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United States Government Accountability Office: 
Washington, DC 20548: 

February 26, 2009: 

The Honorable Carl Levin:
Chairman:
Permanent Subcommittee on Investigations: 
Committee on Homeland Security and Governmental Affairs: 
United States Senate: 

The Honorable Charles Grassley:
Ranking Member:
Committee on Finance:
United States Senate: 

Subject: Securities and Exchange Commission: Oversight of U.S. Equities 
Market Clearing Agencies: 

An effective clearance and settlement process is vital to the 
functioning of equities markets. When investors agree to trade an 
equity security, the purchaser promises to deliver cash to the seller 
and the seller promises to deliver the security to the purchaser. The 
process by which the seller receives payment and the buyer, the 
securities, is known as clearance and settlement. In the United States 
equities market, a centralized clearance and settlement system was 
established to reduce risks and increase efficiency in the market. As 
part of this system, trades in equities and other securities are 
typically cleared and settled through clearing agencies--self- 
regulatory organizations (SRO) that are required to register with and 
are subject to oversight by the Securities and Exchange Commission 
(SEC). Virtually all equities securities trades in the United States 
are cleared and settled through the National Securities Clearing 
Corporation (NSCC) and the Depository Trust Company (DTC), clearing 
agency subsidiaries of the Depository Trust and Clearing Corporation 
(DTCC). According to DTCC, 99.9 percent of daily transactions by dollar 
value clear and settle within the standard 3-day settlement period. In 
the remaining transactions, the seller failed to deliver the securities 
on time, resulting in a fails to deliver (FTD). On December 31, 2007, 
the value of aggregated FTDs was $7.5 billion. 

According to SEC, many FTDs are caused by processing delays or 
mechanical errors, and are typically resolved within a few days. FTD 
can also result from naked short selling. While not defined in the 
federal securities laws or SRO rules, according to SEC, naked short 
selling generally refers to selling short without having borrowed the 
securities to make delivery; potentially resulting in a FTD.[Footnote 
1] When FTDs persist for days or months, they can accumulate to a level 
that may affect the market for that security. In recent years, 
investors, publicly traded companies, and others have expressed 
concerns regarding the intentional failures to deliver by some 
investors. For example, FTDs may be indicative of an illegal trading 
strategy known as manipulative naked short selling, in which short 
sellers attempt to profit by using naked short selling to inundate the 
market with sales of a security and manipulate its price downward. FTDs 
may also deprive shareholders of the benefits of ownership, such as 
voting and lending. 

SEC has taken several actions, in recent years, that were intended to 
address FTD and the potential for manipulative naked short selling. In 
August 2004, SEC adopted Regulation SHO, which intended to address 
large and persistent FTDs and curb the potential for manipulative naked 
short selling by requiring clearing agency participants (participants) 
to close out FTD positions lasting 13 consecutive settlement days in 
certain equity securities.[Footnote 2] In July 2008, concerned that 
false rumors may have fueled market volatility in financial 
institutions of significance, SEC temporarily restricted naked short 
selling in 19 financial stocks by issuing an emergency order requiring 
short sellers to pre-borrow securities before effecting short sales in 
these stocks and deliver the securities by settlement date, with 
limited exceptions. In September 2008, SEC took further action to try 
to curb potential manipulative naked short selling and to address 
volatile markets by issuing an emergency order requiring participants 
with FTD on the third settlement day after trade date, in any equity 
security, to take action to close out their position on the following 
morning, with limited exceptions. SEC extended this requirement in the 
form of an interim final temporary rule in October 2008. 

To facilitate and monitor industry compliance with these rules and 
emergency orders, NSCC electronically submits FTD data daily to SEC and 
the stock exchanges. Because the prompt and accurate settlement of 
trades is essential to the smooth functioning of the United States' 
equities markets, you asked us to provide a background briefing on: (1) 
NSCC and DTC processes for clearing and settling equities trades, 
including their process for identifying and addressing FTD; and (2) 
SEC's efforts to ensure the reliability and efficiency of the clearance 
and settlement system through its examination program for clearing 
agencies.[Footnote 3] 

On January 30, 2009, we briefed the committees' staffs on the results 
of this work. This letter summarizes the briefing. Enclosure I contains 
the full briefing. In response to questions asked during the briefing, 
we have added information to the enclosed briefing slides to clarify 
the acronyms used in these slides. 

To describe NSCC and DTC processes for clearing and settling equities 
trades, including their process for identifying and addressing FTD, we 
reviewed NSCC and DTC rules and procedures, annual reports, press 
releases, a 2005 examination conducted by SEC's Office of Compliance 
Inspections and Examinations (OCIE), and a 2006 amicus brief filed by 
SEC on behalf of DTCC in the Supreme Court of Nevada. We also 
interviewed DTCC officials. To describe SEC's efforts to ensure the 
reliability and efficiency of the clearance and settlement system 
through its examination program for clearing agencies, we reviewed the 
2007 Clearing Agency Examination Guidance issued by OCIE and compared 
it to inspection community best practices; including GAO's Yellow Book, 
federal banking regulators' examination guidance, and Inspectors 
General Examination Standards.[Footnote 4] We also reviewed 13 of 28 
clearing agency examinations completed between August 7, 2000, and 
September 30, 2008, to assess OCIE's compliance with the routine 
examination schedule set forth in the guidance and its procedures for 
recommendation tracking. We chose to review 11 examinations completed 
during this time frame, based on the clearing agency's involvement in 
the clearance and settlement of equity securities transactions, and 2 
additional examinations that OCIE completed after issuing the 2007 
guidance. We did not, however, evaluate the scope, methodology, 
findings, or recommendations related to the 13 examinations. We also 
reviewed training materials OCIE provides to its clearing agency 
examiners and interviewed OCIE officials and clearing agency examiners. 

