    Payments, Clearance, and Settlement: A Guide to the Systems, Risks, and
    Issues (Chapter Report, 06/17/97, GAO/GGD-97-73).

    Pursuant to a congressional request, GAO provided information about the
    nation's systems to effect financial transactions between purchasers and
    sellers of goods, services, and financial assets.

    GAO noted that: (1) the United States has a wide variety of payments,
    clearance, and settlement systems; (2) some systems are used primarily
    for large-dollar payments, such as Fedwire and the Clearing House
    Interbank Payment System (CHIPS), others are used for the clearance and
    settlement of financial products, such as securities, futures, and
    options; (3) these systems are mainly used by major financial players,
    such as banks and other corporations, and are generally referred to as
    wholesale systems; (4) other systems are used for the smaller dollar
    transactions with which most consumers are familiar, e.g., checks,
    credit cards, and automated clearing house payments; (5) generally,
    these smaller dollar systems are referred to as retail systems; (6) new,
    consumer-oriented products, such as stored-value cards, are now being
    introduced; (7) a stored-value card is a credit-card-sized device with
    an implanted computer chip, that has a certain value and can be used for
    a variety of applications including financial transactions; (8) new
    services, such as electronic money, are also being tested and marketed;
    (9) electronic money is funds held in an online account that can be
    transferred over the Internet between any two parties, including
    consumer to consumer; (10) these new products and services have not yet
    gained wide acceptance, but many private sector companies are planning
    for the rapid expansion of these and similar products in the future;
    (11) many significant issues have been raised by industry officials,
    regulators, and others regarding the operations, use, and regulation of
    payments, clearance, and settlement systems; (12) for large-dollar
    transactions, some have raised the issue of the appropriateness of some
    institutions using less secure payment systems to reduce their costs of
    transfers; (13) others have raised issues about new and emerging
    products, such as stored-value cards and home banking; (14) also, many
    have raised questions about the appropriate regulatory structure for
    these products and services; (15) security issues for both wholesale
    systems, such as Fedwire and CHIPS, and emerging services, such as home
    banking, have also been raised; (16) the enormous volume and rapid
    growth in foreign exchange transactions have led to discussion and
    studies of how to better reduce risk in this market; and (17) finally,
    many private industry officials, especially private payment system prov*

    --------------------------- Indexing Terms -----------------------------

     REPORTNUM:  GGD-97-73
         TITLE:  Payments, Clearance, and Settlement: A Guide to the
                 Systems, Risks, and Issues
          DATE:  06/17/97
       SUBJECT:  Electronic funds transfer
                 Financial institutions
                 US government securities
                 Stocks (securities)
                 Foreign currency exchanges
                 Clearinghouses (futures)
                 Options (securities)
                 Financial instruments
                 Securities regulation
                 Stock exchanges
    IDENTIFIER:  FEDNET
                 Society for Worldwide Interbank Financial
                 Telecommunications System
                 Internet
                 World Wide Web
                 New York Clearing House Interbank Payments System

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    Cover
    ================================================================ COVER

    Report to the Chairman
    Committee on Banking and Financial Services
    House of Representatives

    June 1997

    PAYMENTS, CLEARANCE, AND
    SETTLEMENT - A GUIDE TO THE
    SYSTEMS, RISKS, AND ISSUES

    GAO/GGD-97-73

    Payments, Clearance, and Settlement

    (233483)

    Abbreviations
    =============================================================== ABBREV

      ABMS - Account Balance Monitoring System
      ACH - Automated Clearinghouse
      AMEX - American Stock Exchange
      ASO - Additional settlement obligation
      ATM - Automated teller machine
      AVS - Address Verification Service
      BIS - Bank for International Settlements
      BOTCC - Board of Trade Clearing Corporation
      CBCH - California Bankers Clearing House
      CBT - Chicago Board of Trade
      CCH - Chicago Clearing House Association
      CFTC - Commodity Futures Trading Commission
      CHECCS - Clearing House Electronic Check Clearing System
      CHIPS - Clearing House Interbank Payment System
      CME - Chicago Mercantile Exchange
      CNS - Continuous Net Settlement
      CRA - Community Reinvestment Act
      CST - Central Standard Time
      CUSIP - Committee on Uniform Securities Identification Procedures
      DCIA - Debt Collection Improvement Act of 1996
      DM - Deutsche mark
      DTC - Depository Trust Corporation
      DVP - Delivery-versus-payment
      EAF-2 - Frankfurt Electronic Clearing System
      ECHO - Exchange Clearing House
      ECCHO - Electronic Check Clearing House Organization
      ECP - Electronic check presentment
      EDC - Electronic Data Capture
      EFAA - Expedited Funds Availability Act of 1987
      EFT - Electronic Funds Transfer
      EFTA - Electronic Funds Transfer Act
      EMS - Electronic Money System
      EROC - East Rutherford Operations Center
      EST - Eastern Standard Time
      ET - Eastern Time
      FCM - Futures commission merchant
      FDIC - Federal Deposit Insurance Corporation
      FRBNY - Federal Reserve Bank of New York
      FTC - Federal Trade Commission
      GSCC - Government Securities Clearing Corporation
      ICS - Issuer's Clearinghouse Service
      IRS - Internal Revenue Service
      MCA - Monetary Control Act of 1980
      MICR - Magnetic ink character recognition
      NACHA - National Automated Clearing House Association
      NASD - National Association of Securities Dealers
      NOCH - National Organization of Clearing Houses
      NSCC - National Securities Clearing Corporation
      NYACH - New York Automated Clearing House
      NYCHA - New York Clearing House Association
      NYSE - New York Stock Exchange
      OCC - Options Clearing Corporation
      OFAC - Office of Foreign Assets Control
      OTC - Over-the-counter
      PAX - Private ACH Exchange
      PVP - Payment-vs.-payment
      RTGS - Real-Time Gross Settlement System
      S.W.I.F.T.  - Society for Worldwide Interbank Financial
         Telecommunications
      S-HTTP - Secure HyperText Transfer Protocol
      SEC - Securities and Exchange Commission
      SET - Secure Electronic Transaction
      SSL - Secure Sockets Layer
      TAP - Transaction adjusted payment
      TLA - Truth in Lending Act of 1968
      UCC - Uniform Commercial Code
      VISA - VISANet ACH
      WWW - World Wide Web

    Letter
    =============================================================== LETTER

    B-270598

    June 20, 1997

    The Honorable James Leach
    Chairman, House Committee on
      Banking and Financial Services
    House of Representatives

    Dear Mr.  Chairman:

    This report responds to your request that we provide information,
    about the nation's systems to effect financial transactions between
    purchasers and sellers of goods, services, and financial assets.  As
    you know, these systems--often referred to as payments, clearance,
    and settlement systems--are a vital part of the smooth functioning of
    our nation's economy and the free flow of economic activity
    worldwide.  They allow ownership of products, funds, securities,
    futures contracts, and other financial instruments to be exchanged
    and settled among consumers, financial institutions, businesses, and
    others.  They also play a critical role in maintaining the stability
    of financial markets and reducing systemic risk.

    As agreed, the objectives of this report were to

      -- describe the various payments, clearance, and settlement systems
         used in this country;

      -- describe various emerging products and services, which we refer
         to as electronic commerce;

      -- identify and describe certain risks associated with these
         systems, products, and services, and discuss how those risks are
         mitigated; and

      -- identify and describe some significant issues relating to the
         systems, products, and services that face users, regulators, and
         policymakers.

    For purposes of clarity, we present the information on systems,
    products, and services in four major sections:  (1) clearance and
    settlement of wholesale payment systems; (2) clearance and settlement
    of equities, Treasuries, futures, and options; (3) clearance and
    settlement of retail payment systems; and (4) new and emerging
    financial products and services.  An overview precedes each section,
    highlighting some of the main characteristics and other information
    associated with each type of system, product, or service.  Each
    section is organized in the same way--description and use, basic
    data, processes, regulatory oversight, and risk and risk mitigation.
    The final section of the report contains information on some
    significant issues raised by industry officials concerning these
    systems, products, and services.  The remainder of this letter
    includes background information, a short overview of the sections,
    our scope and methodology, and comments from the Federal Reserve
    Board of Governors.

       BACKGROUND
    ------------------------------------------------------------ Letter :1

    The general term payment system refers to a mechanism for the
    transfer of monetary value and related information.  Transfer of
    value can occur, for example, when a customer writes a check to a
    company and the funds are then transferred from the customer's bank
    account to the bank account of the company.  Related information
    exchanged at the same time might include the identification of the
    payee and the payor, bank account numbers, and the date of payment.
    Clearance is the process of transmitting, reconciling, and in some
    cases, confirming payment orders or securities transfer instructions
    before settlement takes place.  Settlement is the final step in the
    transfer of ownership.  In a banking transaction, settlement is the
    process of recording the debit and credit positions of the parties
    involved in a transfer of funds; in a securities transaction,
    settlement includes both the transfer of securities by the seller and
    the payment by the buyer.

    In order to promote the smooth functioning of the nation's economic
    activity, payment systems must provide for a reliable and accurate
    exchange, a measure of security for transactions, and finality of
    payment (i.e., settlement that cannot be reversed or withdrawn at a
    later time).  In most cases, there is a delay between the exchange of
    instructions and information concerning a transaction and its final
    settlement.  For example, when an individual deposits a check into
    his or her bank account, the bank then instructs the bank on which
    the check was drawn (payor's bank) to pay the specified amount to the
    individual's bank, which will, in turn, credit that amount to his or
    her account.  The actual settlement--i.e., the transfer of funds from
    the payor's bank to his or her bank account--may not occur until
    several days after the check was deposited.

    There is a trade-off between the security and speed of settlement and
    its cost.  Wholesale systems for the exchange of large-value payments
    or products tend to have greater security (greater risk controls)
    than do retail systems.  The loss on one wholesale transaction could
    be thousands of times greater than that for a typical retail
    transaction.  Speed of settlement also adds to security.  With less
    time between clearance and settlement, there is less likelihood of a
    default by one of the involved parties, all other things being equal.
    However, increased security and timeliness generally come at an
    increased cost.  An electronic transaction that settles
    instantaneously may cost as much as 50 times more than a transaction
    in a system that settles in 24 hours or more.

    Settlements can be "gross" or "net." Gross settlement means each
    transaction is settled individually.  Net settlement means that
    parties exchanging payments will offset mutual obligations to deliver
    identical items (e.g., dollars and Deutsche Marks) at a time, such as
    the end of the day, after which only one net amount of each item is
    exchanged.

    Each system or product has associated with it some type of risk and,
    in some cases, several types of risk.  For purposes of this report,
    we discuss some of the most important risks and risk mitigations
    associated with these systems, products, and services.  For example,
    counterparty/credit risk arises from the potential that a borrower or
    counterparty will fail to perform on an obligation.  Operational risk
    arises from the potential that inadequate information systems,
    operational problems, breaches in internal controls, or unforeseen
    catastrophes will result in unexpected losses.  Risk of fraud is risk
    of intentional deceptions that could result in monetary loss.
    Payment system participants, regulators, and service providers take
    steps to mitigate these risks.  The risk mitigation strategies vary
    by type of system and are generally more rigorous for large-dollar
    transactions.

       OVERVIEW
    ------------------------------------------------------------ Letter :2

    The United States has a wide variety of payments, clearance, and
    settlement systems.  Some systems are used primarily for large-dollar
    payments, such as Fedwire\1 and the Clearing House Interbank Payment
    System (CHIPS),\2 others are used for the clearance and settlement of
    financial products, such as securities, futures, and options.  These
    systems are mainly used by major financial players, such as banks and
    other corporations, and are generally referred to as wholesale
    systems.  Other systems are used for the smaller dollar transactions
    with which most consumers are familiar--e.g., checks, credit cards,
    and automated clearing house payments (such as electronic deposits of
    paychecks or Social Security payments).  Generally, these smaller
    dollar systems are referred to as retail systems.

    New, consumer-oriented products, such as stored-value cards, are now
    being introduced.  A stored-value card is a credit-card-sized device
    with an implanted computer chip, that has a certain value and can be
    used for a variety of applications including financial transactions.
    New services, such as electronic money, are also being tested and
    marketed.  Electronic money is funds held in an online account that
    can be transferred over the Internet between any two parties,
    including consumer to consumer.  These new products and services have
    not yet gained wide acceptance, but many private-sector companies are
    planning for the rapid expansion of these and similar products in the
    future.

    The types of risk we discuss in this report are generally present in
    all payments, clearance, and settlement systems.  For example,
    operational risk, such as the risk of computer failure, is inherent
    in all systems.  One type of mitigation strategy for operational risk
    focuses on having adequate computer back-up systems.  We do not
    discuss all relevant risks or mitigation strategies but focus on some
    of the more important ones.

    Many significant issues have been raised by industry officials,
    regulators, and others regarding the operations, use, and regulation
    of payments, clearance, and settlement systems.  For large-dollar
    transactions, some have raised the issue of the appropriateness of
    some institutions using less secure payment systems to reduce their
    costs of transfers.  Others have raised issues about new and emerging
    products, such as stored-value cards and home banking.  For example,
    some said these products are being offered, by both banks and their
    nonbank competitors, yet banks are subject to a much greater degree
    of regulation of these products than are nonbanks.  Also, many have
    raised questions about the appropriate regulatory structure for these
    products and services.  Security issues for both wholesale systems,
    such as Fedwire and CHIPS, and emerging services, such as home
    banking, have also been raised.  The enormous volume and rapid growth
    in foreign exchange transactions have led to discussion and studies
    of how to better reduce risk in this market.  Finally, many private
    industry officials, especially private payment system providers, have
    raised issues for some time about the ability of the Federal Reserve
    to be both a regulator of payment systems and a fair competitor in
    delivering these payment services.

    --------------------
    \1 Fedwire is the electronic funds transfer system operated by the
    Federal Reserve.

    \2 CHIPS is a private-sector electronic funds transfer system run by
    the New York Clearing House Association (NYCHA).

       SCOPE AND METHODOLOGY
    ------------------------------------------------------------ Letter :3

    To obtain information on and describe retail and wholesale payments,
    clearance, and settlement systems; to identify risk and risk
    mitigation strategies;\3 and to identify issues concerning these
    systems, we:

      -- interviewed officials from international and federal financial
         regulators, including the Bank for International Settlements,
         the Board of Governors of the Federal Reserve System; the
         Federal Reserve Banks of New York, Richmond, Boston, and San
         Francisco; the Office of the Comptroller of the Currency; the
         Federal Deposit Insurance Corporation; the Office of Thrift
         Supervision; and the Securities and Exchange Commission;

      -- interviewed officials and analyzed statistics and documents from
         various private-sector payments system providers and
         participants, including the National Automated Clearing House
         Association, the New York Clearing House Association, Visa
         International, the Society for Worldwide Interbank Financial
         Telecommunications (S.W.I.F.T.), the Chicago Board of Trade
         (CBOT), the Chicago Mercantile Exchange (CME), and their
         respective clearing organizations--the Board of Trade Clearing
         Corporation and the CME's clearing house division;

      -- interviewed officials and analyzed statistics and documents from
         various consumer groups.

    To identify new and emerging products and services, their associated
    risk and risk mitigation strategies, and related issues, we
    interviewed officials, and analyzed statistics and documents from the
    following:

      -- consultants with expertise in the development of commercial
         sites on the Internet;

      -- representatives of software/hardware companies developing
         products for electronic commerce and electronic banking
         applications;

      -- law firms and others with knowledge of legal issues involved in
         the development of commercial applications for the Internet;

      -- representatives of stored-value card corporations; and

      -- officials from other organizations involved in the development
         of these products and services.

    We did our work primarily in Washington, D.C., and New York between
    January 1996 and April 1997 in accordance with generally accepted
    government auditing standards.

    --------------------
    \3 We did not test the adequacy of any of the risk mitigation
    techniques discussed in this report.

       FEDERAL RESERVE'S COMMENTS AND
       OUR EVALUATION
    ------------------------------------------------------------ Letter :4

    We requested comments on a draft of this report from the Federal
    Reserve Board of Governors.  The Federal Reserve's written comments
    along with our responses appear in appendix I.  In addition, the
    staff of the Board of Governors provided technical comments that were
    incorporated in this report as appropriate.  We chose not to
    incorporate all of the Federal Reserve's complex, technical
    suggestions, because our purpose, as stated, was to provide basic
    information on the systems at a consistent level of detail.

    The Federal Reserve expressed concern about the manner in which we
    categorized various risks in the payments systems.  In addition, the
    Federal Reserve suggested that some types of risks, such as liquidity
    risk, were excluded from our discussion.  The Federal Reserve also
    found our discussion of the legal and regulatory framework for the
    various payment mechanisms to be confusing because it addressed
    regulation of transactions in some instances and supervisory
    regulation of the parties in others.  The Federal Reserve pointed out
    that in its view our draft report did not discuss similar payment
    systems in a manner that provided easy comparison or assessment of
    differences.

    The Federal Reserve also raised concerns about our presentation of
    the issues concerning traditional wholesale and retail payments
    systems and new and emerging products and services.  In some
    instances, the Federal Reserve suggested that our discussion of the
    issues was incomplete.  In other cases, it noted that the potential
    problems we raised about new emerging products and services also
    apply to more traditional products and services such as credit cards
    and checks.  Finally, the Federal Reserve suggested that on several
    issues our draft report did not fully account for the actions that
    the Federal Reserve has taken to mitigate potential problems.

    As we state in our report, our purpose in providing information on
    risks and risk mitigations was to highlight some of the more
    important risks raised by payment industry officials and others with
    respect to specific payment systems.  Our intent was neither to
    provide an exhaustive list of all types of risks present in all
    payment systems nor to evaluate which ones are more or less
    important.  Many public- and private-sector organizations categorize
    risk in different ways; we attempted to be consistent but also tried
    to use the same terms used by our sources.  Although the Federal
    Reserve expressed concern that liquidity risk was not specifically
    identified, liquidity risk generally was not one of the major risks
    raised by industry officials and others we interviewed.

    Our purpose in discussing the legal and supervisory framework was to
    provide a general overview of the applicable laws, regulations, and
    where it might be unclear to the reader, the supervisory framework
    for these systems and products.  For all the products and services,
    we discuss the legal and regulatory structure.  In some instances,
    where we felt additional information would be helpful to the reader,
    we also discuss supervision of the products and services.  Our report
    was not intended to provide a comprehensive survey of the supervision
    and oversight of these payment system products and services.

    With regard to the ease of comparison of various payment systems, our
    purpose in this report was to provide basic information on each of
    these systems, products, and services, not to provide a comparative
    study of them.  But we do present the information in a consistent
    format and report comparable statistics to the extent possible.

    The purpose of presenting information on issues regarding payment
    systems was to highlight rather than discuss in depth, evaluate, or
    resolve potential problems and concerns that were raised by industry,
    public sector, and other officials.  A detailed analysis of the
    various factors that would need to be taken into consideration in
    addressing these issues, or that could affect how these issues can be
    resolved, was beyond the scope of this report.  Section 5 of the
    report is not designed to include a comprehensive list of all of the
    issues in the payments, clearance, and settlement environment.

    With regard to issues related to new and emerging products and
    services, we agree that some of these issues may be applicable to
    more traditional payment systems.  Again, our purpose was simply to
    highlight the issues raised by industry officials in connection with
    these new products and services.  We have reviewed and incorporated
    where appropriate information the Federal Reserve has provided on
    actions it has undertaken to mitigate potential problems associated
    with some issues.

    ---------------------------------------------------------- Letter :4.1

    We are sending copies of this report to the majority and minority
    Members of the House and Senate Banking Committees, Agriculture
    Committees, and Commerce Committees, and to other interested parties.
    We will also make copies available to others on request.

    This report was prepared under the direction of Susan Westin,
    Assistant Director, Financial Institutions and Markets Issues.  Other
    major contributors to this review are listed in appendix II.  If you
    have any questions about this report, please call me at (202)
    512-8678.

    Sincerely yours,

    Jean Gleason Stromberg
    Director, Financial Institutions
      and Markets Issues

    CONTENTS
    ============================================================ Chapter 0

       LETTER
    ---------------------------------------------------------- Chapter 0:1

    1

       SECTION 1
       WHOLESALE PAYMENT SYSTEMS
    ---------------------------------------------------------- Chapter 0:2

    Overview of Clearance and Settlement of Wholesale Payment 15
    Systems
    Fedwire Electronic Transfer of Funds 17
    S.W.I.F.T.  27
    Clearing House Interbank Payments System 28
    Settlement of Foreign Exchange Transactions 37
    Bilateral and Multilateral Netting of Foreign
    Exchange Transactions 46

       SECTION 2
       EQUITIES, TREASURIES, FUTURES,
       AND OPTIONS
    ---------------------------------------------------------- Chapter 0:3

    Overview of Clearance and Settlement Systems of Equities, 47
    Treasuries, Futures, and Options
    Equities Clearance and Settlement 48
    Treasuries and the Fedwire Book-Entry Securities System 58
    Futures 66
    Exchange-Traded Options 77

       SECTION 3
       RETAIL PAYMENT SYSTEMS
    ---------------------------------------------------------- Chapter 0:4

    Overview of Clearance and Settlement of Retail Payment 91
    Systems
    Checks 93
    Electronic Funds Transfer 107
    Credit Cards 108
    Automated Clearing House 116

       SECTION 4
       NEW AND EMERGING FINANCIAL
       PRODUCTS AND SERVICES
    ---------------------------------------------------------- Chapter 0:5

    Overview of New and Emerging Financial Products and Services 131
    The Internet 132
    Stored-Value Cards 133
    Electronic Banking 141
    Financial Services Over the Internet 148

       SECTION 5
       ISSUES
    ---------------------------------------------------------- Chapter 0:6

    Issues Related to Payments, Clearance, and Settlement Systems 157

       APPENDIXES
    ---------------------------------------------------------- Chapter 0:7

    Appendix I:  Comments From the Board of Governors of the Federal
    Reserve System 170

    Appendix II:  Major Contributors to This Report 179

       GLOSSARY
    ---------------------------------------------------------- Chapter 0:8

    180

       TABLES
    ---------------------------------------------------------- Chapter 0:9

    Table 1.1:  Selected Data on Fedwire Funds Transfers 18
    Table 1.2:  Risk and Risk Mitigation for Fedwire 22
    Table 1.3:  Selected Date on CHIPS Transfers 30
    Table 1.4:  Risk and Risk Mitigation for CHIPS 34
    Table 1.5:  Risk and Risk Mitigation for Foreign
    Exchange Transactions 43
    Table 2.1:  Data on NSCC and DTC 50
    Table 2.2:  NSCC Clearance and Settlement Process
    for Depository Equity Shares 51
    Table 2.3:  Risk and Risk Mitigation for Equities 56
    Table 2.4:  Data on GSCC and Fedwire 60
    Table 2.5:  Two Types of Trade Comparisons 62
    Table 2.6:  Risk and Risk Mitigation for Treasuries 65
    Table 2.7:  Data on GSCC and Fedwire 69
    Table 2.8:  Steps in the Futures Clearing Process 70
    Table 2.9:  Two Types of Settlement 71
    Table 2.10:  Risk and Risk Mitigation for Futures 75
    Table 2.11:  Total Volume of Exchange-Traded Options
    Contracts Cleared in 1995 82
    Table 2.12:  Steps in the Options Clearing Process 84
    Table 2.13:  Two Types of Settlement 85
    Table 2.14:  Risk and Risk Mitigation for Options 89
    Table 3.1:  Major Organizations That Process
    or Exchange Checks 95
    Table 3.2:  The Volume of Checks Processed, 1992-1995 97
    Table 3.3:  Risk and Risk Mitigation for Checks 104
    Table 3.4:  The Number of Major U.S.  Credit Card
    Companies' Cards, 1990-1995 109
    Table 3.5:  Risk and Risk Mitigation for Credit Cards 114
    Table 3.6:  Examples of ACH Credit and Debit Transactions 116
    Table 3.7:  Volume of ACH Transactions Processed by the Four
    ACH Providers, 1992-1996 118
    Table 3.8:  Total Amount of Dollars Processed by Each
    ACH Provider, 1992-1996 120
    Table 3.9:  Risk and Risk Mitigation for ACH 129
    Table 4.1:  Stored-Value Card Tests 135
    Table 4.2:  Risk and Potential Risk Mitigation for Stored-Value Cards
    139
    Table 4.3:  Consumer Banking Activities Accessible
    By Electronic Means, 1996 141
    Table 4.4:  Risk and Risk Mitigation for Electronic Banking 146
    Table 4.5:  Risk and Risk Mitigation for Financial Services
    on the Internet 155

       FIGURES
    --------------------------------------------------------- Chapter 0:10

    Figure 1.1:  A Fedwire Funds Transfer Transaction 20
    Figure 1.2:  A Typical CHIPS Transfer 31
    Figure 1.3:  Final Settlement of CHIPS 33
    Figure 1.4:  A Typical Foreign Exchange Transaction 40
    Figure 2.1:  T+3 Clearance and Settlement of Depository-Eligible
    Equity Shares 52
    Figure 2.2:  The 24-Hour Trading, Clearance, and Settlement Cycle 72
    Figure 2.3:  An Options Listing 78
    Figure 2.4:  T+1 Trading, Clearance, and Settlement Cycle 87
    Figure 3.1:  An Example of a Paper Check 94
    Figure 3.2:  The Federal Reserve System for Processing a Paper Check
    100
    Figure 3.3:  Clearance and Settlement Cycle of Credit Cards 110
    Figure 3.4:  The Average Value of an ACH Transaction, 1992-1995 119
    Figure 3.5:  Typical ACH Credit Transaction--The Direct Deposit
    of a Payroll 122
    Figure 3.6:  Typical ACH Debit Transaction--Bill Payment 126
    Figure 4.1:  A Typical Mondex Card Transaction 137
    Figure 4.2:  Illustration of an Electronic Bill Payment Process 144
    Figure 4.3:  Credit Card Payments Over the Internet 152

    ------------------------------------------------------- Chapter 0:10.1

    Abbreviations

    ABMS Account Balance Monitoring System
    ACH Automated Clearing House
    AMEX American Stock Exchange
    ASO Additional settlement obligation
    ATM Automated Teller Machine
    AVS Address Verification Service

    BIS Bank for International Settlements
    BOTCC Board of Trade Clearing Corporation
    CBCH California Bankers Clearing House
    CBT Chicago Board of Trade
    CCH Chicago Clearing House Association
    CFTC Commodity Futures Trading Commission
    CHECCS Clearing House Electronic Check Clearing System
    CHIPS Clearing House Interbank Payment System
    CME Chicago Mercantile Exchange
    CNS Continuous net settlement
    CRA Community Reinvestment Act
    CST Central Standard Time
    CUSIP Committee on Uniform Securities Identification
    Procedures
    DCIA Debt Collection Improvement Act of 1996
    DM Deutsche mark
    DTC Depository Trust Corporation
    DVP Delivery-versus-payment
    EAF-2 Frankfurt Electronic Clearing System
    ECHO Exchange Clearing House
    ECCHO Electronic Check Clearing House Organization
    ECP Electronic check presentment
    EDC Electronic Data Capture
    EFAA Expedited Funds Availability Act of 1987
    EFTA Electronic Funds Transfer Act
    EMS Electronic Money System
    EROC East Rutherford Operations Center
    ET Eastern Time
    FCM Futures Commission Merchant
    FDIC Federal Deposit Insurance Corporation
    FRBNY Federal Reserve Bank of New York
    FTC Federal Trade Commission
    GSCC Government Securities Clearing Corporation
    ICS Issuer's Clearing House Service
    IRS Internal Revenue Service
    MCA Monetary Control Act of 1980
    MICR Magnetic Ink Character Recognition
    NACHA National Automated Clearing House Association
    NASD National Association of Securities Dealers
    NOCH National Organization of Clearing Houses
    NSCC National Securities Clearing Corporation

    NYACH New York Automated Clearing House
    NYCHA New York Clearing House Association
    NYSE New York Stock Exchange
    OCC Options Clearing Corporation
    OFAC Treasury Office of Foreign Assets Control
    OTC Over-the-counter
    PAX Private ACH Exchange
    PVP Payment-vs.-payment
    RTGS Real-Time Gross Settlement System
    S.W.I.F.T.  Society for Worldwide Interbank Financial
    Telecommunications
    S-HTTP Secure HyperText Transfer Protocol
    SEC Securities and Exchange Commission
    SET Securities Electronic Transaction
    SSL Secure Sockets Layer
    TAP Transaction adjusted payment
    TLA Truth in Lending Act of 1968
    UCC Uniform Commercial Code
    WWW World Wide Web

    OVERVIEW OF CLEARANCE AND
    SETTLEMENT OF WHOLESALE PAYMENT
    SYSTEMS
    ===================================================== Chapter Overview

    In this section of the report, we discuss the two primary wholesale
    payment systems in the United States, the Federal Reserve's Fedwire
    funds transfer service, and the Clearing House Interbank Payments
    System (CHIPS), as well as foreign exchange transactions.

       MAIN CHARACTERISTICS
    --------------------------------------------------- Chapter Overview:1

      -- Wholesale payments are large-value payments made by major
         financial players, such as banks and other corporations.

      -- The Federal Reserve's Fedwire funds transfer service, primarily
         used for domestic payments, is a real-time, gross settlement
         system in which the Federal Reserve guarantees payment to the
         receiver of the funds.  CHIPS, a private-sector multilateral
         netting organization, is used mainly to settle the U.S.  dollar
         side of foreign exchange transactions.

      -- Foreign exchange transactions involving U.S.  dollars, being an
         exchange of currencies, involve two settlements:  dollars
         settled in the United States, and another currency settled in
         that currency's national payment system.

       STATISTICAL INFORMATION
    --------------------------------------------------- Chapter Overview:2

    In 1996:

      -- Fedwire funds transfer service's average daily transaction
         amount was $989 billion, and the average amount per transaction
         was $3.0 million.

      -- CHIPS' average total daily transaction value was $1.3 trillion,
         and the average value per transaction was $6.2 million.

      -- On average in early 1995, nearly $1.2 trillion of foreign
         exchange trades were transacted globally per day.

       REGULATORY INFORMATION
    --------------------------------------------------- Chapter Overview:3

      -- Fedwire's funds transfers are regulated under subpart B of the
         Federal Reserve's Regulation J.

      -- Funds transfers processed over CHIPS are regulated under New
         York State's version of the Uniform Commercial Code (UCC)
         Article 4A, and rules adopted by the New York Clearing House
         Association (NYCHA).

      -- Oversight of banks conducting foreign exchange transactions in
         different countries is provided by the bank regulators in those
         countries.

       RISK INFORMATION
    --------------------------------------------------- Chapter Overview:4

      -- The Federal Reserve is exposed to credit risk for those payments
         transmitted over Fedwire that generate daylight overdrafts in a
         participant's account.

      -- A CHIPS failure to settle could create systemic risk and, in
         recognition of this, a series of risk controls has been
         established.

      -- Settlement failure in foreign exchange transactions could
         transmit systemic problems internationally.

    FEDWIRE ELECTRONIC TRANSFER OF
    FUNDS
    ====================================================== Chapter Fedwire

       DESCRIPTION AND USE
    ---------------------------------------------------- Chapter Fedwire:1

    The Fedwire funds transfer system is one of the two primary
    large-dollar electronic payments systems in the United States.\1 In
    1996, Fedwire's average total daily transaction value for the
    electronic transfer of funds was about $989 billion; the average
    value per transaction was $3.0 million.  The Fedwire funds transfer
    service allows depository institutions to transfer funds on their own
    behalf or on behalf of their customers; most Fedwire payments are
    related to domestic transactions.  The Department of the Treasury and
    other federal agencies also use Fedwire to disburse and collect
    funds.

       (See figure in printed
       edition.)

    --------------------
    \1 The other large-dollar electronic payments system, the Clearing
    House Interbank Payments System (CHIPS), is discussed separately in
    this report.

       BASIC DATA
    ---------------------------------------------------- Chapter Fedwire:2

    Virtually all of the approximately 9,500 depository institutions with
    Federal Reserve accounts use them to transmit funds transfers over
    Fedwire.  In 1996, the total volume of dollars transferred over the
    Fedwire funds transfer service was $249 trillion.  As shown in table
    1.1, for the period of 1992 through 1996, the volume and the average
    daily transaction value of Fedwire funds transfers increased, but the
    average value of a Fedwire funds transfer transaction remained
    relatively constant at about $3.0 million.

                                   Table 1.1

                    Selected Data on Fedwire Funds Transfers

                                                                     Perce
                                                                        nt
                                                                     chang
                                                                         e
                                                                     1992-
                               1992    1993    1994    1995    1996     96
    -----------------------  ------  ------  ------  ------  ------  -----
    Average number of daily  267,00  277,00  287,00  302,00  328,00    23%
     transfer messages            0       0       0       0       0
    Average daily transfer     $787    $824    $841    $888    $989     25
     value                   billio  billio  billio  billio  billio
                                  n       n       n       n       n
    Average value per          $2.9    $3.0    $2.9    $2.9    $3.0      3
     transfer                millio  millio  millio  millio  millio
                                  n       n       n       n       n
    Fees per transaction\a    $0.53   $0.53   $0.53   $0.50   $0.50     -6
    ----------------------------------------------------------------------
    \a Both the sender and the receiver of a Fedwire funds transfer are
    charged a fee.  In January 1997, the transfer fee was reduced to
    $0.45.

    Source:  Federal Reserve Bank of New York.

       PROCESSES
    ---------------------------------------------------- Chapter Fedwire:3

    Fedwire is a real-time gross settlement (RTGS) system.  The Fedwire
    funds transfer system operates from 8:30 a.m.  Eastern Time (ET) to
    6:30 p.m.  ET.\2

    The Fedwire funds transfer operating system essentially consists of
    two components:

      -- A high-speed, nationwide communications network (FEDNET) that
         electronically links all Federal Reserve Banks and branches with
         depository institutions;\3 and

      -- A computerized capability to process and record individual funds
         and transfers\4 as they occur.

    Fedwire allows depository institutions to transfer funds on their own
    behalf or on behalf of their customers.  Each depository institution
    using the Fedwire funds transfer system must have a Federal Reserve
    account with its respective Federal Reserve Bank.  Figure 1.1
    illustrates how a typical funds transfer transaction between two
    customers is transmitted over Fedwire.

       Figure 1.1:  A Fedwire Funds
       Transfer Transaction

       (See figure in printed
       edition.)

    \a According to a Federal Reserve Bank of New York publication, once
    a funds transfer is completed, the funds are generally available for
    immediate withdrawal.

