR 240.15c6-1(c).
    \66\ Generally, the current underwriting process requires 
extensive due diligence between trade date and settlement date. 
Underwriters must consult with internal and external counsel and 
auditors, ascertain comfort and opinion letters, meet with senior 
management in order to complete proper due diligence. Final 
prospectuses are generally prepared on the night of pricing (trade 
date), leaving three days to book the deal, allocate trades, confirm 
share amounts, finalize routing instructions for payment, and 
prepare for settlement.
    \67\ 15 U.S.C. 77e(b)(2).
    \68\ 15 U.S.C. 77e(b)(1).
    \69\ 15 U.S.C. 77b(a)(10).
---------------------------------------------------------------------------

    Exchange Act Rule 10b-10 requires that a broker-dealer give or send 
its customers a written confirmation of a purchase or sale of 
securities at or before the completion of a transaction.\70\ The 
Securities Act provides that ``a communication provided after the 
effective date of the registration statement * * * shall not be deemed 
a prospectus if it is proved that prior to or at the same time with 
such communication a written prospectus meeting the requirements of'' 
Section 10(a) is provided.\71\ Because the information contained in a 
Rule 10b-10 confirmation typically does not satisfy the disclosure 
requirements of Securities Act Section 10, a prospectus meeting Section 
10(a) requirements must be sent or given prior to or at the same time 
with the confirmation, otherwise the confirmation could be considered a 
non-conforming prospectus.
---------------------------------------------------------------------------

    \70\ 17 CFR 240.10b-10.
    \71\ 15 U.S.C. 77b(a)(10)(a).
---------------------------------------------------------------------------

    The current settlement cycle may be the shortest time frame within 
which customers may be provided with final prospectuses prior to or 
simultaneously with delivering the Rule 10b-10 confirmation. If the 
Commission adopts a shorter settlement cycle, industry representatives 
have stated that it would be extremely challenging to accurately 
complete necessary due diligence and satisfy the physical prospectus 
delivery requirements. Therefore, the SIA has asked the Commission to 
consider eliminating the requirement that the final prospectus be 
delivered at the same time as the Rule 10b-10 confirmation.\72\ In 
addition, the SIA has asked the Commission to adopt an electronic 
access standard as a means to satisfy prospectus delivery.\73\ 
According to the SIA, an electronic access standard would alleviate 
time pressures in the current settlement cycle as well as accommodate 
future amendments to Rule 15c6-1. Furthermore, should the Commission 
decide to shorten the settlement cycle to T+1, the SIA has asked the 
Commission to consider a T+3 settlement cycle for firm commitment 
offerings priced after 4:30 p.m. Eastern time so that industry 
participants will have sufficient time to complete their due diligence 
processes.\74\ With regard to any such proposals, it must be shown that 
they are consistent with investors receiving the information and 
protections to which they are entitled.
---------------------------------------------------------------------------

    \72\ Supra note 29.
    \73\ Id.
    \74\ For a more complete discussion, see, ``White Paper version 
1.1,'' Syndicate Electronic Storage and Access to Information 
Committee (June 14, 2000) at http://www.sia.com/stp/pdf/electronic_storage.pdf.
---------------------------------------------------------------------------

D. Risk Reduction Benefits of Shortening the Settlement Cycle

    When the Commission adopted Rule 15c6-1, the Commission believed 
that shortening the settlement cycle would reduce risks that can lead 
to systemic disruptions in the financial markets.\75\ Accordingly, when 
considering whether to shorten the settlement cycle further, it would 
be useful to consider the impact of a shorter settlement cycle on 
risk.\76\
---------------------------------------------------------------------------

    \75\ See Securities Exchange Act Release No. 33023, 58 FR at 
52894.
    \76\ See generally CPSS/IOSCO Report at 39-41, Annex 3.
---------------------------------------------------------------------------

1. Risks Prior to Settlement \77\
---------------------------------------------------------------------------

    \77\ While there are a number of risks that may occur prior to 
settlement (e.g., market and counterparty risk), for purposes of 
this release they will be referred to as ``presettlement risk.'' See 
generally CPSS/IOSCO Report at 39-41, Annex 3.
---------------------------------------------------------------------------

    As defined in the CPSS/IOSCO Report, presettlement risk is ``[t]he 
risk that a counterparty to a transaction for completion at a future 
date will default before final settlement. The resulting exposure is 
the cost of replacing the original transaction at current market prices 
and is also known as replacement cost risk.'' \78\
---------------------------------------------------------------------------

    \78\ CPSS/IOSCO Report at 48. ``A failure to perform on the part 
of one party to the transaction will leave the solvent counterparty 
with the need to replace, at current market prices, the original 
transaction. When the solvent counterparty replaces the original 
transaction at current prices, however, it will lose the gains that 
had occurred on the transaction in the interval between the 
transaction and default. The unrealized gain, if any, on a 
transaction is determined by comparing the market price of the 
security at the time of default with the contract price; the seller 
of a security is exposed to a replacement cost loss if the market 
price is below the contract price, while the buyer of the security 
is exposed to such a loss if the market price is above the contract 
price. Because future securities price movements are uncertain at 
the time of the trade, both counterparties face replacement cost 
risk.'' CPSS/IOSCO Report at 39. Supra note 51.
---------------------------------------------------------------------------

    Presettlement risk can present substantial danger to the settlement 
system because it involves the change in the value of securities 
involved in the defaulting party's transactions. In the event of 
default of a major participant, it may entail credit losses so large as 
to create systemic problems.\79\ As previously stated, reducing the 
time period from trade execution to settlement is one of the primary 
methods of reducing this risk.\80\
---------------------------------------------------------------------------

    \79\ Id.
    \80\ Bachmann Report at 6.
---------------------------------------------------------------------------

    Episodes of severe market declines magnify replacement cost risk. 
At the time of the 1987 Market Break, the U.S. settlement cycle was 
five days and ten of the thirty stocks making up the Dow Jones 
Industrial Average (``DJIA'') declined 35 percent or more over five 
days.\81\ A default by a buyer of one of these stocks during that 
period would have exposed the seller to substantial losses. More 
recently, on Monday, October 27, 1997, the nation's securities markets 
experienced a tremendous decline when the DJIA fell by 554.26 points. 
On August 31, 1998, the DJIA experienced a decline of 512.61 
points.\82\ With sharp price movements, traders may be unwilling or 
unable to meet margin calls and default on their delivery obligations.
---------------------------------------------------------------------------

    \81\ ``Clearance and Settlement in U.S. Securities Markets,'' 
Federal Reserve Board (March 1992).
    \82\ ``Trading Analysis of October 27 and 28, 1997,'' report by 
the Division of Market Regulation, Commission (September 1998).
---------------------------------------------------------------------------

    The Commission believes that shortening the settlement cycle could 
reduce replacement cost risk because the magnitude of replacement cost 
risk depends on the volatility of the security price and the amount of 
time that elapses between the trade date and the settlement date.
2. Risks Associated With Settlement
    Settlement risk is ``[a] general term used to designate the risk 
that settlement in a transfer system will not take place as expected. 
This risk may comprise both credit \83\ and liquidity risk.'' \84\ 
Settlement risk is sometimes referred to as principal risk, i.e., the 
risk of loss of securities delivered or payments made to the defaulting 
participant prior to the detection of the default.\85\ Both the buyer 
and the seller are exposed to the risk of loss of the full principal 
value of the securities or funds transferred.
---------------------------------------------------------------------------

    \83\ Credit risk is the risk of loss from default by a 
participant in a settlement system, typically as a consequence of 
insolvency. CPSS/IOSCO Report at 39, 48.
    \84\ Id. at 49.
    \85\ Id. at 39 and 48.

