United States General Accounting Office

GAO Report to the Chairman

Committee on Banking and Financial

Services

House of Representatives

June 1997 PAYMENTS,

CLEARANCE, AND

SETTLEMENT

A Guide to the Systems,

Risks, and Issues

GAO/GGD-97-73

GAO United States

General Accounting Office

Washington, D.C. 20548

General Government Division

B-270598 

June 20, 1997

The Honorable James Leach

Chairman, House Committee on

 Banking and Financial Services

House of Representatives

Dear Mr. Chairman:

This report responds to your request that we provide information, about

the nation’s systems to effect financial transactions between purchasers

and sellers of goods, services, and financial assets. As you know, these

systems—often referred to as payments, clearance, and settlement

systems—are a vital part of the smooth functioning of our nation’s

economy and the free flow of economic activity worldwide. They allow

ownership of products, funds, securities, futures contracts, and other

financial instruments to be exchanged and settled among consumers,

financial institutions, businesses, and others. They also play a critical role

in maintaining the stability of financial markets and reducing systemic

risk.

As agreed, the objectives of this report were to

• describe the various payments, clearance, and settlement systems used in

this country;

• describe various emerging products and services, which we refer to as

electronic commerce;

• identify and describe certain risks associated with these systems,

products, and services, and discuss how those risks are mitigated; and

• identify and describe some significant issues relating to the systems,

products, and services that face users, regulators, and policymakers.

For purposes of clarity, we present the information on systems, products,

and services in four major sections: (1) clearance and settlement of

wholesale payment systems; (2) clearance and settlement of equities,

Treasuries, futures, and options; (3) clearance and settlement of retail

payment systems; and (4) new and emerging financial products and

services. An overview precedes each section, highlighting some of the

main characteristics and other information associated with each type of

system, product, or service. Each section is organized in the same

way—description and use, basic data, processes, regulatory oversight, and

risk and risk mitigation. The final section of the report contains

information on some significant issues raised by industry officials

Page 1 GAO/GGD-97-73 Payments, Clearance, and Settlement
B-270598 

concerning these systems, products, and services. The remainder of this

letter includes background information, a short overview of the sections,

our scope and methodology, and comments from the Federal Reserve

Board of Governors.

Background The general term payment system refers to a mechanism for the transfer of

monetary value and related information. Transfer of value can occur, for

example, when a customer writes a check to a company and the funds are

then transferred from the customer’s bank account to the bank account of

the company. Related information exchanged at the same time might

include the identification of the payee and the payor, bank account

numbers, and the date of payment. Clearance is the process of

transmitting, reconciling, and in some cases, confirming payment orders or

securities transfer instructions before settlement takes place. Settlement is

the final step in the transfer of ownership. In a banking transaction,

settlement is the process of recording the debit and credit positions of the

parties involved in a transfer of funds; in a securities transaction,

settlement includes both the transfer of securities by the seller and the

payment by the buyer.

In order to promote the smooth functioning of the nation’s economic

activity, payment systems must provide for a reliable and accurate

exchange, a measure of security for transactions, and finality of payment

(i.e., settlement that cannot be reversed or withdrawn at a later time). In

most cases, there is a delay between the exchange of instructions and

information concerning a transaction and its final settlement. For

example, when an individual deposits a check into his or her bank

account, the bank then instructs the bank on which the check was drawn

(payor’s bank) to pay the specified amount to the individual’s bank, which

will, in turn, credit that amount to his or her account. The actual

settlement—i.e., the transfer of funds from the payor’s bank to his or her

bank account—may not occur until several days after the check was

deposited.

There is a trade-off between the security and speed of settlement and its

cost. Wholesale systems for the exchange of large-value payments or

products tend to have greater security (greater risk controls) than do retail

systems. The loss on one wholesale transaction could be thousands of

times greater than that for a typical retail transaction. Speed of settlement

also adds to security. With less time between clearance and settlement,

there is less likelihood of a default by one of the involved parties, all other

Page 2 GAO/GGD-97-73 Payments, Clearance, and Settlement
B-270598 

things being equal. However, increased security and timeliness generally

come at an increased cost. An electronic transaction that settles

instantaneously may cost as much as 50 times more than a transaction in a

system that settles in 24 hours or more.

Settlements can be “gross” or “net.” Gross settlement means each

transaction is settled individually. Net settlement means that parties

exchanging payments will offset mutual obligations to deliver identical

items (e.g., dollars and Deutsche Marks) at a time, such as the end of the

day, after which only one net amount of each item is exchanged.

Each system or product has associated with it some type of risk and, in

some cases, several types of risk. For purposes of this report, we discuss

some of the most important risks and risk mitigations associated with

these systems, products, and services. For example, counterparty/credit

risk arises from the potential that a borrower or counterparty will fail to

perform on an obligation. Operational risk arises from the potential that

inadequate information systems, operational problems, breaches in

internal controls, or unforeseen catastrophes will result in unexpected

losses. Risk of fraud is risk of intentional deceptions that could result in

monetary loss. Payment system participants, regulators, and service

providers take steps to mitigate these risks. The risk mitigation strategies

vary by type of system and are generally more rigorous for large-dollar

transactions.

Overview The United States has a wide variety of payments, clearance, and

settlement systems. Some systems are used primarily for large-dollar

payments, such as Fedwire1

 and the Clearing House Interbank Payment

System (CHIPS),2

 others are used for the clearance and settlement of

financial products, such as securities, futures, and options. These systems

are mainly used by major financial players, such as banks and other

corporations, and are generally referred to as wholesale systems. Other

systems are used for the smaller dollar transactions with which most

consumers are familiar—e.g., checks, credit cards, and automated clearing

house payments (such as electronic deposits of paychecks or Social

Security payments). Generally, these smaller dollar systems are referred to

as retail systems.

1

Fedwire is the electronic funds transfer system operated by the Federal Reserve.

2

CHIPS is a private-sector electronic funds transfer system run by the New York Clearing House

Association (NYCHA).

Page 3 GAO/GGD-97-73 Payments, Clearance, and Settlement
B-270598 

New, consumer-oriented products, such as stored-value cards, are now

being introduced. A stored-value card is a credit-card-sized device with an

implanted computer chip, that has a certain value and can be used for a

variety of applications including financial transactions. New services, such

as electronic money, are also being tested and marketed. Electronic

money is funds held in an online account that can be transferred over the

Internet between any two parties, including consumer to consumer. These

new products and services have not yet gained wide acceptance, but many

private-sector companies are planning for the rapid expansion of these

and similar products in the future.

The types of risk we discuss in this report are generally present in all

payments, clearance, and settlement systems. For example, operational

risk, such as the risk of computer failure, is inherent in all systems. One

type of mitigation strategy for operational risk focuses on having adequate

computer back-up systems. We do not discuss all relevant risks or

mitigation strategies but focus on some of the more important ones.

Many significant issues have been raised by industry officials, regulators,

and others regarding the operations, use, and regulation of payments,

clearance, and settlement systems. For large-dollar transactions, some

have raised the issue of the appropriateness of some institutions using less

secure payment systems to reduce their costs of transfers. Others have

raised issues about new and emerging products, such as stored-value

cards and home banking. For example, some said these products are being

offered, by both banks and their nonbank competitors, yet banks are

subject to a much greater degree of regulation of these products than are

nonbanks. Also, many have raised questions about the appropriate

regulatory structure for these products and services. Security issues for

both wholesale systems, such as Fedwire and CHIPS, and emerging

services, such as home banking, have also been raised. The enormous

volume and rapid growth in foreign exchange transactions have led to

discussion and studies of how to better reduce risk in this market. Finally,

many private industry officials, especially private payment system

providers, have raised issues for some time about the ability of the Federal

Reserve to be both a regulator of payment systems and a fair competitor in

delivering these payment services.

Page 4 GAO/GGD-97-73 Payments, Clearance, and Settlement
B-270598 

Scope and

Methodology

To obtain information on and describe retail and wholesale payments,

clearance, and settlement systems; to identify risk and risk mitigation

strategies;3

 and to identify issues concerning these systems, we:

• interviewed officials from international and federal financial regulators,

including the Bank for International Settlements, the Board of Governors

of the Federal Reserve System; the Federal Reserve Banks of New York,

Richmond, Boston, and San Francisco; the Office of the Comptroller of the

Currency; the Federal Deposit Insurance Corporation; the Office of Thrift

Supervision; and the Securities and Exchange Commission;

• interviewed officials and analyzed statistics and documents from various

private-sector payments system providers and participants, including the

National Automated Clearing House Association, the New York Clearing

House Association, Visa International, the Society for Worldwide

Interbank Financial Telecommunications (S.W.I.F.T.), the Chicago Board of

Trade (CBOT), the Chicago Mercantile Exchange (CME), and their

respective clearing organizations—the Board of Trade Clearing

Corporation and the CME’s clearing house division;

• interviewed officials and analyzed statistics and documents from various

consumer groups.

To identify new and emerging products and services, their associated risk

and risk mitigation strategies, and related issues, we interviewed officials,

and analyzed statistics and documents from the following:

• consultants with expertise in the development of commercial sites on the

Internet;

• representatives of software/hardware companies developing products for

electronic commerce and electronic banking applications;

• law firms and others with knowledge of legal issues involved in the

development of commercial applications for the Internet;

• representatives of stored-value card corporations; and

• officials from other organizations involved in the development of these

products and services.

We did our work primarily in Washington, D.C., and New York between

January 1996 and April 1997 in accordance with generally accepted

government auditing standards.

3

We did not test the adequacy of any of the risk mitigation techniques discussed in this report.

Page 5 GAO/GGD-97-73 Payments, Clearance, and Settlement
B-270598 

Federal Reserve’s

Comments and Our

Evaluation

We requested comments on a draft of this report from the Federal Reserve

Board of Governors. The Federal Reserve’s written comments along with

our responses appear in appendix I. In addition, the staff of the Board of

Governors provided technical comments that were incorporated in this

report as appropriate. We chose not to incorporate all of the Federal

Reserve’s complex, technical suggestions, because our purpose, as stated,

was to provide basic information on the systems at a consistent level of

detail.

The Federal Reserve expressed concern about the manner in which we

categorized various risks in the payments systems. In addition, the Federal

Reserve suggested that some types of risks, such as liquidity risk, were

excluded from our discussion. The Federal Reserve also found our

discussion of the legal and regulatory framework for the various payment

mechanisms to be confusing because it addressed regulation of

transactions in some instances and supervisory regulation of the parties in

others. The Federal Reserve pointed out that in its view our draft report

did not discuss similar payment systems in a manner that provided easy

comparison or assessment of differences.

The Federal Reserve also raised concerns about our presentation of the

issues concerning traditional wholesale and retail payments systems and

new and emerging products and services. In some instances, the Federal

Reserve suggested that our discussion of the issues was incomplete. In

other cases, it noted that the potential problems we raised about new

emerging products and services also apply to more traditional products

and services such as credit cards and checks. Finally, the Federal Reserve

suggested that on several issues our draft report did not fully account for

the actions that the Federal Reserve has taken to mitigate potential

problems.

As we state in our report, our purpose in providing information on risks

and risk mitigations was to highlight some of the more important risks

raised by payment industry officials and others with respect to specific

payment systems. Our intent was neither to provide an exhaustive list of

all types of risks present in all payment systems nor to evaluate which

ones are more or less important. Many public- and private-sector

organizations categorize risk in different ways; we attempted to be

consistent but also tried to use the same terms used by our sources.

Although the Federal Reserve expressed concern that liquidity risk was

not specifically identified, liquidity risk generally was not one of the major

risks raised by industry officials and others we interviewed.

Page 6 GAO/GGD-97-73 Payments, Clearance, and Settlement
B-270598 

Our purpose in discussing the legal and supervisory framework was to

provide a general overview of the applicable laws, regulations, and where

it might be unclear to the reader, the supervisory framework for these

systems and products. For all the products and services, we discuss the

legal and regulatory structure. In some instances, where we felt additional

information would be helpful to the reader, we also discuss supervision of

the products and services. Our report was not intended to provide a

comprehensive survey of the supervision and oversight of these payment

system products and services.

With regard to the ease of comparison of various payment systems, our

purpose in this report was to provide basic information on each of these

systems, products, and services, not to provide a comparative study of

them. But we do present the information in a consistent format and report

comparable statistics to the extent possible.

The purpose of presenting information on issues regarding payment

systems was to highlight rather than discuss in depth, evaluate, or resolve

potential problems and concerns that were raised by industry, public

sector, and other officials. A detailed analysis of the various factors that

would need to be taken into consideration in addressing these issues, or

that could affect how these issues can be resolved, was beyond the scope

of this report. Section 5 of the report is not designed to include a

comprehensive list of all of the issues in the payments, clearance, and

settlement environment.

With regard to issues related to new and emerging products and services,

we agree that some of these issues may be applicable to more traditional

payment systems. Again, our purpose was simply to highlight the issues

raised by industry officials in connection with these new products and

services. We have reviewed and incorporated where appropriate

information the Federal Reserve has provided on actions it has undertaken

to mitigate potential problems associated with some issues.

We are sending copies of this report to the majority and minority Members

of the House and Senate Banking Committees, Agriculture Committees,

and Commerce Committees, and to other interested parties. We will also

make copies available to others on request.

Page 7 GAO/GGD-97-73 Payments, Clearance, and Settlement
B-270598 

This report was prepared under the direction of Susan Westin, Assistant

Director, Financial Institutions and Markets Issues. Other major

contributors to this review are listed in appendix II. If you have any

questions about this report, please call me at (202) 512-8678.

Sincerely yours,

Jean Gleason Stromberg

Director, Financial Institutions

 and Markets Issues

Page 8 GAO/GGD-97-73 Payments, Clearance, and Settlement
B-270598 

Page 9 GAO/GGD-97-73 Payments, Clearance, and Settlement
Contents

Letter 1

Section 1

Wholesale Payment

Systems

Overview of Clearance and Settlement of Wholesale Payment 15

Systems

Fedwire Electronic Transfer of Funds 17

S.W.I.F.T. 27

Clearing House Interbank Payments System 28

Settlement of Foreign Exchange Transactions 37

Bilateral and Multilateral Netting of Foreign

Exchange Transactions 46

Section 2

Equities, Treasuries,

Futures, and Options

Overview of Clearance and Settlement Systems of Equities, 47

Treasuries, Futures, and Options

Equities Clearance and Settlement 48

Treasuries and the Fedwire Book-Entry Securities System 58

Futures 66

Exchange-Traded Options 77

Section 3

Retail Payment

Systems

Overview of Clearance and Settlement of Retail Payment 91

Systems

Checks 93

Electronic Funds Transfer 107

Credit Cards 108

Automated Clearing House 116

Section 4

New and Emerging

Financial Products

and Services

Overview of New and Emerging Financial Products and Services 131

The Internet 132

Stored-Value Cards 133

Electronic Banking 141

Financial Services Over the Internet 148

Section 5

Issues

Issues Related to Payments, Clearance, and Settlement Systems 157

Page 10 GAO/GGD-97-73 Payments, Clearance, and Settlement
Contents

Appendixes Appendix I: Comments From the Board of Governors of the Federal

Reserve System 170

Appendix II: Major Contributors to This Report 179

Glossary 180

Tables Table 1.1: Selected Data on Fedwire Funds Transfers 18

Table 1.2: Risk and Risk Mitigation for Fedwire 22

Table 1.3: Selected Date on CHIPS Transfers 30

Table 1.4: Risk and Risk Mitigation for CHIPS 34

Table 1.5: Risk and Risk Mitigation for Foreign

Exchange Transactions 43

Table 2.1: Data on NSCC and DTC 50

Table 2.2: NSCC Clearance and Settlement Process

for Depository Equity Shares 51

Table 2.3: Risk and Risk Mitigation for Equities 56

Table 2.4: Data on GSCC and Fedwire 60

Table 2.5: Two Types of Trade Comparisons 62

Table 2.6: Risk and Risk Mitigation for Treasuries 65

Table 2.7: Data on GSCC and Fedwire 69

Table 2.8: Steps in the Futures Clearing Process 70

Table 2.9: Two Types of Settlement 71

Table 2.10: Risk and Risk Mitigation for Futures 75

Table 2.11: Total Volume of Exchange-Traded Options

Contracts Cleared in 1995 82

Table 2.12: Steps in the Options Clearing Process 84

Table 2.13: Two Types of Settlement 85

Table 2.14: Risk and Risk Mitigation for Options 89

Table 3.1: Major Organizations That Process

or Exchange Checks 95

Table 3.2: The Volume of Checks Processed, 1992-1995 97

Table 3.3: Risk and Risk Mitigation for Checks 104

Table 3.4: The Number of Major U.S. Credit Card

Companies’ Cards, 1990-1995 109

Table 3.5: Risk and Risk Mitigation for Credit Cards 114

Table 3.6: Examples of ACH Credit and Debit Transactions 116

Table 3.7: Volume of ACH Transactions Processed by the Four

 ACH Providers, 1992-1996 118

Page 11 GAO/GGD-97-73 Payments, Clearance, and Settlement
Contents

Table 3.8: Total Amount of Dollars Processed by Each

ACH Provider, 1992-1996 120

Table 3.9: Risk and Risk Mitigation for ACH 129

Table 4.1: Stored-Value Card Tests 135

Table 4.2: Risk and Potential Risk Mitigation for Stored-Value Cards 139

Table 4.3: Consumer Banking Activities Accessible

By Electronic Means, 1996 141

Table 4.4: Risk and Risk Mitigation for Electronic Banking 146

Table 4.5: Risk and Risk Mitigation for Financial Services

on the Internet 155

Figures Figure 1.1: A Fedwire Funds Transfer Transaction 20

Figure 1.2: A Typical CHIPS Transfer 31

Figure 1.3: Final Settlement of CHIPS 33

Figure 1.4: A Typical Foreign Exchange Transaction 40

Figure 2.1: T+3 Clearance and Settlement of Depository-Eligible

Equity Shares 52

Figure 2.2: The 24-Hour Trading, Clearance, and Settlement Cycle 72

Figure 2.3: An Options Listing 78

Figure 2.4: T+1 Trading, Clearance, and Settlement Cycle 87

Figure 3.1: An Example of a Paper Check 94

Figure 3.2: The Federal Reserve System for Processing a Paper Check 100

Figure 3.3: Clearance and Settlement Cycle of Credit Cards 110

Figure 3.4: The Average Value of an ACH Transaction, 1992-1995 119

Figure 3.5: Typical ACH Credit Transaction—The Direct Deposit

of a Payroll 122

Figure 3.6: Typical ACH Debit Transaction—Bill Payment 126

Figure 4.1: A Typical Mondex Card Transaction 137

Figure 4.2: Illustration of an Electronic Bill Payment Process 144

Figure 4.3: Credit Card Payments Over the Internet 152

Abbreviations

ABMS Account Balance Monitoring System

ACH Automated Clearing House

AMEX American Stock Exchange

ASO Additional settlement obligation

ATM Automated Teller Machine

AVS Address Verification Service

Page 12 GAO/GGD-97-73 Payments, Clearance, and Settlement
Contents

BIS Bank for International Settlements

BOTCC Board of Trade Clearing Corporation

CBCH California Bankers Clearing House

CBT Chicago Board of Trade

CCH Chicago Clearing House Association

CFTC Commodity Futures Trading Commission

CHECCS Clearing House Electronic Check Clearing System

CHIPS Clearing House Interbank Payment System

CME Chicago Mercantile Exchange

CNS Continuous net settlement

CRA Community Reinvestment Act

CST Central Standard Time

CUSIP Committee on Uniform Securities Identification

Procedures

DCIA Debt Collection Improvement Act of 1996

DM Deutsche mark

DTC Depository Trust Corporation

DVP Delivery-versus-payment

EAF-2 Frankfurt Electronic Clearing System

ECHO Exchange Clearing House

ECCHO Electronic Check Clearing House Organization

ECP Electronic check presentment

EDC Electronic Data Capture

EFAA Expedited Funds Availability Act of 1987

EFTA Electronic Funds Transfer Act

EMS Electronic Money System

EROC East Rutherford Operations Center

ET Eastern Time

FCM Futures Commission Merchant

FDIC Federal Deposit Insurance Corporation

FRBNY Federal Reserve Bank of New York

FTC Federal Trade Commission

GSCC Government Securities Clearing Corporation

ICS Issuer’s Clearing House Service

IRS Internal Revenue Service

MCA Monetary Control Act of 1980

MICR Magnetic Ink Character Recognition

NACHA National Automated Clearing House Association

NASD National Association of Securities Dealers

NOCH National Organization of Clearing Houses

NSCC National Securities Clearing Corporation

Page 13 GAO/GGD-97-73 Payments, Clearance, and Settlement
Contents

NYACH New York Automated Clearing House

NYCHA New York Clearing House Association

NYSE New York Stock Exchange

OCC Options Clearing Corporation

OFAC Treasury Office of Foreign Assets Control

OTC Over-the-counter

PAX Private ACH Exchange

PVP Payment-vs.-payment

RTGS Real-Time Gross Settlement System

S.W.I.F.T. Society for Worldwide Interbank Financial

Telecommunications

S-HTTP Secure HyperText Transfer Protocol

SEC Securities and Exchange Commission

SET Securities Electronic Transaction

SSL Secure Sockets Layer

TAP Transaction adjusted payment

TLA Truth in Lending Act of 1968

UCC Uniform Commercial Code

WWW World Wide Web

Page 14 GAO/GGD-97-73 Payments, Clearance, and Settlement
Section 1: Wholesale Payment Systems • Overview 

Overview of Clearance and Settlement of

Wholesale Payment Systems

In this section of the report, we discuss the two primary wholesale

payment systems in the United States, the Federal Reserve’s Fedwire

funds transfer service, and the Clearing House Interbank Payments System

(CHIPS), as well as foreign exchange transactions.

Main Characteristics • Wholesale payments are large-value payments made by major financial

players, such as banks and other corporations.

• The Federal Reserve’s Fedwire funds transfer service, primarily used for

domestic payments, is a real-time, gross settlement system in which the

Federal Reserve guarantees payment to the receiver of the funds. CHIPS, a

private-sector multilateral netting organization, is used mainly to settle the

U.S. dollar side of foreign exchange transactions.

• Foreign exchange transactions involving U.S. dollars, being an exchange

of currencies, involve two settlements: dollars settled in the United States,

and another currency settled in that currency’s national payment system.

Statistical Information In 1996:

• Fedwire funds transfer service’s average daily transaction amount was

$989 billion, and the average amount per transaction was $3.0 million.

• CHIPS’ average total daily transaction value was $1.3 trillion, and the

average value per transaction was $6.2 million.

• On average in early 1995, nearly $1.2 trillion of foreign exchange trades

were transacted globally per day.

Page 15 GAO/GGD-97-73 Payments, Clearance, and Settlement
Section 1: Wholesale Payment Systems • Overview 

Overview of Clearance and Settlement of

Wholesale Payment Systems

Regulatory

Information

• Fedwire’s funds transfers are regulated under subpart B of the Federal

Reserve’s Regulation J.

• Funds transfers processed over CHIPS are regulated under New York State’s

version of the Uniform Commercial Code (UCC) Article 4A, and rules

adopted by the New York Clearing House Association (NYCHA).

• Oversight of banks conducting foreign exchange transactions in different

countries is provided by the bank regulators in those countries.

Risk Information • The Federal Reserve is exposed to credit risk for those payments

transmitted over Fedwire that generate daylight overdrafts in a

participant’s account.

• A CHIPS failure to settle could create systemic risk and, in recognition of

this, a series of risk controls has been established.

• Settlement failure in foreign exchange transactions could transmit

systemic problems internationally.

Page 16 GAO/GGD-97-73 Payments, Clearance, and Settlement
Section 1: Wholesale Payment Systems • Fedwire 

Fedwire Electronic Transfer of Funds

Description and Use The Fedwire funds transfer system is one of the two primary large-dollar

electronic payments systems in the United States.1

 In 1996, Fedwire’s

average total daily transaction value for the electronic transfer of funds

was about $989 billion; the average value per transaction was $3.0 million.

The Fedwire funds transfer service allows depository institutions to

transfer funds on their own behalf or on behalf of their customers; most

Fedwire payments are related to domestic transactions. The Department

of the Treasury and other federal agencies also use Fedwire to disburse

and collect funds.

A daylight overdraft is a negative position in an institution's Federal Reserve 

account at any time during the business day.

 

A Federal Reserve account is a noninterest earning account that depository 

financial institutions maintain with a Federal Reserve Bank. The balance in a 

Federal Reserve account is maintained for purposes of (1) satisfying the Federal

Reserve's reserve requirements and/or (2) settling payments cleared through the

Federal Reserve. The balances in these accounts play a central role in the 

exchange of funds between depository institutions. 

Finality is an irrevocable and unconditional transfer of payment.