    Source:  Federal Reserve.

    --------------------
    \2 Beginning on Dec.  8, 1997, the Fedwire funds transfer service is
    scheduled to open at 12:30 a.m.  (ET) and close at 6:30 p.m.  (ET).

    \3 This network is used by depository institutions to access a
    variety of Federal Reserve services, including Fedwire.

    \4 A separate system, the Fedwire securities transfer service is
    discussed in the securities section (Section 2) of this report.

          FEDWIRE OFFERS IMMEDIATE
          FINALITY
    -------------------------------------------------- Chapter Fedwire:3.1

    A critical feature of Fedwire is that it offers immediate finality.
    Immediate finality of payment sets Fedwire apart from any other
    electronic payment system operating in the United States.  Under
    Regulation J, the Federal Reserve "guarantees" the payment to the
    depository institution receiving the Fedwire transaction and assumes
    any credit risk if there are insufficient funds in the Federal
    Reserve account of the bank sending the payment.

          CHANGES IN FEDWIRE'S
          OPERATING ENVIRONMENT
    -------------------------------------------------- Chapter Fedwire:3.2

    The Federal Reserve is undertaking several enhancements to Fedwire's
    operating environment for the purpose of reducing risk related to
    funds transfers and increasing the usefulness of Fedwire.  Two
    significant changes affecting the Fedwire funds transfer service are
    the expansion of Fedwire's operating hours and a new, expanded
    message format for funds transfers.

    As previously mentioned, the Fedwire funds transfer system operates
    from 8:30 a.m.  ET to 6:30 p.m.  ET.  Beginning on December 8, 1997,
    Fedwire's funds transfer online operating hours are to be expanded to
    an 18-hour operating day, from 12:30 a.m.  ET to 6:30 p.m.  ET.  The
    Federal Reserve's decision to extend Fedwire's funds transfer
    operating hours was part of its response in addressing the potential
    risk arising from the growing volume of cross-border payments.  The
    extension of Fedwire's hours for funds transfers means that Fedwire
    would be open while major foreign financial centers are open.
    Cross-border payments are discussed in more detail in the Foreign
    Exchange segment of this section.

    The Federal Reserve is in the process of expanding the Fedwire funds
    transfer message format, which is to be fully implemented by year-end
    1997.  The expanded transfer format is intended to improve efficiency
    in the payments mechanism by reducing the need for manual
    intervention when processing and posting transfers, and by making the
    format more compatible with the formats used by CHIPS and the Society
    for Worldwide Interbank Financial Telecommunication (S.W.I.F.T.).  In
    addition, the expanded format permits the inclusion of additional
    originator and beneficiary information, as required by Treasury
    regulations.

       REGULATORY OVERSIGHT
    ---------------------------------------------------- Chapter Fedwire:4

    Funds transfers through Fedwire are regulated under subpart B of
    Federal Reserve's Regulation J.  This part of Regulation J generally
    incorporates Article 4A of the Uniform Commercial Code (UCC) as the
    governing law for the Fedwire funds system.  The UCC is a set of
    model state laws governing commercial and financial activities.  UCC
    Article 4A sets out the rights and obligations of the various
    participants in a funds transfer, including those of the originator,
    intermediary institutions, and the beneficiary.

    Subpart B of Regulation J also directs each Reserve Bank to issue
    operating circulars governing funds transfer operations.  These
    circulars cover such matters as operating hours, security,
    authentication, and fees.

       RISK AND RISK MITIGATION
    ---------------------------------------------------- Chapter Fedwire:5

    For the purposes of this report, we discuss some of the most
    important risks and risk mitigations associated with Fedwire.

                                   Table 1.2

                      Risk and Risk Mitigation for Fedwire

                            Risk mitigation
    Risk                    ----------------------------------------------
    Counterparty credit     Net debit caps (including zero caps)
    risk

                            Account balance monitoring system

                            Daylight overdraft fees

    Operational risk        Back-up facilities

                            Automated recovery

    Fraud risk              Data security:

                             Encryption

                             Authentication procedures

                             Access controls
    ----------------------------------------------------------------------

          RISK 1:  COUNTERPARTY CREDIT
    -------------------------------------------------- Chapter Fedwire:5.1

    Because the Federal Reserve grants finality (i.e., final and
    irrevocable credit) to the recipients of funds sent over Fedwire, the
    Federal Reserve Bank assumes any credit risk if there are
    insufficient funds in the Federal Reserve account of the depository
    institution sending the funds.  For example, if Bank A, in our
    hypothetical example (see figure 1.1), had an insufficient account
    balance to cover the funds transfer, the Federal Reserve, in its sole
    discretion, may allow Bank A to overdraw its account.  While Bank A's
    account is overdrawn, the Federal Reserve would be at risk for any
    losses should Bank A fail.  This credit risk, commonly referred to as
    a daylight overdraft, is present even for an overdraft position that
    occurs only briefly during the day.  The Federal Reserve requires
    depository institutions to eliminate any daylight overdrafts by the
    close of Fedwire each day.  From 1986 to 1996, the average daily peak
    daylight overdrafts for funds transfers increased from $63 billion to
    $68 billion.  Daylight overdrafts, if not repaid by the end of the
    day, could become unsecured overnight overdrafts.  The Federal
    Reserve attempts to discourage overnight overdrafts by imposing high
    monetary penalties and taking administrative action against
    institutions that incur them repeatedly.

             MITIGATION
    ------------------------------------------------ Chapter Fedwire:5.1.1

    Net debit caps.  In 1985, the Federal Reserve Board adopted a program
    of maximum limits, or net debit caps, for each depository
    institution.  A net debit cap is a maximum level of daylight
    overdrafts that a depository institution may incur in its account at
    the Federal Reserve.  The dollar amount of a specific net debit cap
    is determined by an institution's capital and is a multiple of the
    institution's capital.  The multiple is to be based on the financial
    strength of each institution.  The strongest institutions may obtain
    a higher cap multiple than that obtainable by riskier institutions.
    The most risky institutions are to be assigned a zero net debit cap
    and prohibited from originating a Fedwire funds transfer that would
    cause their account to become overdrawn, or, in an extreme case, the
    Federal Reserve may terminate the institution's online access to
    Fedwire.  In some cases, the Federal Reserve may require weak
    depository institutions to collateralize their overdrafts.  A recent
    Federal Reserve study found that net debit caps seemed to have
    restrained the growth of daylight overdrafts that are not related to
    securities transfers during the 1986 through 1993 period.\5

    According to the Federal Reserve's Policy Statement on Payment System
    Risk, depository institutions that use intraday Federal Reserve
    credit in amounts that exceed 40 percent of risk-based capital on a
    single day or, on average, over a 2-week period must establish their
    daylight overdraft caps by a self-assessment process.  This process
    is required in order to establish a cap in any one of the Average,
    Above Average, or High categories.  A high-cap multiple would permit
    the 2-week average of daily peak daylight overdrafts to be 1.5 times
    the depository institution's capital.  Reserve Banks also have the
    authority to reduce an institution's Fedwire net debit cap
    unilaterally.

    --------------------
    \5 Heidi Richards, "Daylight Overdraft Fees and the Federal Reserve's
    Payment System Risk Policy," Federal Reserve Bulletin, Dec.  1995.

             MITIGATION
    ------------------------------------------------ Chapter Fedwire:5.1.2

    Account balance monitoring.  Net debit caps are permitted at the
    discretion of the Federal Reserve Banks.  Using Fedwire's Account
    Balance Monitoring System (ABMS), the Reserve Banks can hold or
    reject funds transfers that may cause account holders to exceed their
    net debit caps.  ABMS allows the Reserve Banks to monitor depository
    institutions' account positions and payment activity on a real-time
    basis.

             MITIGATION
    ------------------------------------------------ Chapter Fedwire:5.1.3

    Daylight overdraft fees.  In September 1992, the Federal Reserve
    Board adopted a policy under which the Federal Reserve Banks would,
    beginning in April 1994, charge a fee to depository institutions for
    average daylight overdrafts in deposit accounts with Federal Reserve
    Banks as a supplement to the existing net debit cap policy.  The
    Board set the initial fee at an annual interest rate of 10 basis
    points (0.10 percent) of chargeable daily daylight overdrafts.\6 In
    April 1995, the fee was increased to 15 basis points.\7 The
    chargeable overdraft is the institution's average per-minute daylight
    overdraft for a given day, less a deductible amount equal to 10
    percent of its risk-based capital.

    The Federal Reserve study mentioned earlier also found that the
    imposition of daylight overdraft fees resulted in a decline in the
    average per-day overdrafts by depository institutions.  Specifically,
    the study showed that the aggregate intraday peak overdrafts fell
    approximately 40 percent, from nearly $125 billion per day on
    average, during the 6 months preceding April 14, 1994, to about $70
    billion in the 6 months following the introduction of daylight
    overdraft fees on April 14.\8

    --------------------
    \6 A basis point is one-hundredth of one percent.

    \7 Originally, the Board had planned to increase the fee to 25 basis
    points as of Apr.  1996, but in early 1995, the Board determined that
    a smaller fee increase to 15 basis points would be more appropriate.
    In addition, the Board decided to wait 2 years before evaluating the
    results of the Apr.  1995 increase.  This stated rate is based on the
    current 10-hour Fedwire funds transfer operating day.  On Dec.  8,
    1997, the stated rate for the 18-hour operating day is to be 27 basis
    points.

    \8 Richards, p.  1071.

          RISK 2:  OPERATIONAL
    -------------------------------------------------- Chapter Fedwire:5.2

    Because of the enormous value and importance of the funds transfers
    sent over Fedwire daily, any temporary outages in the Fedwire
    electronic system could pose significant economic and financial
    risks.  Moreover, a prolonged outage of the Fedwire electronic system
    could cause an unacceptable disruption of the U.S.  payment system.

             MITIGATION
    ------------------------------------------------ Chapter Fedwire:5.2.1

    Back-up facilities.  If an operational disaster should occur to the
    primary computer at the East Rutherford Operations Center (EROC), the
    Federal Reserve has designed Fedwire to automatically resume payment
    processing almost instantaneously at its back-up computer at the EROC
    site.  If the entire EROC site is down, a remote database is designed
    to allow Fedwire to resume payment processing at its secondary
    back-up center (Federal Reserve Bank of Richmond) within 60 to 90
    minutes of a decision to relocate operations.  The infrastructure is
    in place to allow Fedwire to resume payment processing at its
    tertiary site should an operational disaster occur at both the
    primary and secondary data centers.

             MITIGATION
    ------------------------------------------------ Chapter Fedwire:5.2.2

    Automated recovery.  Fedwire databases are duplicated for
    instantaneous availability in the event of a database device failure.
    If a database recovery is required, each participant has to
    retransmit only those payments that were previously sent on Fedwire
    and indicate the loss of payments through the recovery report.
    Fedwire tests its contingency plans in multiple mandatory exercises
    annually against a variety of simulated events, which include
    computer, site, and network outages.

          RISK 3:  FRAUD
    -------------------------------------------------- Chapter Fedwire:5.3

    There is the potential that fraudulent transfers could be transmitted
    over Fedwire.  For example, a computer hacker could make an
    unauthorized funds transfer over Fedwire, or a bank employee could
    perform unauthorized wire transfers.

             MITIGATION
    ------------------------------------------------ Chapter Fedwire:5.3.1

    Data security measures.  The Federal Reserve has implemented a
    variety of data security measures to protect the integrity,
    confidentiality, and continuity of the Fedwire system.  These
    measures include access, authentication, and verification controls;
    data encryption; procedural controls over such processes as
    application changes, data entry and database updates; physical
    security; and personnel standards.  These controls are designed to
    prevent tampering with, destroying, or disclosing Fedwire data,
    either by Federal Reserve employees or outside hackers.  For example,
    Fedwire messages between depository institutions and the Federal
    Reserve are encrypted and authenticated to prevent interception and
    alteration.  Access controls, such as unique user identification
    codes and passwords, are also a primary means for preventing
    unauthorized transfers.  For example, employees at a depository
    institution must use a valid and unique user identification code and
    password to enter and send a Fedwire message, and that message must
    come from a connection associated with that employee's institution.

    Depository institutions also have strong incentives to establish
    security procedures to govern their initiation, verification, and
    receipt of Fedwire funds transfers as well as other funds transfers.
    In particular, a depository institution assumes full liability for
    any Fedwire funds transfers executed from its authorized connection
    to the Fedwire system.  Furthermore, Article 4A of the UCC, through
    its allocation of liability for erroneous or fraudulent transfers,
    encourages the establishment of commercially reasonable security
    procedures.  A review of depository institutions' funds transfer
    security procedures is also a component of the banking regulators'
    programs.

       S.W.I.F.T.
    ---------------------------------------------------- Chapter Fedwire:6

    Society for Worldwide Interbank Financial Telecommunications
    (S.W.I.F.T.), incorporated in Belgium, is a cooperative owned by over
    2,800 banks from around the world, including over 150 from the United
    States (owning 13 percent of the shares).  It operates a network that
    processes and transmits financial messages among members and other
    users in 137 countries.  The United States accounts for more usage
    than any other country.

    (See figure in printed edition.)

    Users

    S.W.I.F.T.  messages convey information or instructions between
    financial institutions:

      -- Messages are formatted and contain information about the
         originator, purpose, destination, terms, and recipient.

      -- The largest use of S.W.I.F.T.  is for payment messages, through
         which one institution transmits instructions to another to make
         payments.

      -- Other messages are used to confirm the details of a contract
         entered into between two users, such as a foreign exchange trade
         or an interbank deposit placement.

      -- For securities, S.W.I.F.T.  messages can transmit orders to buy
         or sell or convey instructions concerning delivery and
         settlement.

    Statistical Information

      -- An average of 2.4 million messages of all types were processed
         by S.W.I.F.T.  per day in 1995.

      -- S.W.I.F.T.  estimates that the value of the payments messages
         was $2 trillion per day.

    CLEARING HOUSE INTERBANK PAYMENTS
    SYSTEM
    ======================================================== Chapter CHIPS

       DESCRIPTION AND USE
    ------------------------------------------------------ Chapter CHIPS:1

    The Clearing House Interbank Payments System (CHIPS) is one of the
    two large-value electronic payments systems in the United States.
    The other is Fedwire.  CHIPS, which is privately owned and operated
    by the New York Clearing House Association (NYCHA), began operations
    in 1970 as an electronic replacement for paper checks in
    international dollar payments.  Although Fedwire payments are
    principally related to domestic transactions, U.S.  dollar payments
    related to "foreign transactions" (such as the dollar leg of foreign
    exchange and Eurodollar placements) flow primarily through CHIPS.

    Although CHIPS transfers are irrevocable, they are final only after
    the completion of end-of-day settlement.\9 CHIPS nets its
    transactions on a multilateral basis.  Thus, if a bank receiving a
    CHIPS transfer makes funds available to its customers before
    settlement is complete at the end of the day, it is exposed to some
    risk of loss if CHIPS does not settle.  However, in its 27 years of
    operation, CHIPS has never failed to settle.

       (See figure in printed
       edition.)

    --------------------
    \9 In contrast, Fedwire offers immediate finality of settlement--the
    Federal Reserve "guarantees" the payment and assumes any credit risk.

       BASIC DATA
    ------------------------------------------------------ Chapter CHIPS:2

    At year-end 1996, there were 103 CHIPS participants representing
    financial institutions from 29 countries.  CHIPS participants may be
    commercial banks, Edge Act corporations,\10 or investment companies.
    To be a CHIPS participant, a financial institution is required to
    maintain a branch or an agency in New York City.  A nonparticipant
    wishing to make international payments using CHIPS must employ one of
    the CHIPS participants to act as its correspondent or agent.

    As shown in table 1.3, both the volume and the average daily
    transaction value of CHIPS transfers have increased, although the
    average size of a transfer payment has remained relatively constant
    for the period 1992 through 1996.  In addition, the number of CHIPS
    participants has decreased during the same period.

                                   Table 1.3

                        Selected Data on CHIPS Transfers

    Data                              1992    1993    1994    1995    1996
    ---------------------------  ---------  ------  ------  ------  ------
    Average number of daily        154,439  167,31  181,66  203,31  212,54
     transfer messages                           1       7       8       4
    Average daily value of            $942      $1      $1      $1      $1
     transfers                     billion  trilli  trilli  trilli  trilli
                                                on      on      on      on
    Average value of a transfer         $6      $6      $7      $6      $6
                                   million  millio  millio  millio  millio
                                                 n       n       n       n
    Average fee per                    .15     .15     .15     .15     .15
     transaction\a
    Number of CHIPS                    122     121     115     111     103
     participants
    ----------------------------------------------------------------------
    \a The fee listed in the table is an average fee based on the three
    transaction fees that CHIPS charges its participants.  CHIPS charges
    a participant 18 cents per transaction for the first 80,000
    transactions per month that it sends or receives.  After a
    participant sends or receives over 80,000 transactions per month,
    CHIPS charges the participant 13 cents per transaction.  Also, CHIPS
    charges participants 40 cents per transaction for any transaction
    without an account number.

    Source:  CHIPS.

    --------------------
    \10 Edge Act corporations are corporations chartered by the Federal
    Reserve to engage in international banking for financing trade.  The
    Board of Governors acts on applications to establish Edge Act
    corporations and also examines the corporations and their
    subsidiaries.

       PROCESSES
    ------------------------------------------------------ Chapter CHIPS:3

    Figure 1.2 illustrates a typical CHIPS transfer.

    Example:  A wholesaler in Paris wishes to pay $1 million to a U.S.
    software supplier for a shipment of consumer software.  The French
    wholesaler instructs his bank in Paris (Bank A) to debit the French
    franc equivalent of $1 million from his account and to arrange
    payment of the dollar amount to the U.S.  supplier's account in Bank
    B in New York.  This payment of dollars represents a typical CHIPS
    transaction.  Bank A has a branch in New York.  Both Bank A and Bank
    B are participants in CHIPS.

       Figure 1.2:  A Typical CHIPS
       Transfer

       (See figure in printed
       edition.)

    Source:  NYCHA.

    The transaction between Bank A and Bank B is not settled until CHIPS
    settles at the end of the day.  If Bank B makes the $1 million
    available to the U.S.  software supplier prior to final settlement,
    Bank B could expose itself to some risk of loss.

          THE FINAL SETTLEMENT OF
          CHIPS
    ---------------------------------------------------- Chapter CHIPS:3.1

    Figure 1.3 illustrates the final settlement of CHIPS.  Throughout the
    day, the 103 CHIPS participants continuously exchange payments among
    themselves.  As transactions flow, CHIPS continuously recalculates
    each participant's single net position vis-a-vis all other
    participants combined.  This is called multilateral netting.  (See
    discussion in foreign exchange transactions later in this section.)

       Figure 1.3:  Final Settlement
       of CHIPS

       (See figure in printed
       edition.)

    \a Settling participants take part in the actual settlement of CHIPS
    by sending or receiving the Fedwire payments used to effect
    settlement.  Participants that are not settling participants must
    designate a settling participant to settle for them and that settling
    participant must agree to the designation.

    Source:  NYCHA.

    ---------------------------------------------------- Chapter CHIPS:3.2

    After all the settling participants that are in a net debit position
    have paid in funds and participants that are in a net credit position
    receive a Fedwire funds transfer from NYCHA, the CHIPS settlement
    account at the Federal Reserve Bank of New York (FRBNY) reaches a
    zero balance.\11 It is at this point that the transaction transmitted
    over CHIPS between Bank A and Bank B is settled and settlement is
    final.

    --------------------
    \11 FRBNY is not required to provide financial assistance to ensure
    completion of the CHIPS settlement.

       REGULATORY OVERSIGHT
    ------------------------------------------------------ Chapter CHIPS:4

    All CHIPS participants are supervised by the New York State Banking
    Department or a federal bank supervisor.  A coordinated interagency
    full examination is to be conducted of CHIPS every other year and a
    limited examination is to be conducted in the alternate years between
    the full examinations.  CHIPS transfers are governed by UCC Article
    4A.  The UCC is a set of model state laws governing commercial and
    financial activities.  UCC Article 4A sets out the rights and
    obligations of the various participants in a wire transfer.

       RISK AND RISK MITIGATION
    ------------------------------------------------------ Chapter CHIPS:5

    For purposes of this report, we discuss some of the most important
    risks and risk mitigations associated with CHIPS.

                                   Table 1.4

                       Risk and Risk Mitigation for CHIPS

                            Risk mitigation
    Risk                    ----------------------------------------------
    Operational risk        Back-up facilities

                            Automated recovery

    Systemic risk/          Same-day settlement
    counterparty credit
    risk

                            Bilateral credit limits

                            Net debit caps

                            Loss sharing--backed up by collateral

                            Membership requirements
    ----------------------------------------------------------------------

          RISK 1:  OPERATIONAL
    ---------------------------------------------------- Chapter CHIPS:5.1

    Because of the trillions of dollars sent over CHIPS, any temporary
    outage in the CHIPS electronic system would pose significant economic
    and financial risks.

             MITIGATION
    -------------------------------------------------- Chapter CHIPS:5.1.1

    Back-up facilities.  If an operational disaster should occur, the
    remote database, established by CHIPS, is designed to allow CHIPS to
    resume payment processing at its back-up center within 5 minutes of a
    decision to relocate operations.

             MITIGATION
    -------------------------------------------------- Chapter CHIPS:5.1.2

    Automated recovery.  If the CHIPS database suffers damage, CHIPS has
    a computerized method for rebuilding its database.  Each participant
    can automatically retransmit a payment previously sent if CHIPS
    indicates the loss of payments through the transmission of the
    recovery report.  According to an NYCHA document, CHIPS quarterly
    tests its contingency plans against a variety of simulated events in
    mandatory exercises involving all participants.

          RISK 2:  SYSTEMIC
          RISK/COUNTERPARTY CREDIT
    ---------------------------------------------------- Chapter CHIPS:5.2

    The most significant risk to the financial stability of CHIPS is
    systemic risk.  Systemic risk/counterparty credit risk occurs when
    one participant fails to meet its obligations and causes other
    participants not to meet their obligations.  When high-dollar value
    payments are exchanged and the turnover of funds within the
    arrangement is also high, the degree of systemic risk is generally
    high as well.

             MITIGATION
    -------------------------------------------------- Chapter CHIPS:5.2.1

    Same-day settlement.  In 1981, NYCHA instituted same-day settlement.
    Before same-day settlement, CHIPS transactions took up to 2 days to
    settle, except in the case of a weekend or holiday, when it could
    take up to 4 days to settle.  According to an NYCHA publication,
    same-day settlement has eliminated overnight exposure to failures,
    reduced float in the banking system, and accelerated the availability
    of funds to customers.

             MITIGATION
    -------------------------------------------------- Chapter CHIPS:5.2.2

    Bilateral credit limits.  Since October 1984, NYCHA has required each
    CHIPS participant to establish a bilateral credit limit with each of
    the other CHIPS participants.  Each CHIPS participant is required to
    indicate whether or not it is willing to receive payment messages
    from other participants.  If a CHIPS participant is willing to
    receive payment messages from another participant, it must set a
    limit on the maximum net-dollar amount that it is willing to receive
    from that participant.

    The CHIPS operating system continuously and automatically monitors
    payment messages, checking them against bilateral limits.  If a
    payment message would cause a participant to exceed the bilateral
    limit that the receiving participant has set for it, CHIPS is
    designed to not allow the payment message to be released.

             MITIGATION
    -------------------------------------------------- Chapter CHIPS:5.2.3

    Net debit caps.  In 1986, NYCHA established a net debit cap for each
    CHIPS participant.  This cap limits a participant's overall net debit
    position to all other CHIPS participants.  The significance of the
    net debit cap is that it limits the total amount of credit exposure
    that any one participant can pose to the CHIPS system.  Thus, if a
    participant defaults, the potential net loss to all other
    participants can be no greater than its net debit cap.  For each
    participant, the net debit cap is equal to 3.0 percent of the sum of
    the bilateral limits set for it by the other participants.

             MITIGATION
    -------------------------------------------------- Chapter CHIPS:5.2.4

    Loss sharing--backed up by collateral.  In 1990, NYCHA established a
    loss-sharing arrangement supported by pledged collateral to ensure
    that CHIPS settles even if a participant fails.  Under the
    loss-sharing arrangement, each participant that has established
    bilateral limits with the failed participant agrees to assume an
    additional settlement obligation (ASO), equal to its pro rata share
    of the failed participant's net debit position.  To ensure funding of
    the ASO, each participant is to provide collateral in advance equal
    to the participant's "maximum ASO." The maximum ASO is equal to $10
    million or 5 percent of the highest bilateral limit granted to any
    other participant, whichever is greater.  The collateral is U.S.
    Treasury securities, which are held in collateral accounts at FRBNY.

             MITIGATION
    -------------------------------------------------- Chapter CHIPS:5.2.5

    Membership requirements.  CHIPS maintains membership requirements to
    ensure the financial stability of CHIPS and its participants.
    Moreover, to ensure the creditworthiness of CHIPS participants, NYCHA
    requires all participants to (1) be subject to a credit evaluation
    when they apply for membership, (2) submit copies of their financial
    statements, and (3) be subject to periodic review, which includes a
    credit review by the member banks.

    SETTLEMENT OF FOREIGN EXCHANGE
    TRANSACTIONS
    ===================================================== Chapter Exchange

       DESCRIPTION AND USE
    --------------------------------------------------- Chapter Exchange:1

    A foreign exchange transaction is the trade of one currency for
    another, for example a trade of U.S.  dollars for German marks (DM).
    Foreign exchange transactions are typically settled through transfers
    of bank balances (deposits) in the respective currencies.  This is a
    wholesale activity conducted among financial institutions, especially
    banks, that may be trading for their own account or on behalf of
    others.

    Foreign exchange transactions are generated by cross-border
    activities, such as international trade and the purchase or sale of
    foreign assets, as well as by speculation on--or hedging
    against--moves in exchange rates.  The large financial institutions
    that offer to buy or sell foreign currencies for their customers
    commonly do a considerable amount of foreign exchange trading for
    their own account.  This "proprietary" trading enables a financial
    institution to have better market information for its customers and
    itself and may also be conducted to hedge the institution's own risks
    or in an attempt to profit from moves of exchange rates.

       (See figure in printed
       edition.)

       BASIC DATA
    --------------------------------------------------- Chapter Exchange:2

    On an average day, there are nearly $1.2 trillion in foreign exchange
    trades transacted globally, according to a survey conducted by
    central banks in April 1995.\12 This figure--after adjustment for
    exchange rate changes--was 30 percent higher than that found in a
    similar survey conducted in 1992.  Of the 1995 amount, 83
    percent--almost $1 trillion--involved U.S.  dollars.  To put this in
    perspective, the U.S.  money stock at the end of 1995 was $3.509
    trillion.\13 About two-thirds of foreign exchange transactions take
    place between bank dealers trading for their own account.

    --------------------
    \12 Bank for International Settlements, "Central Bank Survey of
    Foreign Exchange and Derivatives Market Activity, 1995."

    \13 U.S.  money stock, M2 measure, is composed of currency outside
    banks, checking and savings deposits, small time deposits, retail
    money market funds, and traveler's checks.

       PROCESSES
    --------------------------------------------------- Chapter Exchange:3

    Example:  A bank in New York (Bank A) has 200,000 German marks
    (DM200,000) on deposit with its correspondent bank in Frankfurt,
    Germany (Bank X) and wishes to sell DM150,000 of that amount in
    exchange for U.S.  dollars.  It might be initiating this trade for
    its own account or on behalf of a customer.

    This will be a "spot" transaction, in which settlement will be 2 days
    after the trade is negotiated.  Figure 1.4 illustrates how this
    transaction is processed.

       Figure 1.4:  A Typical Foreign
       Exchange Transaction

       (See figure in printed
       edition.)

       (See figure in printed
       edition.)

    The timing of the steps in Figure 1.4 is typical but not universal.
    For example, Step 5, shown as taking place on "Settlement day + 1,"
    can take place as late as settlement day + 2 in some banks.
    Similarly, the times of the actions on settlement day (11:00 a.m.
    German time in Frankfurt, and 10:00 a.m.  EST in New York) were
    chosen arbitrarily; these could occur at any time during the open
    hours of the payments systems in the respective cities.

       REGULATORY OVERSIGHT
    --------------------------------------------------- Chapter Exchange:4

    Regulatory oversight of participating institutions in foreign
    exchange trading is in the hands of the central banks and other
    regulators in their respective countries.  In the United States, this
    responsibility generally belongs to the bank regulators.  These
    regulators oversee the foreign exchange trading activities of banks
    through their normal examination procedures.

    Over the last 22 years, the central banks of the major industrial
    countries (the "Group of Ten," G-10 countries) have been working
    together on ways to improve and to better coordinate their
    supervision of foreign exchange trading.\14 Since 1989, this group of
    central banks has issued a series of studies on this topic, which
    included recommendations for private-sector and central-bank actions
    that could decrease foreign exchange settlement risk.  In 1994
    through 1995, a committee of the G-10 central banks surveyed some 80
    banks in their countries to determine current risk-control practices.
    This survey identified practices for reducing risk and shortfalls
    from these practices.

    --------------------
    \14 The G-10 countries include:  Belgium, Canada, France, Germany,
    Italy, Japan, The Netherlands, Sweden, Switzerland, United Kingdom,
    and the United States.

       RISK AND RISK MITIGATION
    --------------------------------------------------- Chapter Exchange:5

    For purposes of this report, we discuss some of the most important
    risks and risk mitigations associated with foreign exchange
    transactions.

       Table 1.5:  Risk and Risk
       Mitigation for Foreign Exchange
       Transactions

       (See figure in printed
       edition.)

          RISK 1:  HERSTATT RISK
    ------------------------------------------------- Chapter Exchange:5.1

    A foreign exchange transaction involves full settlements in two
    different national payments systems; in the case illustrated in
    Figure 1.4, on settlement day DM150,000 were paid through the
    Frankfurt Electronic Clearing System (EAF-2) system in Germany and
    $100,000 through CHIPS.  These systems are not linked in any way, and
    the settlements occur several hours apart.  Bank A's correspondent in
    Frankfurt paid out the German marks before Bank A received the
    dollars.  In other trades (e.g., Japanese yen for dollars), the gap
    between payment and receipt can be 17 hours.  For the entity that
    pays first, the risk is that the other party may fail to carry out
    its payment.  If this is due to computer or other temporary problems,
    the first entity faces liquidity problems; if the failure is due to
    bankruptcy of the second entity, the first entity is exposed to loss
    of up to the full amount that it paid.  This latter risk is commonly
    called "Herstatt risk," after the name of a German bank whose closure
    in 1974 occurred after it had received marks due to it on foreign
    exchange trades but before the corresponding dollar amounts were paid
    in the United States.  One result was a temporary but severe
    disruption of payments across CHIPS; for the next few days, banks
    withheld payments, resulting in a chain reaction of other payments
    not being made.\15 Also, U.S.  banks experienced losses.\16

    --------------------
    \15 See the section on CHIPS for the risk mitigations subsequently
    taken by that institution and its participants.

    \16 In addition to the risk that one party may fail after the other
    has made payment, there is also the risk that a party can fail before
    either party begins settlement.  In this case, the surviving party
    would not pay or lose its side of the trade, but--in order to obtain
    or sell the desired amount of currency--it would have to enter into a
    new foreign exchange transaction with a different counterparty.
    Because the new contract might be at a less favorable exchange rate
    than the original one, counterparty failure prior to settlement
    creates exposure to potential loss, but such a loss would be only a
    fraction of the amount that might be lost if there were a
    counterparty failure at settlement.

             MITIGATION
    ----------------------------------------------- Chapter Exchange:5.1.1

    Credit assessment and control.  A major defense against default risk
    in foreign exchange trading is adequate control of credit exposure.
    This control can be exercised through careful analysis and screening
    of potential trading counterparties, and the setting and enforcement
    of limits on exposure to each counterparty.  These controls are not
    universally practiced.  The survey by the G-10 committee found some
    banks in their countries that do not set any limits on their
    settlement exposures.

             MITIGATION
    ----------------------------------------------- Chapter Exchange:5.1.2

    Bilateral netting of gross payment obligations into smaller net
    obligations.  A way to reduce the magnitude of risk in foreign
    exchange settlement is through netting.  For example, two U.S.  banks
    that actively trade German marks might have entered into numerous
    contracts with each other for settlement in that currency on a
    particular day.  With a netting arrangement in place, the two banks
    could replace these multiple contract amounts with a single net
    amount to be sent through the German payments system on that day.
    This can greatly reduce the amount of settlement risk between the two
    banks.  Some large trading institutions have bilateral netting
    arrangements with each other.  Not all banks surveyed by the G-10 do
    so, however.

             MITIGATION
    ----------------------------------------------- Chapter Exchange:5.1.3

    Multilateral netting.  Such a practice, which involves the netting of
    both sides of currency obligations among more than two trading
    institutions, could further reduce the amounts to be settled in
    foreign exchange trading.\17 Little multilateral netting has been
    done thus far:  one arrangement, called ECHO, has begun operation in
    Europe.  A group of U.S.  and Canadian banks plan to start another,
    called Multinet International Bank.\18

    --------------------
    \17 In the United States, CHIPS, which serves as the medium for
    settling the dollar "leg" of most foreign exchange trades involving
    dollars, performs multilateral netting, but only for those dollar
    transactions sent across it.  Proposals for multilateral netting of
    foreign exchange transactions would involve the multilateral netting
    of both sides of trades.

    \18 The members of the Multinet project already net bilaterally among
    themselves trades in certain currencies, using the VALUNET system
    (see page 45).

          RISK 2:  EXTENDED AND
          ENLARGED EXPOSURES
    ------------------------------------------------- Chapter Exchange:5.2

    Many banks assume that their exposure to settlement risk in foreign
    exchange transactions is only for one day's trades, and is only an
    intraday exposure.  In fact, public- and private-sector studies have
    shown that these exposures commonly are at least overnight and that
    the exposure to settlement risk can be as high as the sum of 2 or 3
    days' trades, depending on the institution's own internal operational
    practices and its arrangements with its correspondent banks.  In Step
    3 of Figure 1.4, Bank A in New York followed the custom of sending
    payments instructions to its correspondent bank (Bank X) a day in
    advance of settlement.  If these banks' systems are fully automated,
    this instruction might be irrevocable.  In that case, if Bank B (the
    German bank) was closed and declared insolvent on settlement day,
    Bank A might nonetheless make scheduled payments to Bank B not only
    on settlement day but also on the next day, without receiving
    incoming payments from Bank B on either day.  The 1994-1995 G-10
    committee survey of major trading institutions found that for some of
    these institutions the amount at risk, even to a single counterparty,
    could exceed the institution's capital.