We conducted our work from February 2008 to February 2009, in 
accordance with all sections of GAO's Quality Assurance Framework that 
are relevant to our objectives. The framework requires that we plan and 
perform the engagement to obtain sufficient and appropriate evidence to 
meet our stated objectives and discuss any limitations in our work. We 
believe that the information and data obtained, and the analysis 
conducted, provide a reasonable basis for any findings and conclusions. 

Background: 

There are two types of clearing agencies: clearing corporations and 
depositories. Clearing corporations provide several essential services 
to the market, including comparing and confirming trade data submitted 
by participants (or reporting to participants the results of trade 
comparisons submitted by the exchanges), acting as the common 
counterparty and guaranteeing the completion of the trade if either 
side defaults or goes out of business, and preparing instructions for 
their participants regarding their settlement obligations. 

Depositories also provide multiple services to the market by retaining 
custody of equity and debt securities issues and maintaining ownership 
records. Specifically, depositories effect deliveries of securities 
between participants via a book entry system that transfers ownership 
of securities electronically, thus eliminating the need for the 
physical movement of securities. Depositories receive instructions from 
the clearing corporation to deliver and receive securities on behalf of 
its participants, or from participants themselves, to move securities 
from one participant's account to another. Depositories also 
communicate with settling banks--banks that transfer money to and from 
DTC and NSCC on behalf of customers--to net settle any financial 
obligations. 

The Securities and Exchange Act of 1934 (Exchange Act) established the 
regulatory framework for clearing agencies.[Footnote 5] Section 17A 
established a system of SEC registration for clearing agencies and 
includes general criteria that clearing agencies must satisfy in order 
to be registered. Section 19 established clearing agencies as SROs, as 
well as provided a framework for SEC oversight over all SROs, including 
SEC review and approval of most clearing agency rules.[Footnote 6] 

SEC oversees clearing agencies primarily through its Division of 
Trading and Markets (Trading and Markets), OCIE, and the Division of 
Enforcement (Enforcement). Trading and Markets administers and executes 
the agency's programs relating to the structure and operations of the 
securities markets, which include regulation of clearing agencies and 
review of their proposed rule changes. OCIE examines clearing agencies 
to assess the overall safety, reliability, and efficiency of the 
clearing agency and its operations. It also examines clearing agencies 
for compliance with their own rules and applicable federal laws and 
regulations. Enforcement investigates and prosecutes violations of 
securities laws. 

Summary: 

Trade clearance and settlement in the United States operates on a 
standard 3-day settlement cycle. Due to the volume and value of trading 
in today's markets, NSCC nets trades and payments among its 
participants, using its Continuous Net Settlement System. This is a 
book entry accounting system, whereby each NSCC participant's daily 
purchases and sales of securities, based on trade date, are 
automatically netted into one long position (right to receive) or one 
short position (obligation to deliver) for each securities issue 
purchased or sold.[Footnote 7] The participant's corresponding payment 
obligations are, similarly, netted into one obligation to pay or one 
obligation to receive money.[Footnote 8] For each participant with a 
short position on settlement date, NSCC instructs the securities 
depository designated by the participant--typically DTC--to deliver 
securities from the participant's account at the depository to the 
NSCC's account. NSCC then instructs the depository to deliver those 
securities from NSCC's account to participants with net long positions 
in the security. 

If a participant fails to deliver the total number of securities that 
they owe NSCC on a particular settlement date, NSCC may be unable to 
meet its delivery obligations, resulting in a fails to receive (FTR) 
for participants who have net long positions. NSCC uses the automated 
Stock Borrow Program to borrow shares to meet as many of its delivery 
obligations as possible. This program allows participants to instruct 
NSCC on the specific securities from their DTC account that are 
available for borrowing to cover NSCC's Continuous Net Settlement 
System delivery shortfalls. Any shares that NSCC borrows are debited 
from the lending participant's DTC account, delivered to NSCC, and, 
subsequently, delivered to a NSCC participant with a net short 
position. NSCC creates a right to receive (net long) position for the 
lender in the Continuous Net Settlement System to show that it is owed 
securities. Until the securities are returned, the lending participant 
no longer has ownership rights in them and, therefore, cannot re-lend 
them. Additionally, any delivery made using the Stock Borrow Program 
does not relieve the participant who fails to deliver from its delivery 
obligation to NSCC. 

OCIE oversees the clearing agency examination program and conducts both 
regular cycle and special examinations of clearing agencies. The 
largest clearing agencies (including NSCC and DTC), which provide 
centralized clearing services, are examined every other year. The 
smaller clearing agencies are examined on a two-or three-year cycle, 
depending on resources. In addition to regular cycle examinations, OCIE 
conducts special examinations targeting clearing activities of more 
than one clearing agency. 

To assist its examiners in planning and conducting examinations, OCIE 
has developed written guidance. OCIE revised and expanded this guidance 
in March 2007. The revised guidance discusses aspects of planning and 
conducting an examination, consistent with inspection community best 
practices. Specifically, the guidance provides examiners with 
background information related to clearing agency functions and the 
legal framework governing them. It also discusses examination planning, 
including staffing, risk-assessment, and coordination with other SEC 
divisions, as well as federal and state regulators; field work, 
including interviews, document requests, sampling and testing of 
parameters; the preparation of the examination reports and deficiency 
letters; and the review and tracking of clearing agencies' responses to 
examination findings and recommendations. The guidance also identifies 
key areas in which examiners may focus during a review. These areas are 
derived from the clearing agency standards contained in Section 17A of 
the Exchange Act and the interpretive guidance issued by Trading and 
Markets. 