---------------------------------------------------------------------------

[[Page 12929]]

    In addition, both parties to a securities trade are exposed to 
liquidity risk on the settlement date. Liquidity risk includes the risk 
that the seller of a security who does not receive payment when due may 
have to borrow or liquidate assets to complete other payments. It also 
includes the risk that the buyer of the security does not receive 
delivery when due and may have to borrow the security in order to 
complete its own delivery obligation. The costs associated with 
liquidity risk depend on the liquidity of the markets in which the 
affected party must make its adjustments; the more liquid the markets, 
the less costly the adjustment.\86\
---------------------------------------------------------------------------

    \86\ Id.
---------------------------------------------------------------------------

    Liquidity problems have the potential to create systemic 
disruptions. In particular, if liquidity problems arise when securities 
prices are changing rapidly, failures to meet obligations when due are 
more likely to elevate concerns about solvency. In the absence of a 
strong linkage between delivery and payment, the emergence of systemic 
liquidity problems at such times is especially likely. The fear of 
losing the full principal value of securities or funds could induce 
some participants to withhold deliveries and payments, which, in turn, 
may prevent other participants from meeting their obligations.\87\
---------------------------------------------------------------------------

    \87\ Id. at 40.
---------------------------------------------------------------------------

    As noted above, one reason for shortening the settlement cycle from 
T+5 to T+3 was that the shorter interval would reduce the liquidity 
risk in derivative and cash markets and reduce financing costs by 
allowing investors that participate in both markets to obtain the 
proceeds of securities transactions sooner. Shortening the settlement 
cycle to T+1, for example, also would synchronize the settlement of 
corporate and derivative securities and have liquidity benefits. By 
reducing the lag between the settlement of derivatives and government 
securities and the settlement of equity and corporate securities, 
investors that participate in both markets would be able to reduce 
their financing costs and obtain the proceeds of their securities 
transactions on a timelier basis.\88\
---------------------------------------------------------------------------

    \88\ See Letter from Sarah A. Miller, Senior Government 
Relations Counsel, American Bankers Association, to Jonathan G. 
Katz, Secretary, Commission (June 30, 1993)(commenting on the 
proposal to adopt Rule 15c6-1).
---------------------------------------------------------------------------

3. Risks Associated With Operations
    The CPSS/IOSCO Report states that ``[o]perational risk is the risk 
that deficiencies in information systems or internal controls, human 
errors, or management failures will result in unexpected losses. As 
clearing and settlement systems become increasingly more dependent on 
information systems, the reliability of these systems is a key element 
in operational risk. The importance of operational risk lies in its 
capacity to impede the effectiveness of measures adopted to address 
other risks in the settlement process and to cause participants to 
incur unforeseen losses, which, if sizeable, could have systemic risk 
implications.'' \89\
---------------------------------------------------------------------------

    \89\ CPSS/IOSCO Report at 17.
---------------------------------------------------------------------------

    Operational deficiencies within a broker-dealer, a clearing 
corporation, or at an exchange can increase the risk of loss to market 
participants and investors. These deficiencies can reduce the 
effectiveness of other measures that the settlement system takes to 
manage risk. For example, operational problems could impair the 
system's ability to complete settlement, create liquidity pressures on 
the market or participants, or hamper the system's ability to monitor 
and manage credit exposures. Possible operational failures include 
errors or delays in processing, system outages, insufficient capacity, 
or fraud by staff.\90\
---------------------------------------------------------------------------

    \90\ Id. at 40.
---------------------------------------------------------------------------

    The events of September 11, 2001, demonstrated how operational risk 
results from unforeseen events that can directly and severely affect 
market functions. Generally, financial crises involve both operational 
and credit issues. In contrast, the events of September 11, 2001, were 
unusual in that the settlement problems that did occur resulted almost 
exclusively from operational problems. No firm failed in the immediate 
aftermath of the terrorist attacks, although some firms were severely 
affected. If credit problems had arisen, the systemic consequences 
could have been severe.\91\ However, the attacks did highlight the need 
to examine the risks in the clearance and settlement system, including 
the need for a resilient clearance and settlement infrastructure.\92\
---------------------------------------------------------------------------

    \91\ Despite the widespread loss and destruction from the events 
of September 11, 2001, the U.S. financial system continued to 
perform its vital economic functions. ``Summary of `Lessons Learned' 
from Events of September 11 and Implications for Business 
Continuity,'' staffs of the Federal Reserve Board, the New York 
State Banking Department, the Office of the Comptroller of the 
Currency, and the Securities and Exhange Commission, discussion 
document for meeting at the Federal Reserve Bank of New York 
(February 26, 2002).
    Though the equity markets remained closed for four days and most 
bond trading was suspended for two, the U.S. clearance and 
settlement system was able to clear and settle trades executed on 
September 11. Largely by switching to back-up systems, DTC and NSCC 
continued clearing and settling trades due for settlement on the 
days following the attacks. As a result, the industry was able to 
sustain its business and resume trading once the markets reopened on 
Monday, September 17, 2001. The Depository Trust and Clearing 
Corporation, Annual Report 2001.
    \92\ See supra note 50.
---------------------------------------------------------------------------

E. Costs of Implementing a Shorter Settlement Cycle

1. SIA Business Case Report
    In July 2000, the SIA published its T+1 Business Case Final Report 
(``SIA Business Case Report'') that included a cost-benefit analysis 
for transitioning to T+1. The SIA Business Case Report's major 
conclusions were the following: (1) The industry could shorten the 
settlement cycle to T+1 by June 2004; (2) moving to T+1 would cost 
approximately $8 billion but would save the industry $2.7 billion a 
year; and (3) moving to T+1 would reduce settlement exposure by 
67%.\93\
---------------------------------------------------------------------------

    \93\ SIA Business Case Report at 7. Based on 1999 volumes, the 
SIA estimated decreased settlement exposure by $250 billion in a T+1 
environment.
---------------------------------------------------------------------------

    The SIA estimated that settlement exposure would decrease by $250 
billion in a T+1 environment. With fewer open positions at the clearing 
agencies, the SIA purported that T+1 settlement could reduce 
participants' clearing fund obligations by one-third. Additionally, 
operational risk for custodians would also be reduced as the number of 
pending settlements decreased.\94\ The SIA further concluded that firms 
would benefit from an annual cost savings of approximately $2.7 
billion, and would therefore recoup their investment three years after 
implementing a T+1 settlement cycle.
---------------------------------------------------------------------------

    \94\ Id.
---------------------------------------------------------------------------

    Since its publication, a number of critics questioned the 
assumptions and conclusions contained in the SIA's Business Case 
Report, arguing that it would cost the industry more than $8 billion 
and the cost recovery would take longer than three years. Critics also 
argued that the SIA's Business Case Report did not adequately quantify 
the risk reduction benefits of moving to T+1.\95\
---------------------------------------------------------------------------

    \95\ For example, the Investment Counsel Association of America 
(``ICAA'') has expressed disagreement with the findings made in the 
SIA's Business Case as they pertain to small and mid-sized 
investment managers. The ICAA stated that the SIA's study contained 
flaws regarding the number of the investment advisers affected by 
T+1 and underestimates the costs they will bear. See Letters from 
ICAA to Harvey L. Pitt, Chairman, Commission (October 9, 2001 and 
January 14, 2002).
    Another report examined the impact of T+1 on the dealer 
community. See the Forrester Report, ``The Real Benefits of T+1,'' 
by Todd Eyler (September 2001). Forrester is an independent research 
company that ``analyzes the future of technology change and its 
impact on business, consumers, and society.'' For more information, 
visit their Web site http://www.forrester.com.

