The Public Securities Association welcomes the opportunity provided by the Securities and Exchange Commission to comment on "The Report of the Bachmann Task Force on Clearance and Settlement Reform in U.S. Securities Markets."
We support the efforts of the task force and believe that implementing the report's recommendations will result in reduced risk and greater efficiency in the U.S. securities markets. We are concerned, however, about the deadlines contained in the recommendations on compressing the settlement cycle to T plus 3 and same-day funds settlement, particularly with respect to the securities market.
Implementing these recommendations in mid-1994 could have serious disruptive effects on the municipal securities market given its heavy retail orientation and its unique distribution system through regional dealers and dealer banks.
Major changes are necessary in confirmation and payment procedures and retail customer behavior to achieve these goals. We therefore strongly urge greater study of the effects of the recommendations on the municipal market before determining time frames for implementation.
In 1984, the Municipal Securities Rulemaking Board amended Rule G-12(f) and G-15(d) to require the use of automated comparison and confirmation for municipal securities transactions to achieve book-entry settlement.
Rule G-12(f) requires transactions between municipal securities dealers to be compared through a registered clearing agency when both parties to the transaction are members, directly or indirectly, of a registered clearing agency. Rule G-15(d) requires that dealers trading with customers confirm delivery versus payment or receipt versus payment transactions in securities assigned a CUSIP number through a registered clearing agency when both parties are direct or indirect members of a registered clearing agency.
When the board proposed the original amendments in 1983, the PSA strongly supported them. At the board's request, the PSA formed an Ad-Hoc Committee on Municipal Securities Automation composed of dealers, dealer-banks, broker's brokers, depositories, and clearing agents across the country.
The committee's primary objective was to increase the preparedness of the industry for the transition into an automated environment. The PSA conducted seminars in 1984 to inform industry participants of the amendments and mechanisms available for compliance. In the last quarter of 1985 and early 1986, the PSA, in conjunction with the depositories, conducted seminars in 15 major cities on the benefits of depository systems.
In March 1987, the PSA requested amendments to Rule G-12 and Rule G-15 to allow for delivery of either registered or bearer forms of a municipal security unless agreed to otherwise by the parties to the transaction. The board's adoption of the amendments allowed depositories to convert securities to registered from bearer form, resulting in significant savings for the industry and ultimately benefiting investors.
More recently, the PSA worked with the National Securities Clearing Corp. to examine the comparison process in the when-issued municipal securities market.
Traditionally, the three major investors in municipal securities have been property and casualty insurance companies, commercial banks, and individuals either through direct holdings or through mutual and money market funds.
The Tax Reform Act of 1986 provided disincentives for both property and casualty insurance companies and commercial banks to invest in municipal securities. This left the municipal market almost completely dependent on the retail sector for demand.
In 1980, the retail investor both through direct holdings and mutual and money market funds held approximately 27% of total municipal securities outstanding. As of the end of the first quarter of 1992, the retail sector held approximately 72.5% of all municipal securities outstanding.
This undiversified base of demand exposes state and local governments to the prospect of increased issuance costs and restricted financing options. The importance of the retail sector to the municipal market cannot be overstated.
Another unique characteristic of the market is its regional nature. There are over 2,700 dealers registered with the MSRB. Over 500 of these dealers are considered active in conducting municipal securities transactions. A vast majority are located outside of New York and range dramatically in size and capital.
All of these "regional" dealers play an integral role in the distribution of new-issue municipal securities and in making markets in local issues. In addition, the investor base tends to be regionalized because of the local tax treatment of interest earned from municipal securities.
We believe the retail and regional nature of the municipal securities market should be stressed as an important factor in examining the effects of T plus 3 settlement and the same-day funds settlement recommendations within the recommended time frames.
As noted in the report, obstacles to compressing the settlement cycle exist that are of particular concern to the municipal market. One obstacle not emphasized in the report is the role of the confirmation process for municipal securities transactions done on the retail level.
Another obstacle is in the comparison and affirmation process. Integral to T plus 3 settlement is T plus 1 comparison and affirmation. According to the National Securities Clearing Corp., T plus 1 comparison stood at 78.6% as of August of this year.
As described above, the PSA, along with other organizations, has conducted extensive educational campaigns in this area. While the percentage has improved over time, more effort is necessary to achieve a T plus 1 comparison rate of 100%. Although the comparison rate for corporate securities transactions is much higher, it is important to note the rate includes "locked-in" trades. These transactions are compared on a de facto basis.