A net debit cap is the maximum dollar amount of daylight overdrafts an institution

is permitted to incur in its Federal Reserve account. Under the Federal Reserve's 

policy, institutions are subject to two caps--a daily cap and a 2-week cap.

An RTGS system is a system that is said to operate in real-time if it processes 

each transaction as it is initiated rather than processing it in a batch. 

Gross settlement means that the system settles each transfer individually. 

Finality

F

N Net debit cap

Real-Time Gross

Settlement (RTGS) system

R

D Daylight overdraft

Key Terms

Federal Reserve account

1

The other large-dollar electronic payments system, the Clearing House Interbank Payments System

(CHIPS), is discussed separately in this report.

Page 17 GAO/GGD-97-73 Payments, Clearance, and Settlement
Section 1: Wholesale Payment Systems • Fedwire 

Fedwire Electronic Transfer of Funds

Basic Data Virtually all of the approximately 9,500 depository institutions with

Federal Reserve accounts use them to transmit funds transfers over

Fedwire. In 1996, the total volume of dollars transferred over the Fedwire

funds transfer service was $249 trillion. As shown in table 1.1, for the

period of 1992 through 1996, the volume and the average daily transaction

value of Fedwire funds transfers increased, but the average value of a

Fedwire funds transfer transaction remained relatively constant at about

$3.0 million.

Table 1.1: Selected Data on Fedwire

Funds Transfers

1992 1993 1994 1995 1996

Percent

change

1992-96

Average number of

daily transfer

messages 267,000 277,000 287,000 302,000 328,000 23%

Average daily

transfer value

$787

billion

$824

billion

$841

billion

$888

billion

$989

billion 25

Average value per

transfer

$2.9

million

$3.0

million

$2.9

million

$2.9

million

$3.0

million 3

Fees per

transactiona $0.53 $0.53 $0.53 $0.50 $0.50 –6

aBoth the sender and the receiver of a Fedwire funds transfer are charged a fee. In January 1997,

the transfer fee was reduced to $0.45.

Source: Federal Reserve Bank of New York.

Processes Fedwire is a real-time gross settlement (RTGS) system. The Fedwire funds

transfer system operates from 8:30 a.m. Eastern Time (ET) to 6:30 p.m. ET.

2

The Fedwire funds transfer operating system essentially consists of two

components:

• A high-speed, nationwide communications network (FEDNET) that

electronically links all Federal Reserve Banks and branches with

depository institutions;3

 and

2

Beginning on Dec. 8, 1997, the Fedwire funds transfer service is scheduled to open at 12:30 a.m. (ET)

and close at 6:30 p.m. (ET).

3

This network is used by depository institutions to access a variety of Federal Reserve services,

including Fedwire.

Page 18 GAO/GGD-97-73 Payments, Clearance, and Settlement
Section 1: Wholesale Payment Systems • Fedwire 

Fedwire Electronic Transfer of Funds

• A computerized capability to process and record individual funds and

transfers4

 as they occur.

Fedwire allows depository institutions to transfer funds on their own

behalf or on behalf of their customers. Each depository institution using

the Fedwire funds transfer system must have a Federal Reserve account

with its respective Federal Reserve Bank. Figure 1.1 illustrates how a

typical funds transfer transaction between two customers is transmitted

over Fedwire.

4

A separate system, the Fedwire securities transfer service is discussed in the securities section

(Section 2) of this report.

Page 19 GAO/GGD-97-73 Payments, Clearance, and Settlement
Section 1: Wholesale Payment Systems • Fedwire 

Fedwire Electronic Transfer of Funds

Figure 1.1: A Fedwire Funds Transfer Transaction

Customer A requests $1M

in its depository account at Bank A

to be transferred to Customer B's

account located at another

depository institution. 

Federal Reserve System 

1

Once the payment of $1M is

credited to Bank B's account, the Fedwire

funds transfer is completed.

For most funds transfers involving

online depository institutions,

the time that elapses between when a funds

transfer message is sent and when a

payment is received is a matter of seconds.

Once the Fedwire transaction is

completed, Bank B makes the designated

$1M payable and available to Customer B

on the day payment occurs. 

4

Fedwire

Bank A transfers $1M for Customer A

by sending a message over Fedwire 

authorizing the Federal Reserve to

electronically debit Bank A's account at

the Reserve Bank for $1M and to transfer

the $1M to Bank B's account.

2

Bank A AAAA AAAAAAAA AAAAAAAA AAAAAAAA AAAAAAAA AAAA

Customer A

Debit Credit

$1M

Bank B AAAA AAAAAAAA AAAAAAAA AAAAAAAA AAAAAAAA AAAA

Customer B

Debit Credit

$1M

a

3

AAAA AAAA AAAAAAAA AAAA AAAAAAAA AAAA AAAAAAAA AAAA AAAAAAAA AAAA AAAAAAAA AAAA AAAAAAA AAA AAA

Bank A Bank B

Debit Credit

$1M

Debit Credit

$1M

aAccording to a Federal Reserve Bank of New York publication, once a funds transfer is

completed, the funds are generally available for immediate withdrawal.

Source: Federal Reserve.

Page 20 GAO/GGD-97-73 Payments, Clearance, and Settlement
Section 1: Wholesale Payment Systems • Fedwire 

Fedwire Electronic Transfer of Funds

Fedwire Offers Immediate

Finality

A critical feature of Fedwire is that it offers immediate finality. Immediate

finality of payment sets Fedwire apart from any other electronic payment

system operating in the United States. Under Regulation J, the Federal

Reserve “guarantees” the payment to the depository institution receiving

the Fedwire transaction and assumes any credit risk if there are

insufficient funds in the Federal Reserve account of the bank sending the

payment.

Changes in Fedwire’s

Operating Environment

The Federal Reserve is undertaking several enhancements to Fedwire’s

operating environment for the purpose of reducing risk related to funds

transfers and increasing the usefulness of Fedwire. Two significant

changes affecting the Fedwire funds transfer service are the expansion of

Fedwire’s operating hours and a new, expanded message format for funds

transfers.

As previously mentioned, the Fedwire funds transfer system operates from

8:30 a.m. ET to 6:30 p.m. ET. Beginning on December 8, 1997, Fedwire’s

funds transfer online operating hours are to be expanded to an 18-hour

operating day, from 12:30 a.m. ET to 6:30 p.m. ET. The Federal Reserve’s

decision to extend Fedwire’s funds transfer operating hours was part of its

response in addressing the potential risk arising from the growing volume

of cross-border payments. The extension of Fedwire’s hours for funds

transfers means that Fedwire would be open while major foreign financial

centers are open. Cross-border payments are discussed in more detail in

the Foreign Exchange segment of this section.

The Federal Reserve is in the process of expanding the Fedwire funds

transfer message format, which is to be fully implemented by year-end

1997. The expanded transfer format is intended to improve efficiency in

the payments mechanism by reducing the need for manual intervention

when processing and posting transfers, and by making the format more

compatible with the formats used by CHIPS and the Society for Worldwide

Interbank Financial Telecommunication (S.W.I.F.T.). In addition, the

expanded format permits the inclusion of additional originator and

beneficiary information, as required by Treasury regulations.

Regulatory Oversight Funds transfers through Fedwire are regulated under subpart B of Federal

Reserve’s Regulation J. This part of Regulation J generally incorporates

Article 4A of the Uniform Commercial Code (UCC) as the governing law for

the Fedwire funds system. The UCC is a set of model state laws governing

Page 21 GAO/GGD-97-73 Payments, Clearance, and Settlement
Section 1: Wholesale Payment Systems • Fedwire 

Fedwire Electronic Transfer of Funds

commercial and financial activities. UCC Article 4A sets out the rights and

obligations of the various participants in a funds transfer, including those

of the originator, intermediary institutions, and the beneficiary.

Subpart B of Regulation J also directs each Reserve Bank to issue

operating circulars governing funds transfer operations. These circulars

cover such matters as operating hours, security, authentication, and fees.

Risk and Risk

Mitigation

For the purposes of this report, we discuss some of the most important

risks and risk mitigations associated with Fedwire.

Table 1.2: Risk and Risk Mitigation for

Fedwire Risk Risk mitigation

Counterparty credit risk Net debit caps (including zero caps)

Account balance monitoring system

Daylight overdraft fees

Operational risk Back-up facilities

Automated recovery

Fraud risk Data security:

• Encryption 

• Authentication procedures

• Access controls

Risk 1: Counterparty

Credit

Because the Federal Reserve grants finality (i.e., final and irrevocable

credit) to the recipients of funds sent over Fedwire, the Federal Reserve

Bank assumes any credit risk if there are insufficient funds in the Federal

Reserve account of the depository institution sending the funds. For

example, if Bank A, in our hypothetical example (see figure 1.1), had an

insufficient account balance to cover the funds transfer, the Federal

Reserve, in its sole discretion, may allow Bank A to overdraw its account.

While Bank A’s account is overdrawn, the Federal Reserve would be at

risk for any losses should Bank A fail. This credit risk, commonly referred

to as a daylight overdraft, is present even for an overdraft position that

occurs only briefly during the day. The Federal Reserve requires

depository institutions to eliminate any daylight overdrafts by the close of

Fedwire each day. From 1986 to 1996, the average daily peak daylight

overdrafts for funds transfers increased from $63 billion to $68 billion.

Page 22 GAO/GGD-97-73 Payments, Clearance, and Settlement
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Fedwire Electronic Transfer of Funds

Daylight overdrafts, if not repaid by the end of the day, could become

unsecured overnight overdrafts. The Federal Reserve attempts to

discourage overnight overdrafts by imposing high monetary penalties and

taking administrative action against institutions that incur them

repeatedly.

Mitigation Net debit caps. In 1985, the Federal Reserve Board adopted a program of

maximum limits, or net debit caps, for each depository institution. A net

debit cap is a maximum level of daylight overdrafts that a depository

institution may incur in its account at the Federal Reserve. The dollar

amount of a specific net debit cap is determined by an institution’s capital

and is a multiple of the institution’s capital. The multiple is to be based on

the financial strength of each institution. The strongest institutions may

obtain a higher cap multiple than that obtainable by riskier institutions.

The most risky institutions are to be assigned a zero net debit cap and

prohibited from originating a Fedwire funds transfer that would cause

their account to become overdrawn, or, in an extreme case, the Federal

Reserve may terminate the institution’s online access to Fedwire. In some

cases, the Federal Reserve may require weak depository institutions to

collateralize their overdrafts. A recent Federal Reserve study found that

net debit caps seemed to have restrained the growth of daylight overdrafts

that are not related to securities transfers during the 1986 through 1993

period.5

According to the Federal Reserve’s Policy Statement on Payment System

Risk, depository institutions that use intraday Federal Reserve credit in

amounts that exceed 40 percent of risk-based capital on a single day or, on

average, over a 2-week period must establish their daylight overdraft caps

by a self-assessment process. This process is required in order to establish

a cap in any one of the Average, Above Average, or High categories. A

high-cap multiple would permit the 2-week average of daily peak daylight

overdrafts to be 1.5 times the depository institution’s capital. Reserve

Banks also have the authority to reduce an institution’s Fedwire net debit

cap unilaterally.

5

Heidi Richards, “Daylight Overdraft Fees and the Federal Reserve’s Payment System Risk Policy,”

Federal Reserve Bulletin, Dec. 1995.

Page 23 GAO/GGD-97-73 Payments, Clearance, and Settlement
Section 1: Wholesale Payment Systems • Fedwire 

Fedwire Electronic Transfer of Funds

Mitigation Account balance monitoring. Net debit caps are permitted at the

discretion of the Federal Reserve Banks. Using Fedwire’s Account Balance

Monitoring System (ABMS), the Reserve Banks can hold or reject funds

transfers that may cause account holders to exceed their net debit caps.

ABMS allows the Reserve Banks to monitor depository institutions’ account

positions and payment activity on a real-time basis.

Mitigation Daylight overdraft fees. In September 1992, the Federal Reserve Board

adopted a policy under which the Federal Reserve Banks would, beginning

in April 1994, charge a fee to depository institutions for average daylight

overdrafts in deposit accounts with Federal Reserve Banks as a

supplement to the existing net debit cap policy. The Board set the initial

fee at an annual interest rate of 10 basis points (0.10 percent) of

chargeable daily daylight overdrafts.6

 In April 1995, the fee was increased

to 15 basis points.7

 The chargeable overdraft is the institution’s average

per-minute daylight overdraft for a given day, less a deductible amount

equal to 10 percent of its risk-based capital.

The Federal Reserve study mentioned earlier also found that the

imposition of daylight overdraft fees resulted in a decline in the average

per-day overdrafts by depository institutions. Specifically, the study

showed that the aggregate intraday peak overdrafts fell approximately 40

percent, from nearly $125 billion per day on average, during the 6 months

preceding April 14, 1994, to about $70 billion in the 6 months following the

introduction of daylight overdraft fees on April 14.8

Risk 2: Operational Because of the enormous value and importance of the funds transfers sent

over Fedwire daily, any temporary outages in the Fedwire electronic

system could pose significant economic and financial risks. Moreover, a

prolonged outage of the Fedwire electronic system could cause an

unacceptable disruption of the U.S. payment system.

6

A basis point is one-hundredth of one percent.

7

Originally, the Board had planned to increase the fee to 25 basis points as of Apr. 1996, but in early

1995, the Board determined that a smaller fee increase to 15 basis points would be more appropriate.

In addition, the Board decided to wait 2 years before evaluating the results of the Apr. 1995 increase.

This stated rate is based on the current 10-hour Fedwire funds transfer operating day. On Dec. 8, 1997,

the stated rate for the 18-hour operating day is to be 27 basis points.

8

Richards, p. 1071.

Page 24 GAO/GGD-97-73 Payments, Clearance, and Settlement
Section 1: Wholesale Payment Systems • Fedwire 

Fedwire Electronic Transfer of Funds

Mitigation Back-up facilities. If an operational disaster should occur to the primary

computer at the East Rutherford Operations Center (EROC), the Federal

Reserve has designed Fedwire to automatically resume payment

processing almost instantaneously at its back-up computer at the EROC

site. If the entire EROC site is down, a remote database is designed to allow

Fedwire to resume payment processing at its secondary back-up center

(Federal Reserve Bank of Richmond) within 60 to 90 minutes of a decision

to relocate operations. The infrastructure is in place to allow Fedwire to

resume payment processing at its tertiary site should an operational

disaster occur at both the primary and secondary data centers.

Mitigation Automated recovery. Fedwire databases are duplicated for

instantaneous availability in the event of a database device failure. If a

database recovery is required, each participant has to retransmit only

those payments that were previously sent on Fedwire and indicate the loss

of payments through the recovery report. Fedwire tests its contingency

plans in multiple mandatory exercises annually against a variety of

simulated events, which include computer, site, and network outages.

Risk 3: Fraud There is the potential that fraudulent transfers could be transmitted over

Fedwire. For example, a computer hacker could make an unauthorized

funds transfer over Fedwire, or a bank employee could perform

unauthorized wire transfers.

Page 25 GAO/GGD-97-73 Payments, Clearance, and Settlement
Section 1: Wholesale Payment Systems • Fedwire 

Fedwire Electronic Transfer of Funds

Mitigation Data security measures. The Federal Reserve has implemented a variety

of data security measures to protect the integrity, confidentiality, and

continuity of the Fedwire system. These measures include access,

authentication, and verification controls; data encryption; procedural

controls over such processes as application changes, data entry and

database updates; physical security; and personnel standards. These

controls are designed to prevent tampering with, destroying, or disclosing

Fedwire data, either by Federal Reserve employees or outside hackers.

For example, Fedwire messages between depository institutions and the

Federal Reserve are encrypted and authenticated to prevent interception

and alteration. Access controls, such as unique user identification codes

and passwords, are also a primary means for preventing unauthorized

transfers. For example, employees at a depository institution must use a

valid and unique user identification code and password to enter and send a

Fedwire message, and that message must come from a connection

associated with that employee’s institution.

Depository institutions also have strong incentives to establish security

procedures to govern their initiation, verification, and receipt of Fedwire

funds transfers as well as other funds transfers. In particular, a depository

institution assumes full liability for any Fedwire funds transfers executed

from its authorized connection to the Fedwire system. Furthermore,

Article 4A of the UCC, through its allocation of liability for erroneous or

fraudulent transfers, encourages the establishment of commercially

reasonable security procedures. A review of depository institutions’ funds

transfer security procedures is also a component of the banking

regulators’ programs.

Page 26 GAO/GGD-97-73 Payments, Clearance, and Settlement
Section 1: Wholesale Payment Systems • Fedwire 

Fedwire Electronic Transfer of Funds

S.W.I.F.T. Society for Worldwide Interbank Financial Telecommunications (S.W.I.F.T.),

incorporated in Belgium, is a cooperative owned by over 2,800 banks from

around the world, including over 150 from the United States (owning

13 percent of the shares). It operates a network that processes and

transmits financial messages among members and other users in 137

countries. The United States accounts for more usage than any other

country.

S.W.I.F.T.

Users

S.W.I.F.T. messages convey information or instructions between financial

institutions:

• Messages are formatted and contain information about the originator,

purpose, destination, terms, and recipient.

• The largest use of S.W.I.F.T. is for payment messages, through which one

institution transmits instructions to another to make payments.

• Other messages are used to confirm the details of a contract entered into

between two users, such as a foreign exchange trade or an interbank

deposit placement.

• For securities, S.W.I.F.T. messages can transmit orders to buy or sell or

convey instructions concerning delivery and settlement.

Statistical Information

An average of 2.4 million messages of all types were processed by S.W.I.F.T.

per day in 1995.

• S.W.I.F.T. estimates that the value of the payments messages was $2 trillion

per day.

Page 27 GAO/GGD-97-73 Payments, Clearance, and Settlement
Section 1: Wholesale Payment Systems • CHIPS 

Clearing House Interbank Payments System

Description and Use The Clearing House Interbank Payments System (CHIPS) is one of the two

large-value electronic payments systems in the United States. The other is

Fedwire. CHIPS, which is privately owned and operated by the New York

Clearing House Association (NYCHA), began operations in 1970 as an

electronic replacement for paper checks in international dollar payments.

Although Fedwire payments are principally related to domestic

transactions, U.S. dollar payments related to “foreign transactions” (such

as the dollar leg of foreign exchange and Eurodollar placements) flow

primarily through CHIPS.

Although CHIPS transfers are irrevocable, they are final only after the

completion of end-of-day settlement.9 CHIPS nets its transactions on a

multilateral basis. Thus, if a bank receiving a CHIPS transfer makes funds

available to its customers before settlement is complete at the end of the

day, it is exposed to some risk of loss if CHIPS does not settle. However, in

its 27 years of operation, CHIPS has never failed to settle.

9

In contrast, Fedwire offers immediate finality of settlement—the Federal Reserve “guarantees” the

payment and assumes any credit risk.

Page 28 GAO/GGD-97-73 Payments, Clearance, and Settlement
Section 1: Wholesale Payment Systems • CHIPS 

Clearing House Interbank Payments System

Net debit cap

Systemic risk

S.W.I.F.T

M Multilateral netting Multilateral netting is an arrangement among three or more parties to net their 

obligations. The obligations covered by the arrangement may arise from 

financial contracts, transfers of funds, or both. The multilateral netting of 

payment obligations normally takes place in the context of a multilateral net 

settlement system.

Net debit cap is the quantitative limit placed on the debit positions that participants

in a funds transfer system can incur during the business day.

Systemic risk is the risk that the failure of one participant in a transfer system,

or in financial markets generally, to meet its required obligations will cause 

other participants or financial institutions to be unable to meet their obligations

(including settlement obligations in a transfer system) when due. 

Society for Worldwide Interbank Financial Telecommunications (S.W.I.F.T.) is 

an international financial payment cooperative organization that operates a

network that facilitates the exchange of payment and other financial messages

between financial institutions throughout the world.

S

N

Key Terms

Basic Data At year-end 1996, there were 103 CHIPS participants representing financial

institutions from 29 countries. CHIPS participants may be commercial

banks, Edge Act corporations,10 or investment companies. To be a CHIPS

participant, a financial institution is required to maintain a branch or an

agency in New York City. A nonparticipant wishing to make international

payments using CHIPS must employ one of the CHIPS participants to act as

its correspondent or agent.

As shown in table 1.3, both the volume and the average daily transaction

value of CHIPS transfers have increased, although the average size of a

transfer payment has remained relatively constant for the period 1992

through 1996. In addition, the number of CHIPS participants has decreased

during the same period.

10Edge Act corporations are corporations chartered by the Federal Reserve to engage in international

banking for financing trade. The Board of Governors acts on applications to establish Edge Act

corporations and also examines the corporations and their subsidiaries.

Page 29 GAO/GGD-97-73 Payments, Clearance, and Settlement
Section 1: Wholesale Payment Systems • CHIPS 

Clearing House Interbank Payments System

Table 1.3: Selected Data on CHIPS

Transfers Data 1992 1993 1994 1995 1996

Average number of daily

transfer messages 154,439 167,311 181,667 203,318 212,544

Average daily value of

transfers $942 billion $1 trillion $1 trillion $1 trillion $1 trillion

Average value of a

transfer $6 million $6 million $7 million $6 million $6 million

Average fee per

transactiona .15 .15 .15 .15 .15

Number of CHIPS

participants 122 121 115 111 103

aThe fee listed in the table is an average fee based on the three transaction fees that CHIPS

charges its participants. CHIPS charges a participant 18 cents per transaction for the first 80,000

transactions per month that it sends or receives. After a participant sends or receives over 80,000

transactions per month, CHIPS charges the participant 13 cents per transaction. Also, CHIPS

charges participants 40 cents per transaction for any transaction without an account number.

Source: CHIPS.

Processes Figure 1.2 illustrates a typical CHIPS transfer.

Example: A wholesaler in Paris wishes to pay $1 million to a U.S. software

supplier for a shipment of consumer software. The French wholesaler

instructs his bank in Paris (Bank A) to debit the French franc equivalent of

$1 million from his account and to arrange payment of the dollar amount

to the U.S. supplier’s account in Bank B in New York. This payment of

dollars represents a typical CHIPS transaction. Bank A has a branch in New

York. Both Bank A and Bank B are participants in CHIPS.

Page 30 GAO/GGD-97-73 Payments, Clearance, and Settlement
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Clearing House Interbank Payments System

Figure 1.2: A Typical CHIPS Transfer

S.W.I.F.T.

Paris

Bank A in Paris instructs its New York branch

to pay $1 million to Bank B for deposit in the

account of the software company.

1

2 Through an automated system,

an employee of Bank A's branch

in New York enters the

payment information into the branch's

CHIPS interface computer.

CHIPS CHIPS

CHIPS screens the amount against limit

controls. If the payment fits within controls,

CHIPS sends the payment message to

Bank B's interface computer (which

authenticates the message), and records

a debit for Bank A and a credit for Bank B.

4

Settlement occurs at the end of the

CHIPS day (see figure 1.3).

New York

Pay to:

For:

From:

Amount:

Bank B

Acct. of software co.

NY br. of Bank A

$1,000,000

Pay to:

For: A

From:

Amount:

Bank B

cct. of software co.

NY br. of Bank A

$1,000,000

Bank B

New York branch of A CHIPS Account

Bank A

Debit Credit

$1M

Bank B

Debit Credit

$1M

New York Clearing House

3 (a)

(b)

The central CHIPS computer

authenticates, stores, and acknowledges

the message.

Bank A's branch bank, via its computer

interface, releases the payment message

to CHIPS.

Source: NYCHA.

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Clearing House Interbank Payments System

The transaction between Bank A and Bank B is not settled until CHIPS

settles at the end of the day. If Bank B makes the $1 million available to

the U.S. software supplier prior to final settlement, Bank B could expose

itself to some risk of loss.

The Final Settlement of

CHIPS

Figure 1.3 illustrates the final settlement of CHIPS. Throughout the day, the

103 CHIPS participants continuously exchange payments among

themselves. As transactions flow, CHIPS continuously recalculates each

participant’s single net position vis-a-vis all other participants combined.

This is called multilateral netting. (See discussion in foreign exchange

transactions later in this section.)

Page 32 GAO/GGD-97-73 Payments, Clearance, and Settlement
Section 1: Wholesale Payment Systems • CHIPS 

Clearing House Interbank Payments System

Figure 1.3: Final Settlement of CHIPS

Participant A

+15

Participant B

-40

Settling participant D

+10

Net Positions Net Positions

Participant E

-10

Participant F

+50

Settling participant H

+70

Net Position

Nonsettling

participants

Settling

participant

-25

+10

Net debit -15

Fedwire

Federal Reserve

Bank of New York

CHIPS Account at FRBNY

Settling

participant D

Net debit -15

Settling

participant H

Net credit +110

Fedwire

Throughout the day, the 103 CHIPS participants

continuously exchange payments among themselves. As

transactions flow, CHIPS continuously recalculates each

participant's single net position vis-a-vis all other

participants combined. This is called multilateral netting.