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[[Page 12930]]

2. Costs to Cross-Border Trading
    Reducing the settlement cycle is neither costless nor without risk. 
``This is especially true for markets with significant cross-border 
activity because differences in time zones and national holidays, and 
the frequent involvement of multiple intermediaries, make timely 
confirmation more difficult. In most markets, a move to T+1 (perhaps 
T+2) would require a substantial reconfiguration of the trade 
settlement process and an upgrade of existing systems. For markets with 
a significant share of cross-border trades, substantial system 
improvements may be essential to shortening settlement cycles. Without 
such investments, a move to a shorter settlement cycle could generate 
increased settlement fails, with a higher proportion of participants 
unable to agree and exchange settlement data or to acquire the 
necessary resources for settlement in the time available. Consequently, 
replacement cost risk would not be reduced as much as anticipated and 
operational risk and liquidity risk could increase.''\96\
---------------------------------------------------------------------------

    \96\ CPSS/IOSCO Report at 10. See generally SIA Business Case 
Report at 18.
---------------------------------------------------------------------------

    The level of cross-border activity is another significant factor 
that should be considered when determining whether to reduce the 
settlement cycle beyond T+3. During the 1990's, non-U.S. investors 
played an increasing role in the U.S. securities markets. For example, 
gross activity in U.S. equities by foreign holders totaled $6.0 
trillion in 2001.\97\ The SIA has projected that T+1 settlement would 
increase global competitiveness, synchronize settlement with other 
markets, better equip the U.S. market to handle increasing volumes, and 
lower transaction costs.\98\
---------------------------------------------------------------------------

    \97\ SIA Annual Securities Industry Fact Book 2002 at 74. 
Available through the SIA.
    \98\ SIA Business Case Report at 8.
---------------------------------------------------------------------------

    On the other hand, because cross-border transactions in U.S. 
securities often involve differences in time zones, the use of multiple 
intermediaries, and the need to convert funds from one currency to 
another, the ability of a non-U.S. entity to settle trades could become 
significantly more difficult and expensive if these factors are not 
addressed adequately. As a result, a settlement cycle shorter than T+3 
could make the U.S. securities markets less attractive rather than more 
attractive to non-U.S. entities.

F. Request for Comment

    The Commission seeks comment on the current operation of Rule 15c6-
1 and the costs and benefits of implementing a settlement cycle shorter 
than T+3. The Commission also seeks comment on alternative means to 
reduce risks in the system while operating in a T+3 settlement cycle. 
In order to evaluate fully the costs and benefits associated with 
shortening the settlement cycle, the Commission requests that 
commenters' estimates be accompanied by specific empirical data 
supporting their statements. The Commission seeks comments on the 
following:
    1. Should the securities covered by Rule 15c6-1 be expanded? If so, 
what securities should be added? Why should these securities be added?
    2. Given the increase in cross-border transactions and dually-
traded securities over the past eight years, are the conditions set 
forth in the Commission's exemption order for securities traded outside 
the United States still appropriate? If not, why not? If the exemption 
should be modified, how should it be modified?
    3. Are the conditions set forth in the Commission's exemption order 
for variable annuity contracts still appropriate? If not, why not? If 
the exemption should be modified, how should it be modified?
    4. If the Commission were to mandate a settlement cycle shorter 
than T+3, should the Commission shorten the settlement cycle for firm 
commitment offerings priced after 4:30 p.m. Eastern time from T+4 to 
T+3 or T+2?
    5. How would a shortened settlement cycle affect processing newly 
issued securities?
    6. What systems and operational changes would be necessary in order 
to settle newly issued securities in a shortened settlement cycle?
    7. How much would it cost to shorten the settlement cycle beyond 
T+3?
    a. Is achieving 100% of confirmation/affirmation or matching on 
trade date a prerequisite for shortening the settlement cycle beyond 
T+3?
    b. If so, what are the additional costs of shortening the 
settlement cycle after achieving 100% of confirmation/affirmation or 
matching on trade date?
    8. What parties will bear the costs of moving to a settlement cycle 
shorter than T+3 (such as broker-dealers, investment managers, 
custodians, investors, and other market participants)?
    9. What are the benefits of shortening the settlement cycle beyond 
T+3? Are there economic benefits in terms of reduction in credit and 
liquidity risk associated with shortening the settlement cycle beyond 
T+3?
    10. Who will benefit from shortening the settlement cycle beyond 
T+3 (such as broker-dealers, investment managers, custodians, 
investors, and other market participants)?
    11. How would shortening the settlement cycle affect efficiency and 
risk?
    a. What are the risks associated with upgrading computer systems 
and transaction processing procedures to convert existing systems to 
new systems and the establishment of necessary linkages between other 
market participants?
    b. Would shortening the settlement cycle beyond T+3 encourage 
market participants to implement additional risk management procedures? 
What additional operational risks would result from shortening the 
settlement cycle beyond T+3?
    c. Would a shorter settlement cycle encourage market participants 
to invest in technology and automation that would enhance their 
operational efficiency? Would such investments improve market 
efficiency?
    d. Are there alternatives to shortening the settlement cycle that 
would increase efficiency in the clearance and settlement system?
    e. Are there alternatives to shortening the settlement cycle that 
would mitigate risks in the clearance and settlement process?
    12. How would shortening the settlement cycle affect the 
information, benefits, and protections that investors have under 
present U.S. clearance and settlement arrangements?
    13. How can the safety and soundness of the U.S. clearance and 
settlement system be increased while ensuring that investors can 
continue to obtain direct registration of their securities on issuer 
records in a less-than-three-day settlement environment?
    14. What impact would a shortened settlement cycle for U.S. 
equities and corporate securities have on cross-border trading by non-
U.S. entities of these instruments?

IV. Immobilization and Dematerialization of Securities Certificates

A. Introduction and Background

    Securities have been issued in the U.S. using paper certificates 
since the eighteenth century.\99\ Issuers

[[Page 12931]]

traditionally used certificates to register securities ownership in the 
name of investors. Certificates are used by issuers both as means to 
evidence and transfer ownership and as a means to identify security 
owners to issuers, in an effort to develop company loyalty and to know 
who owns their securities. As trading volumes soared during the last 
half of the twentieth century, however, processing certificates became 
increasingly problematic.
---------------------------------------------------------------------------

    \99\ A securities certificate evidences that the owner is 
registered on the books of the issuer as a shareholder. The shares, 
as distinct from the certificate, constitute an intangible right to 
participate in the capital and surplus of the company. Guttman, 
Modern Securities Transfers, Para. 1:5 at 1-15 (Thomson West 2002). 
Because the certificate is a negotiable instrument under state 
commercial laws, it allows the registered owner to deliver the 
bundle of rights it represents to a third party without first having 
to change the registration on the books of the issuer. State 
commercial laws specify rules concerning the transfer of the rights 
that constitute securities and the establishment of those rights 
against the issuer and other parties. Official comment to Article 8-
101, The American Law Institute and National Conference of 
Commissioners of Uniform State Laws, Uniform Commercial Code, 1990 
Official Text with Comments (West 1991).
    The first major issue of publicly traded securities occurred in 
1790 when the federal government issued $80 million of bonds to 
refinance federal and state Revolutionary War debt. In 1792, five 
securities, two bank stocks and three government bonds, began 
trading on what was to become the NYSE. For a historical discussion 
of the development of trading on the exchange, see http://www.nyse.com.
---------------------------------------------------------------------------