To better understand OCIE's examination procedures related to clearance 
and settlement, we reviewed a 2005 examination of NSCC's Continuous Net 
Settlement System/Stock Borrow Program. We found that OCIE incorporated 
a review of NSCC's role in the implementation of Regulation SHO during 
this examination. In particular, examiners reviewed the short position 
reports that are generated daily from the Continuous Net Settlement 
System. NSCC transmits the FTD data from these reports to the SROs, who 
then determine those securities that qualify as threshold securities. 
As part of their review, examiners performed independent testing of a 
sample of securities included in these reports. OCIE's review did not 
raise any reliability concerns with the short position reports. 

In addition, in response to media criticism and allegations made by 
certain issuers and shareholders that NSCC and DTC were facilitating 
naked short selling through the operation of the Stock Borrow Program, 
OCIE also incorporated a review of this program into the scope of its 
2005 examination. These critics argued that the Stock Borrow Program 
exacerbated naked short selling by creating and lending shares that are 
not actually deposited at DTC, thereby, flooding the market with shares 
that do not exist. As part of their review, OCIE examiners tested 
transactions in securities that were the subject of the above 
referenced allegations or had high levels of prolonged FTD. The 
examination did not find any instances where critics' claims were 
validated. However, we did not validate OCIE's findings. 

Agency Comments and Our Evaluation: 

We provided a draft of the enclosed briefing to SEC and relevant 
portions to DTCC. We received technical comments that were 
incorporated, where appropriate. We also provided a draft of this 
correspondence to the Chairman of the SEC for her review and comment. 
SEC provided written comments on the draft, which we have reprinted in 
enclosure II. In its written comments, SEC said that OCIE takes its 
responsibility to provide effective oversight of the clearance and 
settlement system for the U.S. equities markets seriously. It also 
noted that an effective clearance and settlement process is vital for 
the functioning of the U.S. securities markets. 

As agreed with your offices, unless you publicly announce its contents 
earlier, we plan no further distribution until 30 days from the report 
date. At that time, we will send copies to interested congressional 
committees and the Chairman of the SEC. The report also will be 
available at no charge on the GAO Web site at [hyperlink, 
http://www.gao.gov]. 

If you or your staffs have any questions about this report, please 
contact me at (202) 512-8678 or williamso@gao.gov. Contact points for 
our Offices of Congressional Relations and Public Affairs can be found 
on the last page of this report. Major contributors to this report were 
Karen Tremba, Assistant Director; Stefanie Jonkman; Matthew Keeler; 
Carl Ramirez; Barbara Roesmann; and Paul Thompson. 

Signed by: 

Orice M. Williams:
Director, Financial Markets and Community Investment: 

Enclosures: 

[End of section] 

Enclosure I: 

Securities and Exchange Commission: Oversight of U.S. Equity Market 
Clearing Agencies: 

Briefing: 

The Honorable Carl Levin: 
Chairman: 
Permanent Subcommittee on Investigations: 
Committee on Homeland Security and Governmental Affairs: 
United States Senate: 

The Honorable Charles Grassley: 
Ranking Member: 
Committee on Finance: 
United States Senate: 

January 30, 2009: 

Overview: 
* Abbreviations; 
* Introduction; 
* Objectives; 
* Summary of Findings; 
* Scope and Methodology; 
* Background; 
* Discussion of Objectives. 

Abbreviations: 

CNS: Continuous Net Settlement: 

DTC: Depository Trust Company: 

DTCC: Depository Trust and Clearing Corporation: 

FTD: Fails to Deliver: 

FTR: Fails to Receive: 

NSCC: National Securities Clearing Corporation: 

OCIE: Office of Compliance Inspections and Examinations: 

Participants: Clearing agency participants: 

SBP: Stock Borrow Program: 

SEC: Securities and Exchange Commission: 

SRO: Self-Regulatory Organization: 

T: Trade Date: 

[End of section] 

Introduction: 

When investors agree to a trade, the purchaser promises to deliver cash 
to the seller and the seller promises to deliver the securities to the 
purchaser. 

In the U.S. equities markets, a centralized clearance and settlement 
system was established to reduce risks and increase efficiency in the 
market. 

Trades in equities and most other securities in the United States are 
typically cleared and settled through clearing agencies. Clearing 
agencies are self-regulatory organizations (SRO) that are required to 
register with and are subject to oversight by the Securities and 
Exchange Commission (SEC). 

Virtually all equities trades in the United States are cleared and 
settled through the Depository Trust Company (DTC) and the National 
Securities Clearing Corporation (NSCC), clearing agency subsidiaries of 
the Depository Trust and Clearing Corporation (DTCC). 

In 2007, NSCC processed 13.5 billion transactions, totaling $283 
trillion. 

Average daily transactions were 54 million, totaling an average of $1.1 
trillion. 

According to DTCC, 99.9 percent of daily transactions, by dollar 
volume, clear and settle within the standard 3-day settlement period. 

* In the remaining transactions, NSCC members did not deliver their 
securities on time, resulting in fails to deliver (FTD). 

* On Dec. 31 2007, the value of aggregated FTD to NSCC totaled $7.5 
billion. 

According to SEC, many FTD are caused by mechanical error or processing 
delays, and typically, are resolved within a few days. 

However, FTD also can result from naked short selling. Naked short 
selling, while not defined in federal securities laws, generally refers 
to selling short without having borrowed the securities to make 
delivery, potentially resulting in a FTD.[Footnote 9] 
* FTD that persist for days or months can accumulate to a level that
could affect the market for that security. 