At 4:30 p.m. ET, CHIPS closes

and notifies each participant

and settling participant of its respective

net debit or net credit position.

1

2 By 5:00 p.m., those settling

participants in a net debit

position must send a Fedwire

funds transfer, in the amount of

their net debits, to the CHIPS

settlement account at the FRBNY.

When all those settling participants

have paid into this account,

NYCHA sends Fedwire funds

transfers from the CHIPS account at

FRBNY to settling participants

in a net credit position.

Prior to this, the nonsettling

participants (A,B,E,F) will have settled

with their settling participants and,

on average, settlement is

normally completed by 5:10 p.m.

New York Clearing House

Net Position

Nonsettling

participants

Settling

participant

Net credit

+40

+70

+110

a

Other settling

participants

net debit -105

Other settling

participants

net debit -10

-120 +120

Page 33 GAO/GGD-97-73 Payments, Clearance, and Settlement
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Clearing House Interbank Payments System

aSettling participants take part in the actual settlement of CHIPS by sending or receiving the

Fedwire payments used to effect settlement. Participants that are not settling participants must

designate a settling participant to settle for them and that settling participant must agree to the

designation.

Source: NYCHA.

After all the settling participants that are in a net debit position have paid

in funds and participants that are in a net credit position receive a Fedwire

funds transfer from NYCHA, the CHIPS settlement account at the Federal

Reserve Bank of New York (FRBNY) reaches a zero balance.11 It is at this

point that the transaction transmitted over CHIPS between Bank A and

Bank B is settled and settlement is final.

Regulatory Oversight All CHIPS participants are supervised by the New York State Banking

Department or a federal bank supervisor. A coordinated interagency full

examination is to be conducted of CHIPS every other year and a limited

examination is to be conducted in the alternate years between the full

examinations. CHIPS transfers are governed by UCC Article 4A. The UCC is a

set of model state laws governing commercial and financial activities. UCC

Article 4A sets out the rights and obligations of the various participants in

a wire transfer.

Risk and Risk

Mitigation

For purposes of this report, we discuss some of the most important risks

and risk mitigations associated with CHIPS.

Table 1.4: Risk and Risk Mitigation for

CHIPS Risk Risk mitigation

Operational risk Back-up facilities

Automated recovery

Systemic risk/counterparty

credit risk

Same-day settlement

Bilateral credit limits

Net debit caps

Loss sharing—backed up by collateral

Membership requirements

11FRBNY is not required to provide financial assistance to ensure completion of the CHIPS settlement.

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Clearing House Interbank Payments System

Risk 1: Operational Because of the trillions of dollars sent over CHIPS, any temporary outage in

the CHIPS electronic system would pose significant economic and financial

risks.

Mitigation Back-up facilities. If an operational disaster should occur, the remote

database, established by CHIPS, is designed to allow CHIPS to resume

payment processing at its back-up center within 5 minutes of a decision to

relocate operations.

Mitigation Automated recovery. If the CHIPS database suffers damage, CHIPS has a

computerized method for rebuilding its database. Each participant can

automatically retransmit a payment previously sent if CHIPS indicates the

loss of payments through the transmission of the recovery report.

According to an NYCHA document, CHIPS quarterly tests its contingency

plans against a variety of simulated events in mandatory exercises

involving all participants.

Risk 2: Systemic

Risk/Counterparty Credit

The most significant risk to the financial stability of CHIPS is systemic risk.

Systemic risk/counterparty credit risk occurs when one participant fails to

meet its obligations and causes other participants not to meet their

obligations. When high-dollar value payments are exchanged and the

turnover of funds within the arrangement is also high, the degree of

systemic risk is generally high as well.

Mitigation Same-day settlement. In 1981, NYCHA instituted same-day settlement.

Before same-day settlement, CHIPS transactions took up to 2 days to settle,

except in the case of a weekend or holiday, when it could take up to 4 days

to settle. According to an NYCHA publication, same-day settlement has

eliminated overnight exposure to failures, reduced float in the banking

system, and accelerated the availability of funds to customers.

Mitigation Bilateral credit limits. Since October 1984, NYCHA has required each

CHIPS participant to establish a bilateral credit limit with each of the other

CHIPS participants. Each CHIPS participant is required to indicate whether or

not it is willing to receive payment messages from other participants. If a

CHIPS participant is willing to receive payment messages from another

participant, it must set a limit on the maximum net-dollar amount that it is

willing to receive from that participant.

The CHIPS operating system continuously and automatically monitors

payment messages, checking them against bilateral limits. If a payment

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Section 1: Wholesale Payment Systems • CHIPS 

Clearing House Interbank Payments System

message would cause a participant to exceed the bilateral limit that the

receiving participant has set for it, CHIPS is designed to not allow the

payment message to be released.

Mitigation Net debit caps. In 1986, NYCHA established a net debit cap for each CHIPS

participant. This cap limits a participant’s overall net debit position to all

other CHIPS participants. The significance of the net debit cap is that it

limits the total amount of credit exposure that any one participant can

pose to the CHIPS system. Thus, if a participant defaults, the potential net

loss to all other participants can be no greater than its net debit cap. For

each participant, the net debit cap is equal to 3.0 percent of the sum of the

bilateral limits set for it by the other participants.

Mitigation Loss sharing—backed up by collateral. In 1990, NYCHA established a

loss-sharing arrangement supported by pledged collateral to ensure that

CHIPS settles even if a participant fails. Under the loss-sharing arrangement,

each participant that has established bilateral limits with the failed

participant agrees to assume an additional settlement obligation (ASO),

equal to its pro rata share of the failed participant’s net debit position. To

ensure funding of the ASO, each participant is to provide collateral in

advance equal to the participant’s “maximum ASO.” The maximum ASO is

equal to $10 million or 5 percent of the highest bilateral limit granted to

any other participant, whichever is greater. The collateral is U.S. Treasury

securities, which are held in collateral accounts at FRBNY.

Mitigation Membership requirements. CHIPS maintains membership requirements

to ensure the financial stability of CHIPS and its participants. Moreover, to

ensure the creditworthiness of CHIPS participants, NYCHA requires all

participants to (1) be subject to a credit evaluation when they apply for

membership, (2) submit copies of their financial statements, and (3) be

subject to periodic review, which includes a credit review by the member

banks.

Page 36 GAO/GGD-97-73 Payments, Clearance, and Settlement
Section 1: Wholesale Payment Systems • Foreign Exchange 

Settlement of Foreign Exchange

Transactions

Description and Use A foreign exchange transaction is the trade of one currency for another,

for example a trade of U.S. dollars for German marks (DM). Foreign

exchange transactions are typically settled through transfers of bank

balances (deposits) in the respective currencies. This is a wholesale

activity conducted among financial institutions, especially banks, that may

be trading for their own account or on behalf of others.

Foreign exchange transactions are generated by cross-border activities,

such as international trade and the purchase or sale of foreign assets, as

well as by speculation on—or hedging against—moves in exchange rates.

The large financial institutions that offer to buy or sell foreign currencies

for their customers commonly do a considerable amount of foreign

exchange trading for their own account. This “proprietary” trading enables

a financial institution to have better market information for its customers

and itself and may also be conducted to hedge the institution’s own risks

or in an attempt to profit from moves of exchange rates.

Page 37 GAO/GGD-97-73 Payments, Clearance, and Settlement
Section 1: Wholesale Payment Systems • Foreign Exchange 

Settlement of Foreign Exchange

Transactions

B 

H

C

Back office

Correspondent bank

Hedging

Back office is a bank department responsible for recording and maintaining 

the official records of the bank and for processing transactions entered into 

by the bank. 

A correspondent bank is a bank that, by arrangement, holds the deposits of 

another bank and provides payments and other services for that bank.

Hedging is engaging in financial transactions to protect against potential 

adverse changes in the values of assets, liabilities, or off-balance-sheet 

activities.

Netting is an agreed offsetting of obligations by trading partners. It can reduce 

a large number of individual obligations to a smaller number of obligations.

Proprietary trading is buying or selling for the trading institution's own 

account, in contrast to trading the institution does on behalf of its customers.

Speculation is engaging in financial transactions, such as purchasing foreign 

currencies, in an attempt to profit from anticipated changes in market prices.

Society for Worldwide Interbank Financial Telecommunications (S.W.I.F.T.)

is an international financial payment cooperative organization that operates

a network that facilitates the exchange of payment and other financial

messages between financial institutions throughout the world.

N 

S

P

Netting

Proprietary trading

Speculation

S.W.I.F.T.

Key Terms

Basic Data On an average day, there are nearly $1.2 trillion in foreign exchange trades

transacted globally, according to a survey conducted by central banks in

April 1995.12 This figure—after adjustment for exchange rate

changes—was 30 percent higher than that found in a similar survey

conducted in 1992. Of the 1995 amount, 83 percent—almost $1

trillion—involved U.S. dollars. To put this in perspective, the U.S. money

stock at the end of 1995 was $3.509 trillion.13 About two-thirds of foreign

exchange transactions take place between bank dealers trading for their

own account.

12Bank for International Settlements, “Central Bank Survey of Foreign Exchange and Derivatives

Market Activity, 1995.”

13U.S. money stock, M2 measure, is composed of currency outside banks, checking and savings

deposits, small time deposits, retail money market funds, and traveler’s checks.

Page 38 GAO/GGD-97-73 Payments, Clearance, and Settlement
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Settlement of Foreign Exchange

Transactions

Processes Example: A bank in New York (Bank A) has 200,000 German marks

(DM200,000) on deposit with its correspondent bank in Frankfurt,

Germany (Bank X) and wishes to sell DM150,000 of that amount in

exchange for U.S. dollars. It might be initiating this trade for its own

account or on behalf of a customer.

This will be a “spot” transaction, in which settlement will be 2 days after

the trade is negotiated. Figure 1.4 illustrates how this transaction is

processed.

Page 39 GAO/GGD-97-73 Payments, Clearance, and Settlement
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Settlement of Foreign Exchange

Transactions

Figure 1.4: A Typical Foreign Exchange Transaction

New York

Process

With the current exchange rate at DM

1.50 per $1.00, one of Bank A's

traders enters into a trade contract

with Bank B in Frankfurt to sell DM

150K for $100K.

Bank A's back office receives the

contract information from the trader

and enters it into its computer system.

Trade day

Settlement day + 1

At Bank A, the back office verifies

that the dollars were received and

marks paid and that these transactions were in conformity with the

original trade details.

Settlement day + 1

Method of

communication/

messaging

New York

A

1

5

Step

10:00 a.m. in New York

Bank Y's computer debits $100K

from Bank B's deposit account and

generates a payment of $100K to

Bank A via CHIPS.

Banks

A

A

via

Initiating

bank

Correspondent

bank

Y

Payment

system

CHIPS

12

3

6

9

S.W.I.F.T.

A Initiating bank in New York City.

Society for Worldwide Interbank Financial CHIPS

Telecommunication. An organization that transmits

payment and other financial messages between

financial institutions worldwide.

The Clearing House Interbank Payments System, in

New York, which processes and settles dollar payments

among banks.

The back office of Bank A exchanges

messages with the back office of

Bank B to confirm the details of the

contract.

If the confirmations were in agreement, Bank A's computer system

automatically sends a message to

Bank X (its correspondent in

Frankfurt), instructing Bank X to pay

DM150K to Bank B on settlement

day.

S.W.I.F.T.

S.W.I.F.T.

2

3

Settlement day

Starts in Frankfurt

4

Y

A

A

Day prior to settlement

Trade day + 1

to Frankfurt

Y In New York City, correspondent bank of Bank B.

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Settlement of Foreign Exchange

Transactions

Process

The back office of Bank B exchanges

messages with the back office of

Bank A to confirm the details of the

contract.

Bank B's computer system automatically sends a message to Bank Y

(its correspondent in New York),

instructing it to pay $100K to Bank A

on settlement day.

Settlement day

11:00 a.m. in Frankfurt

(5:00 a.m. in New York)

Bank X's computer debits DM150K

from the account of Bank A and generates a payment of DM150K to

Bank B via EAF-2.

At Bank B, the back office verifies

that the marks were received and

dollars paid and that these transactions were in conformity with the

original trade details.

Frankfurt

Frankfurt

A Bank B trader enters into a trade

contract with Bank A to buy DM150K

for $100K.

Bank B's back office receives the

contract information from the trader

and enters it into its computer system.

Payment

system

EAF-2

X

B

B

DM

DM

12

3

6

9

Method of

communication/

messaging

1

2

3

4

5

Step

via

Banks

Initiating

bank

Correspondent

bank

B

B

B

X

S.W.I.F.T.

S.W.I.F.T.

EAF-2

Initiating bank in Frankfurt. AB

Elektronische Abrechnung Frankfurt

(Frankfurt Electronic Clearing System),

the interbank payment system in

Frankfurt.

Trade day

Trade day + 1

Day prior to settlement

to New York

X In Frankfurt, correspondent bank of Bank A.

Settlement day + 1

Note: For more information, see S.W.I.F.T. and CHIPS.

Source: First Chicago NBD Corporation.

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Transactions

The timing of the steps in Figure 1.4 is typical but not universal. For

example, Step 5, shown as taking place on “Settlement day + 1,” can take

place as late as settlement day + 2 in some banks. Similarly, the times of

the actions on settlement day (11:00 a.m. German time in Frankfurt, and

10:00 a.m. EST in New York) were chosen arbitrarily; these could occur at

any time during the open hours of the payments systems in the respective

cities.

Regulatory Oversight Regulatory oversight of participating institutions in foreign exchange

trading is in the hands of the central banks and other regulators in their

respective countries. In the United States, this responsibility generally

belongs to the bank regulators. These regulators oversee the foreign

exchange trading activities of banks through their normal examination

procedures.

Over the last 22 years, the central banks of the major industrial countries

(the “Group of Ten,” G-10 countries) have been working together on ways

to improve and to better coordinate their supervision of foreign exchange

trading.14 Since 1989, this group of central banks has issued a series of

studies on this topic, which included recommendations for private-sector

and central-bank actions that could decrease foreign exchange settlement

risk. In 1994 through 1995, a committee of the G-10 central banks surveyed

some 80 banks in their countries to determine current risk-control

practices. This survey identified practices for reducing risk and shortfalls

from these practices.

Risk and Risk

Mitigation

For purposes of this report, we discuss some of the most important risks

and risk mitigations associated with foreign exchange transactions.

14The G-10 countries include: Belgium, Canada, France, Germany, Italy, Japan, The Netherlands,

Sweden, Switzerland, United Kingdom, and the United States.

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Transactions

Table 1.5: Risk and Risk Mitigation for

Foreign Exchange Transactions Risk Risk mitigation

Herstatt risk (counterparty failure/default Credit assessment and control

after one party has made payment)

Bilateral netting of gross payment

obligations into smaller net obligations

Multilateral netting

Risk of extended and enlarged exposures Operations improvements

Arrangements with correspondent

banks to withhold payments

Risk of gridlock

Shaded cells indicate that mitigations have been adopted by some participants or providers

but are not yet widely used. Unshaded cells indicate mitigations in general use.

Risk 1: Herstatt Risk A foreign exchange transaction involves full settlements in two different

national payments systems; in the case illustrated in Figure 1.4, on

settlement day DM150,000 were paid through the Frankfurt Electronic

Clearing System (EAF-2) system in Germany and $100,000 through CHIPS.

These systems are not linked in any way, and the settlements occur

several hours apart. Bank A’s correspondent in Frankfurt paid out the

German marks before Bank A received the dollars. In other trades (e.g.,

Japanese yen for dollars), the gap between payment and receipt can be 17

hours. For the entity that pays first, the risk is that the other party may fail

to carry out its payment. If this is due to computer or other temporary

problems, the first entity faces liquidity problems; if the failure is due to

bankruptcy of the second entity, the first entity is exposed to loss of up to

the full amount that it paid. This latter risk is commonly called “Herstatt

risk,” after the name of a German bank whose closure in 1974 occurred

after it had received marks due to it on foreign exchange trades but before

the corresponding dollar amounts were paid in the United States. One

result was a temporary but severe disruption of payments across CHIPS; for

the next few days, banks withheld payments, resulting in a chain reaction

of other payments not being made.15 Also, U.S. banks experienced losses.16

15See the section on CHIPS for the risk mitigations subsequently taken by that institution and its

participants.

16In addition to the risk that one party may fail after the other has made payment, there is also the risk

that a party can fail before either party begins settlement. In this case, the surviving party would not

pay or lose its side of the trade, but—in order to obtain or sell the desired amount of currency—it

would have to enter into a new foreign exchange transaction with a different counterparty. Because

the new contract might be at a less favorable exchange rate than the original one, counterparty failure

prior to settlement creates exposure to potential loss, but such a loss would be only a fraction of the

amount that might be lost if there were a counterparty failure at settlement.

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Mitigation Credit assessment and control. A major defense against default risk in

foreign exchange trading is adequate control of credit exposure. This

control can be exercised through careful analysis and screening of

potential trading counterparties, and the setting and enforcement of limits

on exposure to each counterparty. These controls are not universally

practiced. The survey by the G-10 committee found some banks in their

countries that do not set any limits on their settlement exposures.

Mitigation Bilateral netting of gross payment obligations into smaller net

obligations. A way to reduce the magnitude of risk in foreign exchange

settlement is through netting. For example, two U.S. banks that actively

trade German marks might have entered into numerous contracts with

each other for settlement in that currency on a particular day. With a

netting arrangement in place, the two banks could replace these multiple

contract amounts with a single net amount to be sent through the German

payments system on that day. This can greatly reduce the amount of

settlement risk between the two banks. Some large trading institutions

have bilateral netting arrangements with each other. Not all banks

surveyed by the G-10 do so, however.

Mitigation Multilateral netting. Such a practice, which involves the netting of both

sides of currency obligations among more than two trading institutions,

could further reduce the amounts to be settled in foreign exchange

trading.17 Little multilateral netting has been done thus far: one

arrangement, called ECHO, has begun operation in Europe. A group of U.S.

and Canadian banks plan to start another, called Multinet International

Bank.18

Risk 2: Extended and

Enlarged Exposures

Many banks assume that their exposure to settlement risk in foreign

exchange transactions is only for one day’s trades, and is only an intraday

exposure. In fact, public- and private-sector studies have shown that these

exposures commonly are at least overnight and that the exposure to

settlement risk can be as high as the sum of 2 or 3 days’ trades, depending

on the institution’s own internal operational practices and its

arrangements with its correspondent banks. In Step 3 of Figure 1.4, Bank

A in New York followed the custom of sending payments instructions to its

17In the United States, CHIPS, which serves as the medium for settling the dollar “leg” of most foreign

exchange trades involving dollars, performs multilateral netting, but only for those dollar transactions

sent across it. Proposals for multilateral netting of foreign exchange transactions would involve the

multilateral netting of both sides of trades.

18The members of the Multinet project already net bilaterally among themselves trades in certain

currencies, using the VALUNET system (see page 45).

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Transactions

correspondent bank (Bank X) a day in advance of settlement. If these

banks’ systems are fully automated, this instruction might be irrevocable.

In that case, if Bank B (the German bank) was closed and declared

insolvent on settlement day, Bank A might nonetheless make scheduled

payments to Bank B not only on settlement day but also on the next day,

without receiving incoming payments from Bank B on either day. The

1994-1995 G-10 committee survey of major trading institutions found that

for some of these institutions the amount at risk, even to a single

counterparty, could exceed the institution’s capital.

Mitigation Operations improvements. To make exposure limits meaningful, they

must be buttressed by operations procedures that allow the institution to

halt outgoing payments up to settlement day, and to know whether

expected incoming payments have been received. The central banks’ G-10

committee has recommended that all banks improve their operational

controls and efficiency.

Mitigation Arrangements with correspondent banks to withhold payments.

Some banks have the ability to halt payments as late as settlement day,

and, in some cases, late on that day. In the previous example, if Bank A in

New York had appropriate arrangements with Bank X, its correspondent

in Frankfurt, it might be able to have Bank X withhold the mark payments

from the German payments system on settlement day until well after the

opening of that system, thus further reducing the time gap between

payment of marks in Germany and receipt of dollars in New York.

Risk 3: Gridlock Tighter operations controls over outgoing payments are a two-edged

sword because they create gridlock risk for the market at the same time

that they protect the institution. If Banks A and X in figure 1.4 had an

arrangement such as described above, Bank A might withhold payment to

Bank B if it heard rumors that Bank B was in trouble, preferring to receive

funds from Bank B before paying to it. Other banks might do the same

vis-a-vis Bank B. Even if the rumors were false and Bank B were sound,

the withholding of payments to Bank B could create a liquidity problem

for the bank; with incoming payments not arriving until late in the day, the

bank could find it difficult to make its own scheduled payments, possibly

affecting others. This phenomenon occurred at the time of the attempted

coup d’etat in the Soviet Union in 1991, when a number of banks withheld

their payments to Soviet banks, thus making it difficult for the latter to

meet their obligations. Were such payment-withholding applied to larger

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Transactions

numbers of banks or to larger banks, the resulting gridlock could involve

broader systemic risk to financial markets more generally.

Bilateral and

Multilateral Netting of

Foreign Exchange

Transactions

Bilateral and multilateral netting of payments in foreign exchange

transactions can reduce the amount of exposure to counterparty risk.

Bilateral netting can be arranged between any two banks. Nonetheless,

three organizations provide systems to facilitate bilateral netting among

members. As regards multilateral netting, there is one organization in

operation, and another that expects to commence operation in 1997. The

following explains the systems in detail.

Bilateral &

Multilateral

Netting

Bilateral Netting Systems

• Accord: This is a service offered to members by S.W.I.F.T. Members

subscribing to this service can have their payments messages matched and

bilaterally netted by the Accord system. In May 1996, 27 institutions were

using this system.

• FXNET: This system is owned by the U.K. subsidiaries of 12 major banks.

In May 1996, 70 banks used this system for bilateral netting.

• VALUNET: This system provides bilateral netting services to 10 U.S. and

Canadian banks for some of those banks’ offices.

Multilateral Netting Systems

• ECHO (Exchange Clearing House): This system is based in London; in

May 1996, 13 banks were using it. ECHO calculates multilateral netting of

trades that are passed through it. For each currency, a user will have only

a single payment obligation or expected receipt. Settlement takes place via

traditional national payment systems into and out of ECHO accounts in each

country.

• Multinet International Bank: This is a project of the U.S. and Canadian

banks involved in VALUNET. Once in operation, it will be a clearing house

to provide multilateral netting and settlement of foreign exchange

transactions among its members, initially in U.S. and Canadian dollars and

eventually in other currencies. For those trades that met its standards,

Multinet Bank would become counterparty.

Page 46 GAO/GGD-97-73 Payments, Clearance, and Settlement
Section 2: Equities, Treasuries, Futures, and Options • Overview 

Overview of Clearance and Settlement

Systems of Equities, Treasuries, Futures,

and Options

In this section, we discuss the clearance and settlement systems for

securities, such as equities and U.S. Treasuries, and derivatives, such as

futures and options.

Main Characteristics • The clearance and settlement systems of equities, Treasuries, futures, and

options are similar yet distinctive to each particular market.

• The systems for equities and U.S. Treasuries center on the transfer of the

ownership of securities from the seller to the buyer.

• The systems for futures and options center more on the transfer of risk

and the value associated with that risk.

Statistical Information • Thousands of these types of financial instruments are traded each day

through either organized exchanges or in the over-the-counter (OTC)

markets.

• Hundreds of billions of dollars of each type of financial instrument are

cleared and settled through clearing organizations each year.

Regulatory

Information

• The Securities and Exchange Commission (SEC) and the Commodity

Futures Trading Commission (CFTC) are the primary regulators and

oversee the actions of the clearing organizations under their jurisdictions

to determine whether or not they are functioning in accordance with

regulations and the law.

Risk Information • The primary type of risk that clearing organizations face is counterparty,

or credit risk.

• Clearing organizations can mitigate counterparty risk by having strict

admission standards and continually monitoring their members, and by

requiring their participants to post “good faith” deposits and/or make

payments that cover any potential significant market movements.

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Equities Clearance and Settlement

Description and Use The National Securities Clearing Corporation (NSCC) clears and settles

98 percent of all equity (stock) and corporate and municipal bond

transactions in the United States. For the purposes of clarity, we will focus

only on equities. NSCC is the clearing corporation for eight stock exchanges

and is owned equally by the American Stock Exchange (AMEX), New York

Stock Exchange (NYSE), and the National Association of Securities Dealers

(NASD).1

The Depository Trust Corporation (DTC) tracks the transfer of equities and

corporate and municipal bonds cleared through NSCC via an automated

book-entry system. During settlement, NSCC instructs DTC on which equities

to move from one account to another. DTC also performs securities custody

services for its participating banks and broker-dealers.