    The processing of securities certificates has long been identified 
as an inefficient and risk-laden mechanism by which to hold and 
transfer ownership. Because securities certificates require manual 
processing, their use can result in significant delays and expenses in 
processing securities transactions and can raise risk concerns 
associated with lost, stolen, and forged certificates.
    Congress has recognized the problems and dangers that the movement 
of certificates presents to the safe and efficient operation of the 
U.S. clearance and settlement system, and has given the Commission 
responsibility and authority to address these issues.\100\ Indeed, for 
over thirty years, the Commission and the financial services industry 
have worked together to reduce the reliance on securities certificates 
in the U.S. clearance and settlement system. The Commission believes 
that it is an appropriate time to consider further steps to remove 
securities certificates from the U.S. trading markets and our clearance 
and settlement system.
---------------------------------------------------------------------------

    \100\ 15 U.S.C. 78q-1(a)(2); 15 U.S.C. 78q-1(e).
---------------------------------------------------------------------------

    In the late 1960s and early 1970s, the securities industry 
experienced a ``Paperwork Crisis'' that nearly brought the industry to 
a standstill and directly or indirectly caused the failure of large 
number of broker-dealers.\101\ This crisis primarily resulted from 
increasing trade volume overburdening an inefficient manual clearance 
and settlement systems. Deliveries to customers of both cash and 
securities were frequently late, and stock certificates were lost in 
the ``rising tide of paper.''\102\ In its review of the Paperwork 
Crisis, Congress found that inefficient clearance and settlement 
procedures imposed unnecessary costs on investors and those acting on 
their behalf.\103\ In an effort to increase efficiency and reduce risk, 
Congress amended the Exchange Act to vest the Commission with the 
authority and responsibility to establish a national system for the 
prompt and accurate clearance and settlement of transactions in 
securities (``National Clearance and Settlement System'').\104\ 
Recognizing the problems associated with the use of securities 
certificates, Congress directed the Commission ``to end the physical 
movement of securities certificates in connection with the settlement 
among brokers and dealers of transactions in securities''\105\ and 
authorized the Commission to establish a system for reporting missing, 
lost, counterfeit, and stolen securities.\106\ Immobilization or 
dematerialization of securities certificates and consequently book-
entry settlement of securities transactions and transfer of ownership 
have become large components of the operation of the U.S. clearance and 
settlement system, particularly in light of substantial trading 
volumes.\107\
---------------------------------------------------------------------------

    \101\ Securities and Exchange Commission, Study of Unsafe and 
Unsound Practices of Brokers and Dealers, H.R. Doc. No. 231, 92nd 
Cong., 1st Sess. 13 (1971). Congress held extensive hearings to 
investigate the problems and ultimately enacted the Securities Acts 
Amendments of 1975.
    \102\ S. Rep. No. 94-75, 94th Cong., 1st Sess. 4 (1975). In 
addressing the Paperwork Crisis, Congress noted that rather than 
responding to investor needs and striving for more efficient ways to 
perform essential functions, securities markets had resisted 
industry modernization and had been ``unable or unwilling to respond 
promptly and effectively to radically altered economic and 
technological conditions.'' Id. at 1.
    \103\ 15 U.S.C. 78q-1(a)(1)(B).
    \104\ 15 U.S.C. 78q-1(a)(2)(A). Congress expressly envisioned 
the Commission's authority to extend to every facet of the 
securities handling process involving securities transactions within 
the United States, including activities by clearing agencies, 
depositories, corporate issuers, and transfer agents. See S. Rep. 
No. 75, 94th Cong., 1st Sess. at 55 (1975).
    \105\ 15 U.S.C. 78q-1(e).
    \106\ 15 U.S.C. 78q(f)(1).
    \107\ Immobilization of securities occurs where the underlying 
certificate is kept in a securities depository (or held in custody 
for the depository by the issuer's transfer agent) and transfers of 
ownership are recorded through electronic book-entry movements 
between the depository's participants' accounts. An issue is 
partially immobilized (as is the case with most equity securities 
traded on an exchange or securities association), when the street 
name positions are immobilized at the securities depository but 
certificates are still available to investors directly registered on 
the issuer's books. Dematerialization of securities occurs where 
there are no paper certificates available, and all transfers of 
ownership are made through book-entry movements.
---------------------------------------------------------------------------

    Consistent with its Congressional directives, the Commission has 
long encouraged the use of alternatives to holding securities in 
certificated form in its effort to improve efficiencies and decrease 
risks associated with processing securities certificates. The 
Commission approved DTC's registration as a clearing agency operating 
as a depository in order to immobilize securities in a registered 
clearing agency and settle transactions by book-entry movements.\108\ 
Registration of DTC as a clearing agency constituted an important step 
in achieving increased immobilization of securities in accordance with 
the goals established by Congress. The Commission also approved rules 
of the exchanges and the NASD that require their members to use the 
facilities of a securities depository for the book-entry settlement of 
all transactions in depository-eligible securities \109\ and to require 
that before any security can be listed for trading it must have been 
made depository-eligible if possible.\110\
---------------------------------------------------------------------------

    \108\ Securities Exchange Act Release No. 20221 (September 23, 
1983), 48 FR 45167 (October 3, 1983), [File No. 600-1, et. al.].
    \109\ Securities Exchange Act Release No. 32455 (June 11, 1993), 
58 FR 33679 (June 18, 1993), [File Nos. SR-Amex-93-07; SR-BSE-93-08; 
SR-MSE-93-03; SR-NASD-93-11; SR-NYSE-93-13; SR-PSE-93-04; SR-PHIX-
93-09] (order approving rules requiring members, member 
organizations, and affiliated members of the NYSE, NASD, AMEX, 
Midwest Stock Exchange, Boston Stock Exchange, Pacific Stock 
Exchange, and Philadelphia Stock Exchange to use the facilities of a 
securities depository for the book-entry settlement of all 
transactions in depository-eligible securities with another 
financial intermediary).
    \110\ Securities Exchange Act Release No. 35798 (June 1, 1995), 
60 FR 30909 (June 12, 1995), [File Nos. SR-Amex-95-17; SR-BSE-95-09; 
SR-CHX-95-12; SR-NASD-95-24; SR-NYSE-95-19; SR-PSE-95-14; SR-Phlx-
95-34] (order approving rules setting forth depository eligibility 
requirements for issuers seeking to have their shares listed on 
national securities exchanges).
---------------------------------------------------------------------------

    Today, DTC, one of the largest, if not the largest, depository in 
the world, provides book-entry depository and settlement services for 
the vast majority of U.S. transactions involving equities, corporate 
and municipal debt, money market instruments, American Depositary 
Receipts, and exchange-traded funds between broker-dealers and between 
broker-dealers and their institutional customers.\111\ Many of the 
issues held at the depository, particularly municipal bonds and 
derivative securities, are fully dematerialized.
---------------------------------------------------------------------------

    \111\ In 2002, DTC handled 224.3 million book-entry deliveries 
valued at nearly $104 trillion. 2002 DTCC Annual Report at 2.