             MITIGATION
    ----------------------------------------------- Chapter Exchange:5.2.1

    Operations improvements.  To make exposure limits meaningful, they
    must be buttressed by operations procedures that allow the
    institution to halt outgoing payments up to settlement day, and to
    know whether expected incoming payments have been received.  The
    central banks' G-10 committee has recommended that all banks improve
    their operational controls and efficiency.

             MITIGATION
    ----------------------------------------------- Chapter Exchange:5.2.2

    Arrangements with correspondent banks to withhold payments.  Some
    banks have the ability to halt payments as late as settlement day,
    and, in some cases, late on that day.  In the previous example, if
    Bank A in New York had appropriate arrangements with Bank X, its
    correspondent in Frankfurt, it might be able to have Bank X withhold
    the mark payments from the German payments system on settlement day
    until well after the opening of that system, thus further reducing
    the time gap between payment of marks in Germany and receipt of
    dollars in New York.

          RISK 3:  GRIDLOCK
    ------------------------------------------------- Chapter Exchange:5.3

    Tighter operations controls over outgoing payments are a two-edged
    sword because they create gridlock risk for the market at the same
    time that they protect the institution.  If Banks A and X in figure
    1.4 had an arrangement such as described above, Bank A might withhold
    payment to Bank B if it heard rumors that Bank B was in trouble,
    preferring to receive funds from Bank B before paying to it.  Other
    banks might do the same vis-a-vis Bank B.  Even if the rumors were
    false and Bank B were sound, the withholding of payments to Bank B
    could create a liquidity problem for the bank; with incoming payments
    not arriving until late in the day, the bank could find it difficult
    to make its own scheduled payments, possibly affecting others.  This
    phenomenon occurred at the time of the attempted coup d'etat in the
    Soviet Union in 1991, when a number of banks withheld their payments
    to Soviet banks, thus making it difficult for the latter to meet
    their obligations.  Were such payment-withholding applied to larger
    numbers of banks or to larger banks, the resulting gridlock could
    involve broader systemic risk to financial markets more generally.

       BILATERAL AND MULTILATERAL
       NETTING OF FOREIGN EXCHANGE
       TRANSACTIONS
    --------------------------------------------------- Chapter Exchange:6

    Bilateral and multilateral netting of payments in foreign exchange
    transactions can reduce the amount of exposure to counterparty risk.
    Bilateral netting can be arranged between any two banks.
    Nonetheless, three organizations provide systems to facilitate
    bilateral netting among members.  As regards multilateral netting,
    there is one organization in operation, and another that expects to
    commence operation in 1997.  The following explains the systems in
    detail.

    (See figure in printed edition.)

    Bilateral Netting Systems

      -- Accord:  This is a service offered to members by S.W.I.F.T.
         Members subscribing to this service can have their payments
         messages matched and bilaterally netted by the Accord system.
         In May 1996, 27 institutions were using this system.

      -- FXNET:  This system is owned by the U.K.  subsidiaries of 12
         major banks.  In May 1996, 70 banks used this system for
         bilateral netting.

      -- VALUNET:  This system provides bilateral netting services to 10
         U.S.  and Canadian banks for some of those banks' offices.

    Multilateral Netting Systems

      -- ECHO (Exchange Clearing House):  This system is based in London;
         in May 1996, 13 banks were using it.  ECHO calculates
         multilateral netting of trades that are passed through it.  For
         each currency, a user will have only a single payment obligation
         or expected receipt.  Settlement takes place via traditional
         national payment systems into and out of ECHO accounts in each
         country.

      -- Multinet International Bank:  This is a project of the U.S.  and
         Canadian banks involved in VALUNET.  Once in operation, it will
         be a clearing house to provide multilateral netting and
         settlement of foreign exchange transactions among its members,
         initially in U.S.  and Canadian dollars and eventually in other
         currencies.  For those trades that met its standards, Multinet
         Bank would become counterparty.

    OVERVIEW OF CLEARANCE AND
    SETTLEMENT SYSTEMS OF EQUITIES,
    TREASURIES, FUTURES, AND OPTIONS
    ===================================================== Chapter Overview

    In this section, we discuss the clearance and settlement systems for
    securities, such as equities and U.S.  Treasuries, and derivatives,
    such as futures and options.

       MAIN CHARACTERISTICS
    --------------------------------------------------- Chapter Overview:1

      -- The clearance and settlement systems of equities, Treasuries,
         futures, and options are similar yet distinctive to each
         particular market.

      -- The systems for equities and U.S.  Treasuries center on the
         transfer of the ownership of securities from the seller to the
         buyer.

      -- The systems for futures and options center more on the transfer
         of risk and the value associated with that risk.

       STATISTICAL INFORMATION
    --------------------------------------------------- Chapter Overview:2

      -- Thousands of these types of financial instruments are traded
         each day through either organized exchanges or in the
         over-the-counter (OTC) markets.

      -- Hundreds of billions of dollars of each type of financial
         instrument are cleared and settled through clearing
         organizations each year.

       REGULATORY INFORMATION
    --------------------------------------------------- Chapter Overview:3

      -- The Securities and Exchange Commission (SEC) and the Commodity
         Futures Trading Commission (CFTC) are the primary regulators and
         oversee the actions of the clearing organizations under their
         jurisdictions to determine whether or not they are functioning
         in accordance with regulations and the law.

       RISK INFORMATION
    --------------------------------------------------- Chapter Overview:4

      -- The primary type of risk that clearing organizations face is
         counterparty, or credit risk.

      -- Clearing organizations can mitigate counterparty risk by having
         strict admission standards and continually monitoring their
         members, and by requiring their participants to post "good
         faith" deposits and/or make payments that cover any potential
         significant market movements.

    EQUITIES CLEARANCE AND SETTLEMENT
    ===================================================== Chapter Equities

       DESCRIPTION AND USE
    --------------------------------------------------- Chapter Equities:1

    The National Securities Clearing Corporation (NSCC) clears and
    settles 98 percent of all equity (stock) and corporate and municipal
    bond transactions in the United States.  For the purposes of clarity,
    we will focus only on equities.  NSCC is the clearing corporation for
    eight stock exchanges and is owned equally by the American Stock
    Exchange (AMEX), New York Stock Exchange (NYSE), and the National
    Association of Securities Dealers (NASD).\1

    The Depository Trust Corporation (DTC) tracks the transfer of
    equities and corporate and municipal bonds cleared through NSCC via
    an automated book-entry system.  During settlement, NSCC instructs
    DTC on which equities to move from one account to another.  DTC also
    performs securities custody services for its participating banks and
    broker-dealers.

    Participants in the clearance and settlement of equities include
    exchanges; NSCC, and members of NSCC (referred to as Direct
    Participants); DTC; and settlement banks (banks that settle on behalf
    of direct participants).

       (See figure in printed
       edition.)

    --------------------
    \1 One regional stock exchange, the Philadelphia Stock Exchange, has
    its own clearing organization.

       BASIC DATA
    --------------------------------------------------- Chapter Equities:2

    As of April 1996, NSCC served 1,974 brokers, dealers, banks, and
    other financial institutions through approximately 400 direct
    participants.  NSCC processes over a million transactions on a daily
    basis that are worth billions of dollars, according to NSCC.

    According to DTC officials, DTC holds approximately $10 trillion of
    securities that make up almost 99 percent of all stocks and
    nonfederal bonds traded in the United States.  (See table 2.1)

                                   Table 2.1

                              Data on NSCC and DTC

                                        1995
    ----------------------------------  ----------------------------------
    NSCC

    Average daily volume of             1,875,600 transactions
    transactions processed

    Average daily value of              $92 billion
    transactions processed

    DTC

    Securities delivered through DTC's  $41 trillion
    book-entry system

    Value of securities in DTC's        $10 trillion
    custody
    ----------------------------------------------------------------------
    Sources:  NSCC and DTC 1995 data.

       PROCESSES
    --------------------------------------------------- Chapter Equities:3

    Equity shares trade, clear, and settle in a 3-day cycle referred to
    by industry participants as "T+3"--the cycle begins on the day of the
    trade ("T") and ends 3 days later (T+3) with settlement.

          THE TRADING PROCESS
    ------------------------------------------------- Chapter Equities:3.1

    Investors may purchase equity shares through a securities
    broker-dealer.  Equities are traded in two different kinds of
    markets-- exchanges and the over-the-counter (OTC) markets.  Through
    exchanges, member firms act for themselves and as agents (brokers)
    for customers, bringing their orders to a central facility--the
    exchange floor--to be executed.  In exchange trading, orders may be
    executed in two ways:  (1) against other orders--a bid to buy
    equities matching an order to sell equities--or, if there is no such
    order at an acceptable price, by (2) a sale to or purchase from a
    specialist.  Trading is done through "open outcry," or orders can be
    inputed into an order management system.  NYSE officials said that 70
    percent of their trades are done through their order management
    system (called Super DOT--Designated Order Turnabout System) and 30
    percent are done through "open outcry." However, open outcry trades
    account for 70 percent of the dollar value of all trades because they
    typically include large transactions or block trades of 10,000 shares
    or more.

    In the Nasdaq OTC market,\2 orders are handled by dealers working
    over the telephone or through a computerized small-order execution
    system; there is no central physical facility or trading floor.  In
    this market, securities firms can act as brokers or dealers with
    respect to any type of stock.  A firm receiving a customer's order to
    buy stock can either sell the stock to the customer from the firm's
    inventory (if it is a dealer in that stock) or act as a broker by
    purchasing the stock from another dealer and then selling it to the
    customer.

    --------------------
    \2 Nasdaq stands for the National Association of Securities Dealers
    Automated Quotation system.  Nasdaq is the automated stock market for
    a portion of the non-exchange-listed securities.  The OTC market for
    securities includes Nasdaq, the so-called "pink sheets"--privately
    published National Daily Quotation Sheets--and the OTC Bulletin
    Board.

          THE CLEARANCE AND SETTLEMENT
          PROCESS
    ------------------------------------------------- Chapter Equities:3.2

    Equities are cleared and settled through NSCC and DTC.  Clearance
    begins after the trade occurs and involves NSCC guaranteeing the
    trade and then netting the delivery and receipt of settlement
    obligations.  Settlement usually occurs on T+3, with the equity
    shares settlement usually performed through book-entry moves at DTC
    and the money settlement through NSCC and settlement banks.  Equities
    that are eligible for depository processing through DTC enter the
    Continuous Net Settlement (CNS) System, which, according to NSCC
    officials, is where the vast majority of equity trades settle.  NSCC
    has three different settlement systems:  one for depository-eligible
    issues, one for the settlement of nondepository-eligible issues, and
    one for trades that bypass the netting process and are settled
    separately.

                                   Table 2.2

                     NSCC Clearance and Settlement Process
                          for Depository Equity Shares

    T+3 day                             Clearance and settlement
    ----------------------------------  ----------------------------------
    T (trade date)                      Trade occurs and trade information
                                        is sent to NSCC, mostly on a
                                        "locked-in" basis.

    T+1                                 Results of trade comparison and
                                        matching are sent to direct
                                        participants.

    T+2                                 NSCC determines participants' net
                                        settlement positions.

    T+3                                 Settlement date--securities are
                                        delivered and payment is made.\
    ----------------------------------------------------------------------
    \a NSCC officials said that the completion of transactions may not
    always occur on T+3.

    Source:  NSCC.

    Figure 2.1 describes in a simplified manner the T+3 trading,
    clearance, and settlement of a single depository-eligible equity
    trade that is not netted with other trades.

       Figure 2.1:  T+3 Clearance and
       Settlement of
       Depository-Eligible Equity
       Shares

       (See figure in printed
       edition.)

       (See figure in printed
       edition.)

          THE 3-DAY CLEARANCE AND
          SETTLEMENT CYCLE
    ------------------------------------------------- Chapter Equities:3.3

             TRADE DAY (T)
    ----------------------------------------------- Chapter Equities:3.3.1

    The 3-day cycle of clearance and settlement for NSCC begins on the
    day of the trade (T).  Trade information is recorded at the exchanges
    and then is transmitted to NSCC (via computers) through a variety of
    automated marketplace trading systems.

    Most of the trades are transmitted as "locked-in" transactions-- the
    details of the trades from the buyer and seller have already been
    matched by the computer systems of the exchanges or OTC market, which
    means that NSCC does not perform a trade comparison.  However, if
    trades are not locked-in, the buy and sell data have to be reported
    by direct participants to NSCC, and NSCC then compares and matches
    the data.\3 NSCC officials said that trades mostly occur on a
    locked-in basis.\4

    Once the trade data have been compared, NSCC guarantees the
    transaction.  This is referred to as "novation" or the substitution
    of one party for another (NSCC becomes the buyer to every seller and
    the seller to every buyer).  The guarantee begins on midnight of the
    day that the trade is reported back to direct participants as having
    been compared.

    --------------------
    \3 These types of trades are compared in either NSCC's Listed
    Comparison System for exchange-listed trades or the OTC Comparison
    System for trades in the OTC market.

    \4 However, municipal bonds and corporate debt are submitted for
    two-sided comparison.

             T+1
    ----------------------------------------------- Chapter Equities:3.3.2

    On T+1, results of the comparison and matching process are reported
    to direct participants.  NSCC transmits to direct participants
    computerized reports (known as contracts) that show every buy and
    sell order reported by the participant and the marketplace on T, and
    also confirm that each transaction has been compared and is ready for
    settlement.

             T+2
    ----------------------------------------------- Chapter Equities:3.3.3

    Participants are informed of their net settlement positions for
    trades that occurred on T and are due to settle on T+3.  NSCC issues
    a report to direct participants that tells them what their net
    settlement is that day and projects what their net settlement will be
    on T+3.  To do this, NSCC uses its CNS system, which "reduces or nets
    the total number of financial obligations requiring settlement."
    Participants then are advised whether they are net buyers or net
    sellers for each issue of a stock.

             T+3
    ----------------------------------------------- Chapter Equities:3.3.4

    T+3 is settlement day for trades that began on T--to the extent that
    securities are available for delivery, delivery will be made, and
    participants with payment obligations will be required to pay.  The
    participants' net settlement positions are determined by the CNS
    system netting all their trades due to settle that day against the
    prior days' unsettled long (buy) and short (sell) positions (referred
    to as fail positions or unsettled positions) for each issue of
    equity.

             EQUITY SETTLEMENT HAS TWO
             PARTS
    ----------------------------------------------- Chapter Equities:3.3.5

    Equity share settlement.  The settlement of equities has two
    parts--equity share settlement and money settlement.  The first phase
    is equity share settlement.  The movement of the shares takes place
    through DTC accounts.  NSCC instructs DTC to move shares from the
    accounts of net sellers to NSCC's account and then from NSCC's
    account to the accounts of net buyers.  If the amount of shares is
    insufficient to satisfy all delivery obligations, NSCC uses a random
    allocation algorithm to determine to whom securities should be
    delivered.  The CNS automatic delivery process occurs in two cycles:
    (1) the night cycle at about 1:30 a.m.  on (T+3) and (2) the
    continuous "day cycle" later that day.

    Money settlement.  The final phase of settlement is the money
    settlement.  The CNS net money settlement is determined on T+3 and
    can be settled with a single payment between NSCC and participants
    through settlement banks.\5 Every trading day, NSCC is to generate a
    settlement statement.  This statement is to include a line item that
    tells each participant what its net CNS money obligation is, based
    upon the dollar value of the participant's equity shares delivered
    and the dollar value of its payment obligation.  Each participant has
    a settlement bank that has guaranteed that it will pay or receive the
    money settlement on the participant's behalf.\6

    Settlement banks are required to make payment before Fedwire's funds
    transfer system\7 closes.

    --------------------
    \5 NSCC has operated a same-day funds settlement system since Feb.
    22, 1996.

    \6 In order to qualify as a settlement bank, each bank has to meet
    specific criteria established by NSCC.

    \7 Fedwire refers to two separate electronic systems--one for the
    electronic transfer of funds, and one for the electronic transfer of
    book-entry securities.

       REGULATORY OVERSIGHT
    --------------------------------------------------- Chapter Equities:4

    The Securities and Exchange Commission (SEC) oversees the actions of
    NSCC to determine whether it is functioning in accordance with the
    law and SEC regulations.  NSCC establishes the rules governing its
    clearance and settlement of equities, subject to SEC's approval.

       RISK AND RISK MITIGATION
    --------------------------------------------------- Chapter Equities:5

    For purposes of this report, we discuss some of the most important
    risks and risk mitigations associated with equities.

    Because NSCC guarantees the trades of its direct participants, it
    incurs risk from the time of the guarantee until the settlement of
    obligations and payments.  As a result, NSCC is exposed to
    counterparty risk, and the amount at risk (or the exposure) is
    dependent on fluctuations in the market.

                                   Table 2.3

                     Risk and Risk Mitigation for Equities

                                        Risk mitigation
    Risk                                ----------------------------------
    Counterparty/credit risk            Requirement of strict membership
                                        standards

                                        Arrangement with DTC

                                        Requirement of clearing fund
                                        account

                                        Marking to market prices of all
                                        unsettled securities
    ----------------------------------------------------------------------
    Source:  NSCC.

          RISK:  COUNTERPARTY/CREDIT
    ------------------------------------------------- Chapter Equities:5.1

    When NSCC guarantees the matched trade, it becomes the buyer to every
    seller and the seller to every buyer.  As a result, the clearing
    organization incurs counterparty risk--the possibility that the
    clearing member buyer or seller might default on its obligations.

    The amount of counterparty risk that NSCC is exposed to is dependent
    on fluctuations in the market.  If a direct participant does not meet
    its settlement and payment obligations, NSCC--because of the
    guarantee to the direct participant buyer and the direct participant
    seller--must liquidate the direct participant's positions, and thus
    is exposed to market risk (the exposure to the possibility of
    financial loss caused by adverse changes in the value of contracts).

             MITIGATION
    ----------------------------------------------- Chapter Equities:5.1.1

    NSCC mitigates counterparty risk by (1) setting strict admissions
    standards to determine that every member is creditworthy upon
    admission to NSCC; and (2) arranging with DTC that--in the event
    participants are unable to complete money settlement and NSCC ceases
    to act on their behalf--shares delivered that day are returned to
    NSCC, or DTC makes payment to NSCC.

    NSCC requires all unsettled securities or fail positions to be marked
    to market prices and payment is to be made by direct participants to
    reflect changes in the market.  The objective is to keep NSCC
    obligations as close to market prices as possible.  In addition, NSCC
    requires participants to contribute to the clearing fund,\8 which is
    designed to cover market risk exposure.

    --------------------
    \8 According to NSCC, the clearing fund was established to secure
    direct participants' obligations to NSCC as well as other liabilities
    and losses if they occur.

    TREASURIES AND THE FEDWIRE
    BOOK-ENTRY SECURITIES SYSTEM
    =================================================== Chapter Treasuries

       DESCRIPTION AND USE
    ------------------------------------------------- Chapter Treasuries:1

    The Fedwire book-entry securities system services all marketable U.S.
    Treasury securities, many federal agency securities, and certain
    international agency securities.  For simplicity, we will focus on
    Treasury securities.

    According to Federal Reserve officials, 99 percent of marketable U.S.
    Treasury debt is in book-entry form.  Treasuries settle through the
    Fedwire book-entry securities system, which is operated by Federal
    Reserve Banks.\9 The Fedwire book-entry securities system is a
    real-time delivery-vs.-payment (DVP) gross settlement system that
    requires the immediate and simultaneous transfer of securities
    against payment.\10 Depository institutions that maintain funds
    accounts at a Reserve Bank are eligible to maintain book-entry
    securities accounts at a Reserve bank, as are certain nondepository
    institutions, subject to certain settlement restrictions.

    The Government Securities Clearing Corporation (GSCC) was established
    to provide a netting mechanism for the clearance and settlement of
    U.S.  Government securities in both the primary and secondary markets
    for Treasury securities.\11 The primary purpose of issuing Treasury
    securities is to raise money for the U.S.  government.  A large
    secondary market also exists for Treasury securities, making it one
    of the most liquid markets (easy to buy and sell the securities
    without moving the price) in the world.\12

    Participants in the clearance and settlement of Treasury securities
    include the Federal Reserve, GSCC, members of GSCC referred to as
    Comparison members and Netting members, and clearing agent banks
    (banks that settle on behalf of members).  GSCC and each of its
    members has a designated clearing agent bank that operates through
    the Fedwire book-entry for securities system.\13

       (See figure in printed
       edition.)

    --------------------
    \9 Fedwire refers to two separate electronic systems--one for the
    electronic transfer of funds, and one for the electronic transfer of
    book-entry securities.

    \10 Transfers of securities may also be made without payment.

    \11 Treasuries may settle outside of GSCC's process.

    \12 Secondary markets consist of exchanges and OTC markets where
    financial instruments are bought and sold subsequent to original
    issuance, which took place in the primary market.

    \13 For the purposes of this report, we focused on GSCC's process,
    which is one mechanism for clearing and settling U.S.  government
    securities.

       BASIC DATA
    ------------------------------------------------- Chapter Treasuries:2

    The trading volume of the treasuries market averages $200 billion per
    day.  According to Federal Reserve Bank of New York officials, the
    Department of the Treasury is the largest single issuer of debt in
    the world, with Treasury securities accounting for approximately $3.5
    trillion in par value or face value (represented by 62 bond issues,
    144 note issues, and 52 bill issues) as of December 1996.  According
    to Federal Reserve data, Treasury issues dominate the transaction
    volume in the book-entry securities system, representing roughly 70
    percent of Fedwire securities transfer volume (see table 2.4).

                                   Table 2.4

                            Data on GSCC and Fedwire

                                                    1995
    ------------------------------------------  --  ----------------------
    GSCC
    ----------------------------------------------------------------------
    Annual dollar value of trades that GSCC         $65.9 trillion
     processes for netting members
    Average daily dollar value of trades that       $263.6 billion
     GSCC processes for netting members
    Annual dollar value of net settlement           $16.3 trillion
     obligations
    Average daily dollar value of net               $65 billion
     settlement obligations

    Fedwire book-entry securities system
    ----------------------------------------------------------------------
    Annual origination (transfer) volume\a          12.8 million
    Annual payment value of transfers\a             $150 trillion
    Average daily volume of Treasuries              36 thousand
     originations (transfers)
    Average daily payment value of transfers\a      $597 billion
    ----------------------------------------------------------------------
    \a Figures include all Fedwire-eligible securities, not just
    Treasuries.

    Sources:  GSCC and Federal Reserve.

       PROCESSES
    ------------------------------------------------- Chapter Treasuries:3

    For Treasuries that are cleared and settled through GSCC, the Fedwire
    book-entry securities system performs the book-entry transfer of the
    Treasury securities through designated clearing agent banks operating
    on behalf of netting members and GSCC.  The Fedwire book-entry
    securities system ordinarily operates from 8:30 a.m.  to 3:30 p.m.
    Eastern Time (ET).\14

    GSCC responsibilities include clearance (trade comparison, trade
    netting, and guarantee) and settlement.  Treasuries that clear and
    settle through GSCC may clear and settle anywhere from "T+1" (trade
    date with next day settlement), to "T+15" (trade date with settlement
    in up to 15 days), to "T+360" (in the case of repurchase agreements
    or "repos").\15 Participants choose when they want to have the trade
    settled.

    --------------------
    \14 The Fedwire book-entry securities system opens early in rare
    instances to meet special needs and closes late under special
    circumstances.

    \15 Cash settlement or Treasuries that settle on "T," or the day of
    the trade, will not clear and settle through GSCC.  According to GSCC
    officials, cash settlement is a very common form of settlement.

          THE AUCTION AND TRADING
          PROCESS
    ----------------------------------------------- Chapter Treasuries:3.1

    Treasuries are typically issued by an auction conducted by Federal
    Reserve Banks accepting competitive and noncompetitive bids from
    individual and institutional investors.  Treasuries can then be
    bought and sold in the secondary OTC market through commercial banks,
    broker-dealers, and other financial service companies.  The secondary
    Treasury OTC market is primarily an institutional investors' market.
    According to GSCC officials, commercial banks, dealers, brokers,
    mutual funds, and pension plans rather than individual investors
    typically participate in this market.  With respect to GSCC, each
    participant in the primary market and secondary markets for Treasury
    securities has to have a netting member--if they are not already a
    netting member--in order to clear and settle their Treasury trades
    through GSCC.

    GSCC clears and settles various types of Treasury security trades,
    such as cash trades, forward trades (trades entered into today for
    settlement more than 1 business day away), and repurchase
    agreements.\16 Members determine the types of trades they want as
    well as the settlement date.

    --------------------
    \16 GSCC does not clear and settle options and futures on Treasuries.
    For more information see clearance and settlement of futures and
    options later in Section 2.

          THE CLEARANCE PROCESS
    ----------------------------------------------- Chapter Treasuries:3.2

    Trade comparison is the first step in the clearance and settlement of
    Treasury securities.  There are two types of comparisons, matched and
    locked-in.  (See table 2.5)

                                   Table 2.5

                         Two Types of Trade Comparisons

    Trade comparison type   Description
    ----------------------  ----------------------------------------------
    Locked-in               The Federal Reserve Banks electronically
                            deliver Treasury auction purchases of GSCC
                            participants in the primary market to GSCC on
                            a locked-in basis--that is, the trades are
                            already matched.

    Matched                 Treasury securities traded in the secondary
                            market by GSCC participants are submitted to
                            GSCC, which compares and matches the buy and
                            sell sides of the trades. Comparison members
                            submit the trade data by electronic
                            transmission or magnetic tape by 10:00 p.m. on
                            the night of each business day.\a By 2:00
                            a.m., GSCC sends confirmation reports--
                            generated electronically--to comparison and
                            netting members that validate the comparison
                            of the trade data.
    ----------------------------------------------------------------------
    \a The comparison process goes on throughout the day and members may
    submit intraday data to GSCC.

    Sources:  GSCC and the Federal Reserve.

    After a trade is compared and matched and is eligible for netting, it
    is netted through the netting system.\17 The netting system combines
    a participant's total buy and sell obligations for each CUSIP number
    to arrive at a single net debit, credit, or flat amount for that
    netting member.\18 Once net settlement positions have been determined
    and have been reported to GSCC members, GSCC becomes the legal
    counterparty to each party of the trade and, as such, guarantees to
    the buyer and seller that the trade will settle.  This process is
    called novation, and it is usually completed before 2:00 a.m.

    --------------------
    \17 In order for nonrepurchase agreement trades to be eligible for
    netting, they must meet the following requirements:  (1) the trade
    must be compared on a final-money basis (including comparison on a
    locked-in basis); (2) the scheduled settlement date must be no more
    than a preestablished number of business days after the date of
    comparison; (3) netting must occur on or before its scheduled date;
    (4) data or each side of the trade must be submitted by a netting
    member or an authorized locked-in trade source; and (5) the
    underlying securities must be eligible for netting.

    \18 Trades that have the same CUSIP number are netted together.

          THE SETTLEMENT PROCESS
    ----------------------------------------------- Chapter Treasuries:3.3

    After net settlement amounts or positions have been determined and
    sent to netting members, settlement can take place.  The settlement
    of Treasury securities includes (1) the Treasury securities transfer
    and (2) the simultaneous payment for the securities.

             TREASURY SECURITIES
             TRANSFER AND PAYMENT
    --------------------------------------------- Chapter Treasuries:3.3.1

    The Treasury securities settlement is done through clearing agent
    banks on behalf of the netting members, and GSCC.  Each clearing
    agent bank instructs the Federal Reserve which of its accounts to
    debit and which to credit for the transfer of securities and payment.

      -- Once net settlement positions have been determined by GSCC, a
         netting member's clearing agent bank is informed by the netting
         member of the securities to be delivered to or received from
         GSCC and the payment against which those deliveries or receipts
         are to be made.  If the member of GSCC is a clearing agent bank,
         then it would do this on its own behalf.

      -- To the extent such deliveries or receipts must occur between
         clearing agent banks, the clearing agent bank sends Fedwire
         instructions to the Federal Reserve authorizing the Federal
         Reserve to transfer Treasury securities from its custody account
         (for the benefit of the net seller's account on the books of the
         clearing agent bank), to the account of the receiving clearing
         agent bank (for the benefit of GSCC's account on the books of
         the receiving clearing agent bank).\19 This transfer is done in
         book-entry form.

      -- GSCC's clearing agent bank then instantaneously redelivers the
         securities to the net buyer's account on the books of its
         clearing agent bank.  GSCC, however, is not obligated to deliver
         securities to member buyers until it receives securities from
         member sellers.  Therefore, if a netting member's clearing agent
         bank fails to deliver the securities for any reason (including
         when the netting member does not have enough securities in its
         account), GSCC fails to deliver securities to the net buyer
         member.

      -- With respect to a clearing agent bank whose customer is a net
         seller of a security, the clearing agent bank (or a bank member
         of GSCC acting on its own behalf) will place a Fedwire
         securities delivery instruction to deliver securities from the
         clearing agent bank's account at the Federal Reserve Bank to the
         GSCC clearing agent bank's account at the Federal Reserve Bank,
         unless the transfer can be made on an intrabank basis.  The only
         instruction necessary for transferring securities over Fedwire
         is made by the deliverer of securities; therefore, the delivery
         instruction from the net seller's clearing agent bank will
         result in a simultaneous debiting of funds from the GSCC
         clearing agent bank's account at the Federal Reserve Bank
         without any debit instruction from GSCC's clearing agent bank.
         If a clearing agent bank receiving securities has insufficient
         funds in its Federal Reserve account to pay for the securities,
         the Federal Reserve Bank will nonetheless complete the transfer
         (if it is within certain risk parameters), and the clearing
         agent bank will incur a daylight overdraft in its account at the
         Federal Reserve Bank.

    --------------------
    \19 The transfer of securities can be done "intrabank," (i.e., both
    the net seller and GSCC use the same clearing agent bank).

             FUNDS-ONLY SETTLEMENT
    --------------------------------------------- Chapter Treasuries:3.3.2

    The funds-only settlement is separate from the delivery and payment
    of the Treasury securities settlement.  It pertains to the net debit
    or net credit dollar amount that each netting member owes or is due
    for its accounts.  For example, settlement has to be made on margin
    or on any open net settlement position, and payment has to be made on
    other positions, including fail to deliver or fail to receive
    obligations, and transaction adjustment payments (TAP).\20

    The funds-only settlement occurs at 10:00 a.m.  and 11:00 a.m.  each
    day and is made via the Fedwire funds transfer system.  Unlike the
    Treasury securities settlement, GSCC will make a funds-only
    settlement whether or not it has received all funds-only settlement
    due it from members on that day.

    --------------------
    \20 TAP refers to the dollar difference between the amount at which
    these securities are to be delivered and received and the amount at
    which these securities are traded.  Since trades included in the
    netting process have been entered into at varying prices, in order
    for netting to work, GSCC must establish a single-system price for
    each CUSIP.  GSCC does so on each business day by use of either a
    third-party source or by a par-weighted average for all compared
    trades in each CUSIP on that date.  The use of this system's
    price--market price for all compared trades--(plus accrued interest)
    should cause the delivery and receipt of securities to occur at
    amounts that are close to current market value, but different from
    contract prices.

       REGULATORY OVERSIGHT
    ------------------------------------------------- Chapter Treasuries:4

    The Securities and Exchange Commission (SEC) oversees the actions of
    GSCC to determine whether it is functioning in accordance with the
    law and SEC regulations.\21 GSCC establishes the rules governing the
    clearance and settlement of Treasury securities that clear and settle
    through GSCC, subject to SEC approval.

    According to Federal Reserve officials, Treasury/government
    securities transactions are governed by a combination of federal and
    state law as well as Reserve bank operating circulars.  Each agency
    that issues securities on Fedwire has promulgated regulations that
    establish a federal legal framework governing the transfer of rights
    and interests in book-entry securities by a Fedwire participant.
    These regulations also specify the status of Fedwire book-entry
    securities under state law, which applies to the transfer of rights
    and interests in the securities in the absence of governing federal
    law.  In most cases, UCC Article 8 is the state law governing the
    settlement phase of securities transactions.

    --------------------
    \21 SEC is the primary agency that oversees GSCC, and the U.S.
    Treasury and the Federal Reserve are considered to be "secondary"
    regulators, according to GSCC officials.

       RISK AND RISK MITIGATION
    ------------------------------------------------- Chapter Treasuries:5

    For purposes of this report, we discuss some of the most important
    risks and risk mitigations associated with treasuries.

    Because GSCC guarantees the trades of its members, it incurs risk
    from the time of the guarantee until the settlement of obligations
    and payments.  As a result, GSCC incurs counterparty risk, but the
    amount at risk (or exposure) is dependent on fluctuations in the
    market.

                                   Table 2.6

                    Risk and Risk Mitigation for Treasuries

    Risk                                Risk mitigation
    ----------------------------------  ----------------------------------
    Counterparty/credit risk             Requirement of strict membership
                                        standards

                                         Monitoring members'
                                        creditworthiness

                                         Marking open positions to market
                                        prices

                                         Maintaining a clearing fund
    ----------------------------------------------------------------------
    Source:  GSCC.

          RISK:  COUNTERPARTY/CREDIT
    ----------------------------------------------- Chapter Treasuries:5.1

    When GSCC guarantees the matched trade, it becomes the buyer to every
    seller and the seller to every buyer.  As a result, GSCC incurs
    counterparty risk--the possibility that the member buyer or member
    seller might default on its obligations.

    The amount of counterparty risk that GSCC is exposed to is dependent
    on fluctuations in the market.  If a member does not meet its
    settlement of obligations and payments, GSCC--because of the
    guarantee to the member buyer and member seller--must liquidate the
    member's position, and thus is exposed to market risk (the exposure
    to the possibility of financial loss caused by adverse changes in the
    value of securities).

             MITIGATION
    --------------------------------------------- Chapter Treasuries:5.1.1

    GSCC mitigates counterparty/credit risk by (1) setting strict
    admissions standards to determine that every member is creditworthy
    upon admission to GSCC and (2) routinely monitoring members'
    creditworthiness through financial reporting requirements and
    reviewing the clearing members' financial results.

    GSCC requires all unsettled securities or fail positions to be marked
    to market prices and payment is made by members to reflect changes in
    the market.  The objective is to keep GSCC obligations as close to
    market prices as possible.  In addition, GSCC requires members to
    contribute to a clearing fund that is designed to cover market risk
    exposure.

