GAO-09-318R SEC Oversight of U.S. Equities Markets 

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.1

 When FTDs persist for days or months, they can accumulate 

 

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. 
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.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.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 

 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. 

Page 2 GAO-09-318R SEC Oversight of U.S. Equities Markets
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.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.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 

 4

GAO, Government Auditing Standards, 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. 

Page 3 GAO-09-318R SEC Oversight of U.S. Equities Markets
framework for SEC oversight over all SROs, including SEC review and approval of most 

clearing agency rules.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.7

 The participant’s corresponding payment obligations are, similarly, netted into one 

obligation to pay or one obligation to receive money.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 

 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.

Page 4 GAO-09-318R SEC Oversight of U.S. Equities Markets
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. 

Page 5 GAO-09-318R SEC Oversight of U.S. Equities 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 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. 

Orice M. Williams 

Director, Financial Markets 

 and Community Investment 

Enclosures 

Page 6 GAO-09-318R SEC Oversight of U.S. Equities Markets
Enclosure I 

1

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

Page 7 GAO-09-318R SEC Oversight of U.S. Equities Markets
Enclosure I 

2

Overview

• Abbreviations

• Introduction

• Objectives

• Summary of Findings

• Scope and Methodology

• Background

• Discussion of Objectives

Page 8 GAO-09-318R SEC Oversight of U.S. Equities Markets
Enclosure I 

3

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

Page 9 GAO-09-318R SEC Oversight of U.S. Equities Markets
Enclosure I 

4

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).

Page 10 GAO-09-318R SEC Oversight of U.S. Equities Markets
Enclosure I 

5

Introduction

• 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.

Page 11 GAO-09-318R SEC Oversight of U.S. Equities Markets
Enclosure I 

6

Introduction

• 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.1 

• 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. 

_____________________________________

1A 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.

Page 12 GAO-09-318R SEC Oversight of U.S. Equities Markets
Enclosure I 

7

Introduction

• 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.2

• 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. _____________________________________

2These 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.

Page 13 GAO-09-318R SEC Oversight of U.S. Equities Markets
Enclosure I 

8

Objectives

• 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.3

_____________________________________

3 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.

Page 14 GAO-09-318R SEC Oversight of U.S. Equities Markets
Enclosure I 

9

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.

Page 15 GAO-09-318R SEC Oversight of U.S. Equities Markets
Enclosure I 

10

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. 

Page 16 GAO-09-318R SEC Oversight of U.S. Equities Markets
Enclosure I 

11

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.

Page 17 GAO-09-318R SEC Oversight of U.S. Equities Markets
Enclosure I 

12

Scope and Methodology

• 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.

Page 18 GAO-09-318R SEC Oversight of U.S. Equities Markets
Enclosure I 

13

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.

Page 19 GAO-09-318R SEC Oversight of U.S. Equities Markets
Enclosure I 

14

Background

• 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.

Page 20 GAO-09-318R SEC Oversight of U.S. Equities Markets
Enclosure I 

15

Background

• 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 Philadelphia4

• 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.

____________________ 4NASDAQ 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.

Page 21 GAO-09-318R SEC Oversight of U.S. Equities Markets
Enclosure I 

16

Background

• 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.

Page 22 GAO-09-318R SEC Oversight of U.S. Equities Markets
Enclosure I 

17

Background

• 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.

Page 23 GAO-09-318R SEC Oversight of U.S. Equities Markets
Enclosure I 

18

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.

Page 24 GAO-09-318R SEC Oversight of U.S. Equities Markets
Enclosure I 

19

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.

Page 25 GAO-09-318R SEC Oversight of U.S. Equities Markets
Enclosure I 

20

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. 

Page 26 GAO-09-318R SEC Oversight of U.S. Equities Markets
Enclosure I 

21

Figure 1: Netting of Trades into One Long 

Position (Net Buyer) or Short Position (Net

Seller)

Page 27 GAO-09-318R SEC Oversight of U.S. Equities Markets
Enclosure I 

22

Figure 2: Delivery to NSCC from Net Sellers and 

NSCC Delivery to Net Buyers

Page 28 GAO-09-318R SEC Oversight of U.S. Equities Markets
Enclosure I 

23

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.

Page 29 GAO-09-318R SEC Oversight of U.S. Equities Markets
Enclosure I 

24

Figure 3: Clearance and Settlement of 

Depository-Eligible Equity Shares

Page 30 GAO-09-318R SEC Oversight of U.S. Equities Markets
Enclosure I 

25

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.

Page 31 GAO-09-318R SEC Oversight of U.S. Equities Markets
Enclosure I 

26

Table 1: NSCC/DTC Positions Prior to

SBP Loan

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

• Lender L has 1000 shares available to lend.

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

Lender L

Buyer B

Seller S

Participant

Flat 1000 ABC

Long 1000 ABC 0 ABC

Short 1000 ABC 0 ABC

NSCC Position DTC Position

Page 32 GAO-09-318R SEC Oversight of U.S. Equities Markets
Enclosure I 

27

Table 2: NSCC/DTC Positions After SBP Loan

• 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.

Lender L

Buyer B

Seller S

Participant

Long 1000 0 ABC

Flat 1000 ABC

Short 1000 ABC 0 ABC

NSCC Position DTC Position

Page 33 GAO-09-318R SEC Oversight of U.S. Equities Markets
Enclosure I 

28

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.

5

• 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. _____________________________________

5 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.

Page 34 GAO-09-318R SEC Oversight of U.S. Equities Markets
Enclosure I 

29

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.

Page 35 GAO-09-318R SEC Oversight of U.S. Equities Markets
Enclosure I 

30

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.

Page 36 GAO-09-318R SEC Oversight of U.S. Equities Markets
Enclosure I 

31

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.

Page 37 GAO-09-318R SEC Oversight of U.S. Equities Markets
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32

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.

Page 38 GAO-09-318R SEC Oversight of U.S. Equities Markets
Enclosure I 

33

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. 

Page 39 GAO-09-318R SEC Oversight of U.S. Equities Markets
Enclosure I 

34

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.

Page 40 GAO-09-318R SEC Oversight of U.S. Equities Markets
Enclosure I 

35

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.

Page 41 GAO-09-318R SEC Oversight of U.S. Equities Markets
Enclosure I 

36

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.

Page 42 GAO-09-318R SEC Oversight of U.S. Equities Markets
Enclosure I 

37

2005 Examination of NSCC: Review of 

Stock Borrow Program (SBP)

• 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.

Page 43 GAO-09-318R SEC Oversight of U.S. Equities Markets
Enclosure I 

38

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.

6

________________ 6 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.

Page 44 GAO-09-318R SEC Oversight of U.S. Equities Markets
Enclosure II: Comments from the Securities and Exchange Commission 

Page 45 GAO-09-318R SEC Oversight of U.S. Equities Markets
Enclosure II 

(250398) 

Page 46 GAO-09-318R SEC Oversight of U.S. Equities Markets
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