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[[Page 12932]]

    To reduce the use of securities certificates by individual 
investors, particularly those of equities and corporate bonds, the 
Commission and industry representatives have explored various ways to 
provide for ownership registered in the name of individual investors 
without reliance on negotiable securities certificates. In 1985, the 
Division of Market Regulation held ``Securities Immobilization 
Workshops'' to discuss the use of central depositories to immobilize 
securities certificates and the development of book-entry systems where 
retail investors could register their securities directly with the 
issuers using issuer or transfer agent operated book-entry 
systems.\112\
---------------------------------------------------------------------------

    \112\ ``Progress and Prospects: Depository Immobilization of 
Securities and Use of Book-Entry Systems,'' Staff Report, Division 
of Market Regulation, Commission (June 14, 1985).
---------------------------------------------------------------------------

    The 1987 Market Break also prompted numerous studies recommending 
specific reforms to address perceived weaknesses in the clearance and 
settlement systems.\113\ The Bachmann Report, discussed above, made a 
number of suggestions including eliminating the delivery of ``physical 
certificates'' through the use of central depositories, but it did not 
advocate eliminating the use of the certificate for retail 
investors.\114\ However, the Report argued that while investors should 
have the right to hold physical certificates, that right should not 
come at the expense of safety of the markets. The Bachmann Report 
strongly encouraged the Commission to explore the possibility of 
requiring retail investors to return their certificates to the system 
before trading.\115\
---------------------------------------------------------------------------

    \113\ See e.g., Division of Market Regulations, The October 1987 
Market Break (February 1988); Working Group on Financial Markets, 
Interim Report to the President of the United States (May 1988).
    \114\ Supra note 41.
    \115\ Some industry representatives continue to recommend the 
Commission adopt regulations that would permit the sale of 
securities only when the securities have been ``returned to the 
system'' (i.e., when certificates either are in the possession of 
the broker-dealer or are accessible to the broker-dealer through a 
direct registration system or through a custodian or other financial 
intermediary). See e.g., ``Defining `Return to the System Prior to 
Entering Sale,' '' Physical Certificates Subcommittee, STP Steering 
Committee, SIA (November 2002).
---------------------------------------------------------------------------

    In 1990, the Commission held a Roundtable on Clearance and 
Settlement to discuss the implementation of the recommendations of the 
Group of Thirty's U.S. Working Committee regarding clearance and 
settlement.\116\ Participants in the Roundtable noted that the pressure 
to have securities available for settlement in shorter settlement time 
frames (at the time the industry was contemplating moving from T+5 to 
T+3 settlement) would increase the need for immobilizing securities 
certificates and the use of book-entry transfer at the retail 
level.\117\ The Roundtable participants envisioned a transfer agent 
operated book-entry registration system that would allow investors to 
be ``directly registered'' in electronic form on the books of the 
issuer. Investors would receive a periodic statement reflecting their 
ownership interest and would retain the option of selling the 
securities through brokers by notifying transfer agents to move the 
securities from the books of the issuers to the books of the brokers. 
Certificates would also be available upon request.
---------------------------------------------------------------------------

    \116\ Concerned with the international financial system 
following the 1987 market break, the 1989 G30 Report offered 
recommendations for reducing risk and improving efficiency in the 
world's clearance and settlement systems for corporate securities. 
1989 G30 Report, supra note 56. For more information on these 
recommendations, see Securities Exchange Act Release No. 33023 
(October 6, 1993), 58 FR 52891 (October 13, 1993). Subsequently, the 
U.S. Working Committee was formed to study the existing U.S. 
clearance and settlement systems and to recommend appropriate 
changes based upon the Group of Thirty's recommendations. Based upon 
its review, the U.S. Working Committee issued its report, 
``Implementing the Group of Thirty Recommendations in the United 
States,'' U.S. Working Committee, Group of Thirty (November 1990).
    \117\ Providing Alternatives to Certificates For the Retail 
Investor, Group of Thirty, U.S. Working Committee, Clearance and 
Settlement Project (August 1991).
---------------------------------------------------------------------------

    In 1992, the Securities Transfer Association, the Corporate 
Transfer Agents Association, the Securities Industry Committee of the 
American Society of Corporate Secretaries, and DTC formed an ad hoc 
committee to further develop the concept of direct registration, 
modeling it after the systems used by transfer agents in their 
administration of issuers' dividend reinvestment and stock purchase 
programs. The committee was expanded to include representatives from 
the SIA and DTC in order to develop both the electronic link by which 
securities could be transferred between transfer agents and broker-
dealers and to develop operational guidelines.
    In 1994, the Commission issued a concept release seeking public 
comment on the policy implications and the regulatory issues raised by 
the use of direct registration.\118\ A vast majority of commenters 
supported the concept, but many also expressed continued support for 
shareholders' abilities to obtain securities certificates if so 
desired.\119\
---------------------------------------------------------------------------

    \118\ Securities Exchange Act Release No. 35038 (December 1, 
1994), 59 FR 63652 (December 8, 1994) [File No. SR-34-94] (``Concept 
Release'').
    \119\ Referring in the Concept Release to the then recently 
adopted Rule 15c6-1, the Commission stated that ``faster trade 
settlements should not require investors to forego the benefits of 
direct registration,'' and noted that ``Rule 15c6-1 does not require 
customers to leave funds, securities, or both subject to the broker-
dealers' possession or control.''
---------------------------------------------------------------------------

    The culmination of these efforts is the establishment of the Direct 
Registration System (``DRS''), which is operated by DTC.\120\ DRS 
allows an investor to establish either through the issuer's transfer 
agent or through the investor's broker-dealer a book-entry position on 
the books of the issuer, and to electronically transfer her position 
between the transfer agent and the broker-dealer. DRS, therefore, 
allows an investor to have securities registered in her name without 
having a certificate issued to her and the ability to electronically 
transfer her securities to her broker-dealer in order to effect a 
transaction without the risk and delays associated with the use of 
certificates. In 1996, the NYSE modified its listing criteria to permit 
listed companies to issue securities in book entry form provided that 
the issue is included in DRS.\121\ Similarly, the NASD modified its 
rule to require that if an issuer establishes a direct registration 
program, it must participate in an electronic link with a securities 
depository in order to facilitate the electronic transfer of the 
issue.\122\ On July 30, 2002, the Commission approved a rule change 
proposed by the NYSE to amend NYSE Section 501.01 of the NYSE Listed

[[Page 12933]]

Company Manual to allow a listed company to issue securities in a 
dematerialized or completely immobilized form and therefore not send 
stock certificates to record holders, provided the company's stock is 
issued pursuant to a dividend reinvestment program, stock purchase 
plan, or is included in DRS.\123\
---------------------------------------------------------------------------