    FUTURES
    ====================================================== Chapter Futures

       DESCRIPTION AND USE
    ---------------------------------------------------- Chapter Futures:1

    A futures contract obligates the holder to buy or sell a specific
    amount or value of an underlying asset, reference rate, or index
    (called the underlying) at a specified price on a specified future
    date.\22 For instance, if an investor were to purchase a December
    futures contract, an agreement would be made to pay a specified price
    for a specified quantity of a commodity, such as wheat, metals, or
    live cattle, for delivery in December.  The buyer (or seller) would
    have an obligation to purchase (or sell) the underlying commodity.
    However, the buyer could satisfy this obligation either by receiving
    and paying for the commodity when the contract expired or by
    "offsetting"\23 the obligation prior to the contract expiring, which
    is how the majority of futures contracts are closed out.  Futures
    previously were limited to commodities such as agricultural products
    and metals, but were extended in the 1970s to include financial
    futures on instruments such as Treasury bonds, foreign currencies,
    and stock indexes.

    Market participants may use futures to hedge their assets or
    liabilities, or to speculate on market movements by correctly
    anticipating price movements.  According to market officials, the
    main function of a futures contract is to shift risks from those less
    willing or able to bear them to those more willing or able to do so.

    Participants in the clearance and settlement of futures contracts
    include exchanges, clearing organizations, clearing members, and
    settlement banks (or banks that settle exchange members' accounts).
    Futures are traded on 11 active exchanges in the United States.  Nine
    futures clearing organizations serve the exchanges.

    Futures clearing organizations may be either clearing houses, which
    are departments within an exchange, or clearing corporations, which
    are separately incorporated and independent from the exchange.
    During this report, we spoke to the Chicago Mercantile Exchange (CME)
    Clearing House Division and the Chicago Board of Trade (CBT) Board of
    Trade Clearing Corporation (BOTCC).  For purposes of clarity, we will
    refer to the CME Clearing House Division and BOTCC as clearing
    organizations.

    Clearing members are financial institutions (generally large futures
    brokers) that transact with the clearing organizations; all futures
    customers and nonclearing members use a clearing member to clear
    their trades through a clearing organization.  Clearing members must
    belong to the exchanges.

    Settlement banks maintain the clearing accounts for the clearing
    organizations through which payments and deposits are made either to
    or from clearing members' accounts to or from the clearing
    organizations.  Settlement in the futures market usually pertains to
    cash flow payments that reflect changes in the market price.  The
    clearing organization officials we spoke to said they have designated
    up to eight banks as settlement banks.

       (See figure in printed
       edition.)

    --------------------
    \22 Underlyings include stocks, bonds, agricultural and other
    physical commodities, interest rates, foreign-currency rates, and
    stock indexes.

    \23 Offsetting means liquidating a purchase (sale) of futures
    contracts through the sale (purchase) of an equal number of futures
    contracts with the same delivery month, thus closing out a position.

       BASIC DATA
    ---------------------------------------------------- Chapter Futures:2

    According to clearing organization officials, about 80 percent of the
    futures trading volume in the United States occurs at CBT and CME.
    CBT has its own separately incorporated clearing house--BOTCC--and
    CME has a clearing house division.  Both clear and settle futures and
    options on futures traded on their respective exchanges.

                                   Table 2.7

                          Data on BOTCC and CME, 1995

                                                                 Number of
                                       Number of                options on
                                         futures      Average      futures
                             Number    contracts        daily    contracts
                                 of  cleared and    number of  cleared and
                            clearin   eventually      futures   eventually
    Clearing organization   g firms    settled\\   contracts\     settled\
    ----------------------  -------  -----------  -----------  -----------
    BOTCC                       124  202,429,356      920,133   65,536,849
    CME                          83  159,787,862      634,079   43,366,350
    ----------------------------------------------------------------------
    Sources:  CME and BOTCC.

       PROCESSES
    ---------------------------------------------------- Chapter Futures:3

    Futures trade, clear, and settle in what is known as "T+0"--trades
    are done with same-day settlement.  The "T" represents the trading,
    clearing, and settlement in one 24-hour period, starting at 6:40 a.m.
    CST and ending 24 hours later at 6:40 a.m.  The "0" indicates that
    there are no additional days in the process.

          THE TRADING PROCESS
    -------------------------------------------------- Chapter Futures:3.1

    Most trading in the futures markets is done on the floor of the
    futures exchanges.  The exchanges operate as auction markets where
    prices are determined by "open outcry." Trading is done in a tiered
    area of the exchange floor, called a "pit." In addition, electronic
    trading may occur during regular trading hours and/or during a night
    session.\24 Trades done electronically are automatically matched and
    then settled in the same manner as are pit trades.

    Two types of traders execute trades on the floor of an exchange:  (1)
    floor traders, or locals, are members of the exchange\25 and (2)
    floor brokers who may be independent or may be employees of firms
    referred to as futures commission merchants (FCM), which are members
    of the exchange.  Floor traders trade exclusively for their own
    accounts.  Floor brokers transact on the floor of the exchange on
    behalf of customers.\26

    --------------------
    \24 Electronic trading occurs on "Project A" at CBT and on "GLOBEX"
    at CME.

    \25 Locals may lease a seat on the exchange and, thus, they
    themselves may not be a member of the exchange.

    \26 In addition, floor brokers may execute customer orders and trade
    for themselves or their firm's account (proprietary trading) during
    the same trading session under limited circumstances, a practice
    referred to by industry officials as "dual trading."

          THE CLEARING PROCESS
    -------------------------------------------------- Chapter Futures:3.2

    The clearance of futures involves capturing, matching, and
    guaranteeing trades.  Clearing organizations also clear and settle
    options on futures, which go through a clearance and settlement
    process similar to those of futures contracts.

                                   Table 2.8

                     Steps in the Futures Clearing Process

    Steps                               Clearing process
    ----------------------------------  ----------------------------------
    (1) Capturing the trade data        Clearing firms (FCMS)/traders
                                        input their trade data to the
                                        clearing organizations.\a

    (2) Matching the trade data         After receiving the trade data,
                                        the clearing organizations match
                                        the data. Soon after the trade
                                        data are submitted, the data are
                                        matched.

    (3) Guaranteeing the trade          Once pit trades\ have been
                                        matched, the clearing
                                        organizations guarantee the
                                        trades.\b The clearing
                                        organizations guarantee to the
                                        clearing members that the
                                        settlement obligations of the
                                        trade will be met.
    ----------------------------------------------------------------------
    \a Electronic data do not have to be captured.

    \b Clearing organizations also guarantee trades of the exchange of
    futures for the underlying physical asset, but the guarantee does not
    become effective until after the day of the trade.

    Sources:  CBT and CME.

          THE SETTLEMENT PROCESS
    -------------------------------------------------- Chapter Futures:3.3

    On a day-to-day basis, the settlement of futures refers to the
    settlement payment of funds between the clearing members and the
    clearing organization.\27 There are two types of payments included in
    the daily settlement in the futures market:  (1) the performance bond
    (also referred to as a margin deposit or "good faith" deposit) and
    (2) the variation settlement (also referred to as the
    mark-to-market).

                                   Table 2.9

                            Two Types of Settlement

    Type              Settlement
    ----------------  ----------------------------------------------------
    Performance bond  Every clearing member has to post performance bonds
    (or margin        with the clearing organization. Performance bonds
    deposit)\a        cover the anticipated one-day loss that a clearing
                      member's portfolio and its customers open positions
                      might incur. The amount required is based on the
                      value of the clearing member's open positions and an
                      assessment of the amount of risk those contracts
                      involve. Performance bonds are calculated at least
                      twice each day for each clearing member at BOTCC and
                      CME. If the performance bond is below the level
                      established by the clearing organization, the
                      clearing member must make a deposit.\b

    Variation         In addition to the performance bond, clearing
    settlement        members are required to meet variation settlements-
                      -the amount that is required when the clearing
                      member's open positions are marked to the market
                      prices. At least twice a day at the BOTCC and CME,
                      the clearing organizations determine a settlement
                      price for each type of futures and options on
                      futures contracts and mark all open positions to
                      that price, and payment is made to reflect the
                      change in market prices. By marking open positions
                      to the market price each day, clearing organizations
                      prevent losses and gains from accumulating over
                      time.
    ----------------------------------------------------------------------
    \a Clearing organizations calculate the performance bond either on a
    gross or net basis.  Gross margining requires clearing members to
    post margin on all of the long (buy) and short (sell) positions in
    their accounts.  The long and the short positions cannot be used to
    offset each other in the case of a deficiency.  Net margining
    requires margin to be posted on the difference between all long and
    short positions, calculated separately for the clearing members'
    accounts and its customers' accounts.

    \b Clearing organization officials said that if a clearing member's
    performance bond is below a certain level and that member is to
    receive a variation margin settlement profit from the clearing
    organization, then the clearing organization will keep the profit and
    apply it toward the clearing member's performance bond.

    Sources:  CBT and CME data.

    Figure 2.2, along with the information that follows, describes in a
    condensed manner the events that take place during the T+0 trading,
    clearance, and settlement cycles.

       Figure 2.2:  The 24-Hour
       Trading, Clearance, and
       Settlement Cycle

       (See figure in printed
       edition.)

    --------------------
    \27 The final closeout of a futures contract occurs by (1) settlement
    by delivery, (2) cash settlement, or (3) settlement by offset.  For
    futures contracts in which the underlying physical asset is to be
    delivered (settlement by delivery), the clearing organization ensures
    that delivery and payment is made.  Futures may also be settled by
    cash settlement rather than actual physical delivery.  Cash
    settlement means that the buyer receives the cash value of the
    physical asset instead of the physical asset.  For settlement by
    offset, an order would be entered to sell (or purchase) futures
    contracts of the same delivery month purchased (or sold) during the
    earlier transaction.  The difference in value at liquidation is
    simply credited to or debited from the clearing member's account.

          THE 24-HOUR CYCLE
    -------------------------------------------------- Chapter Futures:3.4

             HOURS
    ------------------------------------------------ Chapter Futures:3.4.1

    Cycle

             6:40 A.M.  (CST)
    ------------------------------------------------ Chapter Futures:3.4.2

    The 24-hour cycle begins--settlement banks commit to pay or receive
    final settlement on behalf of clearing members for the previous day's
    trades.\28

    --------------------
    \28 The settlement banks' commitment is irrevocable and will occur
    whether or not Fedwire opens.  The settlement amount results from the
    previous days' trading and includes settlement on margin deposit
    changes and mark-to-market calculations done up to a specific time
    before 6:40 a.m.  All payments between settlement banks are made in
    Fedwire funds.

             7:20 A.M.
    ------------------------------------------------ Chapter Futures:3.4.3

    Regular trading begins at the exchanges.

             11:30 A.M.
    ------------------------------------------------ Chapter Futures:3.4.4

    For CME, trades that have been matched since the start of the day
    plus any adjustments to existing positions are used in CME's intraday
    settlement calculation.

             12:15 P.M.- 12:30 P.M.
    ------------------------------------------------ Chapter Futures:3.4.5

    The market price is determined and is used in the intraday settlement
    calculation at CME.

             1:30 P.M.
    ------------------------------------------------ Chapter Futures:3.4.6

    For BOTCC, trades that have been matched up until this time are used
    in BOTCC's intraday calculation.

             1:30 P.M.- 2:00 P.M.
    ------------------------------------------------ Chapter Futures:3.4.7

    Clearing organizations calculate an intraday-settlement and transmit
    reports showing the amounts of what is owed to or from the clearing
    members to the settlement banks.\29 BOTCC uses the market price at
    2:00 p.m.  for its intraday settlement.

    --------------------
    \29 The intraday settlement includes the daily mark to market of all
    open positions to the current market price variation settlement for
    the purposes of collecting the changes in market prices, including
    trades executed during the electronic trading sessions, and the
    current day's trades matched before
    10:30 a.m.  at CME and 1:30 p.m.  at BOTCC.  In addition, at CME, if
    the performance bond is below a particular level, clearing members
    must make a deposit on that as well.  BOTCC requires performance bond
    settlements at 6:40 a.m.  only.

             2:00 P.M.
    ------------------------------------------------ Chapter Futures:3.4.8

    Regular trading ends at the exchanges in most pits.

             2:15 P.M.
    ------------------------------------------------ Chapter Futures:3.4.9

    BOTCC's intraday settlement is made by settlement banks on behalf of
    clearing members.

             3:00 P.M.
    ----------------------------------------------- Chapter Futures:3.4.10

    CME's intraday settlement is made, which is similar to its 6:40 a.m.
    settlement.

             8:00 P.M.
    ----------------------------------------------- Chapter Futures:3.4.11

    Final clearing begins at the clearing organizations.

             11:00 P.M.
    ----------------------------------------------- Chapter Futures:3.4.12

    Final settlement is calculated at CME.  Reports are sent to the
    settlement banks.

             3:00 A.M.
    ----------------------------------------------- Chapter Futures:3.4.13

    Final settlement is calculated at BOTCC and includes all-night
    trading done up until 3:00 a.m.  Reports are sent to the settlement
    banks.

             6:40 A.M.
    ----------------------------------------------- Chapter Futures:3.4.14

    Settlement banks inform the clearing organizations that they will
    commit to pay on behalf of the clearing members, ending the 24-hour
    clearance and settlement cycle.

       REGULATORY OVERSIGHT
    ---------------------------------------------------- Chapter Futures:4

    The Commodity Futures Trading Commission (CFTC) oversees the actions
    of the self-regulatory organizations--the clearing organizations and
    the exchanges--to determine whether they are functioning in
    accordance with the law and CFTC regulations.  Futures clearing
    organizations are responsible for establishing the rules governing
    the clearance and settlement of futures and options on futures, which
    are subject to approval by CFTC.\30

    --------------------
    \30 At CME, the exchange establishes the rules that cover the
    Clearing House Division.

       RISK AND RISK MITIGATION
    ---------------------------------------------------- Chapter Futures:5

    For purposes of this report, we discuss some of the most important
    risks and risk mitigations associated with futures.

    Clearing organizations are exposed to risk from the time they
    guarantee settlement obligations to the time clearing members make
    settlement payments or offset (liquidate) their positions.  As a
    result, clearing organizations are exposed to counterparty risk, but
    the amount at risk (or the exposure) is dependent on fluctuations in
    the market.

                                   Table 2.10

                      Risk and Risk Mitigation for Futures

    Risk                                Risk mitigation
    ----------------------------------  ----------------------------------
    Counterparty/credit risk             Set admission standards

                                         Monitor clearing members'
                                        creditworthiness

                                         Audit departments

                                         Capital requirements

                                         Require performance bonds and
                                        variation margin
                                        settlements
    ----------------------------------------------------------------------
    Sources:  CBT and CME.

          RISK:  COUNTERPARTY/CREDIT
    -------------------------------------------------- Chapter Futures:5.1

    When the clearing organization guarantees the matched trade, it
    becomes the buyer to every clearing member seller and the seller to
    every clearing member buyer; this process is called novation.  As a
    result, the clearing organization incurs counterparty risk--the
    possibility that the clearing member buyer or seller might default on
    its obligations.

    The amount of counterparty risk that clearing organizations are
    exposed to is dependent on fluctuations in the market.  If a clearing
    member does not make settlement payments, the clearing
    organization--because of the guarantee to the clearing member buyer
    and the clearing member seller--must liquidate the clearing member's
    positions, but until it does so, the clearing organization is exposed
    to market risk (the exposure to the possibility of financial loss
    caused by adverse changes in the value of futures contracts).

             MITIGATION
    ------------------------------------------------ Chapter Futures:5.1.1

    Clearing organizations mitigate counterparty risk by (1) setting
    admissions standards to determine that every clearing member is
    creditworthy upon admission to the clearing organization, (2)
    routinely monitoring clearing members' creditworthiness through
    financial reporting requirements and a review of the clearing
    members' trading results, (3) having their audit departments go
    through a prescribed set of audit tests for each clearing member, and
    (4) having clearing members comply with exchange rules for minimum
    capital requirements.  In addition, clearing organizations require
    (1) performance bonds that they consider sufficient to cover the
    maximum 1-day loss that a clearing member's portfolio might incur and
    (2) variation settlements in which all futures contracts are
    marked-to-market prices and payment is made to reflect the change in
    market prices.  (See earlier section on settlements for further
    detail.)

    EXCHANGE-TRADED OPTIONS
    ====================================================== Chapter Options

       DESCRIPTION AND USE
    ---------------------------------------------------- Chapter Options:1

    Options contracts give holders the right but not the obligation, for
    a price, called a premium, to buy or sell an underlying stock or
    other financial instrument at a specified price, called the
    "exercise" or "strike" price, before a specified expiration date.
    Options can be used to protect investors against losses in
    investments they own, lock in profits on positions they already have,
    or speculate on expected price movements.

    An options contract can be terminated in three ways:  (1) expiration,
    (2) exercise, or (3) closeout--the holder of the option enters into
    an equal and offsetting option contract.  Options are usually bought
    and sold without being exercised.

    Settlement in the options markets usually pertains to margin
    settlement, which is a payment that reflects changes in the value of
    the option.  There is also a premium settlement that pertains to the
    amount that must be paid to buy the option, and an exercise and
    assignment settlement that pertains to an option that is exercised.

    The Options Clearing Corporation (OCC) clears and settles all options
    traded on securities exchanges in the United States and is owned by
    five participating exchanges.\31

    All exchange-traded options are cleared and settled through OCC.
    Exchange-traded options include options such as equity options,
    currency options, and equity index options.  Over-the-counter (OTC)
    options, which are privately negotiated, also exist.  For the
    purposes of this section, we will only discuss exchange-traded
    options.

    Exchange-listed options on futures are cleared and settled through
    futures clearing organizations.  However, OCC officials said that
    they clear and settle some options on futures through one of their
    subsidiaries for three exchanges.  (See the section on the clearance
    and settlement of futures for further detail.)

    Participants in the clearance and settlement of options include
    exchanges, OCC and its members (referred to as clearing members), and
    settlement banks (or banks that settle clearing members' accounts).

    Figure 2.3 illustrates an options listing, with an explanation of its
    various components.

       Figure 2.3:  An Options Listing

       (See figure in printed
       edition.)

       Source:  GAO Analysis.

       (See figure in printed
       edition.)

    --------------------
    \31 Exchanges include the Chicago Board Options Exchange, American
    Stock Exchange, Philadelphia Stock Exchange, New York Stock Exchange,
    and the Pacific Stock Exchange.

          OPTIONS CAN BE USED TO LIMIT
          LOSSES OR MAKE PROFITS
    -------------------------------------------------- Chapter Options:1.1

    An investor who wanted to limit potential losses in investments
    already owned might purchase a "put option." If an investor owns 100
    shares of Exxon stock valued at 87 1/2 ($87.50) a share--and wants to
    hold the stock in case the price of the stock rises--but thinks that
    the price of the stock may fall below $80, the investor might
    purchase an "80 Jan Put," which will give the investor the right to
    sell Exxon stock at a locked-in selling price of $80 per share at any
    time before the option expires at
    11:59 a.m.  EST on the third Saturday of January.  If an investor
    wanted to make a profit and thought that the Exxon stock might rise
    above $90 a share, the investor might buy a "90 Oct Call" at a
    locked-in buying price of $90 a share.  If the price rises above $90
    a share, the investor can exercise his or her right to buy Exxon
    stock at $90 a share.  The investor can then profit by reselling the
    shares at the market price.  The investor could also sell the option
    contract at a profit.

       (See figure in printed
       edition.)

       (See figure in printed
       edition.)

       BASIC DATA
    ---------------------------------------------------- Chapter Options:2

    According to OCC officials, OCC has 147 clearing members composed of
    broker-dealers owned by U.S.  securities firms and some of the major
    foreign banks and investment houses.

    As shown in table 2.11, OCC clears and settles millions of options
    contracts annually.  The primary type of option that OCC clears and
    settles is the equity, or stock option.  OCC also clears a
    substantial portion of equity index options and a small portion of
    currency options.

                                   Table 2.11

                    Total Volume of Exchange-Traded Options
                           Contracts Cleared in 1995

                             Total
                            volume
                                of
                          contract                       Average   Average
                                 s   Percent   Average     daily     daily
                          cleared\  of total     daily      call       put
    Types of options             a    volume  volume\b  volume\b  volume\b
    --------------------  --------  --------  --------  --------  --------
    Equity options           174.4     60.7%     692.0     491.3     200.7
    Equity index             107.9      37.6     428.1     191.6     236.4
     options
    Currency options           5.0       1.7      19.8       8.7      11.0
    ======================================================================
    Total                    287.3      100%    1140.1     691.8     448.2
    ----------------------------------------------------------------------
    \a Volume in millions.

    \b Volume in thousands.  Columns do not total because the totals
    include interest rate options that are not included in the table.

    Note:  Numbers based on 1995 data.

    Source:  OCC data.

       PROCESSES
    ---------------------------------------------------- Chapter Options:3

    Options trade, clear, and settle in what is known as "T+1"--i.e.,
    options are settled one day after (+1) the day in which they were
    traded, with the "T" standing for the day of the trade.

          THE TRADING PROCESS
    -------------------------------------------------- Chapter Options:3.1

    Individual investors who want to purchase a call or put option may do
    so through a broker.  The broker usually has a floor broker execute
    the trade on behalf of the customer.  Exchanges also have automatic
    order execution systems for public customer orders.

    Trading in the options markets is done on the floor of options
    exchanges.  The exchanges operate as auction markets.  U.S.
    exchanges that trade options operate with either (1) competing market
    makers (dealers) for each class of options and exchange officials
    such as floor brokers or order book officials or (2) designated
    market makers for each class of options, with additional market
    making provided by registered options traders.

          THE CLEARING PROCESS
    -------------------------------------------------- Chapter Options:3.2

    OCC officials said that their clearance and settlement process starts
    when the exchanges provide computer data on matched trades--trades in
    which the sell side and the buy side of the trade have been compared
    and matched.  (See table 2.12.)

                                   Table 2.12

                     Steps in the Options Clearing Process

                                        Clearing process
    Steps                               ----------------------------------
    (1) OCC receives matched-trade      (a) Exchanges submit the matched-
    data from the exchanges via         trade data in a batch-once-a-day
    computer.                           mode via computer to OCC no later
                                        than 1:00 a.m. after the day of
                                        the trade for clearance and
                                        settlement purposes.\a

                                        (b) OCC officials said that their
                                        clearance system runs
                                        independently for each opions
                                        exchange, so that a problem at one
                                        exchange does not affect the other
                                        options exchanges.

    (2) OCC then guarantees the         (a) When OCC has the matching
    matched trades.                     trade data, it issues a new
                                        contract and becomes the buyer to
                                        every seller and the seller to
                                        every buyer. This process is
                                        called novation.

    (3) OCC then performs what is       (a) Exercise and assignments occur
    known as exercise and assignment    when a holder decides to exercise
    on a random basis. OCC receives an  his or her rights to buy or sell
    exercise notice from the holder's   the underlying asset.\b Because
    broker and then assigns the         OCC keeps the records of all of
    exercise notice to one of its       its clearing members, when a
    clearing members.                   holder decides to exercise its
                                        right to buy or sell an underlying
                                        asset, its broker has to submit an
                                        exercise notice to OCC.

                                        (b) OCC assigns the exercise
                                        notice to a clearing member that
                                        has a position in the unit of
                                        trade, which in turn assigns one
                                        or more of its customers who hold
                                        positions in that series of
                                        options.

                                        (c) The assigned clearing member
                                        is then obligated to sell or buy
                                        the underlying asset at the
                                        specified strike price.\c
    ----------------------------------------------------------------------
    \a Exchanges also send OCC intraday trade information that OCC uses
    for risk management.  But for clearance and settlement, exchanges
    submit trade data to OCC in a batch once a day.  If an exchange is
    unable to provide matched trade information by the final deadline,
    OCC allows additional time.

    \b If an option is held until it expires and it is not in the
    interest of the option holder to exercise the option at expiration,
    then OCC does not settle the option.  However, if the holder decides
    to exercise the option on the date of expiration, then the option
    goes through OCC's exercise and assignment process.

    \c In the case of equity options, OCC then arranges with a stock
    clearing corporation for the delivery of the shares of stock instead
    of the exercise settlement amount.  All other DVP for options are
    exercised within OCC.

    Source:  OCC.

          SETTLEMENT PROCESS
    -------------------------------------------------- Chapter Options:3.3

    OCC calculates the amount of money that is owed by buyers and due
    writers the day after a trade (T+1).  In the case of the buyer, the
    entire amount of money owed to OCC is the amount of the premium
    which, while first paid to OCC, is then passed on to the writer of
    the option.  In the case of the writer, settlement refers to two
    settlement amounts (1) premium settlement and (2) margin
    settlement.\32 On the day after the trade (T+1), OCC notifies the
    buyer of the amount of cash premium that is due; at the same time,
    the writer of the option is notified by OCC of the amount of margin
    that is due.  Both amounts are due on T+1.  (See table 2.13)

                                   Table 2.13

                            Two Types of Settlement

    Participant         Type of settlement
    ------------------  --------------------------------------------------
    Buyer               Premium settlement (in this case it is the price
                        the buyer pays for the option).

    Writer              (1) Premium settlement.\
                        (2) Margin settlement.\a
    ----------------------------------------------------------------------
    \a OCC calculates the margin that the writer has to provide using its
    Theoretical Intermarket Margin System, which is an option pricing
    model that estimates what it would cost to liquidate an option given
    the size of a margin interval.  According to an OCC official, the
    margin interval is the range of potential market scenarios over which
    the risk of the option is being evaluated by OCC.

    Source:  OCC.

    At the end of each trading day, OCC calculates the net amount that
    each member either owes or is owed.  The net figure includes (1) the
    cash premium that the writer is due on each option sold and (2) the
    margin due for each open position--a position that has not been
    exercised by buyers or holders.

    As shown in table 2.13, the first component of the writer's
    settlement is the premium settlement due to the writer, which is the
    price at which the writer sold the option to the buyer.  This
    settlement should reflect the current market price at the time of the
    trade.  The premium settlement is due on the day after the trade
    (T+1).

    The second component of the writer's settlement is the margin
    settlement, which is like a "good faith" deposit.  One part of the
    margin settlement is the daily mark-to-market value of the option,
    which reflects the current market price of the option.  For instance,
    as an option's price gains in value, the options writer pays margin
    to OCC and the buyer of the option gets a margin credit.  If the
    options contract loses value, OCC reduces the amount of margin
    required from the writer.\33 The other part of the margin settlement
    is the daily risk value of the option, which reflects the potential
    change in the current market price of the option.  OCC calculates and
    collects the margin settlement from the option writer until the
    option is terminated.

    Figure 2.4, along with information that follows, describes in a
    condensed manner the events that take place during the T+1 trading,
    clearance, and settlement cycle.

       Figure 2.4:  T+1 Trading,
       Clearance, and Settlement Cycle

       (See figure in printed
       edition.)

    Source:  GAO analysis of OCC data.

    --------------------
    \32 The final settlement of an option can be done either by
    exercise/assignment or by closeout.  OCC officials said that only
    about 10 percent of options contracts are exercised/assigned.  If a
    holder decided to close out its options prior to expiration, the
    holder would sell that option in the market.  The option sold would
    be coded as a closeout option so that OCC's clearance and settlement
    system would eliminate the holder's open position.

    \33 Because the buyer of an option does not have to exercise the
    option contract unless it is in his or her favor, the buyer does not
    owe OCC money if the option price moves against him or her.  Thus, if
    the price of the option continues to move against him or her, the
    option's buyer--by not having to exercise the option--only loses the
    premium settlement amount.

          TRADING, CLEARANCE, AND
          SETTLEMENT CYCLE
    -------------------------------------------------- Chapter Options:3.4

             HOURS
    ------------------------------------------------ Chapter Options:3.4.1

    Cycle

             6:00 A.M.  (CST)
    ------------------------------------------------ Chapter Options:3.4.2

    Settlement banks are notified of the final--margin and
    premium--settlement amounts due from each clearing member, resulting
    from the previous day's trading.

             8:30 A.M.
    ------------------------------------------------ Chapter Options:3.4.3

    Trading begins for stock and stock index options at the exchanges for
    the new trade day (T).\34

    --------------------
    \34 The Pacific Stock Exchange operates from 6:00 a.m.  to 1:50 p.m.
    Pacific Time.

             9:00 A.M.
    ------------------------------------------------ Chapter Options:3.4.4

    All final settlement amounts are due to OCC by each clearing member
    for the previous day's trading--the T+1 settlement.

             10:00 A.M.
    ------------------------------------------------ Chapter Options:3.4.5

    OCC pays final settlement due members, resulting from the previous
    day's trading--also T+1 settlement.  OCC does not pay members money
    owed them until it has received the money it is owed at 9:00 a.m.

             3:15 P.M.
    ------------------------------------------------ Chapter Options:3.4.6

    Trading ends for stock and stock-index trading.

             6:00 P.M.
    ------------------------------------------------ Chapter Options:3.4.7

    Currency option trading begins, and it will end at 2:00 p.m.  the
    next day (20 hours later).

             8:00 P.M.
    ------------------------------------------------ Chapter Options:3.4.8

    Exchanges submit matched-trade data to OCC until 1:00 a.m.  Currency
    option trade data from the previous day's trading are processed along
    with the stock and stock-index option data.

             3:00 A.M.
    ------------------------------------------------ Chapter Options:3.4.9

    OCC updates the clearing members' positions for the end of the
    trading session and calculates the members' settlement requirements,
    both margin and premium.  This settlement amount will be the final
    settlement that is due by the clearing members at 9:00 a.m.  and paid
    by OCC at 10:00 a.m., which will end the T+1 trading, clearing, and
    settlement cycle.

       REGULATORY OVERSIGHT
    ---------------------------------------------------- Chapter Options:4

    The Securities and Exchange Commission (SEC) oversees the actions of
    OCC with regard to exchange-traded equity options, equity index
    options, and currency options to determine whether it is functioning
    in accordance with SEC regulations and the law.  The Commodity
    Futures Trading Commission (CFTC) oversees the actions of OCC with
    regard to options on futures (see the futures section for further
    information on options on futures).  OCC establishes the rules
    governing the clearance and settlement of options, subject to the
    approval of SEC, or of CFTC in the case of options on futures.

       RISK AND RISK MITIGATION
    ---------------------------------------------------- Chapter Options:5

    For purposes of this report, we discuss some of the most important
    risks and risk mitigation associated with exchange-traded options.

    OCC carries risk from the time it guarantees a trade until the
    resulting position is terminated.  As a result, OCC is exposed to
    counterparty risk, but the amount at risk (or the exposure) is
    dependent on fluctuations in the market.

                                   Table 2.14

                      Risk and Risk Mitigation for Options

    Risks                               Risk mitigation
    ----------------------------------  ----------------------------------
    Counterparty/credit risk             Monitoring of the clearing
                                        member's
                                        creditworthiness

                                         Possible requirement of
                                        additional
                                        margin for less
                                        creditworthy
                                        clearing members

                                         Guarantee of matched trades
                                        only

                                         Requirement of margin that acts
                                        as
                                        collateral

                                         Maintaining guarantee fund
    ----------------------------------------------------------------------

          RISK:  COUNTERPARTY/CREDIT
    -------------------------------------------------- Chapter Options:5.1

    OCC guarantees the performance of each clearing member to the other
    clearing member of each trade.  As a result, it incurs the risk that
    a clearing member might default on its obligations.

    The amount of counterparty risk that OCC is exposed to is dependent
    on fluctuations in the market.  If a clearing member does not make
    settlement, OCC--because of the guarantee to the clearing member
    buyer and clearing member seller--must liquidate the clearing
    member's positions, but until it does so, OCC is exposed to market
    risk (the exposure to the possibility of financial loss caused by
    adverse changes in the value of options.

             MITIGATION
    ------------------------------------------------ Chapter Options:5.1.1

    OCC mitigates counterparty/credit risk by (1) monitoring the
    creditworthiness of its clearing members and (2) having the ability
    to require additional margin for less creditworthy clearing members.
    In addition, OCC requires a margin from each clearing member (see the
    section on settlement) and maintains a guarantee fund\35 that OCC may
    use when it needs to.

    --------------------
    \35 The guarantee fund is funded by OCC assessing clearing members on
    their past month's open positions.  The assessment is an amount that
    members pay once a month and is calculated separately from the other
    settlement amounts.

    OVERVIEW OF CLEARANCE AND
    SETTLEMENT OF RETAIL PAYMENT
    SYSTEMS
    ===================================================== Chapter Overview

    In this section of the report, we discuss small-dollar retail payment
    systems, including checks, credit cards, and the automated clearing
    house (ACH).

       MAIN CHARACTERISTICS
    --------------------------------------------------- Chapter Overview:1

      -- Retail payments are primarily small-dollar payments that are
         used by consumers or businesses in payment for goods and
         services.

      -- Unlike checks, ACH transactions can be either credit or debit
         transactions.

      -- In ACH credit transactions, funds flow from the originator
         (payor) to the receiver (payee).  Settlement for an ACH credit
         transaction is generally final by the opening of business on the
         banking day following the settlement day.

      -- In ACH debit and check payments, the payee collects funds from
         the payor.  The interbank settlement for check and ACH debit
         transactions is typically final by the opening of business on
         the banking day following the day checks are presented or ACH
         debit transactions are provisionally settled.

       STATISTICAL INFORMATION
    --------------------------------------------------- Chapter Overview:2

      -- In 1996, approximately 63 billion paper checks were written in
         the United States.

      -- In 1995, credit card transactions accounted for approximately
         14.9 billion transactions.

      -- In 1996, approximately 4.0 billion payments totaling $12.1
         trillion were processed on ACH.

       REGULATORY INFORMATION
    --------------------------------------------------- Chapter Overview:3

      -- Checks are governed by articles 3 and 4 of the Uniform
         Commercial Code (UCC); the Expedited Funds Availability Act
         (EFAA), implemented by the Federal Reserve Board of Governors'
         Regulation CC, "Availability of Funds and Collection of Checks";
         and, when handled by the Federal Reserve Banks, subpart A of the
         Federal Reserve's Regulation J.

      -- The primary regulations for credit cards are the Equal Credit
         Opportunity Act of 1974 and the Truth in Lending Act of 1968,
         implemented by the Board of Governors of the Federal Reserve
         System's Regulations B and Z, respectively.

      -- The basic rules that govern ACH are the National Automated
         Clearing House Association (NACHA) Operating Rules and
         Guidelines.  In addition, ACH is governed by UCC Article 4A for
         commercial ACH credit transactions, 31 CFR 210 for transactions
         originated by the federal government, the Electronic Fund
         Transfer Act and the Federal Reserve's Regulation E for consumer
         transactions, and the Reserve Banks' ACH operating circular for
         transactions processed by the Federal Reserve.