In recent years, investors, publicly traded companies, and others have
expressed concerns about intentional FTD. 
* FTD may deprive shareholders of the benefits of ownership, such as
voting and lending. 
* FTD may be indicative of an illegal trading strategy known as 
manipulative naked short selling, in which short sellers attempt to 
profit by using naked short selling to flood the market with sales of a
stock and manipulate its price downward. 

SEC has taken several actions in recent years to address FTD and the
potential for abusive naked short selling. 
* Regulation SHO: Issued in August 2004 and subsequently amended. Among 
other things, the regulation requires equities markets to publish daily 
lists of securities with significant levels of FTD.[Footnote 10] 
- Clearing agency participants (participants) with FTD in these 
securities lasting 13 consecutive settlement days must close out their 
positions.
* July 2008 Emergency Order: SEC temporarily restricted naked short 
selling in 19 financial stocks by requiring short sellers to pre-borrow
securities and deliver by settlement date, with limited exceptions. 
* September 2008 Emergency Order and October 2008 Interim Final 
Temporary Rule: SEC required participants with FTD on the third 
settlement day after trade date, in any equity security, to take action
on the next morning to close out their position, with limited
exceptions. 

To facilitate and monitor industry compliance with these rules and 
emergency orders, NSCC electronically submits FTD data daily to SEC and 
the stock exchanges. Because the prompt and accurate settlement of 
trades is essential to the smooth functioning of the U.S. equities 
markets, we have conducted an overview of: 

* (1) NSCC and DTC processes for clearing and settling
equities trades, including their processes for identifying and
addressing FTD; and; 

* (2) SEC’s efforts to ensure the reliability and efficiency of the
clearance and settlement system through its examination
program for clearing agencies.[Footnote 11] 

[End of section] 

Summary of Findings: Objective 1: 

NSCC nets trades and payments among its participants using its
Continuous Net Settlement system (CNS). 

* Each day, for each security in which the member has transacted 
business, CNS tabulates the member’s daily purchases and sales of the 
security to determine whether the member has a net obligation to 
deliver securities to NSCC or receive securities from NSCC. 

* NSCC members who do not deliver securities they owe NSCC in time for 
settlement maintain a short, or FTD position, on the books of CNS until 
they satisfy their delivery obligation. 

NSCC has created the Stock Borrow Program (SBP) to allow willing 
members to temporarily lend securities to NSCC to cover delivery 
shortfalls caused by other members’ delivery failures. It does not 
alleviate the failing member’s responsibility to deliver the securities 
they owe and only addresses a portion of open FTD. According to DTCC, 
by facilitating delivery of securities to the buyer, SBP generally 
covers between 15-20 percent of FTD each settlement cycle. 

Summary of Findings: Objective 2: 

SEC’s Office of Compliance Inspections and Examinations (OCIE) recently 
revised written guidance for its examination program for clearing 
agencies discussed aspects of planning and conducting an examination 
consistent with inspection community best practices. 

* OCIE conducts routine examinations of clearing agencies every two to 
three years, depending on their size. 

* In response to concerns that NSCC and DTC were facilitating naked 
short selling through the operation of SBP, OCIE incorporated a review 
of SBP into the scope of a 2005 routine examination. OCIE also reviewed 
the process NSCC uses to generate the FTD reports used by SEC and SROs 
to facilitate and monitor compliance with Regulation SHO. OCIE found 
both programs to be operating as intended. 

OCIE examinations can result in findings and recommendations to the
clearing agency. Twelve of the 13 examinations we reviewed contained
evidence of follow-up on recommendation. 

Scope and Methodology: 

* Reviewed OCIE’s 2007 Clearing Agency Examination Guidance (guidance) 
and compared it to inspection community best practices; including GAO’s 
Yellow Book, Federal Reserve Examination Guidance, and Inspectors 
General Examination Standards. 

* Reviewed 13 of 28 clearing agency examinations completed from August 
7, 2000, through September 30, 2008, to assess OCIE’s compliance with 
the routine examination schedule in the guidance and procedures for 
recommendation tracking. 
- We did not evaluate the scope, methodology, findings, or 
recommendations related to the 13 examinations we reviewed. 

* Reviewed training materials for clearing agency examiners. 

* Reviewed NSCC rules, annual reports, press releases, and a 2005 OCIE 
examination for information on the clearance and settlement processes 
at NSCC and DTC. 

* Interviewed OCIE officials, clearing agency examiners, and DTCC 
officials. 

We conducted our work from February 2008 to January 2009, in accordance 
with all sections of GAO’s Quality Assurance Framework that are 
relevant to our objectives. The framework requires that we plan and 
perform the engagement to obtain sufficient and appropriate evidence to 
meet our stated objectives and to discuss any limitations in our work. 
We believe that the information and data obtained, and the analysis 
conducted, provide a reasonable basis for any findings and conclusions. 

Background: 

Clearing agencies are divided into two categories: clearing
corporations and securities depositories. 

Clearing corporations provide several essential services: 

* Trade comparison: compares and confirms trade data. Trades can be 
submitted to a clearing agency by a locked-in trade source, such as an 
exchange, or by the two members that represent the parties to the 
trade. In the latter situation, the clearing corporation confirms that 
the data entered by the parties agree. 

* Common counterparty or trade guarantee: guarantee delivery of 
securities or cash if either side of a trade defaults or goes out of 
business. 

* Settlement: notify their members of their current securities delivery 
and payment obligations. 

Securities depositories also provide multiple services in the clearance 
and settlement of trades. 

* Custody services: retain custody of equity and debt securities
issues. 