    \120\ With such a system in place, investors would have three 
choices as to how to hold their securities: (1) In street name at 
their broker-dealer; (2) in certificated form; or 3) in electronic 
form on the books of the issuer. This transfer agent operated book-
entry system eventually was realized in the current DRS. For more 
information on alternatives to holding securities certificates, see 
http://www.sec.gov/investor/pubs/holdsec. For a description of DRS 
and the DRS facilities administered by DTC, see Securities Exchange 
Act Release Nos: 37931 (November 7, 1996), 61 FR 58600 (November 15, 
1996), [File No. SR-DTC-96-15] (order granting approval to establish 
DRS); 41862 (September 10, 1999), 64 FR 51162 (September 21, 1999), 
[File No. SR-DTC-99-16] (order approving implementation of the 
Profile Modification System); 42704 (April 19, 2000), 65 FR 24242 
(April 25, 2000), [File No. SR-00-04] (order approving changes to 
the Profile Modification System); 43586 (November 17, 2000), 65 FR 
70745 November 27, 2000), [File No. SR-00-09] (order approving the 
Profile Surety Program in DRS); 44696 (August 14, 2001), 66 FR 43939 
(August 21, 2001), [File No. SR-DTC-2001-07] (order approving 
movement of DRS issues into the Profile Modification System and the 
establishment of the ``S'' position as the default in DRS).
    \121\ Securities Exchange Act Release No. 37937 (November 8, 
1996), 61 FR 58728 (November 18, 1996), [File No. SR-NYSE-96-29].
    \122\ Securities Exchange Act Release No. 39369 (November 26, 
1997), 62 FR 64034 (December 3, 1997), [File No. SR-97-51].
    \123\ Securities Exchange Act Release No. 46282 (July 30, 2002), 
67 FR 50972 (August 6, 2002), [File No. SR-NYSE-2001-33].
---------------------------------------------------------------------------

    Use of DRS has expanded substantially since its inception in 1996, 
but continues to remain limited relative to the total number of 
issuers. As of November 2003, approximately 600 issuers and 17 transfer 
agents participate in DRS with over 37 million shareholders holding 
their securities in DRS.\124\ Issuers, transfer agents, and broker-
dealers continue to meet in order to explore expanding the use of DRS 
to non-equity products and integrate new technologies that would make 
the system more effective and efficient.
---------------------------------------------------------------------------

    \124\ See supra note 120 for more information on alternative 
methods of holding securities.
---------------------------------------------------------------------------

B. CPSS/IOSCO and G30 Recommendations

    Many in the international community view the elimination of 
securities certificates as a critical component in the overall plan to 
make markets more efficient and to minimize risk in the world's 
clearance and settlement system. Recommendation 6 of the CPSS/IOSCO 
Report states: ``Securities should be immobilized or dematerialized and 
transferred by book entry in CSDs (central securities depositories) to 
the greatest extent possible.'' \125\ The CPSS/IOSCO Report states that 
maintaining custody of securities in a central securities depository 
(such as DTC) will significantly reduce costs associated with 
securities settlement and custody through economies of scale and will 
increase efficiency through increased automation. The CPSS/IOSCO Report 
notes that immobilization or dematerialization of securities also 
reduces or eliminates certain risks, such as the destruction or theft 
of certificates. The CPSS/IOSCO Report recognizes that it may not be 
necessary to achieve complete immobilization to realize the benefits of 
central securities depositories as long as the most active market 
participants immobilize their holdings. In practice, retail investors 
may not be prepared to give up their certificates. Less active 
investors who choose to hold certificates could continue to do so; 
however, they should bear the associated costs.\126\
---------------------------------------------------------------------------

    \125\ CPSS/IOSCO Report at 13.
    \126\ Id.
---------------------------------------------------------------------------

    Recommendation 1 of the 2003 G30 Report endorses complete 
dematerialization through the comprehensive use of central securities 
depositories for all records of ownership although the report 
recognizes immobilization as an acceptable step towards 
dematerialization if it can be achieved more quickly and efficiently 
than dematerialization.\127\ The 2003 G30 report maintains that 
dematerialization should be considered best practice in order to 
achieve fast and efficient clearing, settlement, and asset servicing 
and to prevent forgery, theft, or other misappropriation.
---------------------------------------------------------------------------

    \127\ 2003 G30 Report at 67. Recommendation 1 states, 
``Infrastructure providers and relevant public authorities should 
work with issuers and securities industry participants to eliminate 
the issuance, use, transfer and retention of paper securities 
certificates without delay* * *'' G30 believes that the use of 
paper, unautomated communication and manual recording in securities 
processing is time-consuming, expensive and prone to clerical error.
---------------------------------------------------------------------------

C. The Continuing Risks and Costs of Certificates in the U.S. Trading 
Markets

    Virtually all mutual fund securities, government securities, 
options, and municipal bonds in the U.S. are dematerialized and most of 
the equity and corporate bonds in the U.S. market are either 
immobilized or dematerialized. While the U.S. markets have made great 
strides in achieving immobilization and dematerialization for 
institutional and broker-to-broker transactions, many industry 
representatives believe that the small percentage of securities held in 
certificated form impose unnecessary risk and expense to the industry 
and to investors. In addition, the SIA identified the elimination of 
securities certificates in the U.S. marketplace as a necessary 
``building block'' to achieve shorter settlement timeframes.\128\ More 
recently, the SIA has requested that the Commission consider specific 
regulatory initiatives to achieve this goal.\129\ The SIA contends that 
despite the fact that only a small portion of securities positions 
remains certificated and that requests for certificates are declining, 
the risks and costs associated with processing the remaining 
certificates in the marketplace are substantial and avoidable. These 
costs are ultimately passed along to investors generally, rather than 
only those holding their securities in certificated form.
---------------------------------------------------------------------------

    \128\ SIA Business Case Report, supra note 5. The securities 
industry has long supported the elimination of certificates. ``The 
Securities Markets--A Report with Recommendations,'' NYSE (August 5, 
1971).
    \129\ Letter to Robert L.D. Colby, Deputy Director, Division of 
Market Regulation, Commission, from Donald Kittell, Executive Vice 
President, SIA (August 20, 2003); letter to Annette Nazareth, 
Director, Division of Market Regulation, Commission, from Donald 
Kittell, Executive Vice President, SIA (March 24, 2003) (``Nazareth 
Letter'').
---------------------------------------------------------------------------

    The most common risk is that associated with lost or stolen 
certificates. Between 1996 and 2000, the SIA estimated that an average 
of 1.7 million certificates were reported lost or stolen each 
year.\130\ In 2001, that figure increased to approximately 2.5 million 
certificates. Industry experts expect the number of certificates 
reported lost or stolen to continue to rise.\131\ The events of 
September 11, 2001, further underscored the risks associated with 
certificates. Tens of thousands of certificates that were being 
processed or were in vaults at broker-dealers and banks located in and 
around the World Trade Center at the time of the attack were either 
destroyed, lost, or were not accessible when offices located around the 
site were destroyed or were inaccessible for some period of time. 
Settlement activity for immobilized or dematerialized securities 
continued at DTC without significant delay or problems but DTC had to 
suspend certificate processing for four days until it could regain full 
access to its facilities.
---------------------------------------------------------------------------

    \130\ Id.
    \131\ E.g., AT&T conducted a reverse split in November 2002 that 
required shareholders to remit their certificates in exchange for a 
book-entry position in DRS. AT&T estimated that approximately 30% of 
its 2.7 million certificates outstanding at the time of the 
corporate action would be reported lost by shareholders.
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    The SIA also raised concerns about the significant and unnecessary 
costs associated with processing securities certificates. The SIA 
estimates that annual direct and indirect cost of handling certificates 
in the U.S. market exceeds $234,000,000.\132\ Direct costs include 
those associated with processing and supporting certificates at the 
broker-dealers or custodial banks, including expenses for shipping, 
medallion guarantees, custody, and conducting inventory for securities 
held in the firm's vault. According to the SIA, firms also face an 
opportunity cost in processing the certificates as these resources that 
must be devoted to this operation could be used toward other risk 
reducing initiatives or technological and service upgrades.
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    \132\ Nazareth Letter, supra note 129.
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    When a broker-dealer receives certificates to sell, often both the 
registered representative in the front office and staff in the 
operations area in the back office at the broker-dealer examine the 
certificate for negotiability. Among others, broker-dealers must make 
inquiries pursuant to the