       RISK INFORMATION
    --------------------------------------------------- Chapter Overview:4

      -- Consumer delinquency and default are the principal risks that
         confront the credit card industry.

      -- Depository institutions that originate ACH debit transactions
         and that collect checks are exposed to the potential risk that
         some of the checks/debit transactions will be returned unpaid.

      -- Depository institutions that originate ACH credit transactions
         are exposed to potential temporal credit risk if a corporate
         customer does not fund the payment on settlement day.

    CHECKS
    ======================================================= Chapter Checks

       DESCRIPTION AND USE
    ----------------------------------------------------- Chapter Checks:1

    The paper check, the most frequently used and oldest noncash payment
    instrument in the United States, is used by individuals, businesses,
    and governments to pay for goods and services.  According to the
    National Organization of Clearing Houses (NOCH), over 63.4 billion
    paper checks were written in the United States in 1996.\1 Paper
    checks constitute the largest volume of noncash payments made in the
    United States.  In this section, we discuss the clearance and
    settlement of commercial checks drawn on financial institutions.\2

    As illustrated in figure 3.1, a paper check includes the names of the
    payor and the payee, the amount of the check, and the name of the
    paying bank.  In addition, the magnetic ink character recognition
    (MICR) line at the bottom of the check permits checks to be processed
    on high-speed equipment.  It includes a number that identifies the
    bank upon which it is drawn and the account number of the check
    writer.  Before checks are processed, the amount of the check is also
    encoded in magnetic ink at the bottom of the check.

       Figure 3.1:  An Example of a
       Paper Check

       (See figure in printed
       edition.)

    Source:  The Story of Checks and Electronic Payments, Federal Reserve
    Bank of New York.

    Depository institutions have the following alternative methods of
    clearing and settling checks.

    On-us checks.  When checks are deposited into the same bank on which
    they were drawn, banks will settle these items in-house.  Such checks
    are referred to as "on-us" checks.

    Interbank checks.  Interbank checks are checks not drawn on the
    depository institution at which they were deposited.

      -- Direct presentment.  Depositary banks can present checks
         directly to the paying bank.

      -- Correspondent banks.  Correspondent banks can settle the checks
         that they collect for other institutions, known as respondents,
         by using accounts on their books or by sending Fedwire funds
         transfers.

      -- Clearing house association.  Banks can form a voluntary
         association that establishes a meeting place for the exchanging
         of checks drawn on those banks.  Typically, banks participating
         in check clearing houses use the Federal Reserve's net
         settlement service to effect settlement for the checks exchanged
         each business day.

      -- Federal Reserve Banks.  The Federal Reserve System operates a
         comprehensive, nationwide system for clearing and settling
         checks drawn on depository institutions located in all regions
         of the United States.

    There are approximately 150 check clearing house associations in the
    U.S.  Three of the large clearing house associations in the U.S.  are
    the California Bankers Clearing House (CBCH), the Chicago Clearing
    House Association (CCH), and the New York Clearing House Association
    (NYCHA).  NYCHA, established in 1853, is the nation's first clearing
    house association.  Smaller depository institutions typically use the
    check collection services of correspondent banks or of the Federal
    Reserve.

                                   Table 3.1

                      Major Organizations That Process or
                                Exchange Checks

    --------------  ------------------------------------------------------
    Federal         The Federal Reserve System processes commercial checks
    Reserve         through its 12 Reserve Banks, 24 branches, and 10
    System          regional check processing centers. Also, the Federal
                    Reserve processes federal government checks and postal
                    money orders.

    CBCH            CBCH provides check exchange services to over 100
                    depository institutions located mainly in California.

    CCH             CCH provides check exchange services to its 8 member
                    banks and its 260 affiliate members.

    NYCHA           NYCHA provides check exchange services to its 10
                    member banks and to 131 other depository institutions.
    ----------------------------------------------------------------------
    Sources:  Federal Reserve Board, CBCH, CCH, and NYCHA.

       (See figure in printed
       edition.)

    --------------------
    \1 Estimates of the total number of checks written for any given
    period must be considered imprecise estimates because the specific
    number of checks that are cleared through clearing houses,
    correspondent banks, and by direct presentment is unknown.  A
    comprehensive survey of the number of checks written has not been
    conducted since 1979.

    \2 In 1996, the Federal Reserve Banks processed nearly 436 million
    paper checks for the federal government; however, the volume of
    government paper checks is expected to decline as a result of the
    enactment of the Debt Collection Improvement Act (DCIA) of 1996, Pub.
    L.  No.  104-134, Section 31001, which requires that all federal
    payments, except Internal Revenue Service (IRS) payments and payments
    to individuals who certify that they do not have bank accounts, be
    issued via electronic funds transfer by Jan.  1, 1999.

       BASIC DATA
    ----------------------------------------------------- Chapter Checks:2

    Table 3.2 shows the volume of checks handled by the Federal Reserve
    and three major check clearing houses from 1992 to 1995.  In 1995,
    the Federal Reserve Banks handled 15.5 billion checks, a decrease of
    19 percent from the volume of checks they handled in 1992.\3 The
    following factors have contributed to this decline:

      -- adoption of the same-day settlement regulation;\4

      -- increased competition from private clearing houses; and

      -- banking consolidation, resulting in more "on-us" checks, which
         do not need to be cleared.

                                   Table 3.2

                     The Volume of Checks Processed, 1992-
                                      1995

                                                                   Percent
                               1992             1995                change
    -------------------------  ---------------  ------------  ------------
    Federal Reserve\a          19.1 billion     15.5 billion          -19%

    CBCH                       1,294 million    1,554                  +20
                                                million

    CCH                        384.7 million    562.8                  +46
                                                million

    NYCHA                      492.6 million    335.7                  -32
                                                million
    ----------------------------------------------------------------------
    \a These numbers refer only to commercial checks; they do not include
    federal government checks and postal money orders that are processed
    by the Federal Reserve.

    Sources:  The Federal Reserve System 1995 Annual Report, CBCH, CCH,
    NOCH, and NYCHA.

    At the same time, the volume of checks processed by two of the three
    major private clearing houses, CBCH and CCH, has increased for the
    period of 1992 through 1995, as shown in table 3.3.

    --------------------
    \3 Annual Report:  1995, Board of Governors of the Federal Reserve
    System, p.  303.

    \4 Before the Board of Governors adopted the same-day settlement
    rule, which became effective on Jan.  2, 1994, private collecting
    banks, unlike the Federal Reserve Banks, did not have the right to
    present checks to paying banks and to demand settlement in same-day
    funds.  Since the same-day settlement rule became effective, more
    collecting banks have begun to present checks directly to paying
    banks.  Banks have historically had bilateral agreements with each
    other under which they have exchanged checks directly.  In some
    cases, paying banks imposed presentment fees, but not in all cases.
    Even today, banks exchange checks directly at later times than
    permitted under the same-day settlement rule using bilateral
    agreements.

       PROCESSES
    ----------------------------------------------------- Chapter Checks:3

    As previously mentioned, banks have several alternative methods for
    clearing and settling checks.  Figure 3.2 describes how the Federal
    Reserve System processes and clears checks.  The Federal Reserve
    System operates a comprehensive, nationwide system for clearing both
    local and nonlocal checks.  When checks are processed by the Federal
    Reserve, they are sorted through a check sorter and settled by debits
    to the Federal Reserve accounts of the paying banks and credits to
    the Federal Reserve accounts of the collecting banks.  In order to
    facilitate the clearing of checks nationwide, the Federal Reserve
    uses both air transportation and ground transportation networks to
    deliver checks.  Checks, which are drawn on banks in regions far from
    the payee bank, are frequently shipped by air to the city in which
    the payor bank is located.  Locally, checks are delivered by ground
    transportation.

          PROCESSING A CHECK
    --------------------------------------------------- Chapter Checks:3.1

    Figure 3.2 shows how a paper check would be processed through the
    Federal Reserve System, using the following example.

    Example:  A consumer (Consumer A) in Philadelphia orders four books
    from a book company (Company B) in Los Angeles.
    The total cost ofthe order is $75.
    The consumer pays for the books by mailing a check to Company B.

       Figure 3.2:  The Federal
       Reserve System for Processing a
       Paper Check

       (See figure in printed
       edition.)

       (See figure in printed
       edition.)

       Source:  GAO analysis of
       information provided by the
       Federal Reserve Board.

       (See figure in printed
       edition.)

    According to industry officials, extensive use of the paper check
    contributes to some of the inefficiency that is present in the U.S.
    payment system.  One of the goals of any payment system is to
    facilitate the safe, sound, and efficient transfer of value between
    receivers and providers of goods and services in a timely manner.
    According to a payment system expert, paper instruments, such as
    checks, are considered substandard from a payment system design
    perspective.

          NEW TECHNOLOGIES IN CHECK
          PROCESSING
    --------------------------------------------------- Chapter Checks:3.2

    In the last few years, clearing house associations, the banking
    industry, and the Federal Reserve have been actively developing and
    pursuing a new technology that may shorten the amount of time it
    takes to clear and settle checks and, thus, improve the overall
    efficiency of the payment system.  This new check technology is
    called electronic check presentment (ECP).  ECP is a process by which
    the MICR-line information is sent electronically to the paying bank.
    A number of large commercial banks participate in the Electronic
    Check Clearing House Organization (ECCHO), formed in 1990.  ECCHO
    drafts rules and designs formats for electronic check processing
    among its members.  Banks that are ECCHO participants can exchange
    electronic check data among themselves before the paper checks are
    physically presented for payment.

    ECP may include check truncation and may be supported by check
    imaging technology.  Check truncation is a process by which the paper
    checks are retained at some point in the collection process, and only
    the check information is sent forward to the paying bank.  ECCHO is
    developing a set of national rules for check truncation.  Check
    imaging is a process by which a picture is taken of the front and
    back of the check, and the images are stored on electronic media for
    retrieval when needed.

    The Federal Reserve also offers ECP products to paying banks.  During
    1996, the Federal Reserve presented electronically to the paying bank
    nearly 1.4 billion checks, or 9 percent of checks collected by the
    Federal Reserve.  This is an increase of approximately 100 percent
    over the 1994 level.

    As of January 1996, 2,221 depository institutions used the Federal
    Reserve's ECP service.  This is a 37-percent increase over the number
    of depository institutions that were using the Federal Reserve's ECP
    service in January 1995.  In 1992, NYCHA created the Clearing House
    Electronic Check Clearing System (CHECCS), in which ECP is a key
    component.

    Although the use of check truncation and imaging is steadily
    increasing, it is not clear how much check volume will be affected by
    these methods in the foreseeable future.  The reluctance of some
    banks to invest in the technology, and consumer preference for their
    returned checks, may restrain substantial growth in check truncation
    and imaging.  One Federal Reserve official predicted that check
    truncation would not be widely used until consumers accepted the fact
    that their checks would not be returned to them.  Moreover, under
    current law, depositary banks must physically present checks to
    paying banks to obtain settlement for the checks.

       REGULATORY OVERSIGHT
    ----------------------------------------------------- Chapter Checks:4

    Articles 3 and 4 of the Uniform Commercial Code (UCC) provide the
    legal framework for check processing.  In 1987, Congress enacted the
    Expedited Funds Availability Act (EFAA), which limits the time that
    banks can withhold funds from checks deposited into customer accounts
    before the funds are made available for withdrawal.  The law was
    implemented in September 1988 through the Federal Reserve Board of
    Governors' Regulation CC, "Availability of Funds and Collection of
    Checks." Regulation CC also includes a number of provisions designed
    to accelerate the collection of checks and the return of unpaid
    checks to the banks of first deposit.  Among other things, EFAA and
    Regulation CC generally require institutions to make funds from local
    checks available by the second business day after the day of deposit;
    funds from nonlocal checks are to be available by the fifth business
    day after the day of deposit.

    Also, those checks that are collected or returned through the Federal
    Reserve are governed by subpart A of the Federal Reserve's Regulation
    J.  Regulation J establishes the procedures, duties, and
    responsibilities of the sending and paying banks.

       RISK AND RISK MITIGATION
    ----------------------------------------------------- Chapter Checks:5

    For purposes of this report, we discuss some of the most important
    risks and risk mitigations associated with checks.

       Table 3.3:  Risk and Risk
       Mitigation for Checks

       (See figure in printed
       edition.)

          RISK 1:  RETURN ITEM
    --------------------------------------------------- Chapter Checks:5.1

    A check will be returned to the depositary bank unpaid if the paying
    bank determines not to pay the check.  This is called a return item.
    Return item risk is a major risk facing institutions that collect
    checks.  Some of the reasons for which a check may be returned are
    insufficient funds in the account, a closed account, a stop payment
    order, a fraudulent signature, or the failure of the paying bank.  A
    recent Federal Reserve survey on returned checks processed by the
    Reserve Banks showed that it takes, on average, 5.5 calendar days for
    local and nonlocal checks to complete a full return cycle from the
    depositary bank to the payor bank and back to the depositary bank.\5

    The risk faced by depositary banks depends on when they make funds
    available to their customers.  Banks are obligated under EFAA to make
    funds available to their customers in accordance with mandatory funds
    availability schedules.  Thus, a depositary bank may be required to
    make funds available to the customer before a check is returned to
    the depositary bank unpaid.  When the depositary bank receives a
    return item, it will charge back its depositing customer's account
    for the item even if it has already made the funds available to the
    depositing customer.  The depositary bank may be exposed to some risk
    if the customer does not have sufficient funds in his or her account
    to cover the returned check.  When a paying bank returns the item to
    the depositary bank, the paying bank does not necessarily have to
    return the item through the same clearing mechanism from which it
    received the item.

    --------------------
    \5 Report to the Congress on Funds Availability Schedules and Check
    Fraud at Depository Institutions, Board of Governors of the Federal
    Reserve System, Oct.  1996, p.  22.

             MITIGATION
    ------------------------------------------------- Chapter Checks:5.1.1

    Credit monitoring by financial institutions.  For the purpose of
    reducing the return item risk faced by depositary banks, the Federal
    Reserve recommends that depository institutions perform a credit
    assessment of those customers for which they collect large-dollar
    volumes of checks.  Also, the Federal Reserve recommends that
    institutions monitor the payment activity of their customers and take
    appropriate action when credit limits are exceeded.

             MITIGATION
    ------------------------------------------------- Chapter Checks:5.1.2

    Large-dollar return item notification.  Federal Reserve Regulation CC
    requires that when a paying bank decides to return a check of $2,500
    or more, it must provide a notice of nonpayment to the depositary
    bank.  The notice must be received by
    4:00 p.m.  local time for the depositary bank on the second business
    day following the banking day on which the check was presented to the
    paying bank.  A paying bank can send the notice of nonpayment by
    several means, including the return of the check to the depositary
    bank; a telephone call or telex to the depositary bank; a special,
    nonvalue Fedwire funds transfer notice; or a telephone call to a
    Reserve Bank with a request to forward the notice.

             MITIGATION
    ------------------------------------------------- Chapter Checks:5.1.3

    Electronic check presentment.  The exchange of electronic check
    information may reduce risk to the depositary banks because it
    permits them to deliver check data to paying banks more quickly than
    is currently done with paper checks.  The shorter time for check
    information delivery could permit the paying banks to (1) identify
    checks that cannot be paid and (2) notify the depositary bank about
    those returned checks, using an electronic return notice, up to 1 day
    earlier than would occur with the physical exchanging of paper
    checks.  If a depositary bank could be notified of a return item
    earlier, then the risk might be reduced because the depositary bank
    would know sooner that the check was not being paid and that funds
    should not be made available to the depositing customer.

          RISK 2:  CHECK FRAUD
    --------------------------------------------------- Chapter Checks:5.2

    Check fraud is a problem for the banking industry.  The same Federal
    Reserve survey on check fraud and check returns estimated that in
    1995, the value of all check-fraud losses at commercial banks, credit
    unions, and savings institution was $615 million for 529,000 cases of
    check fraud.\6 Also, for that year, commercial banks' check fraud
    losses ($487 million) represented approximately 1 percent of their
    profits.  The survey also found that local checks accounted for about
    72 percent of the total dollar losses reported in the Board's survey.

    One example of check fraud is check kiting.  Check kiting may take
    many forms, but often it involves the writing of checks on two or
    more banks for the purpose of fraudulently obtaining interest-free
    unauthorized loans.  Other types of check fraud include forgery,
    altered checks, counterfeit checks, and paperhanging.  Forgery occurs
    when a person forges the account holder's signature or the
    endorsement.  Altered checks are checks that have information, such
    as the amount, altered without the payor's approval.  Counterfeit
    checks are imitations or copies of genuine checks.  Paperhanging
    refers to checks that are deliberately written on closed accounts.

    --------------------
    \6 Report to the Congress on Funds Availability Schedules and Check
    Fraud at Depository Institutions, Board of Governors of the Federal
    Reserve System, Oct.  1996, p.  5.

             MITIGATION
    ------------------------------------------------- Chapter Checks:5.2.1

    Positive pay.  Corporations use positive pay to guard against check
    fraud.  Under these arrangements, a corporation sends an electronic
    file of information on all checks issued to its bank.  The bank
    compares this information with electronic information about checks
    presented for payment.  If a check presented for payment is not
    included in the positive-pay information, the corporation is notified
    and requested to make the pay/no pay decision.

             MITIGATION
    ------------------------------------------------- Chapter Checks:5.2.2

    Electronic check presentment (ECP).  As in the case of return item
    risk, ECP may reduce check fraud by providing the depositary bank
    with information about unpaid checks earlier than the information is
    currently provided.  By speeding the transmission of the MICR
    information, ECP may allow the paying bank to identify checks that
    cannot be paid earlier and to notify the bank of first deposit
    earlier of an impending returned check, possibly before the funds are
    made available to the depositing customer.

       ELECTRONIC FUNDS TRANSFER
    ----------------------------------------------------- Chapter Checks:6

    Electronic Funds Transfer (EFT) is the transfer of funds from one
    account to another by electronic rather than by paper-based
    instructions, such as checks.  EFT can save time and money in the
    payment system by eliminating paperwork.

    (See figure in printed edition.)

    Types of EFT Systems\7

      -- Consumer electronic payments are small-dollar payments, such as
         transactions made via the ACH,\8 at automated teller machines
         (ATM), point-of-sale payments using debit cards, and the use of
         telephones or personal computers to initiate bill payments.

      -- Electronic benefits transfers are electronic payments for social
         security, pension, and welfare payments; student loans; and
         unemployment compensation.

    Statistics

    In 1994, federal and state governments transferred about $500 billion
    in benefits to recipients.

      -- Federal benefits:  approximately $400 billion.

      -- State benefits:  approximately $95 billion.

    The Financial Management Service of the U.S.  Treasury estimates that
    it costs the government 42 cents to issue and mail a paper check but
    only 2 cents to process an electronic payment.

    Developments

    The number of EFT transactions should increase as a result of the
    passage of the Debt Collection Improvement Act of 1996, which will
    substantially reduce the use of checks as a federal payment
    instrument by January 1999.  The EFT provisions of DCIA require that
    all federal payments (except IRS tax refunds and payments to
    individuals without bank accounts) be issued by EFT.

    --------------------
    \7 Wire transfers, such as Fedwire, are considered electronic funds
    transfers.

    \8 ACH is discussed later in the retail payment systems section.

    CREDIT CARDS
    ======================================================== Chapter Cards

       DESCRIPTION AND USE
    ------------------------------------------------------ Chapter Cards:1

    A credit card is a payment card issued to a person for purchasing
    goods and services and obtaining cash against a line of credit
    established by the issuer.  Credit cards can be of two types:  those
    issued by merchants and vendors, such as department stores or oil
    companies, and general purpose credit cards issued by banks, such as
    VISA and MasterCard.  Credit cards allow a consumer cardholder to pay
    off his or her entire outstanding balance or to make minimum monthly
    payments and carry over balances, on which interest is charged.  In
    addition, a cardholder may be able to receive cash advances under a
    preapproved line of credit with a credit card, either through a bank
    teller or an automated teller network (ATM), for which the cardholder
    is charged a finance charge.

    The two dominant bank-issued general purpose credit cards are VISA
    and MasterCard.  Before 1971, participating banks could not be a
    member of both VISA and MasterCard; this was changed as a result of
    antitrust concerns.  Today, issuers can issue both VISA and
    MasterCard credit cards.  A number of nonbank companies also issue
    credit cards, such as American Express, Discover, and Diners Club.

       (See figure in printed
       edition.)

       BASIC DATA
    ------------------------------------------------------ Chapter Cards:2

    The use of general purpose credit cards in the United States has
    grown substantially since 1981.  In 1995, credit card transactions
    accounted for approximately 14.9 billion transactions.

    As shown in table 3.4, since 1990, VISA and MasterCard have increased
    the number of cards in use by 84 percent and 63 percent,
    respectively.

                                   Table 3.4

                      The Number of Major U.S. Credit Card
                          Companies' Cards, 1990-1995

                                 (In millions)

                                            Number of
                                              cards
                                          --------------
    Credit card company                     1990    1995    Percent change
    ------------------------------------  ------  ------  ----------------
    VISA                                   120.1   221.1               84%
    MasterCard                              88.2   144.1                63
    American Express                        25.9    26.7                 3
    Discover                                37.8    45.1                19
    ----------------------------------------------------------------------
    Source:  Faulkner & Gray.

    In 1995, the total charge volume of VISA, MasterCard, American
    Express, and Discover was $70.9 billion, which was a 318-percent
    increase from 1985.

       PROCESSES
    ------------------------------------------------------ Chapter Cards:3

    The clearance and settlement of credit card transactions involve
    three parts--authorization, clearance, and settlement.  Authorization
    is the process by which the issuer of a credit card (card-issuing
    bank) approves (or declines) a transaction at the point of sale.
    Clearance is the process by which a credit card company collects data
    about a transaction from a bank (referred to as an acquirer or the
    merchant's bank) and delivers the data to the card-issuing bank,
    which will use the information to post the transaction to the
    cardholder's account.  Settlement is the process by which a credit
    card company collects funds from the card-issuing bank and pays funds
    to the merchant's bank for the cleared transactions.  Figure 3.3
    illustrates how a credit card transaction clears and settles after a
    credit cardholder makes a purchase at a store (merchant).  Every
    credit card transaction involves the cardholder, the card-issuing
    bank, a credit card company, a merchant, and the merchant's bank.

       Figure 3.3:  Clearance and
       Settlement Cycle of Credit
       Cards

       (See figure in printed
       edition.)

       (See figure in printed
       edition.)

    Note:  Major credit card companies operate a multilateral settlement
    system.

    Source:  GAO.

             AUTHORIZATION (STEP 1)
    -------------------------------------------------- Chapter Cards:3.0.1

    A cardholder selects goods or services from a store (or merchant) and
    presents a credit card as payment.  The sales clerk of the store
    swipes the card through one of the store's EDC terminals and keys in
    the amount of the transaction.  The authorization request is
    transmitted electronically through the credit card company to the
    issuer of the credit card.\9 The card-issuing bank then approves or
    declines the transaction based on the cardholder's account status,
    and the approval or disapproval is transmitted electronically to the
    store through the credit card company.  If the transaction is
    approved, the salesperson then produces a sales draft for the
    customer to sign.

    --------------------
    \9 If a member bank or its designated processor serve as both the
    card-issuing bank/processor and the merchant's bank/processor, then
    authorization, clearing, and settlement may be handled entirely by
    the member bank or processor as "on-us" transactions.  In this case,
    a credit card company would not be directly involved in processing
    the on-us transaction.

             CLEARANCE (STEPS 2
             THROUGH 4)
    -------------------------------------------------- Chapter Cards:3.0.2

    At the end of the day, the merchant submits all of its credit card
    transaction data electronically (credit card drafts) to its bank(s).
    The merchant's bank then credits (or pays) the merchant for its
    transactions.  At this point, the store has been paid and is out of
    the cycle.\10 The merchant's bank is then responsible for getting
    paid for the transaction, and sends the transaction data
    electronically to the credit card company.  The credit card company
    electronically sends the credit card drafts (transaction data) to
    each card-issuing bank.

    --------------------
    \10 The merchant will get paid an amount minus a merchant discount
    fee, which is retained by the merchant's bank.

             SETTLEMENT (STEPS 5
             THROUGH 8)
    -------------------------------------------------- Chapter Cards:3.0.3

    After the card-issuing bank receives the transaction data, the credit
    card company collects funds from the card-issuing bank's account and
    transfers funds to the account of the merchant's bank, thus ending
    the cycle for the bank.  The card-issuing bank will then present the
    transaction as an item on the cardholder's next monthly statement,
    and once the cardholder pays the card-issuing bank, the cycle will be
    complete.

    The payment and receipts of member banks (card-issuing banks and
    merchant banks) of the credit card company are done through each
    member (or its correspondent bank) and the credit card company's
    settlement banks over Fedwire Funds Transfer System (see section on
    Fedwire Funds Transfer for details on how it works).\11 For each
    card-issuing bank, the credit card company adds up the credit card
    company's transactions for the bank and sends it the net settlement
    amount.\12 Payment is made by the card-issuing bank submitting
    payment to the credit card company (through its settlement banks over
    Fedwire) for transactions plus fees and charges due to the credit
    card company.  The credit card company then pays the merchant's bank
    for the transactions and collects fees and charges from the
    merchant's bank.

    Because of the international aspect of a credit card company's
    business, the major credit card companies operate on a daily
    processing cycle on Greenwich Mean Time, which starts at 7:00 p.m.
    EST and ends 24 hours later at 7:00 p.m.  EST.  Thus, settlement for
    the merchant's bank in the United States usually occurs 1 calendar
    day after a transaction is submitted to the credit card company
    because of the hours of Fedwire.  Settlement for the card-issuing
    bank occurs once it has received payment from the cardholder.

    Each member bank of a major credit card company may be required to
    maintain collateral with the credit card company.  The collateral is
    meant to cover the potential losses that the credit card company may
    incur if the member bank fails.\13

    --------------------
    \11 VISA's settlement banks have to meet specific operational and
    credit rating type criteria.

    \12 According to VISA officials, most of the netting for VISA is done
    on a multilateral basis.

    \13 If a card-issuing member bank fails, VISA may have paid a
    merchant's bank for the transactions but be unable to collect funds
    from the member bank.

       REGULATORY OVERSIGHT
    ------------------------------------------------------ Chapter Cards:4

    The primary federal laws governing credit card issuance and operation
    are the Equal Credit Opportunity Act of 1974 and the Truth in Lending
    Act of 1968 (TLA).  These laws are implemented through Federal
    Reserve Regulations B and Z, respectively.  Regulation B prohibits
    lenders, including credit card companies, from discriminating against
    credit applicants and establishes guidelines for gathering and
    evaluating credit information.  Regulation Z requires uniform methods
    for computing the cost of consumer credit and disclosing credit
    terms, prohibits the unsolicited issuance of credit cards, and limits
    cardholder liability for unauthorized use.

    Other laws applying to credit cards are the Fair Credit and Charge
    Card Disclosure Act of 1988, the Fair Credit Billing Act of 1974, and
    the Fair Credit Reporting Act of 1970.  The Fair Credit and Charge
    Card Disclosure Act amended the TLA to require that applications for
    credit cards that are sent through the mail, canvassed by telephone,
    or made available to the public (e.g., at counters in retail stores)
    must contain information about key terms of the account.  The Fair
    Credit Billing Act amended the TLA to specify how creditors must
    respond to billing complaints from consumers, requiring that
    creditors handle consumer accounts fairly and promptly.  The Fair
    Credit Reporting Act entitles consumers to know the source for the
    credit information and allows them to correct errors in the reported
    information.

       RISK AND RISK MITIGATION
    ------------------------------------------------------ Chapter Cards:5

    For purposes of this report, we discuss some of the most important
    risks and risk mitigations associated with credit cards.

                                   Table 3.5

                      Risk and Risk Mitigation for Credit
                                     Cards

    Risk                Risk mitigation
    ------------------  --------------------------------------------------
    Fraud risk          Neural network

                        Address verification service

                        Issuer's clearing house service

    Credit risk         Credit monitoring
    ----------------------------------------------------------------------

          RISK 1:  FRAUD
    ---------------------------------------------------- Chapter Cards:5.1

    Risk from fraud involving credit cards includes unauthorized use of
    lost or stolen cards, fraudulent applications, counterfeit or altered
    cards, and the fraudulent use of a cardholder's credit card number.
    Lost or stolen credit cards account for approximately 50 percent of
    all credit card fraud, and fraudulent and counterfeit cards account
    for approximately 7 percent and 11 percent of credit card fraud,
    respectively.  If cardholders report the loss of their credit cards,
    they are responsible, at most, for $50.  The issuing bank or the
    merchant pays the costs of any fraud involving credit cards.  The
    merchant is responsible for paying any costs related to credit card
    fraud if the merchant does not do at least one of the following three
    things:  obtain an authorization, the cardholder's signature, or the
    electronic imprint of the card.  According to an industry official,
    usually the issuing banks are responsible for paying approximately 70
    percent of the cost of credit card fraud while the merchants are
    responsible for paying the other 30 percent.

             MITIGATION
    -------------------------------------------------- Chapter Cards:5.1.1

    Neural network.  The neural network allows a card-issuing bank to
    track the cardholder's spending patterns and to detect any spending
    discrepancies and thereby prevent potential credit card fraud.  For
    example, if a cardholder, who typically purchases airplane tickets to
    domestic destinations, starts purchasing an excessive number of
    airplane tickets to international destinations, the neural network
    may alert the issuing bank and the cardholder of potential fraud.

             MITIGATION
    -------------------------------------------------- Chapter Cards:5.1.2

    Address Verification Service.  The mail-order catalog industry
    developed a program called Address Verification Service (AVS).  AVS
    allows mail and telephone order companies to verify a cardholder's
    billing address online.  This program is designed to reduce
    fraudulent use of a cardholder's credit card number.  Using AVS, the
    mail and telephone order companies can verify the address the
    customer provided as well as the billing address on file with the
    card issuer.  If the two addresses are different, then the mail or
    telephone order company may suspect fraud.

             MITIGATION
    -------------------------------------------------- Chapter Cards:5.1.3

    Issuer's Clearing House Service.  VISA and MasterCard have developed
    a type of clearing house database, Issuer's Clearing House Service
    (ICS), to detect fraudulent credit applications.  ICS allows issuing
    banks to compare credit card applications against a database of
    invalid addresses and Social Security numbers.  The ICS database
    includes information such as Social Security numbers, names, and
    dates of birth of credit card applicants.

          RISK 2:  CREDIT
    ---------------------------------------------------- Chapter Cards:5.2

    Consumer delinquency and default are the main credit risks involving
    the use of credit cards.  If a cardholder fails to pay for the
    charges, then the issuing bank is liable to pay the merchant's bank.

             MITIGATION
    -------------------------------------------------- Chapter Cards:5.2.1

    >Credit monitoring.  The card-issuing bank is responsible for
    monitoring and controlling credit risk resulting from consumer
    delinquency and default.  Issuing banks can mitigate the risks of
    consumer delinquency through the normal authorization process of
    charges and credit reviews of cardholders.  For example, during the
    authorization process, when the credit card is swiped, the
    card-issuing bank can deny authorization of a transaction if the
    consumer had been delinquent in paying the credit card bill.  The
    issuing bank can establish financial standards to be used during the
    application process to protect itself from delinquent consumers.

    AUTOMATED CLEARING HOUSE
    ========================================================== Chapter ACH

       DESCRIPTION AND USE
    -------------------------------------------------------- Chapter ACH:1

    An automated clearing house (ACH) network is an electronic batch
    processing system by which payment orders are exchanged among
    financial institutions.  The ACH began, in 1972, as a system operated
    by the Federal Reserve Banks at the request of members of local ACH
    associations.  It is designed for high-volume, predominantly
    small-dollar recurring payments, such as payroll, mortgage, car loan,
    or Social Security.

    An ACH payment can either be a credit transaction or a debit
    transaction.  In an ACH credit transaction, funds flow from the
    originator to the receiver, and in a debit transaction, funds flow
    from the receiver to the originator.  Every ACH transaction,
    regardless of whether it is a credit or a debit transaction, must
    have an originator of the transaction, a receiver of the transaction,
    an originating depository institution, and a receiving depository
    institution.  Listed in table 3.6 are examples of ACH credit and
    debit transactions.

                                   Table 3.6

                        Examples of ACH Credit and Debit
                                  Transactions

    ACH credit transactions             ACH debit transactions
    ----------------------------------  ----------------------------------
    Payrolls                            Consumer bill payments:

                                         Mortgage and loan
                                         Insurance premiums

    Government benefit payments:

     Social Security
     Federal employee retirement
     Disability

    Corporate payments to contractors   Corporate cash concentrations
    and vendors

    Corporate tax payments              Corporate tax payments
    ----------------------------------------------------------------------
    Source:  Federal Reserve.

    There are four ACH processors operating in the United States that
    process ACH transactions:

    (1) American Clearing House Association (American), (2) Federal
    Reserve System (Federal Reserve), (3) New York Automated Clearing
    House (NYACH), and (4) VISANet ACH (VISA).

    The Federal Reserve and VISA are national ACH providers.  NYACH and
    American are regional ACH providers.

       (See figure in printed
       edition.)

       BASIC DATA
    -------------------------------------------------------- Chapter ACH:2

    The volume of ACH payments has been increasing rapidly.  In 1996,
    approximately 4 billion payments, totaling $12.1 trillion, were
    processed on the ACH.  This is a 55-percent increase in the volume of
    payments since 1992.

    The Federal Reserve processes both commercial and government ACH
    payments.  In 1996, the Federal Reserve processed approximately 2.4
    billion commercial ACH transactions, almost 80 percent of all
    interbank commercial ACH payments.  Currently, all government ACH
    payments are processed by the Federal Reserve.\14 Moreover, as a
    result of the Debt Collection Improvement Act of 1996, Section
    31001(x), the volume of government ACH transactions is expected to
    increase substantially.  DCIA Section 31001(x) requires that all
    federal payments, except Internal Revenue Service payments and
    payments to individuals who certify that they do not have bank
    accounts, be issued via EFT by January 1, 1999.

    NYACH serves nearly 800 commercial banks, savings banks, savings and
    loans, and credit unions, and processes approximately 10 percent of
    the ACH's commercial transaction volume in the United States.  VISA
    serves over 290 financial institutions in the United States, and the
    American ACH serves approximately 100 financial institutions.  As
    shown in table 3.7, the volume of all ACH providers is increasing.

