Self-Regulatory Organizations; The Depository Trust Company; Order Temporarily Approving a Proposed Rule Change Expanding the Money Market Instrument Settlement Program on a Pilot Basis

SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-33958; File No. SR-DTC-93-12]

Self-Regulatory Organizations; The Depository Trust Company;

Order Temporarily Approving a Proposed Rule Change Expanding the Money

Market Instrument Settlement Program on a Pilot Basis

April 22, 1994.

On October 19, 1993, The Depository Trust Company (``DTC'') filed

with the Securities and Exchange Commission (``Commission'') a proposed

rule change (File No. SR-DTC-93-12) under section 19(b)(1) of the

Securities Exchange Act of 1934 (``Act'')\1\ to implement a pilot

program to include additional types of money market instruments

(``MMIs'') in its MMI settlement program. Notice of the proposal was

published in the Federal Register on November 8, 1993.\2\ The

Commission did not receive any comment letters on the proposed rule

change.\3\ For the reasons discussed below, the Commission is granting

temporary approval of the pilot program until April 30, 1995.

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\1\15 U.S.C. 78(b)(1) (1988).

\2\Securities Exchange Act Release No. 33126 (November 1, 1993),

58 FR 59283.

\3\At the request of the Commission, the Federal Reserve Bank of

New York (``FRBNY''), and the Board of Governors of the Federal

Reserve System (``Fed'') DTC issued a notice to participants

requesting comment on issues raised by the regulators. DTC received

ten comment letters. The issues and the comment letters will be

discussed in detail later in this approval order.

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I. Description

A. Generally

The proposed rule change makes DTC's existing MMI settlement

services available for transactions in additional types of MMIs. New

MMI programs include those for institutional certificates of deposit

(``CD''), municipal commercial paper, and bankers' acceptances. The

existing DTC MMI programs to be expanded or enhanced include those for

corporate commercial paper, medium-term notes, preferred stock in a CP-

like mode, short-term bank notes, and discount notes.

The new MMI programs, along with the existing MMI programs, are an

extension of DTC's Same-Day Funds Settlement (``SDFS'') system.\4\The

automated operating procedures for MMIs are virtually the same as those

followed by SDFS participants and by Institutional Delivery (``ID'')

system users for basic depository services in other eligible SDFS

securities. The MMI issues being made SDFS-eligible will be distributed

in book-entry-only form by the issuer's issuing agent that, as in the

commercial paper (``CP'') and medium-term note MMI programs, will send

MMI issuance instructions to DTC electronically. Settlement of an issue

will be on the same day as the issuance or on a specified future day.

The issuer's paying agent, that will also serve as DTC's custodian,

will hold a master or balance MMI certificate for DTC unless the issuer

and its issuing and paying agent bank choose to distribute

uncertificated MMIs through DTC.\5\Because SDFS-eligible MMIs will be

book-entry-only, participant operating procedures for deposits and

withdrawals will not apply to MMIs.

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\4\DTC's SDFS system currently includes the following issue

types: Corporate commercial paper, municipal notes and bonds,

municipal variable-rate demand obligations, zero coupon bonds backed

by U.S. Government securities, continuously offered medium-term

corporate notes, short-term bank notes, auction-rate and tender-rate

preferred stocks and notes, collateralized mortgage obligations and

other asset-backed securities, Government trust certificates and

Government agency securities not eligible for the Fed's book-entry

system, retail certificates of deposit, corporate and municipal

variable mode obligations, corporate bonds, discount notes, and unit

trusts. For a detailed description and discussion of DTC's SDFS

system, including the implementation of the commercial paper

program, refer to Securities Exchange Act Release Nos. 26051 (August

31, 1988), 53 FR 34853 [File No. SR-DTC-88-06] (order permanently

approving DTC's SDFS system) and 30986 (July 31, 1992), 57 FR 35856

[File No. SR-DTC-92-01] (order approving implementation of

commercial paper program).

\5\Uncertificated MMIs are not evidenced by any certificate

whatsoever. Bills, notes, bonds, and other securities have been

issued in uncertificated form by U.S. government and federal

agencies for many years.

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B. New MMI Programs

The fundamental risk in the SDFS system is that a participant will

default in its payment obligation. The new MMI programs are offered as

an extension of DTC's current SDFS system; therefore, DTC will employ

the same risk management controls (e.g., net debit collateralization,

net debit caps, and receiver-authorized deliveries) to transactions in

these new programs as are employed in the current SDFS system.\6\

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\6\supra note 4.