Participants in the clearance and settlement of equities include exchanges;

NSCC, and members of NSCC (referred to as Direct Participants); DTC; and

settlement banks (banks that settle on behalf of direct participants).

1

One regional stock exchange, the Philadelphia Stock Exchange, has its own clearing organization.

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Equities Clearance and Settlement

B 

E

Bond

Book-entry system

D Direct participants

Equity/stock

L

S

Locked-in trades

Specialist

A bond is a debt security representing a loan by the buyer to the corporation or 

government issuing the bond; it may either pay interest, or it may be purchased 

at a discount in price from the value at maturity.

A book-entry system is an accounting system that permits the transfer of 

assets (e.g., securities) without the physical movement of paper documents 

or certificates. 

Direct participants are financial institutions that transact with the clearing 

organization, and all customers come to the clearing organization through them.

Equity, or stock, is an instrument that represents ownership in a company. 

Locked-in trades are transactions in which the details of the trade are matched

by a computer, usually at the place of the trade, before being sent to a clearing 

organization. As a result, the clearing organization does not usually perform 

a trade comparison.

Open outcry is a competitive system in which floor participants verbally make 

bids and offers to each other at centralized exchange locations.

A specialist is a member designated by an exchange to be the sole market 

maker for a particular stock.

O Open outcry

Key Terms

Basic Data As of April 1996, NSCC served 1,974 brokers, dealers, banks, and other

financial institutions through approximately 400 direct participants. NSCC

processes over a million transactions on a daily basis that are worth

billions of dollars, according to NSCC.

According to DTC officials, DTC holds approximately $10 trillion of

securities that make up almost 99 percent of all stocks and nonfederal

bonds traded in the United States. (See table 2.1)

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Equities Clearance and Settlement

Table 2.1: Data on NSCC and DTC

1995

NSCC

Average daily volume of transactions

processed

1,875,600 transactions

Average daily value of transactions

processed

$92 billion

DTC

Securities delivered through DTC’s

book-entry system

$41 trillion

Value of securities in DTC’s custody $10 trillion

Sources: NSCC and DTC 1995 data.

Processes Equity shares trade, clear, and settle in a 3-day cycle referred to by

industry participants as “T+3”—the cycle begins on the day of the trade

(“T”) and ends 3 days later (T+3) with settlement.

The Trading Process Investors may purchase equity shares through a securities broker-dealer.

Equities are traded in two different kinds of markets—exchanges and the

over-the-counter (OTC) markets. Through exchanges, member firms act for

themselves and as agents (brokers) for customers, bringing their orders to

a central facility—the exchange floor—to be executed. In exchange

trading, orders may be executed in two ways: (1) against other orders—a

bid to buy equities matching an order to sell equities—or, if there is no

such order at an acceptable price, by (2) a sale to or purchase from a

specialist. Trading is done through “open outcry,” or orders can be inputed

into an order management system. NYSE officials said that 70 percent of

their trades are done through their order management system (called

Super DOT—Designated Order Turnabout System) and 30 percent are

done through “open outcry.” However, open outcry trades account for

70 percent of the dollar value of all trades because they typically include

large transactions or block trades of 10,000 shares or more.

In the Nasdaq OTC market,2

 orders are handled by dealers working over the

telephone or through a computerized small-order execution system; there

is no central physical facility or trading floor. In this market, securities

2

Nasdaq stands for the National Association of Securities Dealers Automated Quotation system.

Nasdaq is the automated stock market for a portion of the non-exchange-listed securities. The OTC

market for securities includes Nasdaq, the so-called “pink sheets”—privately published National Daily

Quotation Sheets—and the OTC Bulletin Board.

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Equities Clearance and Settlement

firms can act as brokers or dealers with respect to any type of stock. A

firm receiving a customer’s order to buy stock can either sell the stock to

the customer from the firm’s inventory (if it is a dealer in that stock) or act

as a broker by purchasing the stock from another dealer and then selling it

to the customer.

The Clearance and

Settlement Process

Equities are cleared and settled through NSCC and DTC. Clearance begins

after the trade occurs and involves NSCC guaranteeing the trade and then

netting the delivery and receipt of settlement obligations. Settlement

usually occurs on T+3, with the equity shares settlement usually

performed through book-entry moves at DTC and the money settlement

through NSCC and settlement banks. Equities that are eligible for

depository processing through DTC enter the Continuous Net Settlement

(CNS) System, which, according to NSCC officials, is where the vast majority

of equity trades settle. NSCC has three different settlement systems: one for

depository-eligible issues, one for the settlement of nondepository-eligible

issues, and one for trades that bypass the netting process and are settled

separately.

Table 2.2: NSCC Clearance and

Settlement Process for Depository

Equity Shares

T+3 day Clearance and settlement

T (trade date) Trade occurs and trade information is sent

to NSCC, mostly on a “locked-in” basis.

T+1 Results of trade comparison and matching

are sent to direct participants.

T+2 NSCC determines participants’ net

settlement positions.

T+3 Settlement date—securities are delivered

and payment is made.

aNSCC officials said that the completion of transactions may not always occur on T+3.

Source: NSCC.

Figure 2.1 describes in a simplified manner the T+3 trading, clearance, and

settlement of a single depository-eligible equity trade that is not netted

with other trades.

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Figure 2.1: T+3 Clearance and

Settlement of Depository-Eligible

Equity Shares

T (Trade Day)

100 Shares

ABC Inc.

Common Stock

Price $10.00 per share

100 Shares

ABC Inc.

Common Stock

Price $10.00 per share

Buyer

Customer A

purchases 100 shares of

stock at $10.00 a share through

Broker A/Direct Participant A (DPA).

T + 1 (Trade Day +1)

T + 2 (Trade Day +2)

T + 3 (Trade Day +3) Settlement

Equity Share Settlement

DTC is instructed by NSCC

to conduct settlement

via book entry.

Settlement occurs

when DTC deducts 100

shares from the seller's

account (DPB) and places

them in NSCC's account;

NSCC then transfers the 100

shares to the net buyer (DPA).

DTC

DPA

NSCC

account at

DTC

NSCC reports

the confirmation of the trade

with DPA.

NSCC reports

the settlement position

to DPA.

Equity Share Settlement

Broker A

(DPA)

Broker A

(DPA)

Broker A

(DPA)

DPB

a

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Equities Clearance and Settlement

NSCC's

account

DPA's

account

Exchange

Trade occurs

at the Exchange and

trade data is sent

via computers to NSCC.

T + 1 (Trade Day +1)

T + 2 (Trade Day +2)

T + 3 (Trade Day +3) Settlement

T (Trade Day)

100 Shares

ABC Inc.

Common Stock

Price $10.00 per share

Seller

Customer B directs

Broker B/Direct Participant B (DPB)

to sell 100 shares at

$10.00 a share.

NSCC

NSCC

NSCC

Money settlement

Payment is performed through

settlement banks over Fedwire.

NSCC requests payment from DPA

via its settlement bank. DPA's

buyer's settlement bank pays

$1,000 to NSCC's settlement

bank. DPB's seller's settlement

bank receives $1,000 from

NSCC's settlement bank.

DPB's

account

DPB's

settlement bank

Fedwire Fedwire

NSCC reports

confirmation of the trade to

DPB.

NSCC reports

the settlement position

to DPB.

NSCC's

settlement bank

Money Settlement

Broker B

(DPB)

Broker B

(DPB)

Broker B

(DPB)

DPA's

settlement bank

a

Equity share and money settlement is normally done on a net basis such that the single purchase of 100 shares

would be combined with DPA's and DPB's other trades to produce one net equity share settlement and money settlement.

a

Source: GAO analysis of NSCC data.

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Equities Clearance and Settlement

The 3-Day Clearance and

Settlement Cycle

Trade Day (T) The 3-day cycle of clearance and settlement for NSCC begins on the day of

the trade (T). Trade information is recorded at the exchanges and then is

transmitted to NSCC (via computers) through a variety of automated

marketplace trading systems.

Most of the trades are transmitted as “locked-in” transactions—the details

of the trades from the buyer and seller have already been matched by the

computer systems of the exchanges or OTC market, which means that NSCC

does not perform a trade comparison. However, if trades are not locked-in,

the buy and sell data have to be reported by direct participants to NSCC,

and NSCC then compares and matches the data.3 NSCC officials said that

trades mostly occur on a locked-in basis.4

Once the trade data have been compared, NSCC guarantees the transaction.

This is referred to as “novation” or the substitution of one party for

another (NSCC becomes the buyer to every seller and the seller to every

buyer). The guarantee begins on midnight of the day that the trade is

reported back to direct participants as having been compared.

T+1 On T+1, results of the comparison and matching process are reported to

direct participants. NSCC transmits to direct participants computerized

reports (known as contracts) that show every buy and sell order reported

by the participant and the marketplace on T, and also confirm that each

transaction has been compared and is ready for settlement.

T+2 Participants are informed of their net settlement positions for trades that

occurred on T and are due to settle on T+3. NSCC issues a report to direct

participants that tells them what their net settlement is that day and

projects what their net settlement will be on T+3. To do this, NSCC uses its

CNS system, which “reduces or nets the total number of financial

obligations requiring settlement.” Participants then are advised whether

they are net buyers or net sellers for each issue of a stock.

T+3 T+3 is settlement day for trades that began on T—to the extent that

securities are available for delivery, delivery will be made, and participants

with payment obligations will be required to pay. The participants’ net

3

These types of trades are compared in either NSCC’s Listed Comparison System for exchange-listed

trades or the OTC Comparison System for trades in the OTC market.

4

However, municipal bonds and corporate debt are submitted for two-sided comparison.

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Equities Clearance and Settlement

settlement positions are determined by the CNS system netting all their

trades due to settle that day against the prior days’ unsettled long (buy)

and short (sell) positions (referred to as fail positions or unsettled

positions) for each issue of equity.

Equity Settlement Has Two

Parts

Equity share settlement. The settlement of equities has two

parts—equity share settlement and money settlement. The first phase is

equity share settlement. The movement of the shares takes place through

DTC accounts. NSCC instructs DTC to move shares from the accounts of net

sellers to NSCC’s account and then from NSCC’s account to the accounts of

net buyers. If the amount of shares is insufficient to satisfy all delivery

obligations, NSCC uses a random allocation algorithm to determine to

whom securities should be delivered. The CNS automatic delivery process

occurs in two cycles: (1) the night cycle at about 1:30 a.m. on (T+3) and

(2) the continuous “day cycle” later that day.

Money settlement. The final phase of settlement is the money

settlement. The CNS net money settlement is determined on T+3 and can be

settled with a single payment between NSCC and participants through

settlement banks.5

 Every trading day, NSCC is to generate a settlement

statement. This statement is to include a line item that tells each

participant what its net CNS money obligation is, based upon the dollar

value of the participant’s equity shares delivered and the dollar value of its

payment obligation. Each participant has a settlement bank that has

guaranteed that it will pay or receive the money settlement on the

participant’s behalf.6

 Settlement banks are required to make payment

before Fedwire’s funds transfer system7

 closes.

Regulatory Oversight The Securities and Exchange Commission (SEC) oversees the actions of

NSCC to determine whether it is functioning in accordance with the law and

SEC regulations. NSCC establishes the rules governing its clearance and

settlement of equities, subject to SEC’s approval.

5

NSCC has operated a same-day funds settlement system since Feb. 22, 1996.

6

In order to qualify as a settlement bank, each bank has to meet specific criteria established by NSCC.

7

Fedwire refers to two separate electronic systems—one for the electronic transfer of funds, and one

for the electronic transfer of book-entry securities.

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Equities Clearance and Settlement

Risk and Risk

Mitigation

For purposes of this report, we discuss some of the most important risks

and risk mitigations associated with equities.

Because NSCC guarantees the trades of its direct participants, it incurs risk

from the time of the guarantee until the settlement of obligations and

payments. As a result, NSCC is exposed to counterparty risk, and the

amount at risk (or the exposure) is dependent on fluctuations in the

market.

Table 2.3: Risk and Risk Mitigation for

Equities Risk Risk mitigation

Counterparty/credit risk Requirement of strict membership

standards

Arrangement with DTC

Requirement of clearing fund account

Marking to market prices of all

unsettled securities

Source: NSCC.

Risk: Counterparty/Credit When NSCC guarantees the matched trade, it becomes the buyer to every

seller and the seller to every buyer. As a result, the clearing organization

incurs counterparty risk—the possibility that the clearing member buyer

or seller might default on its obligations.

The amount of counterparty risk that NSCC is exposed to is dependent on

fluctuations in the market. If a direct participant does not meet its

settlement and payment obligations, NSCC—because of the guarantee to

the direct participant buyer and the direct participant seller—must

liquidate the direct participant’s positions, and thus is exposed to market

risk (the exposure to the possibility of financial loss caused by adverse

changes in the value of contracts).

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Mitigation NSCC mitigates counterparty risk by (1) setting strict admissions standards

to determine that every member is creditworthy upon admission to NSCC;

and (2) arranging with DTC that—in the event participants are unable to

complete money settlement and NSCC ceases to act on their behalf—shares

delivered that day are returned to NSCC, or DTC makes payment to NSCC.

NSCC requires all unsettled securities or fail positions to be marked to

market prices and payment is to be made by direct participants to reflect

changes in the market. The objective is to keep NSCC obligations as close to

market prices as possible. In addition, NSCC requires participants to

contribute to the clearing fund,8

 which is designed to cover market risk

exposure.

8

According to NSCC, the clearing fund was established to secure direct participants’ obligations to

NSCC as well as other liabilities and losses if they occur.

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Treasuries and the Fedwire Book-Entry

Securities System

Description and Use The Fedwire book-entry securities system services all marketable U.S.

Treasury securities, many federal agency securities, and certain

international agency securities. For simplicity, we will focus on Treasury

securities.

According to Federal Reserve officials, 99 percent of marketable U.S.

Treasury debt is in book-entry form. Treasuries settle through the Fedwire

book-entry securities system, which is operated by Federal Reserve

Banks.9

 The Fedwire book-entry securities system is a real-time

delivery-vs.-payment (DVP) gross settlement system that requires the

immediate and simultaneous transfer of securities against payment.10

Depository institutions that maintain funds accounts at a Reserve Bank are

eligible to maintain book-entry securities accounts at a Reserve bank, as

are certain nondepository institutions, subject to certain settlement

restrictions.

The Government Securities Clearing Corporation (GSCC) was established

to provide a netting mechanism for the clearance and settlement of U.S.

Government securities in both the primary and secondary markets for

Treasury securities.11 The primary purpose of issuing Treasury securities is

to raise money for the U.S. government. A large secondary market also

exists for Treasury securities, making it one of the most liquid markets

(easy to buy and sell the securities without moving the price) in the

world.12

Participants in the clearance and settlement of Treasury securities include

the Federal Reserve, GSCC, members of GSCC referred to as Comparison

members and Netting members, and clearing agent banks (banks that

settle on behalf of members). GSCC and each of its members has a

designated clearing agent bank that operates through the Fedwire

book-entry for securities system.13

9

Fedwire refers to two separate electronic systems—one for the electronic transfer of funds, and one

for the electronic transfer of book-entry securities.

10Transfers of securities may also be made without payment.

11Treasuries may settle outside of GSCC’s process.

12Secondary markets consist of exchanges and OTC markets where financial instruments are bought

and sold subsequent to original issuance, which took place in the primary market.

13For the purposes of this report, we focused on GSCC’s process, which is one mechanism for clearing

and settling U.S. government securities.

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Treasuries and the Fedwire Book-Entry

Securities System

A book-entry system is an accounting system that permits the electronic transfer

of assets (e.g., Treasury securities) without the physical movement of paper 

documents or certificates.

Clearing agent banks are Fedwire participants that are regularly engaged in 

the business of providing clearing services in eligible securities for members 

and GSCC.

Comparison members are primarily government securities broker-dealers 

and clearing agent banks that are capable of interacting with GSCC operations.

CUSIP stands for the Committee on Uniform Securities Identification

Procedures. Each type and issue of security will have its own unique

CUSIP number.

A DVP (delivery-vs.-payment) system is a system that ensures that the

final transfer of one asset will simultaneously occur if, and only if, the final 

transfer of another asset (or other assets) occurs.

Netting members are primarily banks and government securities broker-dealers 

that are capable of participating in netting services through GSCC.

Open outcry is a competitive system in which floor participants verbally 

make bids and offers to each other at centralized exchange locations.

Real-time means a system that processes each transaction as it is initiated 

rather than processing by batch. Gross settlement means that the system 

settles each transfer individually.

A repurchase agreement is an agreement between a buyer and seller (usually) 

of U.S. government securities whereby the seller agrees to repurchase the 

securities at an agreed-upon price and, usually, on a stated date.

Trade comparison is the receipt, validation, and matching of data

on the long (buy) and short (sell) side of a transaction and the

reporting of such match.

A Treasury security is a negotiable debt obligation of the U.S. government, 

backed by its full faith and credit, and issued with various maturities.

The Uniform Commercial Code (UCC) is a set of model laws governing 

commercial and financial activities.

D

C

Book-entry system

Clearing agent banks

Comparison member

CUSIP

DVP system

O 

R

N

Open outcry

Netting members

Real-time gross settlement

Repurchase agreement

T 

U

Trade comparison

Treasury security

UCC

Key Terms

B

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Treasuries and the Fedwire Book-Entry

Securities System

Basic Data The trading volume of the treasuries market averages $200 billion per day.

According to Federal Reserve Bank of New York officials, the Department

of the Treasury is the largest single issuer of debt in the world, with

Treasury securities accounting for approximately $3.5 trillion in par value

or face value (represented by 62 bond issues, 144 note issues, and 52 bill

issues) as of December 1996. According to Federal Reserve data, Treasury

issues dominate the transaction volume in the book-entry securities

system, representing roughly 70 percent of Fedwire securities transfer

volume (see table 2.4).

Table 2.4: Data on GSCC and Fedwire

1995

GSCC

Annual dollar value of trades that GSCC processes for

netting members

$65.9 trillion

Average daily dollar value of trades that GSCC

processes for netting members

$263.6 billion

Annual dollar value of net settlement obligations $16.3 trillion

Average daily dollar value of net settlement obligations $65 billion

Fedwire book-entry securities system

Annual origination (transfer) volumea 12.8 million

Annual payment value of transfersa $150 trillion

Average daily volume of Treasuries originations

(transfers)

36 thousand

Average daily payment value of transfersa $597 billion

aFigures include all Fedwire-eligible securities, not just Treasuries.

Sources: GSCC and Federal Reserve.

Processes For Treasuries that are cleared and settled through GSCC, the Fedwire

book-entry securities system performs the book-entry transfer of the

Treasury securities through designated clearing agent banks operating on

behalf of netting members and GSCC. The Fedwire book-entry securities

system ordinarily operates from 8:30 a.m. to 3:30 p.m. Eastern Time (ET).14

GSCC responsibilities include clearance (trade comparison, trade netting,

and guarantee) and settlement. Treasuries that clear and settle through

GSCC may clear and settle anywhere from “T+1” (trade date with next day

settlement), to “T+15” (trade date with settlement in up to 15 days), to

14The Fedwire book-entry securities system opens early in rare instances to meet special needs and

closes late under special circumstances.

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Securities System

“T+360” (in the case of repurchase agreements or “repos”).15 Participants

choose when they want to have the trade settled.

The Auction and Trading

Process

Treasuries are typically issued by an auction conducted by Federal

Reserve Banks accepting competitive and noncompetitive bids from

individual and institutional investors. Treasuries can then be bought and

sold in the secondary OTC market through commercial banks,

broker-dealers, and other financial service companies. The secondary

Treasury OTC market is primarily an institutional investors’ market.

According to GSCC officials, commercial banks, dealers, brokers, mutual

funds, and pension plans rather than individual investors typically

participate in this market. With respect to GSCC, each participant in the

primary market and secondary markets for Treasury securities has to have

a netting member—if they are not already a netting member—in order to

clear and settle their Treasury trades through GSCC.

GSCC clears and settles various types of Treasury security trades, such as

cash trades, forward trades (trades entered into today for settlement more

than 1 business day away), and repurchase agreements.16 Members

determine the types of trades they want as well as the settlement date.

The Clearance Process Trade comparison is the first step in the clearance and settlement of

Treasury securities. There are two types of comparisons, matched and

locked-in. (See table 2.5)

15Cash settlement or Treasuries that settle on “T,” or the day of the trade, will not clear and settle

through GSCC. According to GSCC officials, cash settlement is a very common form of settlement.

16GSCC does not clear and settle options and futures on Treasuries. For more information see

clearance and settlement of futures and options later in Section 2.

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Securities System

Table 2.5: Two Types of Trade

Comparisons Trade comparison type Description

Locked-in The Federal Reserve Banks electronically deliver Treasury

auction purchases of GSCC participants in the primary

market to GSCC on a locked-in basis—that is, the trades

are already matched.

Matched Treasury securities traded in the secondary market by

GSCC participants are submitted to GSCC, which

compares and matches the buy and sell sides of the

trades. Comparison members submit the trade data by

electronic transmission or magnetic tape by 10:00 p.m.

on the night of each business day.a By 2:00 a.m., GSCC

sends confirmation reports—generated electronically—to

comparison and netting members that validate the

comparison of the trade data.

aThe comparison process goes on throughout the day and members may submit intraday data to

GSCC.

Sources: GSCC and the Federal Reserve.

After a trade is compared and matched and is eligible for netting, it is

netted through the netting system.17 The netting system combines a

participant’s total buy and sell obligations for each CUSIP number to arrive

at a single net debit, credit, or flat amount for that netting member.18 Once

net settlement positions have been determined and have been reported to

GSCC members, GSCC becomes the legal counterparty to each party of the

trade and, as such, guarantees to the buyer and seller that the trade will

settle. This process is called novation, and it is usually completed before

2:00 a.m.

The Settlement Process After net settlement amounts or positions have been determined and sent

to netting members, settlement can take place. The settlement of Treasury

securities includes (1) the Treasury securities transfer and (2) the

simultaneous payment for the securities.

Treasury Securities Transfer

and Payment

The Treasury securities settlement is done through clearing agent banks

on behalf of the netting members, and GSCC. Each clearing agent bank

17In order for nonrepurchase agreement trades to be eligible for netting, they must meet the following

requirements: (1) the trade must be compared on a final-money basis (including comparison on a

locked-in basis); (2) the scheduled settlement date must be no more than a preestablished number of

business days after the date of comparison; (3) netting must occur on or before its scheduled date;

(4) data or each side of the trade must be submitted by a netting member or an authorized locked-in

trade source; and (5) the underlying securities must be eligible for netting.

18Trades that have the same CUSIP number are netted together.

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Securities System

instructs the Federal Reserve which of its accounts to debit and which to

credit for the transfer of securities and payment.

• Once net settlement positions have been determined by GSCC, a netting

member’s clearing agent bank is informed by the netting member of the

securities to be delivered to or received from GSCC and the payment

against which those deliveries or receipts are to be made. If the member of

GSCC is a clearing agent bank, then it would do this on its own behalf.

• To the extent such deliveries or receipts must occur between clearing

agent banks, the clearing agent bank sends Fedwire instructions to the

Federal Reserve authorizing the Federal Reserve to transfer Treasury

securities from its custody account (for the benefit of the net seller’s

account on the books of the clearing agent bank), to the account of the

receiving clearing agent bank (for the benefit of GSCC’s account on the

books of the receiving clearing agent bank).19 This transfer is done in

book-entry form.

• GSCC’s clearing agent bank then instantaneously redelivers the securities to

the net buyer’s account on the books of its clearing agent bank. GSCC,

however, is not obligated to deliver securities to member buyers until it

receives securities from member sellers. Therefore, if a netting member’s

clearing agent bank fails to deliver the securities for any reason (including

when the netting member does not have enough securities in its account),

GSCC fails to deliver securities to the net buyer member.

• With respect to a clearing agent bank whose customer is a net seller of a

security, the clearing agent bank (or a bank member of GSCC acting on its

own behalf) will place a Fedwire securities delivery instruction to deliver

securities from the clearing agent bank’s account at the Federal Reserve

Bank to the GSCC clearing agent bank’s account at the Federal Reserve

Bank, unless the transfer can be made on an intrabank basis. The only

instruction necessary for transferring securities over Fedwire is made by

the deliverer of securities; therefore, the delivery instruction from the net

seller’s clearing agent bank will result in a simultaneous debiting of funds

from the GSCC clearing agent bank’s account at the Federal Reserve Bank

without any debit instruction from GSCC’s clearing agent bank. If a clearing

agent bank receiving securities has insufficient funds in its Federal

Reserve account to pay for the securities, the Federal Reserve Bank will

nonetheless complete the transfer (if it is within certain risk parameters),

and the clearing agent bank will incur a daylight overdraft in its account at

the Federal Reserve Bank.