* Ownership records: provide book entry deliveries that transfer the 
ownership of securities electronically, eliminating the need for 
physical movement of securities. 
- Receive instructions from the clearing corporation to deliver and 
receive securities on behalf of its members. 
- Receive instructions from members to move securities from one 
member’s account to another. 

* Communicates with settling banks—banks that transfer money to and 
from DTC and NSCC on behalf of customers—to net settle any financial 
obligations. 

Between 2000 and 2008, six registered clearing agencies provided
significant clearing functions to the U.S. markets. 

* DTCC subsidiaries NSCC, DTC, and the Fixed Income Clearing 
Corporation: 
- Cleared and settled nearly all U.S. market trades in equities, 
corporate and municipal bonds, and a portion of the trades in mortgage 
backed securities, government backed securities, money market 
instruments, and over-the-counter derivatives. 

* Boston Stock Exchange Clearing Corporation and the Securities
Clearing Corporation of Philadelphia:[Footnote 12] 
- Provided specialized clearance and settlement services to their
members, but, ultimately, forwarded or “introduced” their member
transactions to NSCC for clearance and settlement. 

* The Options Clearing Corporation: 
- Cleared and settled trades in options and securities futures. 

Section 17A of the Exchange Act established a system of SEC 
registration for clearing agencies and included general criteria that
clearing agencies must satisfy in order to be registered. The Division 
of Trading and Markets provided further guidance to clearing agencies by
issuing written standards. 

* The standards discuss financial and operational requirements, 
corporate governance, the capacity to enforce rules and discipline
participants, the safeguarding of securities and funds, and the prompt 
and accurate clearance and settlement of securities transactions. 

Section 17a required clearing agencies to maintain prescribed books and 
records. Section 17b provided SEC with examination authority over all 
books and records. 

Section 19 of the Exchange Act established clearing agencies as SROs. 
It also established a framework for SEC oversight over the SROs, 
providing for SEC review and approval of a majority of clearing agency 
rules. 

SEC oversees clearing agencies primarily through its Division of 
Trading and Markets, OCIE, and Division of Enforcement. 

* The Division of Trading and Markets administers and executes the 
agency’s programs relating to the structure and operation of the 
securities markets, which include regulation of clearing agencies and 
review of their proposed rule changes. 

* OCIE examines clearing agencies to assess the overall safety, 
reliability, and efficiency of the clearing agency and its operations. 
It also examines clearing agencies’ compliance with their own rules and 
applicable federal laws and regulations. 

* The Division of Enforcement investigates and prosecutes violations of 
securities laws. 

Objective 1: 

1) Provide an overview of NSCC and DTC processes for clearing and 
settling equities trades, including their processes for identifying and 
addressing FTD. 

U.S. Equity Market Clearance and Settlement: 

NSCC provides clearing and settlement, risk management, central 
counterparty services, and guarantee of completion in the event of a 
member default for virtually all broker-to-broker trades involving 
equities and exchange traded debt. 

DTC is the central depository and acts as a custodian for the
majority of securities issues. 

* DTC, through its nominee Cede & Co., owns most of the equity and debt 
issues traded in U.S. markets. 
- Broker-dealer/clearing firm participants in DTC, in turn, own a pro-
rata beneficial interest in the aggregate number of shares of a 
securities issue held by DTC. 
- The ultimate beneficial owners (that is, investors), each own a pro-
rata beneficial interest in the shares in which their broker-dealer has 
a beneficial interest. 

* DTC transfers ownership, in book-entry form, during settlement. 

Continuous Net Settlement: 

Due to the volume and value of trading in today’s markets, NSCC nets 
trades and payments among its participants, using CNS. 

* CNS system is a book entry accounting system in which each NSCC 
member’s daily purchases and sales of a security, based on trade date, 
automatically are netted into one long position (right to receive 
securities from NSCC) or one short position (obligation to deliver 
securities to NSCC) for each security issue purchased or sold. 

* The member’s corresponding payment obligations are similarly netted 
into one obligation to receive or one obligation to pay money. 

* Figure 1 illustrates how CNS nets a member’s trades into one long or 
short position. 

* Figure 2 illustrates net sellers’ delivery of shares to NSCC and 
NSCC’s delivery of shares to net buyers. 

Figure 1: Netting of Trades into One Long Position (Net Buyer) or Short 
Position (Net Seller): 

[Refer to PDF for image: illustration] 

Trading day: 
Broker A: 10,000 shares sold to Broker B; 
End of trading day CNS records: Short position of 9,000 shares. 

Broker B: 5,000 shares sold to Broker C; 2, 000 shares sold to Broker 
D; 
End of trading day CNS records: Long position of 3,000 shares. 

Broker C: 
End of trading day CNS records: Long position of 3,000 shares. 

Broker D: 1,000 shares sold to Broker A; 
End of trading day CNS records: Long position of 1,000 shares. 

Source: GAO. 

[End of figure] 

Figure 2: Delivery to NSCC from Net Sellers and NSCC Delivery to Net 
Buyers: 

[Refer to PDF for image: illustration] 

Settlement day (T+3): 

Broker A: 9,000 shares of XYC Co. to NSCC; 
End of settlement day CNS records: Flat position of 0. 

Broker B: 3,000 shares of XYC Co. from NSCC; 
End of settlement day CNS records: Flat position of 0. 

Broker C: 5,000 shares of XYC Co. from NSCC; 
End of settlement day CNS records: Flat position of 0. 

Broker D: 1,000 shares of XYC Co. from NSCC; 
End of settlement day CNS records: Flat position of 0. 

Source: GAO. 