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Net debit collateralization requires each participant to maintain

in its account throughout the processing day collateral at least equal

in value to the participant's net settlement debit. If during the

processing day a transaction will cause a net debit greater than the

amount of collateral in the participant's account at the time the

transaction is being processed, DTC will recycle the transaction until

there is sufficient collateral in the participant's account.

Transactions in the new MMI programs also will be subject to the

participant's net debit cap.\7\ The net debit cap helps to protect

against abnormal intraday debit peaks that are out of line with a

participant's prior month's average daily activity level. The net debit

cap also reduces the possibility that the failure to settle by more

than one participant will not cause DTC to exceed its liquidity

resources. The new MMI programs also will utilize the receiver-

authorized delivery control which allows a participant to monitor

deliveries and payment orders directed to its account before the orders

are posted to the account.

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\7\Each participant's net debit is limited throughout the

processing day to a net debit cap that is the least of the following

four amounts: (1) an amount forty times the participant's required

and voluntary deposits to the SDFS fund, (2) an amount that is equal

to seventy-five percent of DTC's liquidity resources, including cash

deposits to the SDFS fund and lines of credit for loans to

facilitate SDFS settlement, (3) an amount, if any, determined by the

participant's settling bank, and (4) an amount, if any, determined

by DTC. Supra note 4.

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In addition, DTC's three failure to settle procedures applicable to

the CP program will be applicable to the new MMI programs. First, DTC

will employ the same procedures with regard to the sequence in which

DTC will use MMI collateral and eliminate payment order debits in a

failing participant's account. Second, if DTC is notified before 3 p.m.

eastern standard time (``E.S.T.'') that a paying agent will not pay on

an MMI issuer's maturity presentments, reorganization presentments,

periodic principal presentments, or periodic income presentments or if

DTC is informed of an MMI issuer's bankruptcy and a participant fails

to settle with DTC on that day, DTC has the authority to reduce the

settlement credits of participants who had transactions on the day of

default with the defaulting issuer or the defaulting participant on the

day of the default. Third, if the paying agent has not settled with DTC

by noon E.S.T. on the DTC business day following the settlement day or

if a paying agent is determined to be insolvent according to DTC's

rules, DTC will notify the issuers utilizing that paying agent and

provide those issuers with information on any presentments related to

their MMIs on which the PA failed to pay DTC.

C. Expanded or Improved Existing MMI Programs

DTC will be expanding its CP program to include ``uncommon CP.''

Uncommon CP is CP paying income periodically, a variable amount of

income, or a variable amount of principal. It also includes CP

denominated in a foreign currency, CP with a maturity of 271 days to a

year, or corporate variable-rate demand obligations in CP mode. These

instruments were not included in the original CP program.

DTC also will be enhancing their MMI programs for medium-term

notes, short-term notes, discount notes, and preferred stock in CP-like

mode. The medium-term note program will be enhanced by DTC's collection

and allocation of income, principal, reorganization, and maturity

payments within the SDFS system. Paying agents will no longer have to

separately wire such payments to DTC. Instead, as with maturity

payments in the CP program, these payments will be included in each

paying agent's net settlement figure due to or from DTC at the end of

each day. Similarly, the short-term note program will be enhanced with

the inclusion in the SDFS system maturity payments and periodic income

payments in the SDFS system and in the paying agents' net SDFS amounts

due to or from DTC. The restriction that short-term notes must have a

minimum maturity period of thirty days to be included in this program

will be removed. The short-term notes program, the discount notes

program, and the preferred stock in CP-like mode program will all

provide for uncertificated issuer programs. However, one master note or

certificate may be held for DTC by the paying agent.

II. Discussion

Section 17A(b)(3)(F)\8\ of the Act requires that the rules of a

clearing agency be designed to promote the prompt and accurate

clearance and settlement of securities transactions and to assure the

safeguarding of securities and funds which are in the custody or

control of the clearing agency or for which it is responsible. As

discussed below, the Commission believes the DTC's proposed rule change

is consistent with DTC's obligations under the Act.

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\8\15 U.S.C. 78q-1(b)(3)(F) (1988).

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As previously described, the new MMI programs and the expanded and

enhanced programs are an extension of DTC's current SDFS system and

include many of the same risk management features that are employed in

the SDFS system. The Commission previously examined these features when

DTC first proposed the SDFS system and again when the CP program was

added.\9\ At those times, the Commission found, and continues to

believe, that these risk management measures are consistent with

Section 17A of the Act and should minimize the impact of a default by a

participant in the SDFS system.