                                   Table 3.7

                    Volume of ACH Transactions Processed by
                       the Four ACH Providers, 1992-1996

                              (Items in millions)

                                                                   Percent
    ACH provider                                  1992      1996    change
    ----------------------------------------  --------  --------  --------
    Federal Reserve: commercial                  1,275     2,372       86%
    Federal Reserve: government                    531       625        18
    NYACH                                          185       317        71
    American                                        49        93        90
    VISA                                           151       311       106
    ----------------------------------------------------------------------
    Note:  Double counting exists in the volume figures for the private
    processors.  The volume figures for NYACH, American, and VISA include
    some ACH entries that are sent or received from the Federal Reserve.

    Sources:  Federal Reserve Board's 1995 Annual Report, American,
    National Automated Clearing House Association (NACHA), NYCHA, and
    VISA.

    The fees charged by ACH providers for processing ACH transactions are
    significantly lower than the fees assessed for Fedwire funds
    transfers and the Clearing House Interbank Payment System (CHIPS)\15

    transfers.  For example, the separate fees charged the originator and
    the receiver are typically slightly less than a penny.  As of January
    2, 1997, the fee charged to the sender and the receiver of a Fedwire
    is $0.45 per transfer.  The fee for a CHIPS transfer ranges from
    $0.13 to $0.40, depending upon the participant's monthly transaction
    volume and other factors.

    As shown in figure 3.4, the average value of an ACH transaction has
    stayed consistently around $4,000; in 1995, the average value of an
    ACH transaction was $3,847.  In comparison, in 1995, the average
    value of a Fedwire funds transfer was $2.9 million.

       Figure 3.4:  The Average Value
       of an ACH Transaction,
       1992-1995

       (See figure in printed
       edition.)

    Source:  NACHA.

    Table 3.8 shows the total dollar amount of ACH transactions for each
    of the four ACH providers for the period 1992 through 1996.

                                   Table 3.8

                      Total Amount of Dollars Processed by
                          Each ACH Provider, 1992-1996

                                                                   Percent
    ACH provider                         1992        1996           change
    -----------------------------------  ----------  ---------  ----------
    Federal Reserve:                     $6.5        $8.7              34%
    commercial                           trillion    trillion

    Federal Reserve:                     860         1.3                51
    government                           billion     trillion

    American                             76.7        174.7             128
                                         billion     billion

    NYACH                                2.0         2.6                30
                                         trillion    trillion

    VISA                                 N/A         656.0
                                                     billion
    ----------------------------------------------------------------------
    N/A:  Not available.

    Note:  Double counting exists in the dollar-value figures for the
    private ACH processors.  The dollar-value figures for NYACH,
    American, and VISA include some ACH entries that are sent to or
    received from the Federal Reserve.

    Sources:  Federal Reserve Board, American, NYCHA, and VISA.

    --------------------
    \14 Government payments refer only to payments originated by the
    federal government.  All other ACH payments are referred to as
    commercial, including those originated by state and local
    governments.  Although the Federal Reserve processes ACH government
    payments for the Treasury, the Treasury is not statutorily mandated
    to use the Federal Reserve.

    \15 Fedwire is an electronic funds transfer network operated by the
    Federal Reserve for large-dollar value transfers.  CHIPS, the other
    large-dollar electronic payment system, is owned by NYCHA.  For more
    discussion on Fedwire and CHIPS, see the Fedwire Funds Transfer and
    Clearing House Interbank Payments System subsections in Section 1.

       PROCESSES
    -------------------------------------------------------- Chapter ACH:3

    The ACH operates by a batch processing system in which groups of
    transactions are transmitted to ACH operators throughout the day.  As
    the groups of transactions are received, they are edited for
    conformance with the operating rules of NACHA, settlement data for
    the originating and receiving depository institutions are captured,
    and individual transactions are sorted to the receiving depository
    institutions.

    Unlike Fedwire transfers, which are processed and settled
    immediately, ACH transactions are valued-dated, that is, the
    originator of ACH transactions includes the settlement date in the
    payment instructions when it originates the transaction.  ACH credit
    transactions may be originated up to 2 business days before the
    settlement date, and the ACH debit transactions may be originated 1
    business day before the settlement date.  Government entries can be
    originated up to 4 days before the settlement date.

    Depository institutions that use the Federal Reserve as their
    provider can deposit files of ACH transactions at the Federal Reserve
    Bank anytime during the day.  ACH transactions may be destined for
    institutions located in the same Federal Reserve district or in
    another Federal Reserve district.  The Federal Reserve processes ACH
    transactions nearly 24 hours a day.\16

    In 1994, NYACH, VISA, and American established the Private ACH
    Exchange (PAX).  Since the establishment of PAX, New York, American,
    and VISA can exchange transactions directly without using the Federal
    Reserve as an intermediary processor.  PAX handles about 1 million
    transactions monthly.  Previously, the three ACH private processors
    had to use the Federal Reserve's ACH service to deliver ACH
    transactions among themselves.  For example, when American sent an
    ACH file to VISA, American would send the file first to the Federal
    Reserve, where the transactions were processed and distributed to
    VISA for its members.  Now, using PAX, American can send the ACH file
    directly to VISA.\17

    The Federal Reserve provides settlement services to all three
    processors--net entries are posted for members of VISA and American;
    gross entries are posted for NYACH.  Net settlement allows
    participants that use private processors to settle their net
    positions either through Fedwire funds transfers, using special
    settlement accounts at Reserve Banks, or by accounting entries, which
    are posted to participants' reserve accounts by Federal Reserve
    Banks.  Currently, VISA is the only one of the three private ACH
    processors that uses the Fedwire funds transfer service for
    settlement.

    Examples of one ACH credit transaction and one ACH debit transaction
    follow.

    --------------------
    \16 All Federal Reserve ACH processing is done at the East Rutherford
    (New Jersey) Operations Center of the FRBNY.

    \17 Private ACH operators still continue to use the Federal Reserve
    to deliver a significant number of transactions.

          EXAMPLE OF AN ACH CREDIT
          TRANSACTION
    ------------------------------------------------------ Chapter ACH:3.1

    Figure 3.5 illustrates how a company's payroll is transmitted over
    the ACH.  Example:  Company A, headquartered in Washington, D.C.,
    with offices located in Chicago, Los Angeles, and New York, pays all
    of its employees by direct deposit using the ACH network.

    Originator of the ACH payment:  Company A.
    Receiver of the ACH payment:  Company A's employees.
    Originating depository institution:  Bank A.
    Receiving depository institutions:  Banks in which Company A's
    employees have their accounts.

       Figure 3.5:  Typical ACH Credit
       Transaction--The Direct Deposit
       of a Payroll

       (See figure in printed
       edition.)

       (See figure in printed
       edition.)

    Note:  The Federal Reserve retains the right to reverse a credit
    given to a receiver of an ACH credit transaction until the Federal
    Reserve's books have been closed, which generally occurs during the
    night of the settlement day.  The Federal Reserve could reverse a
    credit to the receiving institutions on the night of Jan.  15, but
    not later than the morning of Jan.  16.

    Source:  GAO analysis of information provided by the Federal Reserve
    Board.

          EXAMPLE OF AN ACH DEBIT
          TRANSACTION
    ------------------------------------------------------ Chapter ACH:3.2

    Figure 3.6 illustrates an example of an ACH debit transaction in
    which a homeowner sends his or her mortgage payment to a mortgage
    company through the ACH system.  In this example, both the
    originating depository institution and the receiving depository
    institution are using private ACH providers to process the ACH
    transaction.

    Example:  A homeowner in New York authorizes its mortgage company,
    which is located in California, to make a withdrawal of $2,000 each
    month from the customer's deposit account for the purpose of paying
    his or her monthly mortgage.

    Originator of the ACH transaction:  Mortgage Company.
    Receiver of the ACH transaction:  Homeowner.
    Originating depository institution:  Bank A in San Francisco.
    Receiving depository institution:  Bank B in New York.

       Figure 3.6:  Typical ACH Debit
       Transaction--Bill Payment

       (See figure in printed
       edition.)

       (See figure in printed
       edition.)

    \a VISA settles its ACH entries through a special settlement account
    at the Federal Reserve Bank of San Francisco.  Each VISA participant
    in a net debit position sends a Fedwire funds transfer for the amount
    of its net debit position.  When all participants in net debit
    positions have sent Fedwires to fund the account, VISA sends Fedwires
    equal to each of the remaining participants' net credit positions.

    Source:  NACHA.

       REGULATORY OVERSIGHT
    -------------------------------------------------------- Chapter ACH:4

    The ACH is governed primarily by rules written by the private sector,
    NACHA Operating Rules and Guidelines, which are supplemented by the
    rules of local ACH associations.  The National Automated Clearing
    House Association (NACHA) is a nonprofit banking trade association
    that promulgates the rules and operating guidelines for electronic
    payments through the ACH.  NACHA represents 38 regional ACH
    associations and their more than 14,000 depository institution
    members.  The Federal Reserve recognizes NACHA as the informal
    rulemaker for ACH transactions.  According to a Federal Reserve
    official, NACHA, however, has no enforcement authority over
    depository institutions that use the ACH or over ACH providers to
    ensure compliance with its rules.

    Depository institutions using the Federal Reserve's ACH services must
    comply with the Reserve Banks' uniform ACH Operating Circular, which
    incorporates the operating rules of NACHA by reference and indicates
    any rule that the Federal Reserve has not determined to incorporate
    in its uniform circular.  In addition, depository institutions that
    originate and receive consumer ACH transactions must comply with the
    regulations that the Board of Governors of the Federal Reserve System
    promulgates in Regulation E, which implements the Electronic Funds
    Transfer Act.  Corporate ACH credit transactions are governed by UCC
    4(A).  When the federal government is the originator, the
    transactions are governed by the Treasury Department's regulations,
    31 CFR Part 210.

       RISK AND RISK MITIGATION
    -------------------------------------------------------- Chapter ACH:5

    For the purposes of this report, we discuss some of the most
    important risks and risk mitigations associated with the ACH.

                                   Table 3.9

                        Risk and Risk Mitigation for ACH

    Risk                                Risk mitigation
    ----------------------------------  ----------------------------------
    Temporal credit risk                Credit monitoring

    Return item risk                    Credit monitoring
    ----------------------------------------------------------------------

          RISK 1:  TEMPORAL CREDIT
    ------------------------------------------------------ Chapter ACH:5.1

    The originating institution of an ACH credit transaction is obligated
    to pay for any ACH credit entry that it initiates.  Because the ACH
    credit transactions may be originated up to 2 business days before
    the settlement date and a customer may not fund its obligation until
    late on the settlement day, the originating depository institution
    may be exposed to credit risk for nearly 3 business days.  This type
    of risk is called temporal risk.

             MITIGATION
    ---------------------------------------------------- Chapter ACH:5.1.1

    Credit monitoring by financial institutions.  According to the
    Federal Reserve's payments system risk policy, depository
    institutions that originate ACH credit transactions should

      -- perform a credit assessment of all customers originating
         large-dollar volumes of ACH credit transactions;

      -- establish interday credit limits for originating customers that
         originate ACH credit transactions based on each institution's
         credit assessment;

      -- monitor compliance with the credit limit across all processing
         cycles for a given settlement date; and

      -- require the customer either to prefund its account, provide
         collateral, or deposit the ACH file on the night cycle preceding
         the settlement day if the customer's financial condition is
         deteriorating.\18

    --------------------
    \18 Guide to the Federal Reserve's Payments System Risk Policy, Board
    of Governors of the Federal Reserve System, p.  57.

          RISK 2:  RETURN ITEM
    ------------------------------------------------------ Chapter ACH:5.2

    The major risk facing institutions that originate ACH debit
    transactions is return item risk.  Return item risk occurs when
    institutions receiving ACH debit transactions are unable to fund
    payment requests and the transactions must be returned to the
    originating institutions.  Receiving institutions may return ACH
    debit transactions for a number of reasons, including insufficient
    funds, the existence of a stop payment order, or an unauthorized
    transaction.  The risk to depository institutions originating debit
    transactions depends on when they make funds available to their
    customers.  Originating depository institutions typically make funds
    from ACH debit transactions available to their customers at the
    opening of business on the settlement date for the transactions.
    Receiving institutions must return ACH debit transactions so that the
    originating institutions receive the returned transactions by the
    opening of business on the second business day following the
    settlement day.

             MITIGATION
    ---------------------------------------------------- Chapter ACH:5.2.1

    Credit monitoring by financial institutions.  The Federal Reserve's
    payment system risk policy recommends that depository institutions
    originating ACH debit transactions perform a credit assessment and
    monitor the return experience of their customers.  Depending upon the
    results of these analyses, depository institutions are expected to
    take steps to protect themselves from losses, such as delaying
    availability for all or some portion of funds collected or requiring
    balances or collateral to cover the value of potential return items.

    OVERVIEW OF NEW AND EMERGING
    FINANCIAL PRODUCTS AND SERVICES
    ===================================================== Chapter Overview

    In this section we discuss emerging payment technologies.  These
    include stored-value cards, electronic banking, and financial
    transactions made over the Internet.  These technologies have the
    potential to alter the way many everyday payments are made.

       MAIN CHARACTERISTICS
    --------------------------------------------------- Chapter Overview:1

      -- All of these technologies take advantage of advances in computer
         chips, communications, and software.

      -- Some have the potential to reduce the cost and increase the
         convenience of making payments.  Over time, these technologies
         may displace some transactions that are currently made by cash
         and check.

       STATISTICAL INFORMATION
    --------------------------------------------------- Chapter Overview:2

      -- Most technologies are in the testing and implementation stage.

      -- In October 1996, 2.1 million U.S.  households were banking
         online.

      -- Tests of general purpose stored-value cards have been conducted
         for several years, but nowhere in the United States are they
         available for general use.

      -- In 1995, an estimated quarter of a billion dollars of credit
         card purchases were made over the Internet.  The dramatic
         increase in the number of Internet users and businesses offering
         products over the Internet suggests that this volume will
         increase rapidly.

       REGULATORY INFORMATION
    --------------------------------------------------- Chapter Overview:3

    Regulators will have to adapt existing regulations, and perhaps adopt
    new regulations, to accommodate these new technologies.  For example,
    they must decide to what extent regulations governing electronic
    funds transfer (EFT) should be applied to stored-value cards.

       RISK INFORMATION
    --------------------------------------------------- Chapter Overview:4

    Conducting financial transactions over the Internet creates new
    opportunities for counterfeiting, money laundering, and tax evasion.
    Securing payments over the Internet will involve the implementation
    of new and unproven security measures.

       THE INTERNET
    --------------------------------------------------- Chapter Overview:5

    The Internet is a network of networks connecting millions of desktop
    computers in homes, businesses, universities, and governments.

    (See figure in printed edition.)

    Background

      -- The Internet began in the 1960s as a Department of Defense
         effort to link a number of independent computer systems so that
         researchers around the country could share a few super
         computers.

      -- The Internet is largely self-governing.

      -- The Internet is an open communications system with no built-in
         means to protect privacy of information, such as a consumer's
         credit card number.

    Developments

    The number of desktop computers connected to the Internet increased
    dramatically in the mid-1990s as several developments made the
    Internet increasingly useful and easy for nonexperts to use.  These
    developments are

      -- availability of simplified e-mail systems;

      -- establishment of the World Wide Web (WWW),\1 a collection of
         documents interlinked by a shared language, and

      -- development of user-friendly WWW browsers, programs designed to
         read documents on the WWW.

    --------------------
    \1 Many people confuse the World Wide Web and the Internet.  As
    stated earlier, the Internet refers to the overall network of
    networks.

    STORED-VALUE CARDS
    ======================================================== Chapter Cards

       DESCRIPTION AND USE
    ------------------------------------------------------ Chapter Cards:1

    Recent developments in encryption, microchips, and computer network
    technology have enabled consumers to make electronic payments through
    the use of a stored-value card, a credit-card-sized device in which
    money value is stored digitally.\2 Although stored-value cards
    resemble credit or debit cards, transactions made with stored-value
    cards resemble transactions made with currency or coin.  For
    instance, users of stored-value cards do not need a deposit account
    at a financial institution nor do merchants have to verify a
    cardholder's identity when purchases are made.  Stored-value cards
    are intended for repetitive, low-value transactions too small for
    economical use of a credit or debit card, such as payments for mass
    transit or fast food.

    Stored-value cards have features that resemble traveler's checks, in
    that the card purchaser surrenders cash value in exchange for
    obligations of an issuer, which may not be a financial institution.
    However, unlike traveler's checks, stored-value cards are designed
    for small-dollar value purchases and can be used only with hardware
    devices equipped to accept payments.  The maximum dollar value that
    can be held on a stored-value card is determined by the issuer.  One
    industry representative predicted that this amount would be about the
    same as the maximum withdrawal from an automated teller machine
    (ATM).

    Two types of multipurpose stored-value cards exist:  disposable
    stored-value cards, which are loaded with a fixed dollar value and
    are discarded once all the stored cash is spent, and reloadable
    cards--such as the Mondex card--which can be replenished by inserting
    the card in a specially equipped ATM, a specially equipped telephone,
    or an electronic wallet.\3

    In the near future, individuals may be able to transfer funds to a
    stored-value card using a personal computer connected to a network.

       (See figure in printed
       edition.)

    --------------------
    \2 One type of stored-value card is the single-purpose card, e.g., a
    card used to pay for telephone calls and transit fares.  In this
    report, we will focus on general purpose cards that can be used to
    buy goods and services from a variety of vendors.

    \3 A device that looks like a calculator and is designed to transfer
    value from one card to another.

       BASIC DATA
    ------------------------------------------------------ Chapter Cards:2

    General-purpose stored-value cards are still in the early stage of
    development.  Tests of disposable and reloadable stored-value cards
    are being conducted in about two dozen countries, including the
    United States.  Banks, credit card companies, and technologically
    based companies see the automation of small transactions as one of
    the frontiers of payment technology.  Table 4.1 describes a few of
    the most extensive tests of stored-value cards.

                                   Table 4.1

                            Stored-Value Card Tests

    Location          Description
    ----------------  ----------------------------------------------------
    Swindon, England  In July 1995, Mondex, a venture of two British
                      banks, began conducting a test of stored-value cards
                      in Swindon, England, a city with 190,000 residents.
                      The cards and the merchant hook-ups were provided
                      free of charge.

                       Swindon residents were offered reloadable cards to
                      be used at
                      a majority of the city's stores, parking
                      meters,
                      pay phones, and buses.
                       8,000 residents actually used the cards.

                       750 merchants out of the 1,000 in Swindon signed
                      up
                      to accept the cards.

    1996 Olympics in  At the 1996 Olympics in Atlanta, VISA and the three
    Atlanta, GA       largest banks in the southern United States
                      conducted the largest experiment with stored-value
                      cards.

                       About 2 million stored-value cards were made
                      available in
                      denominations of $10, $20, $50, and $100.

                       All of the 85,000 spectators at the opening
                      ceremonies were to
                      be given $5 cards.

                       In July 1996, 198,000 transactions were made with
                      VISA cash cards.

    Manhattan, NY     Chase Manhattan Bank, Citibank, MasterCard, Mondex,
                      and VISA announced an extensive pilot project on the
                      upper west side of Manhattan to begin in October of
                      1997.

                       Between 50,000 and 100,000 bank customers are to
                      be offered
                       reloadable cards that will be subject to
                      predetermined dollar limits.

                       The banks are expected to charge for the cards,
                      although some
                      may be offered at a nominal cost or for
                      free.

                       About 500 merchants are expected to accept the
                      cards.
    ----------------------------------------------------------------------
    Source:  GAO analysis of industry data.

    Initial results of these pilots suggest that consumers will be slow
    to adopt stored-value cards.  According to press reports, in neither
    the Mondex nor the VISA trials did the number of users meet issuers'
    expectations.

    The economic viability of stored-value cards has yet to be proven.
    Since stored-value cards cannot be read by existing ATMs or the card
    readers attached to cash registers, an initial investment in card
    reader machines will be required.  These costs should decrease over
    time as the capacity to read stored-value cards is incorporated into
    POS terminals and other devices.

       PROCESSES
    ------------------------------------------------------ Chapter Cards:3

    Figure 4.1 illustrates how Mondex anticipates processing a
    transaction using a Mondex stored-value card.

    Example:  A consumer purchases a stored-value card to make purchases.
    After the consumer makes the purchase, using stored value as payment,
    the merchant exchanges the stored value for a bank deposit.

    (See figure in printed edition.)Figure 4.1:  A Typical Mondex Card
    Transaction

       Source:  GAO analysis of
       industry data.

       (See figure in printed
       edition.)

       REGULATORY OVERSIGHT
    ------------------------------------------------------ Chapter Cards:4

    Nonbanks offering electronic cash, such as stored-value cards, are
    not subject to the bank supervisory regime.  Similarly, nonbanks are
    not subject to any of the statutory and prudential limits that apply
    to banks.\4 Banking institutions that issue such cards would be
    examined by their respective regulators, such as the Federal Reserve
    or the Comptroller of the Currency.  Currently, there are no federal
    regulations that specifically address the regulatory oversight of
    stored-value cards.  There are, however, regulations that may apply
    to stored-value transactions, such as the Federal Reserve's
    Regulation E.

    Regulation E is intended to protect consumers in electronic funds
    transfers.  In March of 1996, the Federal Reserve Board proposed to
    amend its Regulation E, "Electronic Funds Transfers," to exempt from
    coverage stored-value cards meeting specific criteria.  Among other
    things, the regulation requires that consumers be provided with a
    written record of electronic transactions and generally limits
    consumer liability for unauthorized electronic funds transfers to
    $50.  The Board proposed to exempt from Regulation E stored-value
    cards with a maximum value of $100 or less and stored-value cards
    that are not linked to any central database.\5

    The Economic Growth and Regulatory Paperwork Reduction Act of 1996
    contained provisions instructing the Federal Reserve not to finalize
    any amendments to the Electronic Funds Transfer Act (EFTA) for at
    least 9 months from the date of enactment (September 30, 1996).  It
    also instructed the Federal Reserve to conduct a study of electronic
    stored-value products to determine whether the provisions of EFTA
    could be applied to such products without adversely affecting the
    cost, development, and operation of such products.

    On July 16, 1996, FDIC issued an opinion describing what kinds of
    stored-value cards could qualify for deposit insurance.  Observers
    believe that most stored-value cards will not be covered.  FDIC
    observed that the principles discussed in the opinion also would
    apply to stored-value computer network systems that allow consumers
    to access stored-value using personal computers.

    --------------------
    \4 See, for example, OCC interpretive letters regarding Huntington
    National Bank (Aug.  19, 1996) and Wells Fargo Bank, et al (Dec.  2,
    1996), giving national banks permission to invest in limited
    liability companies that will operate stored-value card systems.

    \5 Like debit cards, stored-value cards that require online
    authorization at the time of transaction would be subject to most
    Regulation E requirements.  Certain off-line
    stored-value-cards--those with balances maintained on a separate
    database--would be subject to only the initial disclosure
    requirements of Regulation E.

       RISK AND RISK MITIGATION
    ------------------------------------------------------ Chapter Cards:5

    For purposes of this report, we discuss some of the most important
    risk and risk mitigations associated with stored-value cards.

       Table 4.2:  Risk and Potential
       Risk Mitigation for
       Stored-Value Cards

       (See figure in printed
       edition.)

          RISK 1:  CREDIT
    ---------------------------------------------------- Chapter Cards:5.1

    When people purchase stored-value cards, or when merchants accept
    stored-value as payment for goods and services, they expose
    themselves to the credit risk that the issuer of the stored-value
    card will be unable to redeem the value stored on the card.

             MITIGATION
    -------------------------------------------------- Chapter Cards:5.1.1

    Restrictions on issuers.  The major stored-value tests in the United
    States are being conducted by nonbanks such as VISA, MasterCard, and
    Mondex.  These issuers' operations are not covered by bank
    regulation, but industry representatives believe that they could be
    covered by applicable state regulations such as those governing
    nonbank "money transmitters"--firms that issue "instruments for the
    transmission of money," such as traveler's checks and money orders.\6
    The state regulations provide a number of safeguards for users of
    these nonbank services.  Issuers must generally be licensed and
    bonded, are required to hold a minimum level of capital, may be
    required to hold reserves equal to 100 percent of outstanding value,
    and are also subject to periodic examinations and audits.

    --------------------
    \6 According to the Federal Reserve, 44 states have enacted such
    laws, which industry representatives believe would apply, or will be
    amended to apply, to multipurpose stored-value cards.

          RISK 2:  FRAUD
    ---------------------------------------------------- Chapter Cards:5.2

    Recognizing that stored-value cards could be attractive targets for
    computer criminals, vendors have made security a high priority.  Some
    researchers assert that a flaw may make it possible to counterfeit
    certain kinds of stored-value cards currently used in Europe and
    being tested in the United States.

             MITIGATION
    -------------------------------------------------- Chapter Cards:5.2.1

    Issuer security measures.  Stored-value cards are constructed in such
    a way that their chips are likely to be destroyed if an attempt is
    made to tamper with them.  Card issuers are studying sophisticated
    cryptographic techniques to prevent fraud.  Card issuers may also
    periodically replace cards with new cards that offer alternative
    safeguards against fraud.

    ELECTRONIC BANKING
    ====================================================== Chapter Banking

       DESCRIPTION AND USE
    ---------------------------------------------------- Chapter Banking:1

    Advances in data communications and computer technology have enabled
    depository institutions as well as securities brokerage firms and
    other nonbank financial service providers--including commercial
    online services--to offer electronic banking services.\7

    Electronic banking services may be delivered by means of automated
    teller machines (ATM); specially equipped telephones, such as screen
    telephones;\8 and personal computers equipped with modems and
    communication software.

    Many consumers may choose one or more of these means to pay bills,
    access information about account balances, transfer funds between
    checking and savings accounts, and purchase mutual fund shares, among
    other banking-related activities.  Specific options available to
    consumers vary by depository institution.  Table 4.3 lists banking
    services accessible through electronic means.

                                   Table 4.3

                    Consumer Financial Activities Accessible
                           By Electronic Means, 1996

                                              Method of payment
                                    --------------------------------------
                                                Screen  Telephon  Computer
    Type of transaction                ATM  telephones        es         s
    ------------------------------  ------  ----------  --------  --------
    Pay bills                          Yes       Yes\a     Yes\a     Yes\b
    Transfer funds between             Yes         Yes       Yes       Yes
     personal accounts
    Inquire about account balances     Yes        Yes\      Yes\      Yes\
    Purchase Certificate of           No\c          No       Yes       Yes
     Deposit (CD)
    Purchase mutual fund shares         No         Yes       Yes       Yes
    Apply for loan                      No         Yes       Yes       Yes
    Obtain currency                    Yes          No        No        No
    ----------------------------------------------------------------------
    \a Capability to make payments is generally limited to certain
    preidentified businesses, such as telephone companies.

    \b Payment of bills through home computers is generally accomplished
    using the services of a third-party service provider.

    \c Some, but not most, ATMs offer opportunities to purchase CDs.

    Source:  GAO analysis of industry data.

    Depository institutions and other financial service providers (e.g.,
    nonbanks\9 ) compete in offering many electronic banking
    services--including services for paying bills, purchasing CDs and
    mutual funds, and processing loan applications.  In addition, some
    foreign banks are using the Internet to provide various services,
    including the sale of securities.

       (See figure in printed
       edition.)

    --------------------
    \7 Electronic banking is the use of electronic means to access
    banking services.  Examples of electronic banking include accessing
    an account balance via an ATM, transfer of funds between personal
    accounts using the telephone, and payment of bills using a computer.

    \8 Screen telephones are telephones that have a small viewing screen
    attached and that may have a keyboard.  Some home banking services
    use these devices.

    \9 For purposes of this report we use the term "nonbank" to refer to
    any nondepository financial service provider, including providers
    such as CheckFree.

       BASIC DATA
    ---------------------------------------------------- Chapter Banking:2

    Accurate data on electronic banking are difficult to obtain and
    interpret because of both the rapidly evolving means of delivery and
    the varied ways in which electronic banking can be done.  One study
    suggests that banks plan to reduce the number of traditional "bricks
    and mortar" branches and replace them, at least in part, with
    alternative electronic delivery means, including increasingly
    sophisticated ATMs that offer many new services and products, such as
    the sale of mutual funds and insurance.\10 The study also estimates
    that telephone banking transactions will grow by 50 percent by 1998.
    Finally, the study predicts continued explosive growth in PC-based
    banking for the foreseeable future.

    --------------------
    \10 Creating the Value Network:  1996, American Bankers Association
    and Ernest & Young, 1996, p.  11.

       PROCESSES
    ---------------------------------------------------- Chapter Banking:3

    Electronic bill payment is a service offered by banks and nonbanks.
    For a fee, electronic bill payment services pay designated bills,
    after authorization, on a consumer's behalf.  Bill payments may be
    made electronically or by printed paper check.  If the payee does not
    accept electronic payment, the bill-paying service would print and
    mail a check on behalf of the consumer.  This type of payment system
    is not very different from a customer writing checks.  The only
    difference is that a centralized computer system is involved in
    delivering the check to the payee.  A representative of Intuit, one
    of the electronic bill payment services, told us that about 40
    percent of merchants are equipped to receive payment electronically,
    and only a fraction of those merchants--about 20 percent--will accept
    payment without a guarantee of the payment from the electronic payor.
    As a result, at least 60 percent of all bills paid by this service
    are paid by paper check.

    There are almost 1 million users of electronic bill payment services
    provided by the two market leaders--CheckFree and Intuit.  As of June
    30, 1996, CheckFree had 729,000 users, and Intuit had approximately
    200,000.  Both CheckFree and Intuit are nonbank financial service
    providers.

    A bank may provide bill payment services in-house to its customers,
    or it may contract with an outside electronic bill payment service to
    provide the service for the bank's customers.  In addition, consumers
    may contract independently with an electronic bill payment service;
    in such case, no contractual relationship exists between the bank and
    the service.

    The electronic bill payment process illustrated in figure 4.2 is that
    of a nonbank providing the service to a consumer without a
    contractual relationship with the consumer's bank.  The merchant in
    this case can accept electronic payments.  To communicate with the
    bill payment system, the consumer uses a home computer equipped with
    a modem and appropriate software.  Messages are transmitted over a
    private communication network (not the Internet).

       Figure 4.2:  Illustration of an
       Electronic Bill Payment Process

       (See figure in printed
       edition.)

       Note:  Electronic bill payment
       providers recommend that
       consumers schedule payments 3
       to 4 days before they are due
       in case the payment has to be
       sent through the mail instead
       of electronically and also to
       allow for settlement time for
       ACH.

       (See figure in printed
       edition.)

       Source:  GAO analysis of
       industry data.

       (See figure in printed
       edition.)

       REGULATORY OVERSIGHT
    ---------------------------------------------------- Chapter Banking:4

    Financial institutions that offer electronic banking services are
    regulated by their respective regulators.  Banks are regulated by OCC
    and the Federal Reserve.  Brokerage firms are regulated by their
    self-regulatory organization.  Businesses other than banks and
    brokerage firms that offer electronic banking services are subject to
    investigation by the Federal Trade Commission (FTC), which operates
    under a broad mandate to regulate interstate commerce.  FTC conducts
    investigations in response to complaints, but it does not regularly
    and routinely conduct examinations of entities under its jurisdiction
    because it is not concerned with the financial soundness of those it
    oversees.

    The specific electronic banking transactions are governed by the
    Electronic Fund Transfer Act of 1978, and the Federal Reserve Board's
    corresponding Regulation E, which is intended to protect consumers
    against losses due to unauthorized electronic funds transfers.  A
    consumer's liability for unauthorized transactions involving an
    electronic fund transfer generally is limited to $50 but can be as
    much as $500 if the consumer fails to timely notify the institution
    that an access device was lost or stolen.  Regulation E also requires
    financial service providers to inform customers of their rights in
    the event an unauthorized transaction occurs.  That disclosure must
    be made when an account is opened or before the first electronic
    transfer is made.  Additional disclosure must be made periodically
    during the life of the account.  Also, the customer must receive a
    written receipt when an electronic transfer is initiated and periodic
    statements describing each transfer.\11

    --------------------
    \11 The receipt requirement applies to transfers at electronic
    terminals but not to transfers initiated by consumers over the
    telephone, such as home banking transactions.

       RISK AND RISK MITIGATION
    ---------------------------------------------------- Chapter Banking:5

    For purposes of this report, we discuss some of the most important
    risk and risk mitigations associated with electronic banking.

       Table 4.4:  Risk and Risk
       Mitigation for Electronic
       Banking

       (See figure in printed
       edition.)

          RISK 1:  FRAUD
    -------------------------------------------------- Chapter Banking:5.1

    Electronic banking poses risks of financial loss due to unauthorized
    transfers by electronic intruders.  Both financial service providers
    and consumers engaged in EFTs are exposed to this risk.

             MITIGATION
    ------------------------------------------------ Chapter Banking:5.1.1

    Use of mechanisms to provide authentication, verification, and
    security of information in electronic banking activity.  Passwords,
    PIN numbers, encryption, and other methods are commonly used to help
    ensure secure management of financial information in electronic
    banking activities.

    In addition, several efforts are under way to legislate the legality
    and use of digital signatures.  Digital signatures are the electronic
    counterpart of requiring a driver's license or passport.  They enable
    a person to verify his or her identity for the electronic transfer of
    funds or some other transaction.

          RISK 2:  SECURITY
    -------------------------------------------------- Chapter Banking:5.2

    Banking regulators have recognized that systems delivering financial
    products and services face risks posed by individuals with a desire
    to disrupt systems rather than to realize any financial gain.  The
    damage from viruses or other forms of attack could be significant.
    If a virus caused the system of a bank to malfunction, for example,
    customers could lose access to their accounts.  Consumers' computer
    systems are also at risk of viruses and other forms of attack
    communicated through use of the Internet.

             MITIGATION
    ------------------------------------------------ Chapter Banking:5.2.1

    Regulatory review of computer security.  The U.S.  bank regulators
    are required to perform extensive reviews of banks' computer
    facilities as part of their routine bank examinations.

             MITIGATION
    ------------------------------------------------ Chapter Banking:5.2.2

    Use of firewalls and other security mechanisms in a security
    strategy.  Some financial institutions use firewalls and other
    methods of filtering information coming from the Internet to
    computers to prevent viruses and other malicious programs from
    damaging computer systems.  A firewall is a set of security
    procedures designed to block off intruders by limiting the
    information that can pass to the server.  Most firewalls involve
    either looking at the "packets" of data individually or resending all
    data destined for an organization through a single "gateway" or
    checkpoint.