[End of figure] 

U.S. Equity Market Clearance and Settlement: 

Trade clearance and settlement in the U.S. operates on a Trade Date (T) 
plus 3 settlement day (T+3) cycle. 

* T: 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 
through DTC and NSCC. 

Figure 3 illustrates the T+3 settlement cycle. 

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

[Refer to PDF for image: illustration] 

Trade Day: 
Buyer: Customer A purchases 100 shares of stock at $10 a share through 
Broker A; 
Broker A to Exchange: Trade occurs at the Exchange and trade data is 
sent via computer to NSCC; 
Seller: Customer B directs Broker B to sell 100 shares at $10 a share; 
Broker B to Exchange: 100 shares of common stock. 

Trade day + 1: 
NSCC reports the confirmation of trade with Broker A; 
NSCC reports the confirmation of the trade with Broker B. 

Trade day + 2: 
NSCC reports the settlement position to Broker A; 
NSCC reports the settlement position to Broker B. 

Trade day + 3 settlement: 
Equity share settlement: 
DTC is instructed by NSCC to conduct settlement via book entry: 
DTC: 
NSCC's account at DTC; 
Broker A's account; 
Broker B's account; 
100 shares of common stock. 

Money settlement: 
Payment is performed through settlement banks over Fedwire; 
NSCC requests payment from Broker A via the settlement bank. Broker A's 
buyer's settlement bank pays $1,000 to NSCC's settlement bank. Broker 
B's seller's settlement bank receives $1,000 from NSCC's settlement 
bank. 

Source: GAO analysis of NSCC data. Art Explosion (images). 

[End of figure] 

Failure to Deliver During Clearance and Settlement: 

If a member fails to deliver the total number of securities owed NSCC 
on a particular settlement date, NSCC may be unable to meet its 
delivery obligations, resulting in a fails to receive (FTR) for the 
participant that is due securities (see table 1). 

* NSCC uses SBP to borrow shares to meet as many of its delivery 
obligations as possible. 

* In SBP, participants can instruct NSCC as to specific securities from 
their DTC account that are available for borrowing to cover NSCC’s CNS 
delivery shortfalls in those securities. 

* DTC debits any shares it borrows from the lender’s DTC account. NSCC 
creates a right to receive position for lenders in CNS (see table 2). 

* Any delivery made using the SBP does not relieve the participant that 
fails to deliver from its delivery obligation to NSCC (see table 2). 

* According to DTCC, SBP generally covers between 15-20 percent of the 
FTD each settlement cycle. 

Table 1: NSCC/DTC Positions Prior to SBP Loan: 

Transaction: Seller S sells 1000 ABC to Buyer B and FTD: 

Participant: Seller S; 
NSCC Position: Short 1000 ABC; 
DTC Position: 0 ABC. 

Participant: Buyer B; 
NSCC Position: Long 1000 ABC; 
DTC Position: 0 ABC. 

Participant: Lender L; 
NSCC Position: Flat; 
DTC Position: 1000 ABC. 

Buyer B has no shares in its DTC account due to delivery shortfall. 

Lender L has 1000 shares available to lend. 

[End of table] 

Table 2: NSCC/DTC Positions After SBP Loan: 

Participant: Seller S; 
NSCC Position: Short 1000 ABC; 
DTC Position: 0 ABC. 

Participant: Buyer B; 
NSCC Position: Flat; 
DTC Position: 1000 ABC. 

Participant: Lender L; 
NSCC Position: Long 1000; 
DTC Position: 0 ABC. 

NSCC borrows 1000 ABC from Lender L and delivers to Buyer B. 

NSCC creates a long 1000 position for Lender L. 

Seller S continues to have an obligation to deliver 1000 ABC to NSCC. 

[End of table] 

U.S. Equity Market Clearance and Settlement: 

Unfulfilled FTR or FTD positions are rolled over into the next 
settlement cycle. 

Members with a FTR position not filled through SBP have three options 
for receiving the securities they are owed. 

* Normal course of business: Wait until NSCC receives securities and CNS
allocates them to the FTR position. 

* Request priority in CNS: Priority FTR positions will be filled with 
any securities NSCC receives after all buy in requests are fulfilled, 
but before CNS begins allocating received shares to other members with 
net short positions in the security.[Footnote 13] 

* Initiate a buy-in: File paperwork with NSCC requiring it to request a 
net short member to deliver securities to NSCC and for NSCC to deliver 
those securities to the net long member. If the position remains 
unfilled, NSCC instructs the member to buy in the unfilled position. 
(NSCC has no authority under SEC rules to force a buy in.) 
- DTCC officials explained that approximately 6,000 notices of 
intention to buy in are filed each day, with approximately 20 resulting 
in executions. Relatively few are executed because the FTD generally 
resolve in the normal course of business. 

[End of Objective 1] 

Objective 2: 

2) Describe SEC’s efforts to ensure the reliability and efficiency of 
the clearance and settlement system through its examination program for 
clearing agencies. 

Clearing Agency Examination Program: 

OCIE oversees the examination program for clearing agencies and 
executes it through the New York Regional Office, Chicago Regional
Office, and Philadelphia Regional Office. 

The program does not have dedicated examiners. Instead, examiners from 
the broker-dealer oversight program also conduct clearing agency
examinations, as needed. 

* Examination teams typically consist of the Assistant Regional 
Director, a Branch Chief, and from 2 to 6 examiners. 

* Examiners typically work on a clearing agency examination full-time
for approximately 3 months. 

* OCIE officials said that examiners’ level of experience varies within 
a team, but they usually are experienced broker-dealer examiners. 
According to OCIE, in every regional office an experienced team leader 
provides examination oversight and continuity. 
- As part of its broker-dealer examiner training program OCIE provides 
general clearance and settlement training. In addition, OCIE offers 
specialized training for clearing agency examiners annually. 