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\9\Supra note 4.

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The use of provisional credits and unwind procedures if an MMI

issuer were to default, however, could increase the risk of settlement

gridlock in certain circumstances. For example, if DTC were to confirm

the insolvency of an MMI issuer before 3:00 p.m.,\10\ DTC would reverse

all participants' credits attributable to the insolvent issuer without

regard to any of the risk management controls. Such reversals of

credits could result in a participant having a net debit that exceeds

the participant's net debit cap and DTC's liquidity resources. If such

a participant then failed to settle its net debit with DTC, DTC would

possibly have difficulty completing other settlements thus creating

systemic risk.

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\10\If DTC cannot confirm that an MMI issuer is insolvent before

3 p.m. EST., DTC will not reverse credits attributable to that

issuer because after 3 p.m. E.S.T. credits are no longer provisional

in DTC's SDFS system.

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As an interim solution, DTC proposed for comment the implementation

of an additional $500 million line of credit dedicated to the

completion of settlement in the SDFS system in the event a participant

fails to settle after application of the unwind procedures. The

additional line of credit would be supported by securities pledged to

the SDFS fund and would not be included as a part of DTC's liquidity

resources when determining a participant's net debit cap. DTC also

proposed as a long term solution, a SDFS system enhancement that would

conduct default scenarios to assure that unwind procedures would not

cause a liquidity problem.\11\

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\11\DTC has proposed two SDFS system enhancements that will

eventually replace the additional line of credit dedicated to

settlement in the SDFS system. The future system enhancements will

retain unwind procedures but will allow DTC to run intraday

computerized double default scenarios (i.e., an MMI issuer default

and an SDFS participant default due to debits created by the unwind

procedures) to help assure that each participant's net debit is

within DTC's liquidity resources.

Under the first system enhancement, DTC will subtract from a

participant's actual overall SDFS net debit or credit amount the

amount of the participant's largest provisional net credit due to

transactions in any single issuer's MMIs. DTC then will limit the

resulting net debit from all other SDFS transactions (``liquidity

net debit'') to the amount of DTC's liquidity resources (``liquidity

net debit cap''), which as of April 18, 1994, was approximately $760

million. If a transaction will cause a participant's liquidity net

debit to exceed DTC's liquidity net debit cap, DTC will block and

recycle the transaction until credits are received from transactions

in MMIs of MMI issues other than those of the issuer of the largest

provisional net credit.

Under the second system enhancement, DTC will subtract the

amount of a participant's largest provisional net credit due to

transactions in any single issuer's MMIs from the participant's

collateral monitor (``simulated collateral monitor''). If a

transaction will cause the simulated collateral monitor to turn

negative (i.e., the participant's collateral would be insufficient

to cover its simulated net debit after the transaction), the

transaction will be blocked. Blocked transactions will be recycled

until credits from other transactions in MMIs of issuers other than

those of the largest provisional net credit cause the simulated

collateral monitor to be positive.

DTC expects to implement the two system enhancements subsequent

to the industry conversion to same-day funds settlement that is

scheduled for implementation in 1996. Letter from Richard B. Nesson,

Executive Vice President and General Counsel, DTC, to Peter R.

Geraghty, [Staff Attorney], Division of Market Regulation,

Commission (April 18, 1994).

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DTC solicited comment from its participants regarding (1) the

necessity of unwind procedures in the SDFS service that override risk

management controls and (2) if unwind procedures are necessary, whether

participants would be prepared to absorb the additional costs of

mechanisms to assure that use of the unwind procedures on the same day

that any DTC participant failed to settle would not deplete DTC's

liquidity resources. DTC received ten comment letters from participants

and two from industry organizations.\12\ Generally, the comments

supported the use of unwind procedures as a way to replicate the risks

taken by parties to transactions in the physical MMI market (i.e., to

place the risk and burden of default on the appropriate party, which is

on the issuer or the purchaser instead of on the issuing and paying

agent). The comments also generally supported the interim solution of

obtaining an additional, dedicated line of credit and allocating its

cost to SDFS system participants.