[[Page 12934]]

Commission's Lost and Stolen Securities Program (``LSSP'').\133\ 
Brokers are charged for each inquiry. If the broker-dealer believes 
that the certificate is negotiable and does not receive a negative LSSP 
report, the certificate is forwarded to DTC for deposit into the 
broker-dealer's account at DTC. DTC then credits the broker-dealer's 
account and forwards the certificate to the transfer agent for 
reregistration into DTC's nominee name. If the transfer agent 
determines the certificate is not transferable, the transfer agent 
returns the certificate to DTC. DTC reverses the deposit credit to the 
broker-dealer's account and returns the certificate to the broker-
dealer, usually many days after the trade has settled and sale proceeds 
have been paid or credited to the customer's account. The rejection of 
a security after settlement date exposes the customer to the costs and 
risks that she may have to purchase replacement securities and exposes 
the broker-dealer to the costs and risks associated with collecting 
should the customer be unable to obtain replacement securities.
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    \133\ The Commission requires, among others, every national 
securities exchange, registered securities association, broker, 
dealer, transfer agent, registered clearing agency, and many banks 
to report to the Commission's LSSP designee, the Securities 
Information Center (``SIC'') the discovery of missing, lost, 
counterfeit, or stolen securities certificates. SIC operates a 
centralized database that records lost and stolen securities. 15 
U.S.C. 78q(f)(1)(A) and 17 CFR 240.17f-1. These entities also must 
inquire of the database as to whether certificates they receive have 
been reported to the LSSP. 15 U.S.C. 78q(f)(1)(B).
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    Another potential cost to investors is the cost of replacing a lost 
certificate. An investor who had lost her certificate, or whose 
certificate was stolen, generally must obtain a surety bond to protect 
the transfer agent from the risk that the lost or stolen certificate 
will reappear before the transfer agent will issue a replacement 
certificate. Pursuant to industry guidelines, most transfer agents 
charge investors two per cent of the current market value of the 
securities for such a surety bond.
    There are also many indirect costs associated with certificates. 
DTC costs include direct and indirect personnel and technology costs 
related to processing certificates.\134\
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    \134\ At the end of 1999, DTC sent an average of 11,460 
certificates to investors each day. By the end of 2002, that number 
had decreased to an average of 5,454 certificates issued per day.
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    Transfer agent costs include personnel, facilities, and technology 
needed to process, custody, store, insure, and inventory unissued and 
cancelled certificates. All costs, both direct and indirect, the SIA 
notes, are ultimately borne by investors.
    The SIA maintains that investors would realize many benefits from 
dematerializing securities issues, including decreased opportunity for 
fraud, earlier access to issuer proceeds, timelier receipt of corporate 
action entitlements, transparent audit trail of ownership, consolidated 
record keeping, and increased ease in estate liquidations.\135\ While 
some investors may remain attached to securities certificates, the 
SIA's research shows that those 55 years of age and younger are 
receptive to dematerialization.\136\
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    \135\ Nazareth Letter, supra note 129.
    \136\ In an attempt to better understand retail investors who 
want their securities in certificated form, the SIA conducted a 
survey to profile customers who had requested a certificate over a 
six-month period. Approximately 76% of investors who responded were 
over 55 years of age. Nearly all respondents had been investing for 
over ten years but had made very few transactions per month. Just 
over one-half of the respondents own a personal computer and use the 
Internet. Even though 62% thought is was ``very important'' to 
retain the option of requesting a physical certificate, 50% of these 
investors indicated they would continue investing if certificates 
were not available. SIA Business Case Report, supra note 5.
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    The SIA believes that given technological advances, the increasing 
acceptance of book-entry positions as the standard for evidencing 
ownership and the availability of DRS, a concerted effort should be 
made to immobilize or dematerialize the remaining equity and corporate 
bond securities. Specifically, the SIA has requested that the 
Commission consider regulatory action that would either directly or 
indirectly require new issues of publicly traded companies to be issued 
only in book-entry form and to be eligible for DRS.\137\ To address the 
matter of companies whose securities are already in the public market, 
the SIA advocates requiring all companies listed on an exchange or 
Nasdaq to have their existing shares be made eligible for DRS and to 
issue any new securities only in book-entry form.
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    \137\ Nazareth Letter, supra note 129.
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    Finally, the SIA urged the Commission to adopt regulations that 
would gradually eliminate the ability of investors to obtain 
certificates from their broker-dealers and to eliminate the ability of 
broker-dealers to obtain a certificate through DTC. Under such a 
regulatory scheme, investors who wanted certificates (if an issuer were 
still issuing certificates) would have to directly contact the issuer's 
transfer agent.

D. Discussion and Request for Comment

    As discussed above, the Commission has long advocated a reduction 
in the use of certificates in the trading environment by immobilizing 
or dematerializing securities. These efforts are consistent with 
Congress's directive to end the physical movement of securities in 
connection with settlement among brokers and dealers. The use of 
certificates increases the costs and risks of clearing and settling 
securities for all parties processing the securities, including those 
involved in the National Clearance and Settlement System. Most of these 
costs and risks are ultimately borne by investors.
    While the Commission endorses the concepts of immobilization or 
dematerialization, the Commission recognizes that they raise 
significant issues. The ability to hold securities certificates to 
evidence ownership in a corporation has a long tradition. There are 
perceived advantages, as well as disadvantages, to holding securities 
in the form of physical certificates instead of street-name 
registration.\138\ DRS now provides a viable alternative to street name 
holding for some investors who do not want to hold securities at a 
broker-dealer, but only for those investors who have an issuer and 
transfer agent that offer DRS services.
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    \138\ See Holding Your Securities--Get the Facts, http://www.sec.gov/investor/pubs/holdsec http://www.sec.gov/investor/pubs/holdsec (as examples of advantages, noting that with certificates 
the issuer knows how to reach the investor and will send annual and 
other reports, dividends, proxies, and other communications directly 
to the investor and that the investor may find it easier to pledge 
securities as collateral for a loan if they are held in the form of 
physical certificates; as examples of disadvantages, noting that 
when investors want to sell stock, they will have to send their 
certificates to their brokers or the companies' transfer agent to 
execute the sales, which may make it harder to sell quickly, that if 
investors lose their certificates, they may be charged a fee for 
replacements, and that if the investors move, they will have to 
contact the companies with their change of address in order not to 
miss any important mailings); Providing Alternatives to Certificates 
For the Retail Investor, Group of Thirty, U.S. Working Committee, 
Clearance and Settlement Project (August 1991), at 9, 25-26 
(discussing various ``needs'' and ``concerns or problems'' expressed 
on behalf of investors regarding certificates, including that with 
certificates the investor can sell securities through the broker-
dealer of his or her choice, without having to transfer a brokerage 
account).
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    Although the Commission believes investors should have the ability 
to register securities in their own names, the Commission also believes 
it is time to explore ways to further reduce certificates in the 
trading environment. There is significant risk, inefficiency, and cost 
related to the use of securities certificates. The possibility exists 
that investors' attachment to the certificate may be based more on 
sentiment than real need. Today, non-negotiable records of ownership 
(e.g., account statements) evidence ownership of not only most 
securities issued in the U.S.