    FINANCIAL SERVICES OVER THE
    INTERNET
    ===================================================== Chapter Internet

       DESCRIPTION AND USE
    --------------------------------------------------- Chapter Internet:1

    An increasing number of merchants and financial service providers are
    using the Internet as a communications infrastructure for financial
    activities.  In this section, we discuss purchases over the Internet
    with payment by credit card and electronic money, and the use of the
    Internet as an avenue for information and communication to facilitate
    trading of government and corporate securities.

    Many retail merchants have established World Wide Web (WWW) sites to
    enable consumers to make online purchases using credit cards.  In
    1996, a private research firm estimated that by 2000, the value of
    online purchases by credit card will likely be more than $6 billion.
    The major difference between a more traditional credit card
    transaction--whether by telephone, fax, or at a sales counter--and a
    credit card transaction over the Internet is in how the customer
    provides credit card information to the merchant, including special
    procedures used to secure confidential information.

    For purposes of our discussion, the term "electronic money" includes
    a wide variety of emerging strategies and mechanisms--many of them
    still in a developmental stage--to enable a consumer to make online
    payments on a cash basis without the use of physical cash, credit
    cards, or a standard checking account.\12 In Internet transactions,
    online merchants would redeem electronic money for the appropriate
    value from the issuer.  Electronic money was not widely used in
    Internet transactions as of October 1996.  An attorney we
    interviewed, who has a practice dealing with issues concerning
    electronic commerce and payment systems, told us that over 20
    electronic money systems were under development or operating as of
    October 1996.  A few of the versions of electronic money offered or
    under development\13 include the following:

      -- E-Cash:  DigiCash was the first company to license the
         technology of electronic money, which it calls e-cash.  Its
         creators claim that e-cash combines the speed of the present
         bank-based wire system with the anonymity of cash.  As of
         October 1996, e-cash was offered by one U.S.  bank, the Mark
         Twain Bank in St.  Louis, MO.  E-cash is a string of digits that
         has been given the value of a digital coin by the issuing bank.
         These digits are stored on the customer's hard drive.  The
         customer uses these digits to pay for the transactions that he
         or she makes.  In an e-cash transaction, when a customer pays
         for e-cash, the bank's deposit liability to the customer is
         reduced, and in its place is a new, e-cash liability for that
         amount.  After the customer transfers the e-cash to a merchant,
         when the merchant deposits e-cash, the deposit reduces the
         e-cash liability and increases the deposit liability.  This
         means that there is a conversion from e-cash to funds available
         for the merchant to withdraw.

      -- Electronic Money System:  Citibank's Electronic Money System
         (EMS) is designed to provide secure, real-time transactions over
         any network, including the Internet.  EMS offers a blend of
         anonymity and disclosure.  According to a Citibank official,
         each electronic transaction would have an audit trail that could
         be traced, but the identity of the parties would remain
         anonymous.

    In recent years, the Internet has also been used to provide
    information to potential investors about exchange-traded government
    and corporate securities.  It has also been used by investors for
    communication of buy and sell orders and even to create electronic
    bulletin-board-based trading mechanisms for shareholders of
    off-exchange corporate securities.  SEC has also allowed a brokerage
    firm to use the Internet to establish a market for qualified
    investors in private placement investments.  As of October 1996,
    securities transactions payments were not made over the Internet;
    such payments were cleared and settled conventionally.

       (See figure in printed
       edition.)

    --------------------
    \12 This is referred to as online scrip in the June 1996
    Congressional Budget Office study, Emerging Electronic Methods for
    Making Retail Payments.

    \13 The examples were selected for purposes of illustration only,
    without any intention to endorse any of the featured products.

       BASIC DATA
    --------------------------------------------------- Chapter Internet:2

    While statistics on the total value of Internet transactions are not
    available, many vendors offer merchandise that can be purchased
    online with a credit card.  With increased use and sophistication of
    home computer technology and WWW services, Internet-assisted
    financial services are expected to increase.

      -- In 1995 about a quarter of a billion dollars of credit card
         purchases were made via the Internet.

      -- In 1995, one bank (The Mark Twain Bank of St.  Louis, MO)
         offered electronic cash that could be used to make purchases
         from a few vendors equipped to take electronic payments.

      -- In 1996, more than 20 electronic money systems were available or
         under development.

       PROCESSES
    --------------------------------------------------- Chapter Internet:3

    Example:  A consumer is planning to purchase an outdoor chair.
    He or she decides to shop online by connecting to L.L.  Brian's WWW
    site.

       Figure 4.3:  Credit Card
       Payments Over the Internet

       (See figure in printed
       edition.)

       (See figure in printed
       edition.)

       Source:  GAO analysis of
       industry data.

       (See figure in printed
       edition.)

       REGULATORY OVERSIGHT
    --------------------------------------------------- Chapter Internet:4

    Regulatory oversight for financial services on the Internet is
    determined largely by the type of entity providing the service.
    Depository institutions, brokerage firms, stock markets, and nonbank
    financial service providers are subject to varying degrees of
    oversight by a variety of federal and state agencies.  The Internet
    itself is generally not regulated by the states or the federal
    government.\14

    Depository institutions are subject to oversight by federal and state
    banking agencies.  They are regularly and routinely examined to help
    ensure safety and soundness and compliance with consumer protection
    and civil rights laws and regulations, including the Federal Reserve
    Board's Regulation E, "Electronic Funds Transfers," which, among
    other things, limit the amount of consumer liability for an
    unauthorized electronic transfer of funds.  Internet-transmitted
    activities in which depository institutions are involved would not be
    exempt from the scrutiny of federal examiners.  Depository
    institutions issue credit cards, distribute electronic money, and
    sell securities.  Under certain conditions, banks may also underwrite
    initial public offerings and assist in private placement
    investments.\15

    --------------------
    \14 Domain names, the Internet addresses that are used to mark the
    network space of an institution, are assigned by an organization
    known as the Internet Network Information Center (InterNIC).
    InterNIC is a nonprofit organization.  It currently subcontracts the
    actual business of domain registration to a private contractor.  A
    number of consortia, such as the World Wide Web Consortium, promote
    uniformity in communication standards used on the Internet.

    \15 Banks are allowed to conduct certain securities activities, such
    as brokerage services, within any licensed bank.  However, if a bank
    wishes to engage in securities underwriting, it may do so only
    through what is known as a Section 20 affiliate.  This institution is
    a subsidiary of the bank's holding company rather than the bank
    itself.

       RISK AND RISK MITIGATION
    --------------------------------------------------- Chapter Internet:5

    For purposes of this report, we discuss some of the most important
    risk and risk mitigations associated with financial services on the
    internet.

       Table 4.5:  Risk and Risk
       Mitigation for Financial
       Services on the Internet

       (See figure in printed
       edition.)

          RISK:  SECURITY
    ------------------------------------------------- Chapter Internet:5.1

    Intruders using advanced programming techniques may be able to break
    into a computer system over the Internet and obtain information they
    are not authorized to have.  The security of the systems is of
    particular concern because a break-in could result in an immense
    amount of information--such as credit card numbers--getting into
    unauthorized hands.  Further, if information is not secured before
    transmission over the Internet, an intruder could obtain a copy of
    the information being transmitted or change the message.  A report
    published by the Bank for International Settlements (BIS) on the
    security of electronic money has recognized security concerns and
    noted that ".  .  .  no single security measure or set of measures .
    .  .  can be said to be sufficient for a particular product.  It is a
    combination of measures, together with the rigor with which they are
    implemented, that will serve to reduce the risk most effectively."\16

    --------------------
    \16 BIS is an organization of central banks based in Basle,
    Switzerland.  It is the principal forum for consultation,
    cooperation, and information exchange among central bankers.

             MITIGATION
    ----------------------------------------------- Chapter Internet:5.1.1

    Use of strong encryption systems.  Systems that transmit credit card
    information and electronic cash generally use encryption systems to
    prevent electronic intruders from obtaining information--such as
    credit card numbers--that could be used to make an unauthorized
    transfer of funds.  Two major secure-communication protocols have
    been used in the Internet/WWW commerce market:  Secure Sockets Layer
    (SSL) and Secure HyperText Transfer Protocol (S-HTTP).  Information
    Law Alert describes the difference between SSL and S-HTTP as similar
    to the difference between an armored car, which protects the channel,
    and an envelope, which secures the specific data being transmitted.

    On February 1, 1996, VISA and MasterCard announced their support for
    a new set of technical standards--to be known as Secure Electronic
    Transaction (SET)--for making secure credit card purchases over open
    networks such as the Internet.  SET is to include universally
    accepted standards for encrypting credit card numbers and verifying
    their use; the standards are to be incorporated into Internet-related
    software--most notably software browsers widely used to access the
    WWW.  Among other things, SET would help prevent merchant misuse of
    credit card numbers.  Instead of receiving an encrypted credit card
    number to be decrypted by the merchant, the merchant would receive
    and pass the encrypted credit card number to the credit card
    association, which would then decrypt the number and transmit an
    authorization code to the merchant.  This standard was not expected
    to be operational until early 1997.

             MITIGATION
    ----------------------------------------------- Chapter Internet:5.1.2

    Avoidance of the Internet for transmitting credit card numbers.  Some
    firms allow shoppers to make credit card purchases over the Internet
    without transmitting their credit card information.  One firm, for
    example, will take a shopper's credit card information over the
    telephone and then act as an intermediary between the shopper and the
    Internet seller.

             MITIGATION
    ----------------------------------------------- Chapter Internet:5.1.3

    Use of firewalls and other security mechanisms in a security
    strategy.  Some financial institutions use firewalls and other
    methods of filtering information coming from the Internet to
    computers to prevent viruses and other such malicious programs from
    damaging computer systems.  The firewall attempts to block off
    intruders by limiting the information that can pass to the server.
    Most firewalls involve either looking at the packets of data
    individually or resending everything destined for an organization
    through a single gateway or checkpoint.

    ISSUES RELATED TO PAYMENTS,
    CLEARANCE, AND SETTLEMENT SYSTEMS
    ======================================================= Chapter Issues

    In this section, we highlight issues we identified in doing our work
    on payments, clearance, and settlement systems.  As discussed in the
    scope and methodology section of this report, many of these issues
    were raised by payments system users, providers, and regulators.  In
    addition, we identified some issues from our review of documents,
    data, and other materials.  Some of the issues relate to specific
    payments systems; others are broader in nature.  We did not seek to
    evaluate or resolve any of these issues in this report.

       ISSUE:  THE SAFETY OF
       TRADITIONAL RETAIL PAYMENT
       TRANSACTIONS
    ----------------------------------------------------- Chapter Issues:1

    Retail payment transactions are generally small-value, large-volume
    payments, such as paper checks for consumer purchases, paychecks,
    Social Security fund transfers, and other payments made via an
    automated clearing house (ACH).  Individually, these types of
    payments represent a fairly low level of risk.  However, to the
    individual expecting to receive an electronic payment, the failure to
    receive the payment could become a potentially serious problem.  In
    addition, when retail payment mechanisms are used for large-dollar
    transactions, risk can escalate.  Thus, proposals have been made to
    enhance the safety of retail payment systems.

          THE USE OF ACH TO TRANSMIT
          LARGE-DOLLAR PAYMENTS
    --------------------------------------------------- Chapter Issues:1.1

    In general, use of an ACH network involves considerably more risk
    than the use of more secure payments systems such as Fedwire.  Unlike
    Fedwire, ACH payments are provisional in nature until final
    settlement, which can occur as many as 2 days after payment
    instructions are received.

    As previously mentioned, ACH networks have largely been used for
    small-dollar payments in which the dollar-value risk if a payment
    were to be returned unpaid would be correspondingly small.  Also, the
    price for an ACH transaction is much lower than that for a Fedwire
    transaction.  The price differential can be as great as $0.01 for an
    ACH transaction versus $0.45 for a Fedwire transaction.  Thus, there
    is a price incentive to use ACH for increasingly larger dollar-value
    transactions.  Currently, the ACH format does not allow any ACH
    transaction greater than $100 million.  However, some industry
    officials told us that this dollar cap has been circumvented in cases
    when the originator of the ACH transaction cuts a large value ACH
    payment into several smaller ACH payments to remain under the $100
    million cap for each individual payment.

    Some industry officials have expressed concerns about ACH being used
    for any large-dollar transactions, even those substantially below the
    $100-million cap.  One industry official has suggested that the ACH
    dollar cap should be as low as $100,000.  Moreover, these officials
    told us that the failure of several large-dollar transactions could
    expose counterparties to risks that go beyond those borne by the
    individual originating institution.  However, other industry
    officials we spoke to said they did not believe in the necessity of
    imposing such dollar limits.  They argued that the risk is borne by
    the individual financial institution that chooses to use an ACH for
    large-dollar transfers.

          SAME-DAY SETTLEMENT FINALITY
          OF ACH TRANSACTIONS
    --------------------------------------------------- Chapter Issues:1.2

    Risks in using an ACH arise from the time lag between payment
    instructions being issued and final settlement being made.  For
    example, if a customer making an ACH payment through his or her bank
    fails to fund the payment on the settlement day, the originating
    institution could suffer a financial loss.

    Some industry officials say that the period of risk could be
    shortened if the Federal Reserve adopted same-day settlement finality
    for its ACH processing.  The Federal Reserve reserves the right to
    reverse credits to banks until some time in the night following
    provision of these credits to banks.  A Federal Reserve official told
    us that there are several obstacles that would need to be overcome
    before same-day settlement finality could be achieved.  For example,
    ACH transactions are provisional payments with the presumption, but
    no guarantee, that the originator of the transaction will fund its
    ACH obligations.  If same-day finality were established for ACH
    transactions, then some sort of guarantee--such as collateral
    requirements--would need to be established to ensure that the
    depository institutions had sufficient funds to settle their ACH
    transactions.

       ISSUE:  NEW AND EMERGING
       FINANCIAL PRODUCTS AND SERVICES
    ----------------------------------------------------- Chapter Issues:2

    New and emerging financial products and services present many legal
    and regulatory challenges.  Some areas of regulatory oversight, such
    as the Community Reinvestment Act (CRA) and credit access, are
    currently directed toward the geographical location of the bank,
    market, or product being supervised.  And consumer protection laws
    and regulations have generally been written with the current,
    predominantly paper-based, processes in mind.  With the growth of
    electronic commerce, such as electronic banking, electronic cash, and
    use of the Internet to purchase securities, regulators are likely to
    face increasing complications in applying existing laws and
    regulations to these new products and services.  Several task forces
    are already under way to look at some of the consumer protection and
    compliance issues.  In addition, the current regulatory structure is
    likely to be tested further as nonbanks increasingly offer these new
    services and products.  Such developments, already under way, are
    likely to raise anew issues related to the extent to which there is a
    "level playing field" between banks and nonbanks.

          CONSUMER REGULATIONS
    --------------------------------------------------- Chapter Issues:2.1

    The Federal Reserve's Regulation E governs electronic funds transfers
    (EFT), among other things.  Currently, Regulation E provides that
    consumers must be given a paper receipt at the conclusion of any
    electronic transaction conducted at an electronic terminal.  For this
    reason, an ATM is to issue a receipt each time a customer uses it.
    This provision may be a problem for new financial products such as
    stored-value cards.

    Geographical jurisdictional issues may arise in a number of areas.
    CRA requires a bank to delineate the territory it serves and take
    steps to meet the credit needs of that territory.  Electronic access
    to banks and banking services, which provides consumers with
    opportunities to bank far from the communities in which they live,
    clearly complicates the task of delineating a community by
    geographical boundaries.  Banks offering services over the Internet
    as one alternative to those offered at their traditional "bricks and
    mortar" branches may be able to continue to satisfy CRA requirements
    using these traditional branches.  However, at least one bank is now
    offering its services exclusively over the Internet, soliciting
    customers nationwide.  As Internet banks increase in number,
    regulators are likely to face a difficult challenge in defining the
    territory of service for these banks for CRA purposes.  Another
    jurisdictional concern related to investor protection is raised by
    offerings of securities over the Internet.

    The use of stored-value cards will likely raise additional issues
    related to legal and regulatory oversight.  Currently, stored-value
    cards are being issued by banks and nonbanks.  Questions have arisen
    about the applicability of deposit insurance to amounts contained on
    the cards issued by banks.  Recently, FDIC issued an opinion having
    the effect that, with the types of cards anticipated to be most
    widely used, the funds paid for them will not be covered by deposit
    insurance.  Only in cases in which the value is actually held in the
    cardholder's account at the financial institution until payment is
    authorized would deposit insurance for the cardholder be available.
    Consumers may not be aware of this and also may not be aware that,
    unlike similar-looking credit cards, stored-value cards generally
    offer no dollar limit against theft or loss.

    When fully implemented, stored-value cards may be issued from a
    provider in any location to a consumer who uses the card in a
    completely different location.  Because of these issues, some bankers
    have suggested that only banks be permitted to issue stored-value
    cards.  However, these cards are already being issued by nonbanks.

          CONSUMER RIGHTS AND ACCESS
          PROTECTION VERSUS FINANCIAL
          INNOVATION
    --------------------------------------------------- Chapter Issues:2.2

    At a U.S.  Department of the Treasury conference on the role of
    government with regard to electronic money and banking,\1 several
    federal policymakers and representatives of the financial services
    industry emphasized that governments wishing to foster financial
    innovation must be careful not to impose rules that inhibit it.
    However, these conference speakers also acknowledged that governments
    should seek to ensure that effective risk management systems are in
    place in the private sector.  Recognizing that transactions over the
    Internet ultimately create demands for universally accepted standards
    for protection of customers, one federal legislator suggested that
    private-sector interests may wish to join forces in developing an
    electronic commercial code of conduct and standards for such
    protection.

    --------------------
    \1 Toward Electronic Money & Banking:  The Role of Government, U.S.
    Department of the Treasury Conference, Sept.  19, 1996.

          ESCHEATMENT
    --------------------------------------------------- Chapter Issues:2.3

    Most states have laws that allow them to "escheat," or take custody
    of abandoned property, such as bank accounts that have been inactive
    for some period.  Given the potentially large sums involved, states
    with escheatment laws might not allow issuers of stored-value cards
    and electronic money to keep abandoned funds for their own accounts.
    But several issues must be resolved.  For example, there is an issue
    of which state would have escheat jurisdiction, particularly if
    issuers of stored-value cards and electronic money do not keep
    records of purchases and customers' addresses.

          BANKS VERSUS NONBANKS
    --------------------------------------------------- Chapter Issues:2.4

    A broader question likely to receive increased attention because of
    the emergence of these new products and services is whether or not
    banks and nonbanks are operating, or should be made to operate, on a
    "level playing field"--that is, that they receive equal regulatory
    treatment.  This question has been debated by bankers and other
    providers of financial services for some time; however, the entry
    into the market of so many new nonbank providers of such services as
    electronic banking, stored-value cards, and Internet-supplied
    financial transactions will likely serve to increase and sharpen the
    debate.

    Brokerage houses provide deposit accounts similar to those of
    commercial banks.  But they do not receive the same regulatory
    oversight as commercial banks do.  Nor are they required to hold
    noninterest bearing reserve accounts at the Federal Reserve.  In
    addition, bankers feel that other regulatory requirements imposed on
    depository institutions, such as CRA requirements, impose additional
    regulatory burdens on their institutions, which place them at a
    competitive disadvantage when competing against nonbanks.

    On the other hand, banks have certain advantages that are derived
    from their bank charters.  For example, the ability to offer deposit
    insurance to customers may give banks a competitive advantage over
    nonbank financial service providers.  Furthermore, reserves enable
    banks to clear and settle obligations.  And although undergoing
    safety-and-soundness examinations may impose regulatory burden on
    banks, it also allows banks to provide a measure of assurance to
    customers that their deposits are being well-handled.

    However, industry observers believe that nonbanks could fall under
    applicable state regulations, for instance, those governing nonbank
    "money transmitters"--firms that issue "instruments for the
    transmission of money," such as traveler's checks or money orders.\2

    The state laws generally provide a number of safeguards for users.
    Issuers typically must be licensed and bonded, are required to hold a
    minimum level of capital, may be required to hold reserves equal to
    100 percent of outstanding value, and are also subject to periodic
    examinations and audits.

    --------------------
    \2 According to the Federal Reserve, 44 states have enacted such
    laws, which industry representatives believe would apply, or will be
    amended to apply, to general-purpose stored-value cards.

       ISSUE:  SECURITY AND PROTECTION
       FOR NEW AND EMERGING FINANCIAL
       PRODUCTS AND SERVICES
    ----------------------------------------------------- Chapter Issues:3

    Electronic technologies now in place or under development, such as
    the use of the Internet for financial transactions, electronic cash,
    and stored-value cards, hold great promise for increasing consumer
    choice in payment methods.  However, such technologies also provide
    additional means for abuse and illegal activity.  Law enforcement
    officials have expressed concerns about the possibility of
    individuals using these new products and services for illegal
    purposes such as money laundering.  Some fraudulent schemes involving
    securities transactions over the Internet have already been
    uncovered.  Because of the newness of these products and services,
    approaches to making such products and services more secure and less
    vulnerable to illegal use are still under development.

          THE SECURITY OF INTERNET
          TRANSACTIONS
    --------------------------------------------------- Chapter Issues:3.1

    Through the Internet, customers now have access to credit card
    payment systems, electronic banking, and other financial services in
    a way that was never before possible.  Such services bring to the
    consumer an array of new, convenient methods for doing financial
    transactions.  However, because of the nature of the Internet--the
    fact that it is basically an unsecured means of transmitting
    information--customers, merchants, and other service providers have
    increasing concerns about the safety and security of their
    transactions.  For example, if an intruder could successfully attack
    a credit card association, customers could lose access to their
    accounts, or in the worst case, the credit card payment system would
    grind to a halt.

    Firewalls and other methods of filtering information coming from the
    Internet to computers can be used, in part, to increase the security
    of Internet transactions.  A firewall is a method that attempts to
    block intruders by limiting the information that can pass to the
    merchant's or the financial institution's internal network.  Use of
    encryption is another means by which the security of Internet
    transactions could be increased.  However, neither firewalls nor
    encryption provides a guarantee of safety for Internet transactions.
    To the extent that financial transactions over the Internet remain
    vulnerable to intrusion or capture by unauthorized parties, consumers
    may be reluctant to dramatically increase their usage of the Internet
    for their financial business, and any major successful attacks would
    likely affect the public confidence in electronic commerce in
    general.

    In addition to the issue of the basic security of the Internet, the
    Internet also provides a new means for criminal elements to
    perpetuate fraudulent schemes against consumers.  Such schemes pose
    risks to consumers because the Internet provides relatively easy and
    cost-effective access to millions of individuals.  Pennsylvania
    securities regulators we interviewed described several illegal
    schemes conducted over the Internet, including sales of nonexistent
    bonds.  Law enforcement agencies are stepping up their efforts to
    identify and stop such schemes, but it remains to be seen whether
    these efforts can keep pace with the rapid growth of the use of
    electronic commerce and the Internet for such illicit purposes.

    In addition, new technologies, such as the use of the Internet for
    financial transactions or stored-value cards, are likely to provide
    additional avenues for money laundering.\3 Law enforcement officials
    are especially concerned with systems that allow person-to-person
    transfers, which would include stored-value cards and Internet
    transfers.  Financial institutions offering accounts over the
    Internet are not limited to domestic U.S.  institutions.  Foreign,
    off-shore banks, which may not be regulated by U.S.  bank supervisory
    agencies, are now offering U.S.  customers accounts and financial
    services.  In at least one case, an off-shore bank is advertising its
    services over the Internet as a tax haven for U.S.  investors.
    Stored-value cards may enable individuals to move illegal money from
    a bank account onto a stored-value card, where it will be untraceable
    when used.  However, because stored-value cards generally are
    designed for small-value purchases and many have low limits, such as
    $500, for the amounts that can be stored on them, they may not be
    very efficient vehicles for laundering large amounts of cash.

    --------------------
    \3 Money laundering is the disguising or concealing of illicit income
    to make it appear legitimate.  Although precise figures are not
    available, federal law enforcement officials estimate that between
    $100 billion and $300 billion in U.S.  currency is laundered each
    year.

          LEGAL STATUS OF DIGITAL
          SIGNATURES
    --------------------------------------------------- Chapter Issues:3.2

    To deter forgery, a person wishing to cash a check is usually
    required to provide a signature and some type of identification--such
    as a driver's license or passport--to verify that the signature is
    actually his or hers.  A digital identification, or digital
    certificate, is the electronic counterpart of requiring a driver's
    license or passport.  It enables a person to verify his or her
    identity for the electronic transfer of funds or some other
    transaction.

    A digital identification allows individuals to sign, or
    "authenticate," digital transactions.  For example, a person wishing
    to make an electronic money payment over the Internet could verify
    that the party requesting the payment was actually the generator of
    the request and not an impersonator.

    If digital signatures are to substitute for handwritten signatures,
    they must have the same legal status as handwritten signatures--i.e.,
    they must be legally binding.  The legal status of digital signatures
    is not well defined.  For example, banks are required to acquire a
    signature card for every customer, but none of the banking regulators
    has ruled on the validity of digital signatures.

    Several efforts are under way to legislate the legality and use of
    digital signatures.  In 1995, Utah became the first government entity
    to adopt a comprehensive statute allowing electronic commerce using
    digital signatures.  Similar legislation is under consideration in
    some other states.

       ISSUE:  MITIGATION OF
       SETTLEMENT RISKS IN WHOLESALE
       AND FOREIGN EXCHANGE
       TRANSACTIONS
    ----------------------------------------------------- Chapter Issues:4

    The emergence of the global marketplace has rapidly increased the
    speed and volume of wholesale financial transactions.  With this
    growth has come the potential for increased risk and the call for new
    mitigation strategies.  As explained in the section on foreign
    exchange transactions, Herstatt risk exists because the two sides of
    a contract are not settled simultaneously; therefore, if a
    participant defaulted after receiving its side of a contract but
    before making the payments due to the other party, all the payors
    could lose up to the full value of the contracts, which might be
    sizeable.\4 Participants in the foreign exchange market might seek to
    diminish this gap between payment and receipt by delaying payments,
    but this could create gridlock; that is, if payments were delayed,
    the intended recipients--even though solvent--might be unable to make
    their own payments to others, thus spreading the same problems to
    still other participants.  In addition, within the United States, the
    growth in wholesale transactions could place the Federal Reserve and
    the taxpayers at increased risk, in part because of the provision of
    daylight overdrafts.

    A variety of proposals have been made for mitigating various risks in
    wholesale payments.  Some of these address Herstatt and gridlock
    risks in foreign exchange transactions.  These proposals include
    establishing simultaneous payment arrangements, known as
    payment-vs.-payment (PVP), and creating a clearing house as a
    counterparty.  Other proposals are concerned with domestic wholesale
    payments in the United States.  Some of these proposals include (1)
    increasing the fees banks are charged for incurring daylight
    overdrafts and (2) fully funding each Clearing House Interbank
    Payment System (CHIPS) transaction rather than allowing debit and
    credit positions to accumulate until end-of-day settlement.

    --------------------
    \4 Herstatt risk can exist within the same time zone, as long as
    settlement of one currency occurs before settlement of the other.
    Time zone differences obviously can increase the length of the time
    gap between the two settlements.

          TIMING OF PAYMENT RELEASE
    --------------------------------------------------- Chapter Issues:4.1

    A committee of major banks involved in foreign exchange trading has
    opposed delaying payments until late in the settlement day.  Its
    "best-case" settlement assumption is for payments to be made at
    opening time on settlement day to ensure adequate liquidity for
    counterparties.\5 We are not aware of any regulatory proposals for
    standards for payment release.

    --------------------
    \5 The New York Foreign Exchange Committee, Reducing Foreign Exchange
    Settlement Risk, Oct.  1994.

          SIMULTANEOUS PAYMENT PROCESS
          OR PVP
    --------------------------------------------------- Chapter Issues:4.2

    Herstatt risk in foreign exchange transactions could be eliminated by
    procedures to make payment of each currency leg dependent on payment
    of the other; as mentioned earlier, the process for allowing
    simultaneous payment is called PVP.  To enhance the potential for PVP
    in foreign exchange transactions, the Federal Reserve has announced
    plans to extend the opening hours of Fedwire in 1997.  By the end of
    this year, Fedwire is to be open from Monday through Friday 12:30
    a.m.  to 6:30 p.m.  ET, thus ensuring that it will be possible to
    process dollar final settlements during hours when payment systems in
    major foreign countries are also open.  Expanded Fedwire hours should
    make simultaneous payments possible.

    PVP does not automatically follow from overlapping payment system
    hours:  expanded Fedwire hours should make simultaneous payments
    possible, but realization will depend on private-sector actions.  In
    that regard, a group of major banks in the industrial countries,
    calling themselves the Group of Twenty, have an objective of bringing
    about a private-sector PVP system by 1999.

    A concern of market participants is that any risk-mitigation measures
    should not be so costly or cumbersome as to interfere with the
    ability of the markets to function effectively.  To that end,
    proposals for clearing houses and PVP are being examined in terms of
    the amount of liquidity that may need to be tied up as collateral.
    The central banks' G-10 committee raises the question as to whether
    some proposed PVP schemes might heighten the potential for
    transmission of problems from one country to another by increasing
    links between them.  Yet another consideration is the degree to which
    a proposed measure would allocate costs to those institutions that
    bring risk to the system, thus retaining incentives on each
    institution to manage risks prudently.

          CLEARING HOUSE BECOMES
          COUNTERPARTY
    --------------------------------------------------- Chapter Issues:4.3

    One approach to reducing Herstatt risk in foreign exchange contracts
    involves the creation of a clearing house, which would become the
    counterparty--and thus guarantor--of all the trades among members.
    If such an institution had sufficient collateral or other backing
    available to be used in case of potential payment failures by one or
    more of its members, a clearing house could reduce credit risk.  With
    reduced concerns over credit risk, there might be less incentive to
    withhold or delay payments, thus lessening the risk of gridlock.
    Exchange Clearing House (ECHO) is a clearing house based in London,
    which had 13 member banks as of May 1996.  Multinet International
    Bank, once in operation, is to be a clearing house that becomes
    counterparty to trades initially in U.S.  and Canadian dollars among
    its members.

          U.S.  TREASURY OFAC POWERS
          OVER ASSETS OF NON-U.S.
          COMPANIES
    --------------------------------------------------- Chapter Issues:4.4

    Under the Emergency Economic Powers Act, the President can prohibit
    or regulate transactions relating to the interests and assets of any
    foreign country or foreign national.  Using this authority, the
    President can, among other things, prohibit (1) any transactions in
    foreign exchange; (2) transfers of credit or payments between, by,
    through, or to any banking institution, to the extent that the
    transfer or payment involves any interest of a foreign country or
    national thereof; and (3) the importing or exporting of currency or
    securities.\6 Regulations implementing Presidential Orders under the
    act are promulgated by the Office of Foreign Assets Control (OFAC)
    within the Department of the Treasury.  OFAC powers are exercised
    under laws intended to thwart terrorism or crime.  OFAC powers are to
    be exercised on payments flowing across Fedwire or CHIPS, even if the
    payments are legal in the payor's country.  Presently, all major
    players in global finance are heavily dependent on these two payments
    systems.  Foreign financial institutions might want to divert their
    payments outside the United States.  Some officials raise the concern
    that if international payments flows are pulled out of the U.S.
    payments systems, this action might affect the ability of the Federal
    Reserve to monitor financial flows and risks.

    --------------------
    \6 50 U.S.C.   1701-1706.  The act authorizes such action in cases
    in which the President has declared a national emergency because of
    an "unusual and extraordinary threat" to the U.S.  national security,
    foreign policy, or economy, "which has its source in whole or
    substantial part outside the United States." The President has used
    this power to issue "freeze" orders against the assets of Iraq
    (1990), Panama (1988), Libya (1986), Iran (1979), South Vietnam
    (1975), and other countries.  See Rachel R.  Gerstenhaber, Comment,
    Freezer Burn:  United States Extraterritorial Freeze Orders and the
    Case for Efficient Risk Allocation, 140 U.  Pa.  L.  Rev.  2333
    (1992).  See 31 C.F.R.   575.101-575.901.

          PRICING AND PROVISION OF
          DAYLIGHT OVERDRAFTS
    --------------------------------------------------- Chapter Issues:4.5

    Some private-sector officials believe that the Federal Reserve is
    significantly underpricing daylight overdrafts.  They argue that the
    rate charged for daylight overdrafts should be equal to the costs of
    providing those same funds to banks at the federal funds rate, which
    recently has been around 600 basis points.  The Federal Reserve told
    us that they strongly disagree that daylight overdrafts are
    underpriced.  Federal Reserve officials do not believe that daylight
    overdrafts fall within the meaning of a "new priced service" being
    offered under Monetary Control Act and, thus, Federal Reserve
    officials believe that cost recovery is not required.  Instead,
    officials told us that the Federal Reserve's position is that
    charging fees for daylight overdrafts is a risk control mechanism as
    opposed to a charge for a priced service.  Further, they argued that
    to raise daylight overdraft fees precipitously would likely cause
    disruptions, e.g., causing a substantial volume of large-value
    payments to be shifted to less secure payments systems, thereby
    increasing payment system risk.

    Regardless of the level of pricing of daylight overdrafts at the
    Federal Reserve, it is recognized that they pose credit risks to the
    Federal Reserve.  If the bank receiving an overdraft fails before it
    repays the overdraft, there could potentially be a loss experienced
    by the Federal Reserve.  However, the institutions at the highest
    risk of failure are not permitted to incur daylight overdrafts.  In
    addition, virtually all daylight overdrafts that are attributable to
    Fedwire securities transfers, and by extension the majority of
    daylight overdrafts, are collateralized.  In this regard, it is
    noteworthy that some major European central banks either do not
    provide uncollateralized daylight overdrafts or plan to require full
    collateralization for central bank, real-time gross settlement
    systems in the future.  A Federal Reserve official said that
    provision of Federal Reserve intraday credit in the Federal Reserve's
    payment system was indispensable in maintaining the liquidity of the
    Treasury market, which underpinned the smooth functioning of other
    financial markets in this country and abroad as well.