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\12\Letters from Albert Howell, Vice President, Money Market

Operations, Merrill Lynch, to James Reilly, Vice President, DTC

(March 7, 1994); Christopher T. Amico, Assistant Vice President,

Chemical Bank, to James Reilly, Vice President, DTC (February 1,

1994); Gary S. Schayne, Vice President, Citibank, to James Reilly,

Vice President, DTC (January 31, 1994); Ronald M. Thalheimer, Vice

President, The First National Bank of Chicago, to James Reilly, Vice

President, DTC (February 3, 1994); Michael J. Stein, Vice President,

State Street Bank and Trust Company, to James Reilly, Vice

President, DTC (February 7, 1994); Stephen J. Melanaski, Vice

President, United States Trust Company of New York, to James Reilly,

Vice President, DTC (January 21, 1994); Mark Handsman, Vice

President-Assistant Treasurer, Goldman Sachs, to James Reilly, Vice

President, DTC (February 23, 1994); Michael J. Gardiner, Vice

President, The Chase Manhattan Bank, N.A., to James Reilly, Vice

President, DTC (February 28, 1994); S. Michael Barnes, Vice

President, and Lloyd A. Baggs, Trust Officer, Morgan Guaranty Trust

Company of New York, to James Reilly, Vice President, DTC (February

24, 1994); R. May Lee, Assistant General Counsel, Public Securities

Association, to James Reilly, Vice President, DTC (March 2, 1994);

Jill M. Considine, President, New York Clearing House to James

Reilly, Vice President, DTC (March 23, 1994).

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Two of DTC's bank participants did not support DTC's proposals and

offered alternative solutions. One of these two commentators argued

that issuing and paying agents should fund presentments earlier or that

unwind procedures should be employed earlier in the day.\13\ The other

commentator suggested that DTC should create a system similar to the

procedures employed by the Clearing House Interbank Payment System.\14\

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\13\Letter from State Street Bank and Trust Co., supra note 12.

\14\Letter from Bankers Trust Co., supra note 12.

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DTC has agreed to implement the dedicated line of credit as an

interim solution and proceed with the necessary modifications to

implement the system enhancements. DTC also has agreed to continue to

employ its liquidity monitoring system which simulates double default

scenarios every fifteen minutes beginning at 2 p.m. E.S.T.\15\

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\15\Letter from Richard B. Nesson, DTC to Christine M. Cumming,

Vice President, Domestic Banking Department, FRBNY (March 8, 1994).

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DTC will begin the expansion of its MMI programs with the

institutional CDs programs. DTC will begin the pilot program with four

bank issuers and will expand the pilot program over the net two months.

Until DTC secures the additional $500 million line of credit, the pilot

program will be limited to: (1) 120 CD programs, (2) A value not to

exceed $20 billion on deposit with DTC, (3) A percentage of the total

CD market on deposit at DTC not to exceed 5.7%, and (4) A daily average

face amount of CD issuances not to exceed $1 billion.\16\ DTC has

agreed that if prior to securing the $500 million line of credit the

addition of CDs according to the schedule increases simulated breaches

of its liquidity resources (currently $760 million), DTC will slow down

or stop the addition of CD programs after consultation with the

regulators. DTC also has agreed that if subsequent to attaining the

additional line of credit, simulations show breaches of DTC's new

overall liquidity resources, due to the expansion of the MMI program to

include different types of MMI instruments, DTC again will slow down or

stop expansion of the program after consultation with the

regulators.\17\

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\16\Supra note 11.

\17\Supra note 15.

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The Commission believes that the additional risk management

controls to be implemented with the new and enhanced MMI programs in

conjunction with the current SDFS system risk management controls

should help further reduce the possibility that a double default

scenario will exceed DTC's liquidity resources. In addition, the

Commission believes the controlled expansion of the SDFS program to

include additional types of MMIs will reduce the costs, inefficiencies,

and risks associated with the clearance and settlement of physically

transferred securities by providing the benefits of centralized,

automated, book-entry clearance and settlement.

III. Conclusion

On the basis of the foregoing, the Commission finds that the

proposed rule change is consistent with the requirements of the Act and

in particular with the requirements of Section 17A of the Act, and the

rules and regulations thereunder.

It is therefore ordered, pursuant to section 19(b)(2) of the

Act,\18\ that the proposed rule change (File No. SR-DTC-93-12) be, and

hereby is, approved on a temporary basis until April 30, 1995.

\18\15 U.S.C. 78s(b)(2).

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For the Commission by the Division of Market Regulation,

pursuant to delegated authority.\19\

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\19\17 CFR 200.30-3(a)(12).

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Margaret H. McFarland,

Deputy Secretary.

[FR Doc. 94-10474 Filed 5-2-94; 8:45 am]

BILLING CODE 8010-01-M