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. ***