19The transfer of securities can be done “intrabank,” (i.e., both the net seller and GSCC use the same

clearing agent bank).

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Securities System

Funds-Only Settlement The funds-only settlement is separate from the delivery and payment of

the Treasury securities settlement. It pertains to the net debit or net credit

dollar amount that each netting member owes or is due for its accounts.

For example, settlement has to be made on margin or on any open net

settlement position, and payment has to be made on other positions,

including fail to deliver or fail to receive obligations, and transaction

adjustment payments (TAP).20 The funds-only settlement occurs at 10:00

a.m. and 11:00 a.m. each day and is made via the Fedwire funds transfer

system. Unlike the Treasury securities settlement, GSCC will make a

funds-only settlement whether or not it has received all funds-only

settlement due it from members on that day.

Regulatory Oversight The Securities and Exchange Commission (SEC) oversees the actions of

GSCC to determine whether it is functioning in accordance with the law and

SEC regulations.21 GSCC establishes the rules governing the clearance and

settlement of Treasury securities that clear and settle through GSCC,

subject to SEC approval.

According to Federal Reserve officials, Treasury/government securities

transactions are governed by a combination of federal and state law as

well as Reserve bank operating circulars. Each agency that issues

securities on Fedwire has promulgated regulations that establish a federal

legal framework governing the transfer of rights and interests in

book-entry securities by a Fedwire participant. These regulations also

specify the status of Fedwire book-entry securities under state law, which

applies to the transfer of rights and interests in the securities in the

absence of governing federal law. In most cases, UCC Article 8 is the state

law governing the settlement phase of securities transactions.

Risk and Risk

Mitigation

For purposes of this report, we discuss some of the most important risks

and risk mitigations associated with treasuries.

20TAP refers to the dollar difference between the amount at which these securities are to be delivered

and received and the amount at which these securities are traded. Since trades included in the netting

process have been entered into at varying prices, in order for netting to work, GSCC must establish a

single-system price for each CUSIP. GSCC does so on each business day by use of either a third-party

source or by a par-weighted average for all compared trades in each CUSIP on that date. The use of

this system’s price—market price for all compared trades—(plus accrued interest) should cause the

delivery and receipt of securities to occur at amounts that are close to current market value, but

different from contract prices.

21SEC is the primary agency that oversees GSCC, and the U.S. Treasury and the Federal Reserve are

considered to be “secondary” regulators, according to GSCC officials.

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Securities System

Because GSCC guarantees the trades of its members, it incurs risk from the

time of the guarantee until the settlement of obligations and payments. As

a result, GSCC incurs counterparty risk, but the amount at risk (or

exposure) is dependent on fluctuations in the market.

Table 2.6: Risk and Risk Mitigation for

Treasuries Risk Risk mitigation

Counterparty/credit risk • Requirement of strict membership

standards

• Monitoring members’ creditworthiness

• Marking open positions to market prices

• Maintaining a clearing fund

Source: GSCC.

Risk: Counterparty/Credit When GSCC guarantees the matched trade, it becomes the buyer to every

seller and the seller to every buyer. As a result, GSCC incurs counterparty

risk—the possibility that the member buyer or member seller might

default on its obligations.

The amount of counterparty risk that GSCC is exposed to is dependent on

fluctuations in the market. If a member does not meet its settlement of

obligations and payments, GSCC—because of the guarantee to the member

buyer and member seller—must liquidate the member’s position, and thus

is exposed to market risk (the exposure to the possibility of financial loss

caused by adverse changes in the value of securities).

Mitigation GSCC mitigates counterparty/credit risk by (1) setting strict admissions

standards to determine that every member is creditworthy upon admission

to GSCC and (2) routinely monitoring members’ creditworthiness through

financial reporting requirements and reviewing the clearing members’

financial results.

GSCC requires all unsettled securities or fail positions to be marked to

market prices and payment is made by members to reflect changes in the

market. The objective is to keep GSCC obligations as close to market prices

as possible. In addition, GSCC requires members to contribute to a clearing

fund that is designed to cover market risk exposure.

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Futures

Description and Use A futures contract obligates the holder to buy or sell a specific amount or

value of an underlying asset, reference rate, or index (called the

underlying) at a specified price on a specified future date.22 For instance, if

an investor were to purchase a December futures contract, an agreement

would be made to pay a specified price for a specified quantity of a

commodity, such as wheat, metals, or live cattle, for delivery in December.

The buyer (or seller) would have an obligation to purchase (or sell) the

underlying commodity. However, the buyer could satisfy this obligation

either by receiving and paying for the commodity when the contract

expired or by “offsetting”23 the obligation prior to the contract expiring,

which is how the majority of futures contracts are closed out. Futures

previously were limited to commodities such as agricultural products and

metals, but were extended in the 1970s to include financial futures on

instruments such as Treasury bonds, foreign currencies, and stock

indexes.

Market participants may use futures to hedge their assets or liabilities, or

to speculate on market movements by correctly anticipating price

movements. According to market officials, the main function of a futures

contract is to shift risks from those less willing or able to bear them to

those more willing or able to do so.

Participants in the clearance and settlement of futures contracts include

exchanges, clearing organizations, clearing members, and settlement

banks (or banks that settle exchange members’ accounts). Futures are

traded on 11 active exchanges in the United States. Nine futures clearing

organizations serve the exchanges.

Futures clearing organizations may be either clearing houses, which are

departments within an exchange, or clearing corporations, which are

separately incorporated and independent from the exchange. During this

report, we spoke to the Chicago Mercantile Exchange (CME) Clearing

House Division and the Chicago Board of Trade (CBT) Board of Trade

Clearing Corporation (BOTCC). For purposes of clarity, we will refer to the

CME Clearing House Division and BOTCC as clearing organizations.

22Underlyings include stocks, bonds, agricultural and other physical commodities, interest rates,

foreign-currency rates, and stock indexes.

23Offsetting means liquidating a purchase (sale) of futures contracts through the sale (purchase) of an

equal number of futures contracts with the same delivery month, thus closing out a position.

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Futures

Clearing members are financial institutions (generally large futures

brokers) that transact with the clearing organizations; all futures

customers and nonclearing members use a clearing member to clear their

trades through a clearing organization. Clearing members must belong to

the exchanges.

Settlement banks maintain the clearing accounts for the clearing

organizations through which payments and deposits are made either to or

from clearing members’ accounts to or from the clearing organizations.

Settlement in the futures market usually pertains to cash flow payments

that reflect changes in the market price. The clearing organization officials

we spoke to said they have designated up to eight banks as settlement

banks.

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Futures

F Floor broker

Floor trader

Futures

Futures commission merchant

H Hedging

O

S

Offsetting

Open outcry

Options on futures

Speculating

A floor broker executes trades for customers and may also execute trades for 

their personal or employer accounts.

A floor trader executes trades only for their personal accounts. A floor trader is 

also referred to as a "local."

A futures contract obligates the holder to buy or sell a specific amount or value 

of an underlying asset, reference rate, or index (called the underlying) at a

specified price on a future date. Underlying assets include stocks, bonds, 

agricultural and other physical commodities, interest rates, foreign-currency 

rates, and stock indexes.

A futures commission merchant is an individual, association, partnership, 

corporation, and trust that solicits or accepts orders for the purchase or sale 

of any commodity for future delivery on or subject to the rules of any contract 

market and that accepts payment from or extends credit to those whose 

orders are accepted. A futures commission merchant is the equivalent of a 

brokerage house in the securities industry.

Hedging means to protect oneself from market risk. Typically, hedgers have

a position in the underlying commodity and use futures or options on futures

to create an opposite position.

Offsetting means liquidating a purchase (sale) of futures contracts through the 

sale (purchase) of an equal number of futures contracts with the same delivery 

month, thus closing out a position.

Open outcry is a competitive system in which floor participants verbally make

bids and offers to each other at centralized exchange locations.

An option on a futures contract gives an investor the right but not the obligation, 

in exchange for a price (called a premium), to buy or sell a specified futures 

contract at a specific price (called the exercise price) within a specified period.

Speculating means to take on risk in an attempt to profit from changes in the

values of financial instruments.

Key Terms

Basic Data According to clearing organization officials, about 80 percent of the

futures trading volume in the United States occurs at CBT and CME. CBT has

its own separately incorporated clearing house—BOTCC—and CME has a

clearing house division. Both clear and settle futures and options on

futures traded on their respective exchanges.

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Futures

Table 2.7: Data on BOTCC and CME,

1995

Clearing

organization

Number of

clearing

firms

Number of

futures

contracts

cleared and

eventually

settled

Average daily

number of

futures

contracts

Number of

options on

futures

contracts

cleared and

eventually

settled

BOTCC 124 202,429,356 920,133 65,536,849

CME 83 159,787,862 634,079 43,366,350

Sources: CME and BOTCC.

Processes Futures trade, clear, and settle in what is known as “T+0”—trades are

done with same-day settlement. The “T” represents the trading, clearing,

and settlement in one 24-hour period, starting at 6:40 a.m. CST and ending

24 hours later at 6:40 a.m. The “0” indicates that there are no additional

days in the process.

The Trading Process Most trading in the futures markets is done on the floor of the futures

exchanges. The exchanges operate as auction markets where prices are

determined by “open outcry.” Trading is done in a tiered area of the

exchange floor, called a “pit.” In addition, electronic trading may occur

during regular trading hours and/or during a night session.24 Trades done

electronically are automatically matched and then settled in the same

manner as are pit trades.

Two types of traders execute trades on the floor of an exchange: (1) floor

traders, or locals, are members of the exchange25 and (2) floor brokers

who may be independent or may be employees of firms referred to as

futures commission merchants (FCM), which are members of the exchange.

Floor traders trade exclusively for their own accounts. Floor brokers

transact on the floor of the exchange on behalf of customers.26

24Electronic trading occurs on “Project A” at CBT and on “GLOBEX” at CME.

25Locals may lease a seat on the exchange and, thus, they themselves may not be a member of the

exchange.

26In addition, floor brokers may execute customer orders and trade for themselves or their firm’s

account (proprietary trading) during the same trading session under limited circumstances, a practice

referred to by industry officials as “dual trading.”

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Futures

The Clearing Process The clearance of futures involves capturing, matching, and guaranteeing

trades. Clearing organizations also clear and settle options on futures,

which go through a clearance and settlement process similar to those of

futures contracts.

Table 2.8: Steps in the Futures

Clearing Process Steps Clearing process

(1) Capturing the trade data Clearing firms (FCMS)/traders input their

trade data to the clearing organizations.a

(2) Matching the trade data After receiving the trade data, the clearing

organizations match the data. Soon after

the trade data are submitted, the data are

matched.

(3) Guaranteeing the trade Once pit trades have been matched, the

clearing organizations guarantee the

trades.b The clearing organizations

guarantee to the clearing members that

the settlement obligations of the trade will

be met.

aElectronic data do not have to be captured.

bClearing organizations also guarantee trades of the exchange of futures for the underlying

physical asset, but the guarantee does not become effective until after the day of the trade.

Sources: CBT and CME.

The Settlement Process On a day-to-day basis, the settlement of futures refers to the settlement

payment of funds between the clearing members and the clearing

organization.27 There are two types of payments included in the daily

settlement in the futures market: (1) the performance bond (also referred

to as a margin deposit or “good faith” deposit) and (2) the variation

settlement (also referred to as the mark-to-market).

27The final closeout of a futures contract occurs by (1) settlement by delivery, (2) cash settlement, or

(3) settlement by offset. For futures contracts in which the underlying physical asset is to be delivered

(settlement by delivery), the clearing organization ensures that delivery and payment is made. Futures

may also be settled by cash settlement rather than actual physical delivery. Cash settlement means

that the buyer receives the cash value of the physical asset instead of the physical asset. For

settlement by offset, an order would be entered to sell (or purchase) futures contracts of the same

delivery month purchased (or sold) during the earlier transaction. The difference in value at liquidation

is simply credited to or debited from the clearing member’s account.

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Futures

Table 2.9: Two Types of Settlement

Type Settlement

Performance bond (or

margin deposit)a

Every clearing member has to post performance bonds with the

clearing organization. Performance bonds cover the anticipated

one-day loss that a clearing member’s portfolio and its customers

open positions might incur. The amount required is based on the

value of the clearing member’s open positions and an

assessment of the amount of risk those contracts involve.

Performance bonds are calculated at least twice each day for

each clearing member at BOTCC and CME. If the performance

bond is below the level established by the clearing organization,

the clearing member must make a deposit.b

Variation settlement In addition to the performance bond, clearing members are

required to meet variation settlements—the amount that is

required when the clearing member’s open positions are marked

to the market prices. At least twice a day at the BOTCC and

CME, the clearing organizations determine a settlement price for

each type of futures and options on futures contracts and mark

all open positions to that price, and payment is made to reflect

the change in market prices. By marking open positions to the

market price each day, clearing organizations prevent losses and

gains from accumulating over time.

aClearing organizations calculate the performance bond either on a gross or net basis. Gross

margining requires clearing members to post margin on all of the long (buy) and short (sell)

positions in their accounts. The long and the short positions cannot be used to offset each other

in the case of a deficiency. Net margining requires margin to be posted on the difference

between all long and short positions, calculated separately for the clearing members’ accounts

and its customers’ accounts.

bClearing organization officials said that if a clearing member’s performance bond is below a

certain level and that member is to receive a variation margin settlement profit from the clearing

organization, then the clearing organization will keep the profit and apply it toward the clearing

member’s performance bond.

Sources: CBT and CME data.

Figure 2.2, along with the information that follows, describes in a

condensed manner the events that take place during the T+0 trading,

clearance, and settlement cycles.

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Futures

Figure 2.2: The 24-Hour Trading,

Clearance, and Settlement Cycle

6 a.m. 6 p.m.

12

12 1

3

8 4

5

9

10

11

7

8

9

10

1 11

2

3

4

5

Noon

6:40

Clearance

and settlement cycle

6:40 a.m.

11:30 a.m.

12:15 p.m.

12:30 p.m.

1:30 p.m.

2:00 p.m.

2:30 p.m.

3:00 p.m.

8:00 p.m.

11:00 p.m.

3:00 a.m.

6:40 a.m.

Banks commit to pay

final settlement of

previous day's trades

Matched trades

submitted at CME

Market price CME

uses in intraday

settlement

Match trades

submitted at BOTCC

Market price BOTCC

uses in intraday

settlement

Intraday settlement

made at BOTCC

Intraday settlement

made at CME

Final clearing begins

Final settlement

calculated at CME

Final settlement

calculated at BOTCC

Banks commit to pay

final settlement

Midnight Trading

7:20 a.m.

2:00 p.m.

Regular trading

begins

Regular trading

ends a

Note: For clarity, this figure represents a condensation of the

clearance and settlement cycle.

Electronic trading, such as "Project A" (CBT) and "GLOBEX"

(CME), may occur during regular trading hours and/or during a

night session.

Source: GAO analysis of CBT and CME data.

a

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Futures

The 24-Hour Cycle

Hours Cycle

6:40 a.m. (CST) The 24-hour cycle begins—settlement banks commit to pay or receive final

settlement on behalf of clearing members for the previous day’s trades.28

7:20 a.m. Regular trading begins at the exchanges.

11:30 a.m. For CME, trades that have been matched since the start of the day plus any

adjustments to existing positions are used in CME’s intraday settlement

calculation.

12:15 p.m.-12:30 p.m. The market price is determined and is used in the intraday settlement

calculation at CME.

1:30 p.m. For BOTCC, trades that have been matched up until this time are used in

BOTCC’s intraday calculation.

1:30 p.m.-2:00 p.m. Clearing organizations calculate an intraday-settlement and transmit

reports showing the amounts of what is owed to or from the clearing

members to the settlement banks.29 BOTCC uses the market price at

2:00 p.m. for its intraday settlement.

2:00 p.m. Regular trading ends at the exchanges in most pits.

2:15 p.m. BOTCC’s intraday settlement is made by settlement banks on behalf of

clearing members.

28The settlement banks’ commitment is irrevocable and will occur whether or not Fedwire opens. The

settlement amount results from the previous days’ trading and includes settlement on margin deposit

changes and mark-to-market calculations done up to a specific time before 6:40 a.m. All payments

between settlement banks are made in Fedwire funds.

29The intraday settlement includes the daily mark to market of all open positions to the current market

price variation settlement for the purposes of collecting the changes in market prices, including trades

executed during the electronic trading sessions, and the current day’s trades matched before

10:30 a.m. at CME and 1:30 p.m. at BOTCC. In addition, at CME, if the performance bond is below a

particular level, clearing members must make a deposit on that as well. BOTCC requires performance

bond settlements at 6:40 a.m. only.

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3:00 p.m. CME’s intraday settlement is made, which is similar to its 6:40 a.m.

settlement.

8:00 p.m. Final clearing begins at the clearing organizations.

11:00 p.m. Final settlement is calculated at CME. Reports are sent to the settlement

banks.

3:00 a.m. Final settlement is calculated at BOTCC and includes all-night trading done

up until 3:00 a.m. Reports are sent to the settlement banks.

6:40 a.m. Settlement banks inform the clearing organizations that they will commit

to pay on behalf of the clearing members, ending the 24-hour clearance

and settlement cycle.

Regulatory Oversight The Commodity Futures Trading Commission (CFTC) oversees the actions

of the self-regulatory organizations—the clearing organizations and the

exchanges—to determine whether they are functioning in accordance with

the law and CFTC regulations. Futures clearing organizations are

responsible for establishing the rules governing the clearance and

settlement of futures and options on futures, which are subject to approval

by CFTC.

30

Risk and Risk

Mitigation

For purposes of this report, we discuss some of the most important risks

and risk mitigations associated with futures.

Clearing organizations are exposed to risk from the time they guarantee

settlement obligations to the time clearing members make settlement

payments or offset (liquidate) their positions. As a result, clearing

organizations are exposed to counterparty risk, but the amount at risk (or

the exposure) is dependent on fluctuations in the market.

30At CME, the exchange establishes the rules that cover the Clearing House Division.

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Futures

Table 2.10: Risk and Risk Mitigation for

Futures Risk Risk mitigation

Counterparty/credit risk • Set admission standards

• Monitor clearing members’

creditworthiness

• Audit departments

• Capital requirements

• Require performance bonds and

variation margin settlements

Sources: CBT and CME.

Risk: Counterparty/Credit When the clearing organization guarantees the matched trade, it becomes

the buyer to every clearing member seller and the seller to every clearing

member buyer; this process is called novation. As a result, the clearing

organization incurs counterparty risk—the possibility that the clearing

member buyer or seller might default on its obligations.

The amount of counterparty risk that clearing organizations are exposed

to is dependent on fluctuations in the market. If a clearing member does

not make settlement payments, the clearing organization—because of the

guarantee to the clearing member buyer and the clearing member

seller—must liquidate the clearing member’s positions, but until it does so,

the clearing organization is exposed to market risk (the exposure to the

possibility of financial loss caused by adverse changes in the value of

futures contracts).

Mitigation Clearing organizations mitigate counterparty risk by (1) setting admissions

standards to determine that every clearing member is creditworthy upon

admission to the clearing organization, (2) routinely monitoring clearing

members’ creditworthiness through financial reporting requirements and a

review of the clearing members’ trading results, (3) having their audit

departments go through a prescribed set of audit tests for each clearing

member, and (4) having clearing members comply with exchange rules for

minimum capital requirements. In addition, clearing organizations require

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Futures

(1) performance bonds that they consider sufficient to cover the maximum

1-day loss that a clearing member’s portfolio might incur and (2) variation

settlements in which all futures contracts are marked-to-market prices and

payment is made to reflect the change in market prices. (See earlier

section on settlements for further detail.)

Page 76 GAO/GGD-97-73 Payments, Clearance, and Settlement
Section 2: Equities, Treasuries, Futures, and Options • Options 

Exchange-Traded Options

Description and Use Options contracts give holders the right but not the obligation, for a price,

called a premium, to buy or sell an underlying stock or other financial

instrument at a specified price, called the “exercise” or “strike” price,

before a specified expiration date. Options can be used to protect

investors against losses in investments they own, lock in profits on

positions they already have, or speculate on expected price movements.

An options contract can be terminated in three ways: (1) expiration,

(2) exercise, or (3) closeout—the holder of the option enters into an equal

and offsetting option contract. Options are usually bought and sold

without being exercised.

Settlement in the options markets usually pertains to margin settlement,

which is a payment that reflects changes in the value of the option. There

is also a premium settlement that pertains to the amount that must be paid

to buy the option, and an exercise and assignment settlement that pertains

to an option that is exercised.

The Options Clearing Corporation (OCC) clears and settles all options

traded on securities exchanges in the United States and is owned by five

participating exchanges.31 All exchange-traded options are cleared and

settled through OCC. Exchange-traded options include options such as

equity options, currency options, and equity index options.

Over-the-counter (OTC) options, which are privately negotiated, also exist.

For the purposes of this section, we will only discuss exchange-traded

options.

Exchange-listed options on futures are cleared and settled through futures

clearing organizations. However, OCC officials said that they clear and

settle some options on futures through one of their subsidiaries for three

exchanges. (See the section on the clearance and settlement of futures for

further detail.)

Participants in the clearance and settlement of options include exchanges,

OCC and its members (referred to as clearing members), and settlement

banks (or banks that settle clearing members’ accounts).

Figure 2.3 illustrates an options listing, with an explanation of its various

components.

31Exchanges include the Chicago Board Options Exchange, American Stock Exchange, Philadelphia

Stock Exchange, New York Stock Exchange, and the Pacific Stock Exchange.

Page 77 GAO/GGD-97-73 Payments, Clearance, and Settlement
Section 2: Equities, Treasuries, Futures, and Options • Options 

Exchange-Traded Options

Figure 2.3: An Options Listing

Listed Options Quotations

Option/

EXXON

Strike Exp. Vol. Last

 Call 

Vol. Last

 Put 

80 8 1 Oct 137 1 8

Strike price is the price the underlying stock will be bought and sold for. For example, the 

Exxon Call will give you the right to buy Exxon shares at $80, $85, and $90. 

So, at a Strike Price of $90, you could buy 100 shares of Exxon for $9,000.

Expiration of the call and put options contracts.

Volume of the call options traded.

Premium (price of the option) for a call option. The price of an 80 

Jan option is 8 1/2 ($8.50) per share, which makes the

options contract price $850 ($8.50 x 100 shares).

Volume of put options traded.

Premium for put options.

Closing price of the underlying stock for each row of strike prices.

In the example, Exxon’s stock is worth 87 1/2 or $87.50 per share.

Options buyers bid or make offers in 100 shares per option contract.

Name of the underlying stock.

87

87

871 2

1 2

1 2

8

16

1 2

16

8

1 2

7

3

5

7

1 2

1 2 8 1

16 21 1 8

87

87

90

90

138 1

92

Nov

Jan 15 4

80

85

90

8

2

1

50

20

89

412

75

Jan

Oct

Oct 1

Source: GAO Analysis.

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Exchange-Traded Options

Options Can Be Used to

Limit Losses or Make

Profits

An investor who wanted to limit potential losses in investments already

owned might purchase a “put option.” If an investor owns 100 shares of

Exxon stock valued at 87 1/2 ($87.50) a share—and wants to hold the

stock in case the price of the stock rises—but thinks that the price of the

stock may fall below $80, the investor might purchase an “80 Jan Put,”

which will give the investor the right to sell Exxon stock at a locked-in

selling price of $80 per share at any time before the option expires at

11:59 a.m. EST on the third Saturday of January. If an investor wanted to

make a profit and thought that the Exxon stock might rise above $90 a

share, the investor might buy a “90 Oct Call” at a locked-in buying price of

$90 a share. If the price rises above $90 a share, the investor can exercise

his or her right to buy Exxon stock at $90 a share. The investor can then

profit by reselling the shares at the market price. The investor could also

sell the option contract at a profit.

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Exchange-Traded Options

C

F

E

Call option

Clearing member

Currency option

Equity index option

Exercise

Floor broker

O

P

Open outcry

Order-book official

Premium

Put option

A call option is a contract that gives one the right, but not the obligation, to buy

a specified amount of an underlying asset, such as stocks or currency, at a 

specified price by a certain date.

A clearing member is a financial institution that OCC determines is qualified to

interact with it on behalf of market participants.

A currency option is a contract that gives one the right, but not the obligation, 

to buy or sell a foreign currency at a particular price within a specified period.

An equity index option is an option covering the price of a diversified stock

portfolio that matches a designated stock-index (a statistical indicator used 

to measure changes in stock groupings).