The affirmation rate for municipal securities transactions stood at 82% as of July of this year. As indicated in the report, the Depository Trust Co. has proposed an interactive ID system to accommodate the current settlement cycle. We agree with the task force that implementation of an interactive ID system that permits affirmation as of T plus 1 would allow for a compressed settlement cycle.
The PSA continues to work with Depository Trust in developing an interactive ID system. We firmly believe the comparison and affirmation process for municipal securities transactions needs to be addressed before establishing a time frame for T plus 3 settlement.
A large portion of trading activity in municipals occurs on a when-issued basis. The heaviest trading in a municipal securities issue usually occurs during the four- to six-week period between the date of sale and the delivery of the securities by the issuer. This extended settlement system has functioned quite well for many years and has served to add liquidity to the market. Another obstacle mentioned in the report, which is true for both corporate and municipal transactions, is the payment mechanism under a compressed settlement.
The report says the automated clearinghouse, an electronic payment system, as a more efficient mechanism for payments by retail investors. We agree with the task force and believe that National Automated Clearing House Association rules need to be amended to eliminate recision rights.
The report expects these changes to be approved in this year for implementation in 1993. We understand, however, that the association voted against such changes because of technical problems and opposition to the elimination of protection for consumers and financial institutions. This decision may serve to delay the 1994 implementation date for the recommendations.
MSRB rules do not require settlement within a specific number of days after trade date. MSRB Rule G-12(b) (ii) defines settlement dates for "cash" transactions (trade date), "regular way" (T plus 5), and for "when, as and if issued" transactions (a date agreed upon by both parties which cannot be earlier than the fifth business day following the date the confirmation indicating the final settlement date is sent), and for all other transactions a date agreed upon by both parties.
Thus, flexibility exists for counterparties depending on the nature and type of transaction. A T plus 3 settlement scenario may require that new regulations be promulgated.
Setting aside for a moment the practical aspects of compressing the settlement cycle to T plus 3, the most serious concern to the PSA is customer behavior. As noted in the report, 21% of retail transactions are settled by check through the mail, and only 20% of these transactions, measured by dollar value, arrive on or before T plus 3.
Retail investors, particularly with respect to municipal securities, typically wait for receipt of the confirmation before making payment. In addition, many retail investors take possession of physical certificates to the extent they are available. If a retail investor wishes to sell the securities, the certificates need to be delivered to the dealer. This would serve to delay a T plus 3 settlement. Massive educational campaigns would be necessary to change client behavior to expedite payment and convince clients of the benefits of a shortened settlement cycle.
These campaigns will be costly and could prove unsuccessful. Given current customer behavior, and even assuming an automated clearinghouse becomes available to retail investors, a T plus 3 settlement cycle would still be hard to achieve.
A majority of transactions in the municipal market are already settled by book-entry. About 95% of all municipal securities outstanding are immobilized at the Depository Trust Co. The PSA continues to support settlement by book-entry.
With book-entry-only securities, the dealer must process interest and redemption payments throughout the investor's holding period. Before the advent of book-entry-only securities, the issuer bore this cost by having a paying agent perform this function. This additional cost has had an adverse impact on smaller regional dealers. We urge the SEC to consider the increased costs incurred by regional dealers.
Under a same-day funds scenario, dealers with substantial retail business would incur significant costs in paying for securities using same-day funds and receiving payment from retail customers at some later date. We believe the smaller retail municipal securities dealers would be affected adversely.
In addition, a two-tiered market may develop in that a dealer may price securities that are sold to retail customers differently than those securities sold to institutional customers or other dealers. This tiering effect would serve to decrease the liquidity of the municipal securities market.
The difficulties presented by this recommendation could be prevented by providing a same-day funds payment mechanism for the retail investor. We, however, do not envision such a system in place over the next several years.
We wish to reiterate our support for the goals of the task force. The PSA is concerned, however, about the aggressive time frames of the recommendations. We believe a more deliberate approach would lessen the likelihood of disrupting the municipal market.
We are concerned that dealers would incur substantial financing costs under the same-day funds recommendation. The compression of the settlement cycle from T plus 5 to T plus 3 represents a significant change from customary procedures.
To achieve T plus 3 settlement, the following are necessary: a faster confirmation delivery system; an electronic payment system; and major changes in customer behavior.
We strongly urge a more comprehensive analysis of the effects of the recommendations on the municipal market before determining time frames for implementation.
We hope this has been helpful in providing you with the PSA's specific concerns and we look forward to working with the SEC to improve the efficiency of clearance and settlement systems for the municipal market. Please do not hesitate to contact me or George Brakatselos, PSA vice president, with any questions and/or comments.
Dominick F. Antonelli is chairman of the PSA Task Force on Group of 30 Recommendations.