          CHIPS END-OF-DAY SETTLEMENT
    --------------------------------------------------- Chapter Issues:4.6

    On an average day, over $1.2 trillion of large-dollar payments are
    made among CHIPS' participants.  These payments are netted among the
    members during the day, but the participants' net credit/debit
    positions are not settled until the end of the day.  Individual
    participants could fail, at cost to their creditors; hypothetically,
    if enough participants were to fail, then end-of-day settlement would
    not occur; in the latter case, there would be systemic disruption to
    payments in this country and elsewhere.

    Regulators and industry officials pointed out that the CHIPS system
    had rigorous controls over payments and debit positions and had
    access to collateral that would cover the largest failures.  They
    added that the netting system helps maintain liquidity in the markets
    since the huge amount of daily payments that are sent over the system
    only require an average settlement amount of $5 to $10 billion each
    night.

       ISSUE:  APPROPRIATE ROLE OF THE
       FEDERAL RESERVE IN THE PAYMENTS
       SYSTEM
    ----------------------------------------------------- Chapter Issues:5

    Several issues concern the role of the Federal Reserve in the
    payments system.  Currently, the Federal Reserve serves as both a
    regulator and provider of certain payment system services and, as
    such, is in competition with private payment-service providers.  The
    Monetary Control Act of 1980\7 (MCA) required the Federal Reserve to
    price, on a basis comparable with private business firms, all the
    payment services it offered at the time the law was enacted and any
    other services it developed after that date.  Private-sector
    providers and others have raised questions about the Federal
    Reserve's ability to fully adhere to this law; others see an inherent
    conflict in the Federal Reserve's dual role as regulator and service
    provider.

    --------------------
    \7 Monetary Control Act of 1980, Pub.  L.  No.  96-221, Title I, 94
    Stat.  132 (codified as amended in scattered sections of 12 U.S.C.).

          POTENTIAL CONFLICT BETWEEN
          FEDERAL RESERVE'S ROLE AS
          BOTH SERVICE PROVIDER AND
          SYSTEM REGULATOR
    --------------------------------------------------- Chapter Issues:5.1

    The Federal Reserve is currently the largest single provider of
    priced payments services--e.g., check clearing, ACH services, and
    wire funds transfer services--in the nation.  Yet, the growth of
    private check clearing houses, such as the Chicago Clearing House
    Association (CCH), and the California Bankers Clearing House (CBCH),
    all of which directly compete with the Federal Reserve, has been a
    principal reason that the Federal Reserve's volume of checks cleared
    has declined in recent years.  MCA placed the Federal Reserve in a
    unique position--competing actively with private-sector institutions
    in providing services, such as check clearing, on the basis of price
    and quality of service, even though it has supervisory authority over
    these competing institutions and has responsibility for ensuring that
    the nation's payment system functions properly.

    Some private-sector service providers have expressed the concern that
    the Federal Reserve faces a potential conflict of interest in being
    both a provider of services and a regulator of payment systems.
    These private sector providers fear that the Federal Reserve could be
    unfairly competing with them in two ways:  first, by writing the
    regulatory rules so as to favor its own services; and second, by
    underpricing its services so as to retain a larger market share.

    Federal Reserve officials told us that they have taken steps to
    ensure they are competing fairly with the private sector in providing
    payment services.  For example, any proposed change in the Federal
    Reserve's operations must undergo an impact analysis to assess the
    impact of the proposed change on private-sector competition.

          POTENTIAL CONFLICT BETWEEN
          MCA AND FEDERAL RESERVE'S
          FUTURE CHECK CLEARING ROLE
    --------------------------------------------------- Chapter Issues:5.2

    The Federal Reserve, in providing its check clearing services,
    operates under two potentially conflicting requirements.  First,
    under MCA, the Federal Reserve is required to recover all the costs
    of doing business that it would incur if it were a private business.
    The second requirement is that the Federal Reserve be the "clearer of
    last resort." This means that the Federal Reserve is required to
    provide check clearing services, regardless of the costs it incurs,
    to any financial institution that needs to use its services for this
    purpose.

    The large private clearing houses have an advantage in that they,
    unlike the Federal Reserve, need not provide check clearing services
    to small and unprofitable depository institutions.  For example,
    private check clearing houses often only cover certain geographical
    areas or handle only certain types of payments, such as those for
    large-dollar amounts.  If the private clearing houses increasingly
    attract the most profitable business, leaving the most costly
    business for the Federal Reserve, the Federal Reserve may eventually
    be unable to meet its legal requirement to recover its costs of doing
    business.  In addition, with the financial industry's move toward
    interstate banking, larger banks will be clearing checks within their
    own banks, and possibly exchanging checks among their organizations.

          POSSIBLE INEFFICIENCY IN THE
          U.S.  PAYMENT SYSTEM
    --------------------------------------------------- Chapter Issues:5.3

    There are many estimates of the share of gross domestic product
    devoted to the U.S.  payment system.  For example, the Federal
    Reserve estimates this share to be below 0.5 percent of gross
    domestic product.  One economist has estimated this share to be
    higher--between 1 percent and 1.5 percent, or in dollar terms,
    between $72 billion and $109 billion in 1995.  Because electronic
    payments, such as ACH, credit cards, or stored- value cards, are
    estimated to cost only one-third to one-half that of payments by
    check, a shift from paper checks to these electronic systems could
    lower financial costs in the economy.  In that regard, the usage of
    paper check payments in the United States is considerably higher than
    that in other industrial countries.\8 The federal government should
    be making fewer check payments by 1999 under the Debt Collection
    Improvement Act of 1996.  Nonetheless, because federal government
    checks only account for about 1.3 percent of all U.S.  checks
    written, this decrease in check payments should have little impact on
    the total U.S.  volume of check payments.

    (See figure in printed edition.)Appendix I

    --------------------
    \8 In 1993, 80.4 percent of the volume of noncash payments in the
    United States was checks; among 9 other industrial countries, the
    share of checks in noncash payments averaged 25.6 percent, ranging
    from a low of 3.3 percent to high of 58.7 percent.

    COMMENTS FROM THE BOARD OF
    GOVERNORS OF THE FEDERAL RESERVE
    SYSTEM
    ======================================================= Chapter Issues

    (See figure in printed edition.)

    (See figure in printed edition.)

    (See figure in printed edition.)

    (See figure in printed edition.)

    (See figure in printed edition.)

    The following are GAO's comments on the Board of Governors of the
    Federal Reserve System's letter dated April 16, 1997.

    GAO COMMENTS

    1.  The Federal Reserve acknowledged that we had incorporated a
    number of the comments they provided on earlier versions of the draft
    report.  However, they expressed disappointment that many of their
    substantive comments were not addressed.

    While the Federal Reserve was reviewing our draft, we were in
    frequent contact with staff regarding technical comments.  We
    incorporated their suggested changes where appropriate.  In addition,
    officials responsible for operating many of these payment systems or
    developing new products, such as CHIPS, GSCC, and Mondex, reviewed
    sections of the report and commented on its accuracy.  We made a
    number of changes to these sections based on their comments.  Because
    our presentation of the issues did not include evaluation or
    conclusions, we did not incorporate the Federal Reserve's detailed
    comments on the issues if, in our judgment, their comments were
    evaluative in nature.  However, their comments on the issues are
    presented in their entirety in the Board of Governors' letter.

    2.  The Federal Reserve stated that our discussion of the clearance
    and settlement in the U.S.  government securities market only focuses
    on a portion of the market, the GSCC members and the securities
    clearing banks.  The Federal Reserve believes this leaves the reader
    with the erroneous impression that these organizations represent all
    of the clearance and settlement activity that occurs over Fedwire.

    We have added a footnote to our discussion of Treasuries stating that
    we focused only on GSCC's process, which is one mechanism for
    clearing and settling U.S.  government securities.  See page 58.

    3.  The Federal Reserve commented that our discussion regarding the
    risk that ACH debit transactions will be returned should be deleted
    because this risk relates to the finality of the underlying payment,
    not to the finality of the settlement of the transaction.

    We have deleted our example of the ACH debit transaction in our
    discussion of same-day settlement finality of ACH transactions.  See
    page 158.

    4.  The Federal Reserve commented that it is not clear why the report
    discusses the problems associated with providing receipts for
    stored-value cards in the context of privacy concerns, when such
    concerns have not been raised with respect to debit or credit card
    transactions.

    We deleted our discussion describing the problems associated with
    providing receipts for stored-value cards in the context of privacy.
    See page 159.

    5.  The Federal Reserve commented that our report was incorrect in
    stating that brokerage firms and other nonbanks that provide accounts
    similar to demand deposits are subject to Federal Reserve reserve
    requirements.

    We have clarified our discussion of banks versus nonbanks to remove
    the mistaken impression that brokerage firms and other nonbanks that
    provide accounts similar to demand deposits are subject to Federal
    Reserve reserve requirements.  See page 160.

    6.  The Federal Reserve stated that our report was misleading in that
    it implied Herstatt risk is only an intraday risk and results
    primarily from the different time zones of the settling currencies.

    We state in the report that intraday risk could accumulate to the sum
    of 2 or 3 days' trading volume.  See page 44.  We have added language
    to the report recognizing that Herstatt risk can exist within the
    same time zone.  See page 164.

    7.  The Federal Reserve commented that if GAO includes a discussion
    of the G-20 initiative, it should do so as part of its discussion of
    PVP, rather than in the "clearing house becomes counterparty"
    section.

    We have moved the discussion of the G-20 initiative in foreign
    exchange transactions to the section discussing simultaneous PVP.
    See page 165.

    8.  The Federal Reserve believes that our discussion of the issues in
    the report fails to give the reader an appreciation of the differing
    perspectives and associated considerations.  For example, with regard
    to the potential conflict between the Federal Reserve's role as
    service provider and system regulator, the Federal Reserve believes
    the report would be more balanced if it included a discussion of any
    actual evidence of unfair competition by the Federal Reserve.  In
    addition, the Board provided information in its letter and in its
    discussion of other issues on efforts it has made to minimize the
    potential conflict between its two roles.

    We raise the issues of the potential conflict in the Federal
    Reserve's dual role because many private-sector individuals and
    organizations expressed such concerns.  We do not present any
    evidence that would either substantiate or refute the contention that
    the Federal Reserve is actually competing unfairly with its
    private-sector competitors.  We have, however, incorporated where
    appropriate additional information the Board has given us about its
    efforts to minimize the potential conflict between its two roles.
    For example, we acknowledge that the Federal Reserve said that when
    it is considering any proposed change in its payment system
    operations, it conducts an analysis to assess the impact of the
    proposed change on private-sector competition.  See page 168.

    9.  The Federal Reserve stated that our report overestimated the
    share of gross domestic product devoted to the payments system and
    offered an alternative estimate.

    Recognizing that there are many different ways to measure possible
    inefficiencies in the U.S.  payment system, we have included the
    Federal Reserve's estimate.  See page 169.

    MAJOR CONTRIBUTORS TO THIS REPORT
    ========================================================== Appendix II

    GENERAL GOVERNMENT DIVISION,
    WASHINGTON, D.C.

    Nolani T.  Traylor, Evaluator-in-Charge
    Tamara E.  Cross, Senior Evaluator
    Nancy Eibeck, Evaluator
    Robert Pollard, Economist
    Charles Kilian, Advisor
    John Treanor, Banking Advisor
    Desiree W.  Whipple, Reports Analyst
    Kim Wheeler, Publishing Advisor
    Hazel Bailey, Evaluator (Communications Analyst)

    SAN FRANCISCO REGIONAL OFFICE

    Abuid Amaro, Evaluator
    Linda Chu, Evaluator

    OFFICE OF GENERAL COUNSEL,
    WASHINGTON, D.C.

    Paul Thompson, Senior Attorney

    GLOSSARY
    ============================================================ Chapter 1

             ACH OPERATOR/PROCESSOR
    ------------------------------------------------------ Chapter 1:0.0.1

    An ACH operator/processor is a central clearing facility that
    receives batches of ACH credit and debit transactions from
    originating depository institutions; edits, sorts, and distributes
    the transactions to receiving depository institutions; and
    facilitates the settlement among participants.

             AUTHENTICATION
    ------------------------------------------------------ Chapter 1:0.0.2

    Authentication is the process of verifying the identification of the
    true sender of a message and also that the text of the message itself
    has not been altered.

             BACK OFFICE
    ------------------------------------------------------ Chapter 1:0.0.3

    The back office of a financial institution is made up of employees
    responsible for (1) recording and maintaining the official records of
    the financial institutions and (2) processing transactions entered
    into by the financial institutions or its customers.

             BATCH PROCESSING
    ------------------------------------------------------ Chapter 1:0.0.4

    Batch processing is the transmission or processing of a group of
    payment orders and/or securities transfer instructions.

             BOND
    ------------------------------------------------------ Chapter 1:0.0.5

    A bond is a debt security representing a loan by the buyer to the
    corporation or government issuing the bond; it may pay interest, or
    it may be discounted in price from the value at maturity.

             BOOK-ENTRY SYSTEM
    ------------------------------------------------------ Chapter 1:0.0.6

    A book-entry system is an accounting system that permits the transfer
    of assets (e.g., securities) without the physical movement of paper
    documents or certificates.

             BROWSER
    ------------------------------------------------------ Chapter 1:0.0.7

    A browser is a computer program that facilitates locating and
    displaying information on the World Wide Web (e.g., Netscape
    Navigator or Microsoft Explorer).  The browser could work on the
    Internet or through internal information management systems called
    Intranets.

             CALL OPTION
    ------------------------------------------------------ Chapter 1:0.0.8

    A call option is a contract that gives one the right, but not the
    obligation, to buy a specified amount of an underlying asset, such as
    stocks or currency, at a specified price by a certain date.

             CASH LETTER
    ------------------------------------------------------ Chapter 1:0.0.9

    A cash letter is a group of checks, accompanied by a listing of the
    checks, which is sent to a clearing house, a correspondent bank, or
    the Federal Reserve for collection.

             CHECK
    ----------------------------------------------------- Chapter 1:0.0.10

    A check is a written order from one party (the payor) to another
    party (the payee) requiring the payor to pay a specified sum on
    demand to the payee or to a third party specified by the payee.

             CHECK CLEARING
    ----------------------------------------------------- Chapter 1:0.0.11

    Check clearing is the movement of a check from the depository
    institution at which it was deposited back to the institution on
    which it was written.  The funds move in the opposite direction, with
    a corresponding credit and debit to the involved accounts.

             CHECK TRUNCATION
    ----------------------------------------------------- Chapter 1:0.0.12

    Check truncation is the practice of holding a paper check at the bank
    at which it was deposited (or at an intermediary bank) and
    electronically forwarding the essential information on the check to
    the bank on which it was written.  A truncated check is not returned
    to the writer.

             CLASS OF OPTIONS
    ----------------------------------------------------- Chapter 1:0.0.13

    A class of options consists of options that are of the same type and
    style and cover the same underlying asset.

             CLEARANCE
    ----------------------------------------------------- Chapter 1:0.0.14

    Clearance is the process of transmitting, reconciling, and in some
    cases, confirming payment orders or security transfer instructions
    prior to settlement, possibly including the netting of instructions
    and the establishment of final positions for settlement.  In the
    context of securities markets, this process is often referred to as
    clearance.

             CLEARING AGENT BANKS
    ----------------------------------------------------- Chapter 1:0.0.15

    Clearing agent banks are Fedwire participants that are regularly
    engaged in the business of providing clearing services in eligible
    securities for members and GSCC.

             CLEARING HOUSE
    ----------------------------------------------------- Chapter 1:0.0.16

    A clearing house is a voluntary association of depository
    institutions that facilitates the exchange of payment transactions
    such as checks, automated clearing house transactions, and
    large-value funds transfers and the settlement of participants' net
    debit or credit positions.

             CLEARING MEMBERS
    ----------------------------------------------------- Chapter 1:0.0.17

    Clearing members are firms that are determined by OCC to be qualified
    to interact with OCC on behalf of market participants.

             COMMERCIAL/MERCHANT
             SERVER
    ----------------------------------------------------- Chapter 1:0.0.18

    A commercial/merchant server is a computer and/or computer program
    that provides information in response to requests by other computer
    programs.  Some servers are capable of sending and receiving secure
    messages.

             COMMERCIAL ONLINE SERVICE
    ----------------------------------------------------- Chapter 1:0.0.19

    A commercial online service is an integrated package of services
    providing news, e-mail, a special-interest forum, information
    resources, shopping, and other services accessed by consumer and
    business computer users using proprietary software and a modem
    (examples include America Online, Microsoft Network, CompuServe,
    etc.).

             COMPARISON MEMBERS
    ----------------------------------------------------- Chapter 1:0.0.20

    Comparison members are primarily government securities broker-dealers
    and clearing agent banks that are capable of interacting with GSCC
    operations.

             CORPORATE PAYMENTS
    ----------------------------------------------------- Chapter 1:0.0.21

    Corporate payments are payments that are used by businesses to pay
    other businesses for goods or services.

             CORRESPONDENT BANK
    ----------------------------------------------------- Chapter 1:0.0.22

    A correspondent bank is a bank that--by arrangement--holds the
    deposits of another bank and provides payments and other services for
    that bank.

             CREDIT CARD COMPANY
    ----------------------------------------------------- Chapter 1:0.0.23

    A credit card company is a company that owns the trademark of a
    particular credit card and may also provide a number of marketing,
    processing, or other services to the members using the card services.

             CREDIT LINE
    ----------------------------------------------------- Chapter 1:0.0.24

    A credit line is the maximum amount of credit available in an
    open-ended credit arrangement, such as a bank credit card, which the
    lender may change at any time.  The credit line is disclosed in the
    credit card agreement.

             CURRENCY OPTION
    ----------------------------------------------------- Chapter 1:0.0.25

    Currency options are options that represent the right to buy or sell
    foreign currency at a particular price within a specified period.

             CUSIP
    ----------------------------------------------------- Chapter 1:0.0.26

    CUSIP stands for the Committee on Uniform Securities Identification
    Procedures.  Each type and issue of security will have its own unique
    CUSIP number.

             DAYLIGHT OVERDRAFT
    ----------------------------------------------------- Chapter 1:0.0.27

    A daylight overdraft is an intraday loan that occurs when a bank
    transfers funds in excess of its reserve account.

             DEPOSITARY BANK
    ----------------------------------------------------- Chapter 1:0.0.28

    A depositary bank is the bank at which a check is first deposited.

             DIRECT PARTICIPANTS
    ----------------------------------------------------- Chapter 1:0.0.29

    Direct participants are financial institutions that are permitted to
    transact with the clearing organization, and all customers come to
    the clearing organization through them.  The term usually refers to
    institutions that interact with NSCC.

             DUAL TRADING
    ----------------------------------------------------- Chapter 1:0.0.30

    Dual trading occurs when an individual (or representative of a firm)
    trades on behalf of customers and also trades for his or her own or
    the firm's proprietary account.

             DECRYPTION
    ----------------------------------------------------- Chapter 1:0.0.31

    Decryption is the restoration of encrypted data to their original
    text.

             DVP SYSTEM
    ----------------------------------------------------- Chapter 1:0.0.32

    A delivery vs.  payment (DVP) system is a system that ensures that
    the final transfer of one asset will occur if, and only if, the final
    transfer of another asset (or other assets) occurs.

             ELECTRONIC BANKING
    ----------------------------------------------------- Chapter 1:0.0.33

    Electronic banking is a banking activity accessed by electronic
    means.

             ELECTRONIC FUNDS TRANSFER
             (EFT)
    ----------------------------------------------------- Chapter 1:0.0.34

    EFT is any transfer of funds between accounts using an electronic
    terminal, telephone, computer, or magnetic tape and that does not use
    checks or other paper.

             ELECTRONIC DATA CAPTURE
             (EDC)
    ----------------------------------------------------- Chapter 1:0.0.35

    EDC is a point-of-sale terminal that reads the information encoded in
    the magnetic stripe of bank cards.  These terminals electronically
    authorize and capture transaction data, eliminating the need for a
    paper deposit.

             ENCRYPTION
    ----------------------------------------------------- Chapter 1:0.0.36

    Encryption is the process of disguising a message (using mathematical
    formulas called algorithms) in such a way as to hide its substance, a
    process of creating secret writing.

             EQUITY INDEX OPTION
    ----------------------------------------------------- Chapter 1:0.0.37

    An equity index option is an options contract that covers the price
    of a diversified stock portfolio that matches a designated
    stock-index (a statistical indicator used to measure changes in stock
    groupings).

             EQUITY/STOCK
    ----------------------------------------------------- Chapter 1:0.0.38

    Equity or stock is a financial instrument that represents ownership
    in a company.

             EXCHANGE
    ----------------------------------------------------- Chapter 1:0.0.39

    An exchange is an organized market with transactions concentrated in
    a physical facility with participants entering two-sided quotations
    (bid and ask) on a continuous basis.

             EXERCISE
    ----------------------------------------------------- Chapter 1:0.0.40

    Exercise means to make use of the "rights" in a contract.  For
    instance, a buyer of a call option may exercise the right to buy the
    underlying asset at a particular price agreed upon when the contract
    was purchased.

             FEDERAL FUNDS RATE
    ----------------------------------------------------- Chapter 1:0.0.41

    The federal funds rate is the rate charged by a depository
    institution on an overnight sale of federal funds to another
    depository institution.  The rate may vary from day to day and from
    bank to bank.

             FEDERAL RESERVE ACCOUNT
    ----------------------------------------------------- Chapter 1:0.0.42

    A federal reserve account is a noninterest-earning account that a
    depository institution maintains with a Federal Reserve Bank.  The
    balance in this account is maintained for purposes of (1) satisfying
    the Federal Reserve's reserve requirements and/or (2) settling
    payments cleared through the Federal Reserve.  The balances in these
    accounts play a central role in the exchange of funds between
    depository institutions.

             FILE
    ----------------------------------------------------- Chapter 1:0.0.43

    A file is a group of entries transmitted by originating institutions
    or to receiving institutions by ACH operators.  A file may contain
    one or more batches of entries.

             FINALITY
    ----------------------------------------------------- Chapter 1:0.0.44

    Finality is an irrevocable and unconditional transfer of payment.

             FLOAT
    ----------------------------------------------------- Chapter 1:0.0.45

    Float is checkbook money that appears on the books of both the check
    writer (the payor) and the check receiver (the payee) while a check
    is being processed.

             FLOOR BROKER
    ----------------------------------------------------- Chapter 1:0.0.46

    A floor broker executes trades for customers and may also execute
    trades for their personal or employer accounts.

             FLOOR TRADER
    ----------------------------------------------------- Chapter 1:0.0.47

    A floor trader executes trades only for their personal accounts.  A
    floor trader is also referred to as a "local."

             FUTURES COMMISSION
             MERCHANT (FCM)
    ----------------------------------------------------- Chapter 1:0.0.48

    An FCM is a firm that buys or sells futures contracts and accepts
    payment from or extends credit to those whose orders it accepts.

             HEDGING
    ----------------------------------------------------- Chapter 1:0.0.49

    Hedging is engaging in financial transactions to protect against
    potential adverse changes in the values of assets, liabilities, or
    off-balance-sheet activities.

             THE INTERNET
    ----------------------------------------------------- Chapter 1:0.0.50

    The Internet is an open, worldwide communication infrastructure
    consisting of interconnected computer networks that allow access to
    remote information and the exchange of information between computers.

             LIQUIDITY
    ----------------------------------------------------- Chapter 1:0.0.51

    Liquidity is a quality that makes an asset easily convertible into
    cash with relatively little loss of value in the conversion process.

             LOCKED-IN TRADES
    ----------------------------------------------------- Chapter 1:0.0.52

    Locked-in trades are transactions that are matched by a computer,
    usually at the place of the trade, before being sent to a clearing
    organization.

             MARKET MAKER
    ----------------------------------------------------- Chapter 1:0.0.53

    Market maker is a dealer that makes bids and offers at which he/she
    will trade.

             MICR-LINE INFORMATION
    ----------------------------------------------------- Chapter 1:0.0.54

    MICR-line information refers to the data characters at the bottom of
    a check.  The magnetic ink character recognition (MICR) line at the
    bottom of a check includes the routing number of the payor bank, the
    amount of the check, the number of the check, and the account number
    of the customer.

             MORTGAGE-BACKED
             SECURITIES
    ----------------------------------------------------- Chapter 1:0.0.55

    MBS are securities that are backed by mortgages in which investors
    receive payments out of the interest and principal payments made on
    the underlying mortgages.

             MULTILATERAL NETTING
    ----------------------------------------------------- Chapter 1:0.0.56

    Multilateral netting is an arrangement among three or more parties to
    net their obligations, which may arise from financial contracts,
    transfers of funds, or both.  This type of netting normally takes
    place in the context of a multilateral net settlement system.

             NET DEBIT CAP
    ----------------------------------------------------- Chapter 1:0.0.57

    A net debit cap is the quantitative limit placed on the debit
    position that participants in a funds or securities transfer system
    can incur during the business day.  Under the Federal Reserve's
    policy, institutions are subject to two caps--a daily cap and a
    2-week cap.

             NET SETTLEMENT
    ----------------------------------------------------- Chapter 1:0.0.58

    Net settlement is the settlement of a number of obligations or
    transfers between or among counterparties on a net basis.

             NETTING
    ----------------------------------------------------- Chapter 1:0.0.59

    Netting is an agreed upon offsetting of positions or obligations by
    trading partners that can reduce a large number of individual
    obligations or positions to a smaller number.

             NETTING MEMBERS
    ----------------------------------------------------- Chapter 1:0.0.60

    Netting members are primarily government securities broker-dealers
    and banks that are capable of participating in the netting services
    through GSCC.

             NOVATION
    ----------------------------------------------------- Chapter 1:0.0.61

    Novation is an agreement to replace one party to a contract with a
    new party.  The novation transfers both rights and duties and
    requires the consent of both the original and the new party.

             OFFSETTING
    ----------------------------------------------------- Chapter 1:0.0.62

    Offsetting is liquidating a purchase of contracts (e.g., futures
    contracts) by the sale of an equal number of contracts with the same
    delivery month, thus closing out a position.

             ON-US CHECK
    ----------------------------------------------------- Chapter 1:0.0.63

    An "on-us check" is a check payable from funds on deposit at the same
    bank where it is presented for collection.

             OPEN OUTCRY
    ----------------------------------------------------- Chapter 1:0.0.64

    Open outcry is a form of trading whereby buyers and sellers trade by
    shouting their orders and using hand signals.

             OPPORTUNITY COSTS
    ----------------------------------------------------- Chapter 1:0.0.65

    Opportunity costs refer to the present value of income that could be
    earned (or saved) by investing in the most attractive alternative to
    the one being considered.

             OPTIONS ON FUTURES
    ----------------------------------------------------- Chapter 1:0.0.66

    An option on a futures contract gives an investor the right but not
    the obligation, in exchange for a price (called a premium), to buy or
    sell a specified futures contract at a specific price (called the
    exercise price) within a specified period.

             ORDER-BOOK OFFICIAL
    ----------------------------------------------------- Chapter 1:0.0.67

    An order-book official is an exchange official who accepts and
    executes limit orders from customers--orders to buy or sell when the
    market reaches a certain price.

             ORIGINATING DEPOSITORY
             INSTITUTION
    ----------------------------------------------------- Chapter 1:0.0.68

    An originating depository institution is a depository institution
    that initiates and warrants electronic payments processed through the
    ACH network on behalf of its customers.

             ORIGINATOR
    ----------------------------------------------------- Chapter 1:0.0.69

    An originator is the person or organization that initiates an ACH
    entry.

             PAYING BANK
    ----------------------------------------------------- Chapter 1:0.0.70

    A paying bank is the bank at which a check is payable and to which it
    is sent for payment or collection.

             PAYMENT PROCESSOR OR
             CREDIT CARD ASSOCIATION
    ----------------------------------------------------- Chapter 1:0.0.71

    A payment processor is an association dedicated to the settlement and
    clearance of transactions using credit cards.  Examples of such
    associations are VISA and MasterCard.

             PAYMENTS SYSTEM
    ----------------------------------------------------- Chapter 1:0.0.72

    Payments system is a collective term for mechanisms (both
    paper-backed and electronic) for moving funds, payments, and money
    among financial institutions throughout the nation.  The Federal
    Reserve plays a major role in the nation's payments system through
    distribution of currency and coin, processing of checks, electronic
    transfer of funds, and the operation of automated clearing houses
    that transfer funds electronically among depository institutions;
    various private organizations also perform payments system functions.

             PREMIUM
    ----------------------------------------------------- Chapter 1:0.0.73

    A premium is the amount that the buyer of an option pays the writer
    or seller of the option.

             PRESENTMENT FEE
    ----------------------------------------------------- Chapter 1:0.0.74

    A presentment fee is a fee that a bank receiving a check may impose
    on the bank that presents the check for payment.

             PROPRIETARY TRADING
    ----------------------------------------------------- Chapter 1:0.0.75

    Proprietary trading is the buying and selling for the trading
    institution's own account, in contrast to the trading the institution
    does on behalf of its customers.

             PUT OPTION
    ----------------------------------------------------- Chapter 1:0.0.76

    A put option is a contract that gives one the right, but not the
    obligation, to sell a specified amount of an underlying asset, such
    as stocks or currency, at a specified price by a certain date.

             REAL-TIME GROSS
             SETTLEMENT
    ----------------------------------------------------- Chapter 1:0.0.77

    Real-time gross settlement is a system that processes each
    transaction as it is initiated rather than processing it in a batch.
    Gross settlement means that the system settles each transaction
    individually.

             RECEIVER
    ----------------------------------------------------- Chapter 1:0.0.78

    A receiver is the individual or organization that has authorized an
    originator to initiate an ACH credit or debit transaction entry to
    the receiver's account with the receiving depository institution.

             REGISTERED OPTIONS TRADER
    ----------------------------------------------------- Chapter 1:0.0.79

    A trader that trades on the exchange floor but has an obligation to
    make markets similar to that of specialists.

             REPURCHASE AGREEMENT
    ----------------------------------------------------- Chapter 1:0.0.80

    A repurchase agreement is an agreement between a buyer and seller
    (usually) of U.S.  government securities, whereby the seller agrees
    to repurchase the securities at an agreed-upon price and, usually, at
    a stated time.

             RESPONDENT BANK
    ----------------------------------------------------- Chapter 1:0.0.81

    A respondent bank is a bank that regularly buys check processing and
    other services from a correspondent bank.

             RETURN ITEM
    ----------------------------------------------------- Chapter 1:0.0.82

    A return item is a transaction that has been returned by a receiving
    depository institution because it cannot be posted.

             SECURITIES
    ----------------------------------------------------- Chapter 1:0.0.83

    Securities refer to a financial instrument that represents a share of
    ownership in a corporation--a stock; a loan to a corporation,
    government, or governmental body--a bond; or conditional rights to
    ownership, e.g., an option.

             SELF-REGULATORY
             ORGANIZATIONS
    ----------------------------------------------------- Chapter 1:0.0.84

    Self-regulatory organizations are industry organizations and
    associations responsible for enforcement and practices in their
    market.

             SERIES OF OPTIONS
    ----------------------------------------------------- Chapter 1:0.0.85

    Series of options are all options of the same class that also have
    the same unit of trade, strike price, and expiration date.

             SERVER
    ----------------------------------------------------- Chapter 1:0.0.86

    A server is a computer that stores information that is retrieved by
    other computers.

             SETTLEMENT
    ----------------------------------------------------- Chapter 1:0.0.87

    In banking, settlement refers to the process of recording the debit
    and credit positions of two parties in a transfer of funds.  Also, it
    is the delivery of securities by a seller and the payment by the
    buyer.

             SETTLEMENT BANKS
    ----------------------------------------------------- Chapter 1:0.0.88

    Settlement banks are banks that maintain the settlement accounts for
    clearing members whereby payments and deposits are made.

             SPECIALIST
    ----------------------------------------------------- Chapter 1:0.0.89

    A specialist is a member designated by an exchange to be the sole
    market maker for a particular stock.

             SPECULATION
    ----------------------------------------------------- Chapter 1:0.0.90

    Speculation is the assumption of risk in anticipation of gain but
    recognizing a higher than average possibility of loss.  The term
    speculation implies that a business or investment risk can be
    analyzed and measured, and its distinction from the term investment
    is one of degree of risk.

             STOCK/EQUITY OPTION
    ----------------------------------------------------- Chapter 1:0.0.91

    A stock option gives one the right to purchase or sell a certain
    number of shares of stock at a particular price within a specified
    period.

             STORED-VALUE CARD
    ----------------------------------------------------- Chapter 1:0.0.92

    A stored-value card is a credit-card-sized device, implanted with a
    computer chip, with stored money value.  A reloadable stored-value
    card can be reused by transferring value to it from an automated
    teller machine or other device.  A disposable card cannot be
    reloaded.

             S.W.I.F.T.
    ----------------------------------------------------- Chapter 1:0.0.93

    The Society for Worldwide Interbank Financial Telecommunication is an
    international financial payment cooperative organization that
    operates a network that facilitates the exchange of payment and other
    financial messages between financial institutions throughout the
    world.

             SYSTEMIC RISK
    ----------------------------------------------------- Chapter 1:0.0.94

    Systemic risk refers to the risk that the failure of one participant
    in a transfer system (or financial markets generally) to meet its
    required obligations will cause other participants or financial
    institutions to be unable to meet their obligations when due.

             TRADE COMPARISON
    ----------------------------------------------------- Chapter 1:0.0.95

    Trade comparison is the receipt, validation, and matching of data on
    the long (buy) and short (sell) side of a transaction and the
    reporting of such match.

             TREASURY SECURITY
    ----------------------------------------------------- Chapter 1:0.0.96

    A Treasury security is a negotiable debt obligation of the U.S.
    government, backed by its full faith and credit, and issued with
    various maturities.

             UCC
    ----------------------------------------------------- Chapter 1:0.0.97

    The Uniform Commercial Code (UCC) is a set of model laws governing
    commercial and financial transactions.

             VALUE ADDED NETWORKS
    ----------------------------------------------------- Chapter 1:0.0.98

    Value added networks refer to a third-party service provider that
    manages data communications networks for businesses that exchange
    electronic data with other businesses.

             VERIFICATION
    ----------------------------------------------------- Chapter 1:0.0.99

    Verification is the ability to positively identify and authenticate a
    particular encrypted communication.

             WRITER (OPTION)
    ---------------------------------------------------- Chapter 1:0.0.100

    An options seller is called a writer of options, a "covered" writer
    if owning the underlying asset and a "naked" writer if not.  The
    writer of an option is obligated to sell, in the case of a call
    option, or buy, in the case of a put option, a specified amount of
    the underlying asset at a predetermined price when the buyer or
    holder exercises the option.  The writer earns a premium paid by the
    buyer.

    *** End of document. ***