Exercise means to make use of the "rights" in the options contract. For 

instance, a buyer of a call option may exercise the right to buy the underlying

asset at the particular price agreed upon (called the exercise or strike price)

when the contract was purchased.

A floor broker executes trades for customers and may also execute trades 

for their personal or employer accounts.

Open outcry is a competitive system in which floor participants verbally make

bids and offers to each other at centralized exchange locations.

An order-book official is an exchange official who accepts and executes limit 

orders from customers--orders to buy or sell when the market reaches a certain

price.

The premium is the amount that the buyer of an option pays the writer (or seller) 

of the option.

A put option is a contract that gives one the right, but not the obligation, to sell a 

specified amount of an underlying asset, such as stocks or currency, at a 

specified price by a certain date.

Key Terms

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Exchange-Traded Options

Registered option traders are those who trade on the exchange floor for their

own account but have an obligation, similar to that of specialists, to make 

markets.

A series of options consists of options of the same class that also have the 

same unit of trade, strike price, and expiration date.

Settlement banks maintain the settlement accounts for clearing members

whereby payments and deposits are made.

A stock option gives the holder the right to purchase or sell a certain number of 

shares of stock at a particular price within a specified period.

An options seller is called a writer of options, a "covered" writer if owning

the underlying asset and a "naked" writer if not. The writer of an option is

obligated to sell (call option), or buy (put option), a specified amount of the 

underlying asset at a predetermined price when the buyer, or holder, exercises 

the option. The writer receives a premium paid by the buyer.

R Registered option traders

S

W

Series of options

Settlement banks

Stock option

Writer

Basic Data According to OCC officials, OCC has 147 clearing members composed of

broker-dealers owned by U.S. securities firms and some of the major

foreign banks and investment houses.

As shown in table 2.11, OCC clears and settles millions of options contracts

annually. The primary type of option that OCC clears and settles is the

equity, or stock option. OCC also clears a substantial portion of equity

index options and a small portion of currency options.

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Exchange-Traded Options

Table 2.11: Total Volume of

Exchange-Traded Options Contracts

Cleared in 1995

Types of

options

Total

volume of

contracts

cleareda

Percent of

total volume

Average

daily

volumeb

Average

daily call

volumeb

Average

daily put

volumeb

Equity options 174.4 60.7% 692.0 491.3 200.7

Equity index 

options 107.9 37.6 428.1 191.6 236.4

Currency

options 5.0 1.7 19.8 8.7 11.0

Total 287.3 100% 1140.1 691.8 448.2

aVolume in millions.

bVolume in thousands. Columns do not total because the totals include interest rate options that

are not included in the table.

Note: Numbers based on 1995 data.

Source: OCC data.

Processes Options trade, clear, and settle in what is known as “T+1”—i.e., options

are settled one day after (+1) the day in which they were traded, with the

“T” standing for the day of the trade.

The Trading Process Individual investors who want to purchase a call or put option may do so

through a broker. The broker usually has a floor broker execute the trade

on behalf of the customer. Exchanges also have automatic order execution

systems for public customer orders.

Trading in the options markets is done on the floor of options exchanges.

The exchanges operate as auction markets. U.S. exchanges that trade

options operate with either (1) competing market makers (dealers) for

each class of options and exchange officials such as floor brokers or order

book officials or (2) designated market makers for each class of options,

with additional market making provided by registered options traders.

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Exchange-Traded Options

The Clearing Process OCC officials said that their clearance and settlement process starts when

the exchanges provide computer data on matched trades—trades in which

the sell side and the buy side of the trade have been compared and

matched. (See table 2.12.)

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Exchange-Traded Options

Table 2.12: Steps in the Options

Clearing Process Steps Clearing process

(1) OCC receives matched-trade data from

the exchanges via computer.

(a) Exchanges submit the matched-trade

data in a batch-once-a-day mode via

computer to OCC no later than 1:00 a.m.

after the day of the trade for clearance and

settlement purposes.a

(b) OCC officials said that their clearance

system runs independently for each opions

exchange, so that a problem at one

exchange does not affect the other options

exchanges.

(2) OCC then guarantees the matched

trades.

(a) When OCC has the matching trade

data, it issues a new contract and

becomes the buyer to every seller and the

seller to every buyer. This process is

called novation.

(3) OCC then performs what is known as

exercise and assignment on a random

basis. OCC receives an exercise notice from

the holder’s broker and then assigns the

exercise notice to one of its clearing

members.

(a) Exercise and assignments occur when

a holder decides to exercise his or her

rights to buy or sell the underlying asset.b

Because OCC keeps the records of all of

its clearing members, when a holder

decides to exercise its right to buy or sell

an underlying asset, its broker has to

submit an exercise notice to OCC.

(b) OCC assigns the exercise notice to a

clearing member that has a position in the

unit of trade, which in turn assigns one or

more of its customers who hold positions in

that series of options.

(c) The assigned clearing member is then

obligated to sell or buy the underlying

asset at the specified strike price.c

aExchanges also send OCC intraday trade information that OCC uses for risk management. But

for clearance and settlement, exchanges submit trade data to OCC in a batch once a day. If an

exchange is unable to provide matched trade information by the final deadline, OCC allows

additional time.

bIf an option is held until it expires and it is not in the interest of the option holder to exercise the

option at expiration, then OCC does not settle the option. However, if the holder decides to

exercise the option on the date of expiration, then the option goes through OCC’s exercise and

assignment process.

cIn the case of equity options, OCC then arranges with a stock clearing corporation for the

delivery of the shares of stock instead of the exercise settlement amount. All other DVP for options

are exercised within OCC.

Source: OCC.

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Exchange-Traded Options

Settlement Process OCC calculates the amount of money that is owed by buyers and due

writers the day after a trade (T+1). In the case of the buyer, the entire

amount of money owed to OCC is the amount of the premium which, while

first paid to OCC, is then passed on to the writer of the option. In the case

of the writer, settlement refers to two settlement amounts (1) premium

settlement and (2) margin settlement.32 On the day after the trade (T+1),

OCC notifies the buyer of the amount of cash premium that is due; at the

same time, the writer of the option is notified by OCC of the amount of

margin that is due. Both amounts are due on T+1. (See table 2.13)

Table 2.13: Two Types of Settlement

Participant Type of settlement

Buyer Premium settlement (in this case it is the price the buyer

pays for the option).

Writer (1) Premium settlement.

(2) Margin settlement.a

aOCC calculates the margin that the writer has to provide using its Theoretical Intermarket Margin

System, which is an option pricing model that estimates what it would cost to liquidate an option

given the size of a margin interval. According to an OCC official, the margin interval is the range

of potential market scenarios over which the risk of the option is being evaluated by OCC.

Source: OCC.

At the end of each trading day, OCC calculates the net amount that each

member either owes or is owed. The net figure includes (1) the cash

premium that the writer is due on each option sold and (2) the margin due

for each open position—a position that has not been exercised by buyers

or holders.

As shown in table 2.13, the first component of the writer’s settlement is the

premium settlement due to the writer, which is the price at which the

writer sold the option to the buyer. This settlement should reflect the

current market price at the time of the trade. The premium settlement is

due on the day after the trade (T+1).

32The final settlement of an option can be done either by exercise/assignment or by closeout. OCC

officials said that only about 10 percent of options contracts are exercised/assigned. If a holder

decided to close out its options prior to expiration, the holder would sell that option in the market. The

option sold would be coded as a closeout option so that OCC’s clearance and settlement system would

eliminate the holder’s open position.

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Exchange-Traded Options

The second component of the writer’s settlement is the margin settlement,

which is like a “good faith” deposit. One part of the margin settlement is

the daily mark-to-market value of the option, which reflects the current

market price of the option. For instance, as an option’s price gains in

value, the options writer pays margin to OCC and the buyer of the option

gets a margin credit. If the options contract loses value, OCC reduces the

amount of margin required from the writer.33 The other part of the margin

settlement is the daily risk value of the option, which reflects the potential

change in the current market price of the option. OCC calculates and

collects the margin settlement from the option writer until the option is

terminated.

Figure 2.4, along with information that follows, describes in a condensed

manner the events that take place during the T+1 trading, clearance, and

settlement cycle.

33Because the buyer of an option does not have to exercise the option contract unless it is in his or her

favor, the buyer does not owe OCC money if the option price moves against him or her. Thus, if the

price of the option continues to move against him or her, the option’s buyer—by not having to exercise

the option—only loses the premium settlement amount.

Page 86 GAO/GGD-97-73 Payments, Clearance, and Settlement
Section 2: Equities, Treasuries, Futures, and Options • Options 

Exchange-Traded Options

Figure 2.4: T+1 Trading, Clearance,

and Settlement Cycle

6 a.m. 6 p.m.

12

12 1

3

8 4

5

9

10

11

7

8

9

10

1 11

2

3

4

5

Noon

Clearance

and settlement cycle

6:00 a.m. OCC notifies

settlement banks of

final settlement

amounts

9:00 a.m. OCC paid final

settlement

10:00 a.m. OCC pays final

settlement

8:00 p.m. Matched trade data

submitted to OCC

3:00 a.m. Margin requirements

are calculated

Midnight

Trading

8:30 a.m. Trading begins

3:10 p.m. Trading ends

6:00 p.m. Currency option

trading begins and

will end at 2:00 p.m.

the next day

(20 hours later)

Source: GAO analysis of OCC data.

Page 87 GAO/GGD-97-73 Payments, Clearance, and Settlement
Section 2: Equities, Treasuries, Futures, and Options • Options 

Exchange-Traded Options

Trading, Clearance, and

Settlement Cycle

Hours Cycle

6:00 a.m. (CST) Settlement banks are notified of the final—margin and

premium—settlement amounts due from each clearing member, resulting

from the previous day’s trading.

8:30 a.m. Trading begins for stock and stock index options at the exchanges for the

new trade day (T).34

9:00 a.m. All final settlement amounts are due to OCC by each clearing member for

the previous day’s trading—the T+1 settlement.

10:00 a.m. OCC pays final settlement due members, resulting from the previous day’s

trading—also T+1 settlement. OCC does not pay members money owed

them until it has received the money it is owed at 9:00 a.m.

3:15 p.m. Trading ends for stock and stock-index trading.

6:00 p.m. Currency option trading begins, and it will end at 2:00 p.m. the next day

(20 hours later).

8:00 p.m. Exchanges submit matched-trade data to OCC until 1:00 a.m. Currency

option trade data from the previous day’s trading are processed along with

the stock and stock-index option data.

3:00 a.m. OCC updates the clearing members’ positions for the end of the trading

session and calculates the members’ settlement requirements, both margin

and premium. This settlement amount will be the final settlement that is

due by the clearing members at 9:00 a.m. and paid by OCC at 10:00 a.m.,

which will end the T+1 trading, clearing, and settlement cycle.

34The Pacific Stock Exchange operates from 6:00 a.m. to 1:50 p.m. Pacific Time.

Page 88 GAO/GGD-97-73 Payments, Clearance, and Settlement
Section 2: Equities, Treasuries, Futures, and Options • Options 

Exchange-Traded Options

Regulatory Oversight The Securities and Exchange Commission (SEC) oversees the actions of

OCC with regard to exchange-traded equity options, equity index options,

and currency options to determine whether it is functioning in accordance

with SEC regulations and the law. The Commodity Futures Trading

Commission (CFTC) oversees the actions of OCC with regard to options on

futures (see the futures section for further information on options on

futures). OCC establishes the rules governing the clearance and settlement

of options, subject to the approval of SEC, or of CFTC in the case of options

on futures.

Risk and Risk

Mitigation

For purposes of this report, we discuss some of the most important risks

and risk mitigation associated with exchange-traded options.

OCC carries risk from the time it guarantees a trade until the resulting

position is terminated. As a result, OCC is exposed to counterparty risk, but

the amount at risk (or the exposure) is dependent on fluctuations in the

market.

Table 2.14: Risk and Risk Mitigation for

Options Risks Risk mitigation

Counterparty/credit risk • Monitoring of the clearing member’s

creditworthiness

• Possible requirement of additional

margin for less creditworthy

clearing members

• Guarantee of matched trades only

• Requirement of margin that acts as

collateral

• Maintaining guarantee fund

Page 89 GAO/GGD-97-73 Payments, Clearance, and Settlement
Section 2: Equities, Treasuries, Futures, and Options • Options 

Exchange-Traded Options

Risk: Counterparty/Credit OCC guarantees the performance of each clearing member to the other

clearing member of each trade. As a result, it incurs the risk that a clearing

member might default on its obligations.

The amount of counterparty risk that OCC is exposed to is dependent on

fluctuations in the market. If a clearing member does not make settlement,

OCC—because of the guarantee to the clearing member buyer and clearing

member seller—must liquidate the clearing member’s positions, but until it

does so, OCC is exposed to market risk (the exposure to the possibility of

financial loss caused by adverse changes in the value of options.

Mitigation OCC mitigates counterparty/credit risk by (1) monitoring the

creditworthiness of its clearing members and (2) having the ability to

require additional margin for less creditworthy clearing members. In

addition, OCC requires a margin from each clearing member (see the

section on settlement) and maintains a guarantee fund35 that OCC may use

when it needs to.

35The guarantee fund is funded by OCC assessing clearing members on their past month’s open

positions. The assessment is an amount that members pay once a month and is calculated separately

from the other settlement amounts.

Page 90 GAO/GGD-97-73 Payments, Clearance, and Settlement
Section 3: Retail Payment Systems • Overview 

Overview of Clearance and Settlement of

Retail Payment Systems

In this section of the report, we discuss small-dollar retail payment

systems, including checks, credit cards, and the automated clearing house

(ACH).

Main Characteristics • Retail payments are primarily small-dollar payments that are used by

consumers or businesses in payment for goods and services.

• Unlike checks, ACH transactions can be either credit or debit transactions.

• In ACH credit transactions, funds flow from the originator (payor) to the

receiver (payee). Settlement for an ACH credit transaction is generally final

by the opening of business on the banking day following the settlement

day.

• In ACH debit and check payments, the payee collects funds from the payor.

The interbank settlement for check and ACH debit transactions is typically

final by the opening of business on the banking day following the day

checks are presented or ACH debit transactions are provisionally settled.

Statistical Information • In 1996, approximately 63 billion paper checks were written in the United

States.

• In 1995, credit card transactions accounted for approximately 14.9 billion

transactions.

• In 1996, approximately 4.0 billion payments totaling $12.1 trillion were

processed on ACH.

Regulatory

Information

• Checks are governed by articles 3 and 4 of the Uniform Commercial Code

(UCC); the Expedited Funds Availability Act (EFAA), implemented by the

Federal Reserve Board of Governors’ Regulation CC, “Availability of

Funds and Collection of Checks”; and, when handled by the Federal

Reserve Banks, subpart A of the Federal Reserve’s Regulation J.

• The primary regulations for credit cards are the Equal Credit Opportunity

Act of 1974 and the Truth in Lending Act of 1968, implemented by the

Board of Governors of the Federal Reserve System’s Regulations B and Z,

respectively.

• The basic rules that govern ACH are the National Automated Clearing

House Association (NACHA) Operating Rules and Guidelines. In addition,

ACH is governed by UCC Article 4A for commercial ACH credit transactions,

31 CFR 210 for transactions originated by the federal government, the

Electronic Fund Transfer Act and the Federal Reserve’s Regulation E for

consumer transactions, and the Reserve Banks’ ACH operating circular for

transactions processed by the Federal Reserve.

Page 91 GAO/GGD-97-73 Payments, Clearance, and Settlement
Section 3: Retail Payment Systems • Overview 

Overview of Clearance and Settlement of

Retail Payment Systems

Risk Information • Consumer delinquency and default are the principal risks that confront the

credit card industry.

• Depository institutions that originate ACH debit transactions and that

collect checks are exposed to the potential risk that some of the

checks/debit transactions will be returned unpaid.

• Depository institutions that originate ACH credit transactions are exposed

to potential temporal credit risk if a corporate customer does not fund the

payment on settlement day.

Page 92 GAO/GGD-97-73 Payments, Clearance, and Settlement
Section 3: Retail Payment Systems • Checks 

Checks

Description and Use The paper check, the most frequently used and oldest noncash payment

instrument in the United States, is used by individuals, businesses, and

governments to pay for goods and services. According to the National

Organization of Clearing Houses (NOCH), over 63.4 billion paper checks

were written in the United States in 1996.1

 Paper checks constitute the

largest volume of noncash payments made in the United States. In this

section, we discuss the clearance and settlement of commercial checks

drawn on financial institutions.2

As illustrated in figure 3.1, a paper check includes the names of the payor

and the payee, the amount of the check, and the name of the paying bank.

In addition, the magnetic ink character recognition (MICR) line at the

bottom of the check permits checks to be processed on high-speed

equipment. It includes a number that identifies the bank upon which it is

drawn and the account number of the check writer. Before checks are

processed, the amount of the check is also encoded in magnetic ink at the

bottom of the check.

1

Estimates of the total number of checks written for any given period must be considered imprecise

estimates because the specific number of checks that are cleared through clearing houses,

correspondent banks, and by direct presentment is unknown. A comprehensive survey of the number

of checks written has not been conducted since 1979.

2

In 1996, the Federal Reserve Banks processed nearly 436 million paper checks for the federal

government; however, the volume of government paper checks is expected to decline as a result of the

enactment of the Debt Collection Improvement Act (DCIA) of 1996, Pub. L. No. 104-134, Section 31001,

which requires that all federal payments, except Internal Revenue Service (IRS) payments and

payments to individuals who certify that they do not have bank accounts, be issued via electronic

funds transfer by Jan. 1, 1999.

Page 93 GAO/GGD-97-73 Payments, Clearance, and Settlement
Section 3: Retail Payment Systems • Checks 

Checks

Figure 3.1: An Example of a Paper Check

Pay To

The Order Of

19

$

Dollars

No. 687

Consumer A

123 Main Street

Anywhere, U.S.A. 00000

First National Bank

Anywhere, U.S.A.

Memo

:121908288:0981234567:0687 0000007500

Payor's name

Number of the check

Payee

Payor's

bank

Payor's

account number

Check digit:

This number, combined with the first

eight digits, verifies the routing number's

accuracy.

Payor's bank:

These four digits are the payor bank's

institutional identifier.

Check routing symbol:

The first two digits identify the payor bank's Federal

Reserve district.

The third digit identifies the Federal Reserve office

(head office or branch) or special collection arrangement.

The fourth digit shows the payor bank's state or special

collection arrangement.

Check number

00

January 1, 97

Company B 75.00

Seventy Five and

Consumer A

00

100

Dollar amount

is printed by the first

bank receiving the

check.

Routing number

is repeated in a different

format from that shown

below and is used in

manual processing.

MICR

Number:

Magnetic ink

character

recognition

number

12-3-45

Source: The Story of Checks and Electronic Payments, Federal Reserve Bank of New York.

Depository institutions have the following alternative methods of clearing

and settling checks.

Page 94 GAO/GGD-97-73 Payments, Clearance, and Settlement
Section 3: Retail Payment Systems • Checks 

Checks

On-us checks. When checks are deposited into the same bank on which

they were drawn, banks will settle these items in-house. Such checks are

referred to as “on-us” checks.

Interbank checks. Interbank checks are checks not drawn on the

depository institution at which they were deposited.

• Direct presentment. Depositary banks can present checks directly to the

paying bank.

• Correspondent banks. Correspondent banks can settle the checks that

they collect for other institutions, known as respondents, by using

accounts on their books or by sending Fedwire funds transfers.

• Clearing house association. Banks can form a voluntary association

that establishes a meeting place for the exchanging of checks drawn on

those banks. Typically, banks participating in check clearing houses use

the Federal Reserve’s net settlement service to effect settlement for the

checks exchanged each business day.

• Federal Reserve Banks. The Federal Reserve System operates a

comprehensive, nationwide system for clearing and settling checks drawn

on depository institutions located in all regions of the United States.

There are approximately 150 check clearing house associations in the U.S.

Three of the large clearing house associations in the U.S. are the California

Bankers Clearing House (CBCH), the Chicago Clearing House Association

(CCH), and the New York Clearing House Association (NYCHA). NYCHA,

established in 1853, is the nation’s first clearing house association. Smaller

depository institutions typically use the check collection services of

correspondent banks or of the Federal Reserve.

Table 3.1: Major Organizations That

Process or Exchange Checks

Federal Reserve

System

The Federal Reserve System processes commercial checks

through its 12 Reserve Banks, 24 branches, and 10 regional

check processing centers. Also, the Federal Reserve processes

federal government checks and postal money orders.

CBCH CBCH provides check exchange services to over 100

depository institutions located mainly in California.

CCH CCH provides check exchange services to its 8 member banks

and its 260 affiliate members.

NYCHA NYCHA provides check exchange services to its 10 member

banks and to 131 other depository institutions.

Sources: Federal Reserve Board, CBCH, CCH, and NYCHA.

Page 95 GAO/GGD-97-73 Payments, Clearance, and Settlement
Section 3: Retail Payment Systems • Checks 

Checks

C

F

D

Cash letter

Check

Check clearing

Check truncation

Depositary bank

Float

M

P

MICR-line information

Paying bank

Presentment fee

A cash letter is a group of checks, accompanied by a listing of the checks, 

which is sent to a clearinghouse, a correspondent bank, or the Federal 

Reserve for collection.

A check is a written order from one party (the payor) to another (the payee)

requiring the payor to pay a specified sum on demand to the payee or to a 

third party specified by the payee.

Check clearing is the movement of a check from the depository institution 

at which it was deposited back to the institution on which it was written; the

funds move in the opposite direction, with a corresponding credit and debit

to the involved accounts.

Check truncation is the practice of holding a paper check at the bank at which

it was deposited (or at an intermediary bank) and electronically forwarding 

the essential information on the check to the bank on which it was written. 

A truncated check is not returned to the writer.

A depositary bank is the bank at which a check is first deposited.

Float is checkbook money that appears on the books of both the check writer 

(the payor) and the check receiver (the payee) while a check is 

being processed.

MICR-line information refers to data characters at the bottom of a check. The

magnetic ink character recognition (MICR) line at the bottom of a check includes

the routing number of the payor bank, the amount of the check, the number of 

the check, and the account number of the customer.

A paying bank is the bank at which a check is payable and to which it

is sent for payment or collection.

A presentment fee is a fee that a bank receiving a check may impose on

the bank that presents the check for payment.

Key Terms

Basic Data Table 3.2 shows the volume of checks handled by the Federal Reserve and

three major check clearing houses from 1992 to 1995. In 1995, the Federal

Reserve Banks handled 15.5 billion checks, a decrease of 19 percent from

Page 96 GAO/GGD-97-73 Payments, Clearance, and Settlement
Section 3: Retail Payment Systems • Checks 

Checks

the volume of checks they handled in 1992.3 The following factors have

contributed to this decline:

• adoption of the same-day settlement regulation;4

• increased competition from private clearing houses; and

• banking consolidation, resulting in more “on-us” checks, which do not

need to be cleared.

Table 3.2: The Volume of Checks

Processed, 1992-1995

1992 1995

Percent

change

Federal Reservea 19.1 billion 15.5 billion –19%

CBCH 1,294 million 1,554 million +20

CCH 384.7 million 562.8 million +46

NYCHA 492.6 million 335.7 million –32

aThese numbers refer only to commercial checks; they do not include federal government checks

and postal money orders that are processed by the Federal Reserve.

Sources: The Federal Reserve System 1995 Annual Report, CBCH, CCH, NOCH, and NYCHA.

At the same time, the volume of checks processed by two of the three

major private clearing houses, CBCH and CCH, has increased for the period

of 1992 through 1995, as shown in table 3.3.

3

Annual Report: 1995, Board of Governors of the Federal Reserve System, p. 303.

4

Before the Board of Governors adopted the same-day settlement rule, which became effective on

Jan. 2, 1994, private collecting banks, unlike the Federal Reserve Banks, did not have the right to

present checks to paying banks and to demand settlement in same-day funds. Since the same-day

settlement rule became effective, more collecting banks have begun to present checks directly to

paying banks. Banks have historically had bilateral agreements with each other under which they have

exchanged checks directly. In some cases, paying banks imposed presentment fees, but not in all

cases. Even today, banks exchange checks directly at later times than permitted under the same-day

settlement rule using bilateral agreements.

Page 97 GAO/GGD-97-73 Payments, Clearance, and Settlement
Section 3: Retail Payment Systems • Checks 

Checks

Processes As previously mentioned, banks have several alternative methods for

clearing and settling checks. Figure 3.2 describes how the Federal Reserve

System processes and clears checks. The Federal Reserve System operates

a comprehensive, nationwide system for clearing both local and nonlocal

checks. When checks are processed by the Federal Reserve, they are

sorted through a check sorter and settled by debits to the Federal Reserve

accounts of the paying banks and credits to the Federal Reserve accounts

of the collecting banks. In order to facilitate the clearing of checks

nationwide, the Federal Reserve uses both air transportation and ground

transportation networks to deliver checks. Checks, which are drawn on

banks in regions far from the payee bank, are frequently shipped by air to

the city in which the payor bank is located. Locally, checks are delivered

by ground transportation.