Clearing Agency Examination Cycle: 

Clearing agency examinations include regular cycle and special 
examinations. 

* The largest registered clearing agencies (including NSCC and DTC), 
which provide centralized clearing services, are examined on a cycle of 
every other year. The smaller clearing agencies are examined on a 2- or 
3-year cycle, depending on resources. Our review found that OCIE 
conducted cycle examinations according to this schedule. 

Some clearing agency examinations are targeted examinations that cover 
the activities of more than one clearing agency. 

Clearing Agency Examination Guidance: 

To assist examiners in planning and conducting examinations, OCIE has 
developed written guidance. OCIE revised and expanded this guidance in 
March 2007. The new guidance discusses aspects of planning and 
conducting an examination consistent with inspection community best 
practices. 

Specifically, the new guidance provides information related to: 

* background on the registered clearing agencies, their functions, and 
the legal framework governing them; 

* examination planning, including staffing, risk-assessment, and 
coordination with other SEC divisions and federal and state regulators 
of clearing agencies; 

* field work, including interviews, document requests and reviews, 
sample and testing parameters, and exit interviews; 

* the preparation of examination reports and deficiency letters, 
including report content, format, and the review process; and; 

* the review and tracking of clearing agencies’ responses to the 
examination findings and recommendations. 

Examination Approach: 

The guidance directs OCIE examiners to use an internal controls
approach to assess a clearing agency’s safety, reliability, and
efficiency. 

* This approach requires examiners to gain an understanding of how the 
internal control structure functions at a given clearing agency and 
test controls over key clearing functions to identify any weaknesses. 

According to OCIE officials and the guidance, clearing agency 
examinations also are risk-based. Examiners can use multiple sources of 
information to identify high-risk areas. 

When planning an examination, examiners can leverage the work of the 
clearing agency’s internal audit department or other 
auditors/regulators. 

* As part of its examination program, OCIE routinely reviews the 
internal audit functions of the registered clearing agencies. 

Pursuant to formal information-sharing agreements, OCIE shares 
examination information with federal and state banking regulators on-
site at DTC. 

Key Review Areas: 

OCIE also has identified key areas on which examiners may focus during 
a review. Key areas are derived from the clearing agency standards, 
contained in Section 17A of the Exchange Act, and the interpretive 
guidance issued by the Division of Trading and Markets. 

* Examples of key areas reviewed in our sample of examinations included 
risk management, internal audit/controls, clearing fund administration, 
and clearing and settlement. 

The guidance discusses an examination approach for each key area. For 
clearing and settlement, examiners are to assess the procedures and 
controls relating to the processing of daily payments and collections 
and securities transactions. 

In a recent examination of NSCC’s CNS/SBP program, examiners conducted 
this assessment though transaction testing, report validation, 
observation of the settlement process, and interviews. 

2005 Examination of NSCC: Implementation of Regulation SHO: 

As part of the NSCC examination, OCIE incorporated a review of NSCC’s 
role in the implementation of SEC’s recently issued Regulation SHO. 

* In particular, examiners reviewed the CNS short position reports that 
NSCC generates daily to identify FTD for each clearing participant in 
each security. NSCC transmits these reports electronically to SEC and 
SROs. 

* The reliability of the CNS short position reports is essential to the
effective implementation of Regulation SHO. As discussed earlier, the 
SROs use FTD data generated from these reports to identify those 
securities with enough accumulated FTD to qualify as threshold 
securities and publish lists of them. 

* To test for data reliability, examiners assessed both the process 
NSCC uses to generate the reports and the internal controls NSCC 
employs to test and validate them. They also performed independent 
testing of a sample of securities included in the report. 

* The review did not raise any reliability concerns with the short 
position reports. 

2005 Examination of NSCC: Review of Stock Borrow Program (SBP): 

In response to media criticism and allegations made by certain issuers 
and shareholders that NSCC and DTC were facilitating naked short 
selling through the operation of SBP, OCIE also incorporated a review 
of SBP into the scope of its 2005 examination. 

These critics argued that SBP exacerbated naked short selling by 
creating and lending shares that are not actually in deposit at DTC, 
thereby flooding the market with shares that do not exist. 

* Specifically, they asserted that inappropriate accounting conventions 
at DTC allowed it to record stock loans made by lending participants 
and continue to report the loaned shares as free and available in the 
lender’s depository account, thus allowing the shares to be loaned 
repeatedly by the same lender. 

We found that examiners tested stock borrow transactions in securities 
that were the focus of the above-referenced allegations or had high 
levels of prolonged FTD to determine if shares loaned through SBP were 
free and available in the lending participant’s depository account 
prior to the transaction, and if they were deducted from that 
participant’s account when the loan was made. The examination did not 
find any instances where critics’ claims were validated. 

Recommendation Tracking: 

Examinations can result in findings and recommendations to the clearing 
agency. Examples of deficiencies OCIE identified in the examinations we 
reviewed included areas such as record retention, risk management, and
clearing fund administration. 