[[Page 12935]]

but also other financial assets, such as money in bank accounts.
    Therefore, we seek comment on the following:
    1. Should securities be completely immobilized or dematerialized in 
the U.S.? If so, which would better serve the market--complete 
immobilization or dematerialization? Why?
    2. What are the costs and benefits of complete immobilization or 
dematerialization?
    3. Are there operational, legal, or regulatory impediments to 
immobilization or dematerialization?
    4. What advantages might certificates have over securities held in 
book-entry-only form (i.e., proof of ownership in the event of a loss 
of electronic records of ownership)? What regulatory initiatives should 
be considered to address these advantages if the markets were to move 
away from certificates?
    5. Should the existence of a viable, widely available direct 
registration system that preserves the benefits of holding securities 
in the form of physical certificates be a prerequisite to complete 
immobilization or dematerialization?
    6. What should be done to increase the availability and use of DRS 
or to otherwise improve DRS? For example, should the Commission adopt 
operational or processing rules specifically for processing book-entry 
transactions (i.e., DRS and dividend reinvestment and stock purchase 
plans), including, but not limited to, timeframes for processing these 
transactions?
    7. What are the back office costs at broker-dealers to process 
securities certificates? What are the costs at transfer agents to 
process securities certificates? How do these costs compare to the 
costs of processing book-entry securities?
    8. What should be done to encourage more companies to issue their 
securities in a completely immobilized or dematerialized format? Should 
publicly traded companies be required to do so?
    9. What can broker-dealers do to facilitate complete immobilization 
or dematerialization on both the retail and institutional customer 
levels? Are registered representatives sufficiently educated about DRS 
and do they communicate to investors available options to holding a 
certificate?
    10. What can transfer agents do to facilitate complete 
immobilization or dematerialization on both the issuer and investor 
level?
    11. What incentives or disincentives can be employed to discourage 
shareholders from requesting certificates? Will investors be less 
inclined to request a certificate if they were required to pay more to 
obtain, transfer, and trade certificated securities than book-entry 
securities? Should investors who choose to hold certificates bear a 
greater amount of the overall costs associated with producing and 
processing those certificates?
    12. Are any rules or regulations needed to enhance the safety of 
book-entry systems operated by transfer agents or broker-dealers?
    13. What can be done to engender public confidence in certificate-
less systems?

V. Solicitation of Additional Comments

    In addition to the areas for comment identified above, we are 
interested in any other issues that commenters may wish to address 
relating to trade confirmation, settlement cycles and physical 
securities. Please be as specific as possible in your discussion and 
analysis of any additional issues.

    By the Commission.

    Dated: March 11, 2004.
Lynn Taylor,
Assistant Secretary.

Appendix 1

CPSS-IOSCO Task Force

Recommendations for Securities Settlement Systems

Legal Risk

1. Legal Framework

    Securities settlement systems should have a well-founded, clear, 
and transparent legal basis in the relevant jurisdictions.

Presettlement Risk

2. Trade Confirmation

    Confirmation of trades between direct market participants should 
occur as soon as possible after trade execution, but no later than 
trade date (T+0). Where confirmation of trades by indirect market 
participants (such as institutional investors) is required, it 
should occur as soon as possible after trade execution, preferably 
on T+0, but no later than T+1.

3. Settlement Cycles

    Rolling settlement should be adopted in all securities markets. 
Final settlement should occur no later than T+3. The benefits and 
costs of a settlement cycle shorter than T+3 should be assessed.

4. Central Counterparties

    The benefits and costs of a central counterparty should be 
assessed. Where such a mechanism is introduced, the central 
counterparty should rigorously control the risks it assumes.

5. Securities Lending

    Securities lending and borrowing (or repurchase agreements and 
other economically equivalent transactions) should be encouraged as 
a method for expediting the settlement of securities transactions. 
Barriers that inhibit the practice of lending securities for this 
purpose should be removed.

Settlement Risk

6. Central Securities Depositories (CSDs)

    Securities should be immobilised or dematerialised and 
transferred by book-entry in CSDs to the greatest extent possible.

7. Delivery Versus Payment (DVP)

    Securities settlement systems should eliminate principal risk by 
linking securities transfers to funds transfers in a way that 
achieves delivery-versus-payment.

8. Timing of Settlement Finality

    Final settlement on a DVP basis should occur no later than the 
end of the settlement day. Intraday or real-time finality should be 
provided where necessary to reduce risks.

9. CSD Risk Controls to Address Participant Defaults

    Deferred net settlement systems should institute risk controls 
that, at a minimum, ensure timely settlement in the event the 
participant with the largest payment obligation is unable to settle. 
In any system in which a CSD extends credit or arranges securities 
loans to facilitate settlement, best practice is for the resulting 
credit exposures to be fully collateralised.

10. Cash Settlement Assets

    Assets used to settle the cash leg of securities transactions 
between CSD members should carry little or no credit or liquidity 
risk. If central bank money is not used, steps must be taken to 
protect CSD members from potential losses and liquidity pressures 
arising from the failure of a settlement bank.

Operational Risk

11. Operational Reliability

    Sources of operational risk arising in the clearing and 
settlement process should be identified and minimised through the 
development of appropriate systems, controls, and procedures. 
Systems should be reliable and secure, and have adequate, scaleable 
capacity. Contingency plans and backup facilities should be 
established to allow for timely recovery of operations and 
completion of the settlement process.

Custody Risk

12. Protection of Customers' Securities

    Entities holding securities in custody should employ accounting 
practices and safekeeping procedures that fully protect customers' 
securities. It is essential that customers' securities be protected 
against the claims of a custodian's creditors.

Other Issues

13. Governance

    Governance arrangements for CSDs and central counterparties 
should be designed to fulfill public interest requirements and to 
promote the objectives of owners and users.

14. Access

    CSDs and central counterparties should have objective and 
publicly disclosed criteria for participation that permit fair and 
open access.

[[Page 12936]]

15. Efficiency

    While maintaining safe and secure operations, securities 
settlement systems should be cost effective in meeting the 
requirements of users.

16. Communication Procedures and Standards

    Securities settlement systems should use or accommodate the 
relevant international communication procedures and standards in 
order to facilitate efficient settlement of cross-border 
transactions.

17. Transparency

    CSDs and central counterparties should provide market 
participants with sufficient information so that they can accurately 
identify and evaluate the risks and costs associated with using the 
CSD or central counterparty services.

18. Regulation and Oversight

    Securities settlement systems should be subject to regulation 
and oversight. The responsibilities and objectives of the securities 
regulator and the central bank with respect to SSSs should be 
clearly defined, and their roles and major policies should be 
publicly disclosed. They should have the ability and the resources 
to perform their responsibilities, including assessing and promoting 
implementation of these recommendations. They should cooperate with 
each other and with other relevant authorities.

19. Risks in Cross-Border Links

    CSDs that establish links to settle cross-border trades should 
design and operate such links to reduce effectively the risks 
associated with cross-border settlements.

[FR Doc. 04-5981 Filed 3-17-04; 8:45 am]
BILLING CODE 8010-01-P