Page 98 GAO/GGD-97-73 Payments, Clearance, and Settlement
Section 3: Retail Payment Systems • Checks 

Checks

Processing a Check Figure 3.2 shows how a paper check would be processed through the

Federal Reserve System, using the following example.

Example: A consumer (Consumer A) in Philadelphia orders four books

from a book company (Company B) in Los Angeles.

The total cost ofthe order is $75.

The consumer pays for the books by mailing a check to Company B.

Page 99 GAO/GGD-97-73 Payments, Clearance, and Settlement
Section 3: Retail Payment Systems • Checks 

Checks

Figure 3.2: The Federal Reserve System for Processing a Paper Check

LA Branch of the

Federal Reserve of SF

Federal Reserve Bank

of Philadelphia

1

5

2

3

4

12-3-45

Pay To

The Order Of

19

$

Dollars

No. 687

Consumer A

123 Main Street

Anywhere, U.S.A. 00000

First National Bank

Anywhere, U.S.A.

Memo

:121908288:0981234567:0687 0000007500

00

January 1, 97

Company B 75.00

Seventy Five and

Consumer A

00

100

Company B

Credit Debit

Deposit $75

12-3-45

Pay To

The Order Of

19

$

Dollars

No. 687

Consumer A

123 Main Street

Anywhere, U.S.A. 00000

First National Bank

Anywhere, U.S.A.

Memo

:121908288:0981234567:0687 0000007500

00

January 1, 97

Company B 75.00

Seventy Five and

Consumer A

00

100

12-3-45

Pay To

The Order Of

19

$

Dollars

No. 687

Consumer A

123 Main Street

Anywhere, U.S.A. 00000

First National Bank

Anywhere, U.S.A.

Memo

:121908288:0981234567:0687 0000007500

00

January 1, 97

Company B 75.00

Seventy Five and

Consumer A

00

100

12-3-45

Pay To

The Order Of

19

$

Dollars

No. 687

Consumer A

123 Main Street

Anywhere, U.S.A. 00000

First National Bank

Anywhere, U.S.A.

Memo

:121908288:0981234567:0687 0000007500

00

January 1, 97

Company B 75.00

Seventy Five and

Consumer A

00

100

12-3-45

Pay To

The Order Of

19

$

Dollars

No. 687

Consumer A

123 Main Street

Anywhere, U.S.A. 00000

First National Bank

Anywhere, U.S.A.

Memo

:121908288:0981234567:0687 0000007500

00

January 1, 97

Company B 75.00

Seventy Five and

Consumer A

00

100

Bank B

Bank B

To Bank A

Company B receives Consumer A's

check for $75 and deposits the check

into its account with Bank B.

Bank B codes the value of the

checks it received from Company B

(using magnetic ink) on the bottom of the

check; bundles it with other checks it

received in deposits on day 0, and deposits

the bundle of checks with the LA Branch of the

Federal Reserve Bank of San Francisco in

the evening. Bank B credits Company B for

the value of its deposit as "unavailable" or

"uncollected" funds.

The LA branch sorts

the checks deposited by Bank B

using high-speed sorters that read

the magnetic ink characters on the bottom

of the checks to verify the amount of

Bank B's deposit and to sort checks

by their various destinations. Consumer A's

check will be bundled with other checks

drawn on banks located in the checkprocessing territory served by the

Federal Reserve Bank of Philadelphia.

The Los Angeles Branch

ships the bundle of checks to

the Federal Reserve Bank of

Philadelphia by air transportation.

The Federal Reserve Bank

of Philadelphia receives the bundle of

checks shipped to it by the LA Branch.

Using high-speed sorters, it verifies the dollar

amount and number of the checks received from

the LA Branch, sorts them by the banks on which

they are drawn, and bundles them by those

paying banks.

Day 0 Day 1

Page 100 GAO/GGD-97-73 Payments, Clearance, and Settlement
Section 3: Retail Payment Systems • Checks 

Checks

Company B

Credit Debit

Deposit $75

12-3-45

Pay To

The Order Of

19

$

Dollars

No. 687

Consumer A

123 Main Street

Anywhere, U.S.A. 00000

First National Bank

Anywhere, U.S.A.

Memo

:121908288:0981234567:0687 0000007500

00

January 1, 97

Company B 75.00

Seventy Five and

Consumer A

00

100

12-3-45

Pay To

The Order Of

19

$

Dollars

No. 687

Consumer A

123 Main Street

Anywhere, U.S.A. 00000

First National Bank

Anywhere, U.S.A.

Memo

:121908288:0981234567:0687 0000007500

00

January 1, 97

Company B 75.00

Seventy Five and

Consumer A

00

100

12-3-45

Pay To

The Order Of

19

$

Dollars

No. 687

Consumer A

123 Main Street

Anywhere, U.S.A. 00000

First National Bank

Anywhere, U.S.A.

Memo

:121908288:0981234567:0687 0000007500

00

January 1, 97

Company B 75.00

Seventy Five and

Consumer A

00

100

12-3-45

Pay To

The Order Of

19

$

Dollars

No. 687

Consumer A

123 Main Street

Anywhere, U.S.A. 00000

First National Bank

Anywhere, U.S.A.

Memo

:121908288:0981234567:0687 0000007500

00

January 1, 97

Company B 75.00

Seventy Five and

Consumer A

00

100

6

Bank A

7

8

9

The Philadelphia Reserve Bank delivers

the checks to the paying banks, including

Bank A, via ground carriers

Federal Reserve

Bank of Philadelphia

Reserve Account of Bank A

Debit Credit

$75

Federal Reserve

Branch of Los Angeles

Reserve Account of Bank B

Debit Credit

$75

LA Branch of the

Federal Reserve of SF

Bank B

Debit Credit

$75

Account of Company B

Bank B

Federal Reserve Bank

of Philadelphia

Bank A

Day 2-5

Bank B makes the $75 available

to Company B.

Bank A processes the checks using

its sorting equipment, capturing data on

the value of each check written by each of its

customers. Using this information, Bank A

debits Consumer A's account.

After Bank A receives its checks, the

Philadelphia Reserve Bank debits its

Federal Reserve account and credits the

LA Branch through the Federal Reserve's

accounting system. Almost simultaneously

the LA Branch credits the Federal Reserve

account of Bank B.

Source: GAO analysis of information provided by the Federal Reserve Board.

Page 101 GAO/GGD-97-73 Payments, Clearance, and Settlement
Section 3: Retail Payment Systems • Checks 

Checks

According to industry officials, extensive use of the paper check

contributes to some of the inefficiency that is present in the U.S. payment

system. One of the goals of any payment system is to facilitate the safe,

sound, and efficient transfer of value between receivers and providers of

goods and services in a timely manner. According to a payment system

expert, paper instruments, such as checks, are considered substandard

from a payment system design perspective.

New Technologies in

Check Processing

In the last few years, clearing house associations, the banking industry,

and the Federal Reserve have been actively developing and pursuing a new

technology that may shorten the amount of time it takes to clear and settle

checks and, thus, improve the overall efficiency of the payment system.

This new check technology is called electronic check presentment (ECP).

ECP is a process by which the MICR-line information is sent electronically to

the paying bank. A number of large commercial banks participate in the

Electronic Check Clearing House Organization (ECCHO), formed in 1990.

ECCHO drafts rules and designs formats for electronic check processing

among its members. Banks that are ECCHO participants can exchange

electronic check data among themselves before the paper checks are

physically presented for payment.

ECP may include check truncation and may be supported by check imaging

technology. Check truncation is a process by which the paper checks are

retained at some point in the collection process, and only the check

information is sent forward to the paying bank. ECCHO is developing a set

of national rules for check truncation. Check imaging is a process by

which a picture is taken of the front and back of the check, and the images

are stored on electronic media for retrieval when needed.

The Federal Reserve also offers ECP products to paying banks. During

1996, the Federal Reserve presented electronically to the paying bank

nearly 1.4 billion checks, or 9 percent of checks collected by the Federal

Reserve. This is an increase of approximately 100 percent over the 1994

level.

As of January 1996, 2,221 depository institutions used the Federal

Reserve’s ECP service. This is a 37-percent increase over the number of

depository institutions that were using the Federal Reserve’s ECP service in

January 1995. In 1992, NYCHA created the Clearing House Electronic Check

Clearing System (CHECCS), in which ECP is a key component.

Page 102 GAO/GGD-97-73 Payments, Clearance, and Settlement
Section 3: Retail Payment Systems • Checks 

Checks

Although the use of check truncation and imaging is steadily increasing, it

is not clear how much check volume will be affected by these methods in

the foreseeable future. The reluctance of some banks to invest in the

technology, and consumer preference for their returned checks, may

restrain substantial growth in check truncation and imaging. One Federal

Reserve official predicted that check truncation would not be widely used

until consumers accepted the fact that their checks would not be returned

to them. Moreover, under current law, depositary banks must physically

present checks to paying banks to obtain settlement for the checks.

Regulatory Oversight Articles 3 and 4 of the Uniform Commercial Code (UCC) provide the legal

framework for check processing. In 1987, Congress enacted the Expedited

Funds Availability Act (EFAA), which limits the time that banks can

withhold funds from checks deposited into customer accounts before the

funds are made available for withdrawal. The law was implemented in

September 1988 through the Federal Reserve Board of Governors’

Regulation CC, “Availability of Funds and Collection of Checks.”

Regulation CC also includes a number of provisions designed to accelerate

the collection of checks and the return of unpaid checks to the banks of

first deposit. Among other things, EFAA and Regulation CC generally

require institutions to make funds from local checks available by the

second business day after the day of deposit; funds from nonlocal checks

are to be available by the fifth business day after the day of deposit.

Also, those checks that are collected or returned through the Federal

Reserve are governed by subpart A of the Federal Reserve’s Regulation J.

Regulation J establishes the procedures, duties, and responsibilities of the

sending and paying banks.

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Checks

Risk and Risk

Mitigation

For purposes of this report, we discuss some of the most important risks

and risk mitigations associated with checks.

Table 3.3: Risk and Risk Mitigation for

Checks Risk Risk mitigation

Return item risk Credit monitoring

Large-dollar return notifications

Electronic check presentment

Check fraud risk Positive pay

Electronic check presentment

Shaded cells indicate mitigations that have been adopted by some participants or providers

but are not yet widely used. Unshaded cells indicate mitigations in general use.

Risk 1: Return Item A check will be returned to the depositary bank unpaid if the paying bank

determines not to pay the check. This is called a return item. Return item

risk is a major risk facing institutions that collect checks. Some of the

reasons for which a check may be returned are insufficient funds in the

account, a closed account, a stop payment order, a fraudulent signature, or

the failure of the paying bank. A recent Federal Reserve survey on

returned checks processed by the Reserve Banks showed that it takes, on

average, 5.5 calendar days for local and nonlocal checks to complete a full

return cycle from the depositary bank to the payor bank and back to the

depositary bank.5

The risk faced by depositary banks depends on when they make funds

available to their customers. Banks are obligated under EFAA to make

funds available to their customers in accordance with mandatory funds

availability schedules. Thus, a depositary bank may be required to make

funds available to the customer before a check is returned to the

depositary bank unpaid. When the depositary bank receives a return item,

it will charge back its depositing customer’s account for the item even if it

has already made the funds available to the depositing customer. The

depositary bank may be exposed to some risk if the customer does not

have sufficient funds in his or her account to cover the returned check.

When a paying bank returns the item to the depositary bank, the paying

bank does not necessarily have to return the item through the same

clearing mechanism from which it received the item.

5

Report to the Congress on Funds Availability Schedules and Check Fraud at Depository Institutions,

Board of Governors of the Federal Reserve System, Oct. 1996, p. 22.

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Checks

Mitigation Credit monitoring by financial institutions. For the purpose of

reducing the return item risk faced by depositary banks, the Federal

Reserve recommends that depository institutions perform a credit

assessment of those customers for which they collect large-dollar volumes

of checks. Also, the Federal Reserve recommends that institutions monitor

the payment activity of their customers and take appropriate action when

credit limits are exceeded.

Mitigation Large-dollar return item notification. Federal Reserve Regulation CC

requires that when a paying bank decides to return a check of $2,500 or

more, it must provide a notice of nonpayment to the depositary bank. The

notice must be received by

4:00 p.m. local time for the depositary bank on the second business day

following the banking day on which the check was presented to the paying

bank. A paying bank can send the notice of nonpayment by several means,

including the return of the check to the depositary bank; a telephone call

or telex to the depositary bank; a special, nonvalue Fedwire funds transfer

notice; or a telephone call to a Reserve Bank with a request to forward the

notice.

Mitigation Electronic check presentment. The exchange of electronic check

information may reduce risk to the depositary banks because it permits

them to deliver check data to paying banks more quickly than is currently

done with paper checks. The shorter time for check information delivery

could permit the paying banks to (1) identify checks that cannot be paid

and (2) notify the depositary bank about those returned checks, using an

electronic return notice, up to 1 day earlier than would occur with the

physical exchanging of paper checks. If a depositary bank could be

notified of a return item earlier, then the risk might be reduced because

the depositary bank would know sooner that the check was not being paid

and that funds should not be made available to the depositing customer.

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Checks

Risk 2: Check Fraud Check fraud is a problem for the banking industry. The same Federal

Reserve survey on check fraud and check returns estimated that in 1995,

the value of all check-fraud losses at commercial banks, credit unions, and

savings institution was $615 million for 529,000 cases of check fraud.6

Also, for that year, commercial banks’ check fraud losses ($487 million)

represented approximately 1 percent of their profits. The survey also

found that local checks accounted for about 72 percent of the total dollar

losses reported in the Board’s survey.

One example of check fraud is check kiting. Check kiting may take many

forms, but often it involves the writing of checks on two or more banks for

the purpose of fraudulently obtaining interest-free unauthorized loans.

Other types of check fraud include forgery, altered checks, counterfeit

checks, and paperhanging. Forgery occurs when a person forges the

account holder’s signature or the endorsement. Altered checks are checks

that have information, such as the amount, altered without the payor’s

approval. Counterfeit checks are imitations or copies of genuine checks.

Paperhanging refers to checks that are deliberately written on closed

accounts.

Mitigation Positive pay. Corporations use positive pay to guard against check fraud.

Under these arrangements, a corporation sends an electronic file of

information on all checks issued to its bank. The bank compares this

information with electronic information about checks presented for

payment. If a check presented for payment is not included in the

positive-pay information, the corporation is notified and requested to

make the pay/no pay decision.

Mitigation Electronic check presentment (ECP). As in the case of return item risk,

ECP may reduce check fraud by providing the depositary bank with

information about unpaid checks earlier than the information is currently

provided. By speeding the transmission of the MICR information, ECP may

allow the paying bank to identify checks that cannot be paid earlier and to

notify the bank of first deposit earlier of an impending returned check,

possibly before the funds are made available to the depositing customer.

6

Report to the Congress on Funds Availability Schedules and Check Fraud at Depository Institutions,

Board of Governors of the Federal Reserve System, Oct. 1996, p. 5.

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Checks

Electronic Funds

Transfer

Electronic Funds Transfer (EFT) is the transfer of funds from one account

to another by electronic rather than by paper-based instructions, such as

checks. EFT can save time and money in the payment system by eliminating

paperwork.

Electronic Funds Transfer

Types of EFT Systems7

• Consumer electronic payments are small-dollar payments, such as

transactions made via the ACH,

8

 at automated teller machines (ATM),

point-of-sale payments using debit cards, and the use of telephones or

personal computers to initiate bill payments.

• Electronic benefits transfers are electronic payments for social security,

pension, and welfare payments; student loans; and unemployment

compensation.

Statistics

In 1994, federal and state governments transferred about $500 billion in

benefits to recipients.

• Federal benefits: approximately $400 billion.

• State benefits: approximately $95 billion.

The Financial Management Service of the U.S. Treasury estimates that it

costs the government 42 cents to issue and mail a paper check but only 2

cents to process an electronic payment.

Developments

The number of EFT transactions should increase as a result of the passage

of the Debt Collection Improvement Act of 1996, which will substantially

reduce the use of checks as a federal payment instrument by January 1999.

The EFT provisions of DCIA require that all federal payments (except IRS tax

refunds and payments to individuals without bank accounts) be issued by

EFT.

7

Wire transfers, such as Fedwire, are considered electronic funds transfers.

8

ACH is discussed later in the retail payment systems section.

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Credit Cards

Description and Use A credit card is a payment card issued to a person for purchasing goods

and services and obtaining cash against a line of credit established by the

issuer. Credit cards can be of two types: those issued by merchants and

vendors, such as department stores or oil companies, and general purpose

credit cards issued by banks, such as VISA and MasterCard. Credit cards

allow a consumer cardholder to pay off his or her entire outstanding

balance or to make minimum monthly payments and carry over balances,

on which interest is charged. In addition, a cardholder may be able to

receive cash advances under a preapproved line of credit with a credit

card, either through a bank teller or an automated teller network (ATM), for

which the cardholder is charged a finance charge.

The two dominant bank-issued general purpose credit cards are VISA and

MasterCard. Before 1971, participating banks could not be a member of

both VISA and MasterCard; this was changed as a result of antitrust

concerns. Today, issuers can issue both VISA and MasterCard credit cards.

A number of nonbank companies also issue credit cards, such as American

Express, Discover, and Diners Club.

C Credit card company

Credit line

A credit card company is a company that owns the trademark of a

particular credit card, and it may also provide a number of marketing,

processing, or other services to the members using the card services.

A credit line is the maximum amount of credit available in an openended credit arrangement, such as a bank credit card, which the lender

may change at any time. The line is disclosed in the credit card 

agreement.

Electronic Data Capture (EDC) is a point-of-sale terminal that reads

the information embedded in the magnetic stripe of banks cards. These

terminals electronically authorize and capture transaction data, thus

eliminating the need for a paper deposit.

E EDC

Key Terms

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Credit Cards

Basic Data The use of general purpose credit cards in the United States has grown

substantially since 1981. In 1995, credit card transactions accounted for

approximately 14.9 billion transactions.

As shown in table 3.4, since 1990, VISA and MasterCard have increased the

number of cards in use by 84 percent and 63 percent, respectively.

Table 3.4: The Number of Major U.S.

Credit Card Companies’ Cards,

1990-1995 Number of cards

In millions

Credit card company 1990 1995 Percent change

VISA 120.1 221.1 84%

MasterCard 88.2 144.1 63

American Express 25.9 26.7 3

Discover 37.8 45.1 19

Source: Faulkner & Gray.

In 1995, the total charge volume of VISA, MasterCard, American Express,

and Discover was $70.9 billion, which was a 318-percent increase from

1985.

Processes The clearance and settlement of credit card transactions involve three

parts—authorization, clearance, and settlement. Authorization is the

process by which the issuer of a credit card (card-issuing bank) approves

(or declines) a transaction at the point of sale. Clearance is the process by

which a credit card company collects data about a transaction from a bank

(referred to as an acquirer or the merchant’s bank) and delivers the data to

the card-issuing bank, which will use the information to post the

transaction to the cardholder’s account. Settlement is the process by

which a credit card company collects funds from the card-issuing bank

and pays funds to the merchant’s bank for the cleared transactions. Figure

3.3 illustrates how a credit card transaction clears and settles after a credit

cardholder makes a purchase at a store (merchant). Every credit card

transaction involves the cardholder, the card-issuing bank, a credit card

company, a merchant, and the merchant’s bank.

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Credit Cards

Figure 3.3: Clearance and Settlement Cycle of Credit Cards

Merchant Originator

1

4

A cardholder uses a major credit card

to make a purchase from

a merchant.

2 The merchant electronically submits

the cardholder's CCC draft, along with all the

other credit card drafts, to its bank at the

end of the day.

Authorization

Clearance

3 The merchant's bank credits the

merchant's account. The merchant's

bank submits the cardholder's draft, as well

as other credit card drafts, to the major

credit card company.

The major credit card company

receives the drafts and sends them

to each card-issuing bank.

Merchant's bank

CCC

CCC

Cardholder

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Credit Cards

Merchant's

bank

Merchant's bank

6

8

The card-issuing bank pays the major

credit card company.

Settlement

7 The major credit card company

pays the merchant bank.

The card-issuing bank then bills

the cardholder and eventually receives

payment from the cardholder.

Card-issuing

bank

Card-issuing bank

(of cardholder)

Fedwire

Fedwire

Cardholder

5

The major credit card company

determines the amount of

money that each card-issuing bank

(including the cardholder's bank) owes.

CCC

CCC

Note: Major credit card companies operate a multilateral settlement system.

Source: GAO.

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Credit Cards

Authorization (Step 1) A cardholder selects goods or services from a store (or merchant) and

presents a credit card as payment. The sales clerk of the store swipes the

card through one of the store’s EDC terminals and keys in the amount of

the transaction. The authorization request is transmitted electronically

through the credit card company to the issuer of the credit card.9

 The

card-issuing bank then approves or declines the transaction based on the

cardholder’s account status, and the approval or disapproval is

transmitted electronically to the store through the credit card company. If

the transaction is approved, the salesperson then produces a sales draft

for the customer to sign.

Clearance (Steps 2 Through 4) At the end of the day, the merchant submits all of its credit card

transaction data electronically (credit card drafts) to its bank(s). The

merchant’s bank then credits (or pays) the merchant for its transactions.

At this point, the store has been paid and is out of the cycle.10 The

merchant’s bank is then responsible for getting paid for the transaction,

and sends the transaction data electronically to the credit card company.

The credit card company electronically sends the credit card drafts

(transaction data) to each card-issuing bank.

Settlement (Steps 5 Through 8) After the card-issuing bank receives the transaction data, the credit card

company collects funds from the card-issuing bank’s account and transfers

funds to the account of the merchant’s bank, thus ending the cycle for the

bank. The card-issuing bank will then present the transaction as an item

on the cardholder’s next monthly statement, and once the cardholder pays

the card-issuing bank, the cycle will be complete.

The payment and receipts of member banks (card-issuing banks and

merchant banks) of the credit card company are done through each

member (or its correspondent bank) and the credit card company’s

settlement banks over Fedwire Funds Transfer System (see section on

Fedwire Funds Transfer for details on how it works).11 For each

card-issuing bank, the credit card company adds up the credit card

company’s transactions for the bank and sends it the net settlement

9

If a member bank or its designated processor serve as both the card-issuing bank/processor and the

merchant’s bank/processor, then authorization, clearing, and settlement may be handled entirely by

the member bank or processor as “on-us” transactions. In this case, a credit card company would not

be directly involved in processing the on-us transaction.

10The merchant will get paid an amount minus a merchant discount fee, which is retained by the

merchant’s bank.

11VISA’s settlement banks have to meet specific operational and credit rating type criteria.

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Credit Cards

amount.12 Payment is made by the card-issuing bank submitting payment

to the credit card company (through its settlement banks over Fedwire)

for transactions plus fees and charges due to the credit card company. The

credit card company then pays the merchant’s bank for the transactions

and collects fees and charges from the merchant’s bank.

Because of the international aspect of a credit card company’s business,

the major credit card companies operate on a daily processing cycle on

Greenwich Mean Time, which starts at 7:00 p.m. EST and ends 24 hours

later at 7:00 p.m. EST. Thus, settlement for the merchant’s bank in the

United States usually occurs 1 calendar day after a transaction is

submitted to the credit card company because of the hours of Fedwire.

Settlement for the card-issuing bank occurs once it has received payment

from the cardholder.

Each member bank of a major credit card company may be required to

maintain collateral with the credit card company. The collateral is meant

to cover the potential losses that the credit card company may incur if the

member bank fails.13

Regulatory Oversight The primary federal laws governing credit card issuance and operation are

the Equal Credit Opportunity Act of 1974 and the Truth in Lending Act of

1968 (TLA). These laws are implemented through Federal Reserve

Regulations B and Z, respectively. Regulation B prohibits lenders,

including credit card companies, from discriminating against credit

applicants and establishes guidelines for gathering and evaluating credit

information. Regulation Z requires uniform methods for computing the

cost of consumer credit and disclosing credit terms, prohibits the

unsolicited issuance of credit cards, and limits cardholder liability for

unauthorized use.

Other laws applying to credit cards are the Fair Credit and Charge Card

Disclosure Act of 1988, the Fair Credit Billing Act of 1974, and the Fair

Credit Reporting Act of 1970. The Fair Credit and Charge Card Disclosure

Act amended the TLA to require that applications for credit cards that are

sent through the mail, canvassed by telephone, or made available to the

public (e.g., at counters in retail stores) must contain information about

key terms of the account. The Fair Credit Billing Act amended the TLA to

12According to VISA officials, most of the netting for VISA is done on a multilateral basis.