* Twelve of the 13 examinations we reviewed contained evidence of 
follow-up on recommendations.[Footnote 14] 

[End of Enclosure I] 

Enclosure II: Comments from the Securities and Exchange Commission: 

United States Securities And Exchange Commission: 
Office Of Compliance Inspections And Examinations: 
Washington, D.C. 20549: 

February 20, 2009: 

Orice M. Williams: 
Director,
Financial Markets and Community Investment: 
U.S. Government Accountability Office: 
441 G Street, N.W. 
Washington, D.C. 20548: 

Re: GAO Draft Report "Securities and Exchange Commission: Oversight of 
US. Equity Market Clearing Agencies" (GAO-09-381R): 

Dear Ms. Williams: 

Thank you for the opportunity to review the Government Accountability 
Office's (GAO) draft correspondence letter and briefing slides 
entitled: "Securities and Exchange Commission: Oversight of U.S. Equity 
Market Clearing Agencies." The draft report and briefing slides provide 
a valuable summary of the clearance and settlement system for the U.S. 
equities markets. As GAO notes in the draft report, an effective 
clearance and settlement process is vital to the functioning of the 
U.S. securities markets. 

As part of this project, GAO also reviewed the SEC's efforts to ensure 
the reliability and efficiency of this system through its examination 
program for registered clearing agencies administered by the SEC's 
Office of Compliance Inspections and Examinations (OCIE). GAO made no 
recommendations in the draft report regarding OCIE's clearing agency 
examination program. 

OCIE takes its responsibility to provide effective oversight of this 
process seriously, and, leveraging available resources, has developed a 
comprehensive examination program for the registered clearing agencies. 
In the draft report, the GAO notes that OCIE's clearing agency 
examination program: (i) has developed examination guidance that is 
consistent with inspection community best practices; (ii) meets its 
routine examination schedules for registered clearing agencies; (iii) 
provides specialized training in clearance and settlement issues to its 
examination staff; (iv) regularly reviews the work of clearing agency 
internal audit staff, and leverages, as appropriate, the work of 
internal audit as well as that of other federal and state regulators; 
and (v) identifies and regularly tracks the remediation of deficiencies 
and related recommendations made to clearing agencies through the 
examination process. In addition, GAO specifically reviewed OCIE's 
examination testing of the National Securities Clearing Corporation's 
continuous net settlement and stock borrow program in connection with 
its assessment of the SEC's actions to address short selling issues. 

We would like to thank you and your staff for the opportunity to review 
GAO's draft report, and we appreciate the courtesy you and your staff 
extended to us during this review. 

Sincerely, 

Signed by: 

Lori A. Richards: 
Director: 
Office of Compliance Inspections and Examinations: 

[End of enclosure] 

Footnotes: 

[1] A short sale is the sale of a security that the seller does not own 
or any sale that is consummated by the delivery of a security borrowed 
by, or for the account of, the seller. In general, short selling is 
used to profit from an expected downward price movement, to provide 
liquidity in response to unanticipated demand, or to hedge the risk of 
a long position in the same or related security. 

[2] These securities are termed threshold securities. A threshold 
security is an equity security where, for 5 consecutive settlement 
days, (1) there are aggregate FTD at a registered clearing agency of 
10,000 shares or more, (2) the level of FTD is equal to at least one- 
half of one percent of the issuer's total shares or more, and (3) the 
security is included on a list published by the SROs. 

[3] At your request, we are also assessing SEC's Regulation SHO and 
other recent regulatory actions that SEC intended to address FTD and 
manipulative naked short selling. As agreed with your staffs, we will 
report our findings with respect to this work in April 2009. 

[4] GAO, Government Auditing Standards, [hyperlink, 
http://www.gao.gov/products/GAO-07-731G] (Washington, D.C.: July 2007 
Revision); Office of the Comptroller of the Currency, Examination 
Planning and Control, Comptroller's Handbook, (Washington, D.C., July 
1997); Federal Reserve System, Framework for Risk-Focused Supervision 
of Large Complex Institutions, (Washington, D.C., Aug. 8, 1997); Office 
of Inspector General, Quality Standards for Inspections, (Washington, 
D.C., January 2005). 

[5] 15 U.S.C. §§ 78q-1. 

[6] 15 U.S.C. §§ 78s. 

[7] Continuous Net Settlement System positions do not represent 
ownership. Only DTC account positions represent ownership. 

[8] According to NSCC, the Continuous Net Settlement System reduces the 
value of securities and payments that need to be exchanged by an 
average of 97 percent each day. 

[9] A short sale is the sale of a security that the seller does not own 
or any sale that is consummated by the delivery of a security borrowed 
by, or for the account of, the seller. In general, short selling is 
used to profit from an expected downward price movement, to provide 
liquidity in response to unanticipated demand, or to hedge the risk of 
a long position in the same or related security. 

[10] These securities are termed “threshold securities." A threshold 
security is an equity security where, for five consecutive settlement 
days, (1) there are aggregate FTD at a registered clearing agency of 
10,000 shares or more per security, (2) the level of FTD is equal to at 
least one-half of one percent of the issuer’s total shares outstanding, 
and (3) the security is included on a list published by the self-
regulatory organizations. 

[11] At your request, we also are assessing SEC’s Regulation SHO and 
the other recent regulatory actions with which SEC intended to address 
FTD and manipulative naked short selling. As agreed with your staffs, 
we will report our findings with respect to this work in April 2009. 

[12] NASDAQ OMX acquired the Securities Clearing Corporation of 
Philadelphia and the Boston Stock Exchange Clearing Corporation in July 
2008 and August 2008, respectively, and intends to launch the NASDAQ 
Clearing Corporation in 2009. 

[13] NSCC employs an algorithm to allocate shares to members with net 
short positions. The algorithm is based on priority groups in 
descending order, age of position within priority group, and random 
numbers within age group. 

[14] Current guidance states that examination report files should 
include the results of their recommendation follow-up. The one 
examination we reviewed where we did not see this evidence was from 
2002, before the guidance was in effect. We did not review the 
underlying work papers to determine whether or not the follow-up had 
been completed. 

[End of section] 

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