13If a card-issuing member bank fails, VISA may have paid a merchant’s bank for the transactions but

be unable to collect funds from the member bank.

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Credit Cards

specify how creditors must respond to billing complaints from consumers,

requiring that creditors handle consumer accounts fairly and promptly.

The Fair Credit Reporting Act entitles consumers to know the source for

the credit information and allows them to correct errors in the reported

information.

Risk and Risk

Mitigation

For purposes of this report, we discuss some of the most important risks

and risk mitigations associated with credit cards.

Table 3.5: Risk and Risk Mitigation for

Credit Cards Risk Risk mitigation

Fraud risk Neural network

Address verification service

Issuer’s clearing house service

Credit risk Credit monitoring

Risk 1: Fraud Risk from fraud involving credit cards includes unauthorized use of lost or

stolen cards, fraudulent applications, counterfeit or altered cards, and the

fraudulent use of a cardholder’s credit card number. Lost or stolen credit

cards account for approximately 50 percent of all credit card fraud, and

fraudulent and counterfeit cards account for approximately 7 percent and

11 percent of credit card fraud, respectively. If cardholders report the loss

of their credit cards, they are responsible, at most, for $50. The issuing

bank or the merchant pays the costs of any fraud involving credit cards.

The merchant is responsible for paying any costs related to credit card

fraud if the merchant does not do at least one of the following three things:

obtain an authorization, the cardholder’s signature, or the electronic

imprint of the card. According to an industry official, usually the issuing

banks are responsible for paying approximately 70 percent of the cost of

credit card fraud while the merchants are responsible for paying the other

30 percent.

Mitigation Neural network. The neural network allows a card-issuing bank to track

the cardholder’s spending patterns and to detect any spending

discrepancies and thereby prevent potential credit card fraud. For

example, if a cardholder, who typically purchases airplane tickets to

domestic destinations, starts purchasing an excessive number of airplane

tickets to international destinations, the neural network may alert the

issuing bank and the cardholder of potential fraud.

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Credit Cards

Mitigation Address Verification Service. The mail-order catalog industry

developed a program called Address Verification Service (AVS). AVS allows

mail and telephone order companies to verify a cardholder’s billing

address online. This program is designed to reduce fraudulent use of a

cardholder’s credit card number. Using AVS, the mail and telephone order

companies can verify the address the customer provided as well as the

billing address on file with the card issuer. If the two addresses are

different, then the mail or telephone order company may suspect fraud.

Mitigation Issuer’s Clearing House Service. VISA and MasterCard have developed a

type of clearing house database, Issuer’s Clearing House Service (ICS), to

detect fraudulent credit applications. ICS allows issuing banks to compare

credit card applications against a database of invalid addresses and Social

Security numbers. The ICS database includes information such as Social

Security numbers, names, and dates of birth of credit card applicants.

Risk 2: Credit Consumer delinquency and default are the main credit risks involving the

use of credit cards. If a cardholder fails to pay for the charges, then the

issuing bank is liable to pay the merchant’s bank.

Mitigation Credit monitoring. The card-issuing bank is responsible for monitoring

and controlling credit risk resulting from consumer delinquency and

default. Issuing banks can mitigate the risks of consumer delinquency

through the normal authorization process of charges and credit reviews of

cardholders. For example, during the authorization process, when the

credit card is swiped, the card-issuing bank can deny authorization of a

transaction if the consumer had been delinquent in paying the credit card

bill. The issuing bank can establish financial standards to be used during

the application process to protect itself from delinquent consumers.

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Automated Clearing House

Description and Use An automated clearing house (ACH) network is an electronic batch

processing system by which payment orders are exchanged among

financial institutions. The ACH began, in 1972, as a system operated by the

Federal Reserve Banks at the request of members of local ACH

associations. It is designed for high-volume, predominantly small-dollar

recurring payments, such as payroll, mortgage, car loan, or Social Security.

An ACH payment can either be a credit transaction or a debit transaction. In

an ACH credit transaction, funds flow from the originator to the receiver,

and in a debit transaction, funds flow from the receiver to the originator.

Every ACH transaction, regardless of whether it is a credit or a debit

transaction, must have an originator of the transaction, a receiver of the

transaction, an originating depository institution, and a receiving

depository institution. Listed in table 3.6 are examples of ACH credit and

debit transactions.

Table 3.6: Examples of ACH Credit and

Debit Transactions ACH credit transactions ACH debit transactions

Payrolls Consumer bill payments:

• Mortgage and loan 

• Insurance premiums

Government benefit payments:

• Social Security 

• Federal employee retirement

• Disability

Corporate payments to contractors and

vendors

Corporate cash concentrations

Corporate tax payments Corporate tax payments

Source: Federal Reserve.

There are four ACH processors operating in the United States that process

ACH transactions:

(1) American Clearing House Association (American), (2) Federal Reserve

System (Federal Reserve), (3) New York Automated Clearing House

(NYACH), and (4) VISANet ACH (VISA).

The Federal Reserve and VISA are national ACH providers. NYACH and

American are regional ACH providers.

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Automated Clearing House

ACH operator/processor

C Clearing house

An ACH operator/processor is a central clearing facility that receives batches

of ACH credit and debit transactions from originating depository institutions,

edits, sorts, and distributes the transactions to receiving depository institutions,

and facilitates the settlement among participants.

Batch processing is the transmission or processing of a group of related 

electronic payment instructions.

A clearing house is a voluntary association of depository institutions

that facilitates the exchange of payment transactions, such as checks, 

automated clearing house transactions, and large-value funds transfers, 

and the settlement of participants' net debit or credit positions.

A file is a group of entries transmitted by originating institutions or to receiving

institutions by ACH operators. A file may contain one or more batches of entries. 

An originator is a person or an organization that initiates an ACH entry.

An originating depository institution is a financial institution that initiates and 

warrants electronic payments processed through the ACH network on behalf 

of its customers.

A receiver is the individual or organization that has authorized an originator to

initiate an ACH credit or debit transaction entry to the receiver's account with the

receiving depository institution.

A receiving depository institution is a financial institution that maintains 

accounts for individuals and corporations that receive ACH credit and 

debit transactions.

A return item is a transaction that has been returned by a receiving depository 

institution because it cannot be posted. For example, the receiving customer

may not have an account with the institution or may not have sufficient funds

in his/her account to fund a debit transaction. 

B Batch processing

F File

O Originator

Originating depository

institution

R Receiver

Receiving depository 

institution

Return item

Key Terms

A

Basic Data The volume of ACH payments has been increasing rapidly. In 1996,

approximately 4 billion payments, totaling $12.1 trillion, were processed

on the ACH. This is a 55-percent increase in the volume of payments since

1992.

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Automated Clearing House

The Federal Reserve processes both commercial and government ACH

payments. In 1996, the Federal Reserve processed approximately

2.4 billion commercial ACH transactions, almost 80 percent of all interbank

commercial ACH payments. Currently, all government ACH payments are

processed by the Federal Reserve.14 Moreover, as a result of the Debt

Collection Improvement Act of 1996, Section 31001(x), the volume of

government ACH transactions is expected to increase substantially. DCIA

Section 31001(x) requires that all federal payments, except Internal

Revenue Service payments and payments to individuals who certify that

they do not have bank accounts, be issued via EFT by January 1, 1999.

NYACH serves nearly 800 commercial banks, savings banks, savings and

loans, and credit unions, and processes approximately 10 percent of the

ACH’s commercial transaction volume in the United States. VISA serves over

290 financial institutions in the United States, and the American ACH serves

approximately 100 financial institutions. As shown in table 3.7, the volume

of all ACH providers is increasing.

Table 3.7: Volume of ACH

Transactions Processed by the Four

ACH Providers, 1992-1996

Items in millions

ACH provider 1992 1996

Percent

change

Federal Reserve: commercial 1,275 2,372 86%

Federal Reserve: government 531 625 18

NYACH 185 317 71

American 49 93 90

VISA 151 311 106

Note: Double counting exists in the volume figures for the private processors. The volume figures

for NYACH, American, and VISA include some ACH entries that are sent or received from the

Federal Reserve.

Sources: Federal Reserve Board’s 1995 Annual Report, American, National Automated Clearing

House Association (NACHA), NYCHA, and VISA.

The fees charged by ACH providers for processing ACH transactions are

significantly lower than the fees assessed for Fedwire funds transfers and

14Government payments refer only to payments originated by the federal government. All other ACH

payments are referred to as commercial, including those originated by state and local governments.

Although the Federal Reserve processes ACH government payments for the Treasury, the Treasury is

not statutorily mandated to use the Federal Reserve.

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Automated Clearing House

the Clearing House Interbank Payment System (CHIPS)15 transfers. For

example, the separate fees charged the originator and the receiver are

typically slightly less than a penny. As of January 2, 1997, the fee charged

to the sender and the receiver of a Fedwire is $0.45 per transfer. The fee

for a CHIPS transfer ranges from $0.13 to $0.40, depending upon the

participant’s monthly transaction volume and other factors.

As shown in figure 3.4, the average value of an ACH transaction has stayed

consistently around $4,000; in 1995, the average value of an ACH

transaction was $3,847. In comparison, in 1995, the average value of a

Fedwire funds transfer was $2.9 million.

Figure 3.4: The Average Value of an

ACH Transaction, 1992-1995 Dollars

3500

3600

3700

3800

3900

4000

4100

4200

4300

4400

4500

1992 1993 1994 1995

Year

Source: NACHA.

Table 3.8 shows the total dollar amount of ACH transactions for each of the

four ACH providers for the period 1992 through 1996.

15Fedwire is an electronic funds transfer network operated by the Federal Reserve for large-dollar

value transfers. CHIPS, the other large-dollar electronic payment system, is owned by NYCHA. For

more discussion on Fedwire and CHIPS, see the Fedwire Funds Transfer and Clearing House

Interbank Payments System subsections in Section 1.

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Automated Clearing House

Table 3.8: Total Amount of Dollars

Processed by Each ACH Provider,

1992-1996

ACH provider 1992 1996 Percent change

Federal Reserve:

 commercial

$6.5 trillion $8.7 trillion

34%

Federal Reserve:

 government

860 billion 1.3 trillion

51

American 76.7 billion 174.7 billion 128

NYACH 2.0 trillion 2.6 trillion 30

VISA N/A 656.0 billion

N/A: Not available.

Note: Double counting exists in the dollar-value figures for the private ACH processors. The

dollar-value figures for NYACH, American, and VISA include some ACH entries that are sent to or

received from the Federal Reserve.

Sources: Federal Reserve Board, American, NYCHA, and VISA.

Processes The ACH operates by a batch processing system in which groups of

transactions are transmitted to ACH operators throughout the day. As the

groups of transactions are received, they are edited for conformance with

the operating rules of NACHA, settlement data for the originating and

receiving depository institutions are captured, and individual transactions

are sorted to the receiving depository institutions.

Unlike Fedwire transfers, which are processed and settled immediately,

ACH transactions are valued-dated, that is, the originator of ACH

transactions includes the settlement date in the payment instructions

when it originates the transaction. ACH credit transactions may be

originated up to 2 business days before the settlement date, and the ACH

debit transactions may be originated 1 business day before the settlement

date. Government entries can be originated up to 4 days before the

settlement date.

Depository institutions that use the Federal Reserve as their provider can

deposit files of ACH transactions at the Federal Reserve Bank anytime

during the day. ACH transactions may be destined for institutions located in

the same Federal Reserve district or in another Federal Reserve district.

The Federal Reserve processes ACH transactions nearly 24 hours a day.16

16All Federal Reserve ACH processing is done at the East Rutherford (New Jersey) Operations Center

of the FRBNY.

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Automated Clearing House

In 1994, NYACH, VISA, and American established the Private ACH Exchange

(PAX). Since the establishment of PAX, New York, American, and VISA can

exchange transactions directly without using the Federal Reserve as an

intermediary processor. PAX handles about 1 million transactions monthly.

Previously, the three ACH private processors had to use the Federal

Reserve’s ACH service to deliver ACH transactions among themselves. For

example, when American sent an ACH file to VISA, American would send the

file first to the Federal Reserve, where the transactions were processed

and distributed to VISA for its members. Now, using PAX, American can send

the ACH file directly to VISA.

17

The Federal Reserve provides settlement services to all three

processors—net entries are posted for members of VISA and American;

gross entries are posted for NYACH. Net settlement allows participants that

use private processors to settle their net positions either through Fedwire

funds transfers, using special settlement accounts at Reserve Banks, or by

accounting entries, which are posted to participants’ reserve accounts by

Federal Reserve Banks. Currently, VISA is the only one of the three private

ACH processors that uses the Fedwire funds transfer service for settlement.

Examples of one ACH credit transaction and one ACH debit transaction

follow.

Example of an ACH Credit

Transaction

Figure 3.5 illustrates how a company’s payroll is transmitted over the ACH.

Example: Company A, headquartered in Washington, D.C., with offices

located in Chicago, Los Angeles, and New York, pays all of its employees

by direct deposit using the ACH network.

Originator of the ACH payment: Company A.

Receiver of the ACH payment: Company A’s employees.

Originating depository institution: Bank A.

Receiving depository institutions: Banks in which Company A’s employees

have their accounts.

17Private ACH operators still continue to use the Federal Reserve to deliver a significant number of

transactions.

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Automated Clearing House

Figure 3.5: Typical ACH Credit Transaction—The Direct Deposit of a Payroll

FRB

Dallas

Company A

Employee Paid

Total

A

B

C

1,200

2,000

1,500

4,700

Day 0 (January 13 or 14)

Company A

Employee Paid

Total

A

B

C

1,200

2,000

1,500

4,700

Pay:

Amount:

Date:

Acct. no.:

Bank no. :

John Doe

$1,200

1/15/96.

1234567891011

0001

Company A

Company A

originator

Company A

originator

From: Company A

Pay: Bank A no. 0001

Amount: $4,700

Total

Bank A ACH batches

Company

Grnd. total

A

B

C

$4,700

6,000

4,300

$15,000

Bank A

originating institution

Bank A

originating institution

After EROC receives Bank A's ACH

transactions, Fed ACH (operating system)

sends a copy of them to a back-up

processor in Dallas.

Bank A ACH batches

Company Total

Grnd. total

A

B

C

$4,700

6,000

4,300

$15,000

Federal Reserve

EROC

1

3

5

4

2

Company A (originator) originates

an ACH credit transaction for each

of its employees.

Company A electronically transmits

its ACH transactions to its bank,

Bank A (originating institution).

Bank A edits the ACH transactions;

then it balances the total value of the

individual transactions against the

total value Company A says it sent

to Bank A.

Bank A combines Company A's

ACH transactions with batches of

transactions from its other customers;

then it electronically transmits these to the

Federal Reserve, which receives them at

its centralized ACH processing

center (EROC).

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Automated Clearing House

Employee A's account

Debit Credit

$1,200

Employee B's account

Debit Credit

$2,000

Employee C's account

Debit Credit

$1,500

Chicago

Chicago

Federal Reserve

EROC

Fed ACH sorts all transactions: then

it electronically transmits them to the

banks (receiving Institutions) of

Co. A's employees (receivers) in Chicago,

Los Angeles, Washington, D.C.,

and to NYACH. NYACH will transmit the

Los Angeles transactions to the New York bank.

Los Angeles

Washington, DC

Washington, DC

NYACH

Day 2 or 3 (January 15)

Each of the employees' banks posts

the value of their pay to their accounts,

making it available at the

opening of business.

Day 3 or 4 (January 16)

After the Federal Reserve completes its

accounting, settlement of the ACH

transaction is final.

6

At 8:30 a.m. (ET), the Federal Reserve

posts the debit to Bank A's reserve account

(or Bank A's correspondent account) and

posts the credits to the receiving institutions

of Co. A's employees in Chicago,

Los Angeles, Washington, D.C.,

and New York.

The payment is now provisionally settled.

Sometime during the day, Bank A

will fund the ACH payment.

7

8

9

Bank A reserve account

Debit Credit

$15,000

Federal Reserve

EROC

(Figure notes on next page)

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Automated Clearing House

Note: The Federal Reserve retains the right to reverse a credit given to a receiver of an ACH

credit transaction until the Federal Reserve’s books have been closed, which generally occurs

during the night of the settlement day. The Federal Reserve could reverse a credit to the receiving

institutions on the night of Jan. 15, but not later than the morning of Jan. 16.

Source: GAO analysis of information provided by the Federal Reserve Board.

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Automated Clearing House

Example of an ACH Debit

Transaction

Figure 3.6 illustrates an example of an ACH debit transaction in which a

homeowner sends his or her mortgage payment to a mortgage company

through the ACH system. In this example, both the originating depository

institution and the receiving depository institution are using private ACH

providers to process the ACH transaction.

Example: A homeowner in New York authorizes its mortgage company,

which is located in California, to make a withdrawal of $2,000 each month

from the customer’s deposit account for the purpose of paying his or her

monthly mortgage.

Originator of the ACH transaction: Mortgage Company.

Receiver of the ACH transaction: Homeowner.

Originating depository institution: Bank A in San Francisco.

Receiving depository institution: Bank B in New York.

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Automated Clearing House

Figure 3.6: Typical ACH Debit Transaction—Bill Payment

Day 0 (January 13)

W/d acct. no.:

Amount:

Date:

Bank no. :

Deposit in:

Bank no. :

Acct. no. :

123456789

$2,000

First of the month

0001 (Bank B)

Bank A

0002

987654321

W/d acct. no.:

Amount:

Date:

Bank no. :

Deposit in:

Bank no. :

Acct. no. :

123456789

$2,000

First of the month

0001 (Bank B)

Bank A

0002

987654321

W/d acct. no.:

Amount:

Date:

Bank no. :

Deposit in:

Bank no. :

Acct. no. :

123456789

$2,000

First of the month

0001 (Bank B)

Bank A

0002

987654321

W/d acct. no.:

Amount:

Date:

Bank no. :

Deposit in:

Bank no. :

Acct. no. :

123456789

$2,000

First of the month

0001 (Bank B)

Bank A

0002

987654321

Mortgage company

originator

Bank A

originating institution

1

2

3

4

The mortgage company

(originator) prepares the withdrawal

information and submits the

information to its deposit institution,

Bank A, in San Francisco.

Bank A presents the

ACH debit entry for $2,000 to

VISA, Bank A's

ACH operator.

VISAOriginator

VISA processes

the information and transmits the ACH

debit entry for $2,000 to NYACH via PAX.

The homeowner's depository institution

Bank B (receiving institution), uses

NYACH as its ACH operator.

NYACH

NYACH presents the

debit information to Bank B.

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Automated Clearing House

Bank B

receiving institution

Bank A

originating institution

5

6

7

VISAOriginator

John Doe Homeowner

Acct. no. 123456789

Debit Credit

$2,000

Bank A

Acct. no. 987654321

Debit Credit

Bank A

Acct. no. 987654321

Debit Credit

$2,000

$2,000

Bank B debits

the homeowner's account for $2,000

and sends that transaction in

a file to VISA.

VISA receives the file

from Bank B including the $2,000

transaction and sends the file to Bank A

including the $2,000 transaction using

the Federal Reserve net

settlement service.

.

VISA settlement

is final when Bank A is credited.

Bank A makes funds available to the

mortgage company no later then

close-of -business that day.

Day 1 (January 14)

a

aVISA settles its ACH entries through a special settlement account at the Federal Reserve Bank of

San Francisco. Each VISA participant in a net debit position sends a Fedwire funds transfer for

the amount of its net debit position. When all participants in net debit positions have sent

Fedwires to fund the account, VISA sends Fedwires equal to each of the remaining participants’

net credit positions.

Source: NACHA.

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Automated Clearing House

Regulatory Oversight The ACH is governed primarily by rules written by the private sector, NACHA

Operating Rules and Guidelines, which are supplemented by the rules of

local ACH associations. The National Automated Clearing House

Association (NACHA) is a nonprofit banking trade association that

promulgates the rules and operating guidelines for electronic payments

through the ACH. NACHA represents 38 regional ACH associations and their

more than 14,000 depository institution members. The Federal Reserve

recognizes NACHA as the informal rulemaker for ACH transactions.

According to a Federal Reserve official, NACHA, however, has no

enforcement authority over depository institutions that use the ACH or over

ACH providers to ensure compliance with its rules.

Depository institutions using the Federal Reserve’s ACH services must

comply with the Reserve Banks’ uniform ACH Operating Circular, which

incorporates the operating rules of NACHA by reference and indicates any

rule that the Federal Reserve has not determined to incorporate in its

uniform circular. In addition, depository institutions that originate and

receive consumer ACH transactions must comply with the regulations that

the Board of Governors of the Federal Reserve System promulgates in

Regulation E, which implements the Electronic Funds Transfer Act.

Corporate ACH credit transactions are governed by UCC 4(A). When the

federal government is the originator, the transactions are governed by the

Treasury Department’s regulations, 31 CFR Part 210.

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Automated Clearing House

Risk and Risk

Mitigation

For the purposes of this report, we discuss some of the most important

risks and risk mitigations associated with the ACH.

Table 3.9: Risk and Risk Mitigation for

ACH Risk Risk mitigation

Temporal credit risk Credit monitoring

Return item risk Credit monitoring

Risk 1: Temporal Credit The originating institution of an ACH credit transaction is obligated to pay

for any ACH credit entry that it initiates. Because the ACH credit

transactions may be originated up to 2 business days before the settlement

date and a customer may not fund its obligation until late on the

settlement day, the originating depository institution may be exposed to

credit risk for nearly 3 business days. This type of risk is called temporal

risk.

Mitigation Credit monitoring by financial institutions. According to the Federal

Reserve’s payments system risk policy, depository institutions that

originate ACH credit transactions should

• perform a credit assessment of all customers originating large-dollar

volumes of ACH credit transactions;

• establish interday credit limits for originating customers that originate ACH

credit transactions based on each institution’s credit assessment;

• monitor compliance with the credit limit across all processing cycles for a

given settlement date; and

• require the customer either to prefund its account, provide collateral, or

deposit the ACH file on the night cycle preceding the settlement day if the

customer’s financial condition is deteriorating.18

Risk 2: Return Item The major risk facing institutions that originate ACH debit transactions is

return item risk. Return item risk occurs when institutions receiving ACH

debit transactions are unable to fund payment requests and the

transactions must be returned to the originating institutions. Receiving

institutions may return ACH debit transactions for a number of reasons,

including insufficient funds, the existence of a stop payment order, or an

unauthorized transaction. The risk to depository institutions originating

18Guide to the Federal Reserve’s Payments System Risk Policy, Board of Governors of the Federal

Reserve System, p. 57.

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Automated Clearing House

debit transactions depends on when they make funds available to their

customers. Originating depository institutions typically make funds from

ACH debit transactions available to their customers at the opening of

business on the settlement date for the transactions. Receiving institutions

must return ACH debit transactions so that the originating institutions

receive the returned transactions by the opening of business on the second

business day following the settlement day.

Mitigation Credit monitoring by financial institutions. The Federal Reserve’s

payment system risk policy recommends that depository institutions

originating ACH debit transactions perform a credit assessment and

monitor the return experience of their customers. Depending upon the

results of these analyses, depository institutions are expected to take steps

to protect themselves from losses, such as delaying availability for all or

some portion of funds collected or requiring balances or collateral to

cover the value of potential return items.

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Section 4: New and Emerging Products and Services • Overview 

Overview of New and Emerging Financial

Products and Services

In this section we discuss emerging payment technologies. These include

stored-value cards, electronic banking, and financial transactions made

over the Internet. These technologies have the potential to alter the way

many everyday payments are made.

Main Characteristics • All of these technologies take advantage of advances in computer chips,

communications, and software.

• Some have the potential to reduce the cost and increase the convenience

of making payments. Over time, these technologies may displace some

transactions that are currently made by cash and check.

Statistical Information • Most technologies are in the testing and implementation stage.

• In October 1996, 2.1 million U.S. households were banking online.

• Tests of general purpose stored-value cards have been conducted for

several years, but nowhere in the United States are they available for

general use.

• In 1995, an estimated quarter of a billion dollars of credit card purchases

were made over the Internet. The dramatic increase in the number of

Internet users and businesses offering products over the Internet suggests

that this volume will increase rapidly.

Regulatory

Information

Regulators will have to adapt existing regulations, and perhaps adopt new

regulations, to accommodate these new technologies. For example, they

must decide to what extent regulations governing electronic funds transfer

(EFT) should be applied to stored-value cards.

Risk Information Conducting financial transactions over the Internet creates new

opportunities for counterfeiting, money laundering, and tax evasion.

Securing payments over the Internet will involve the implementation of

new and unproven security measures.

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Section 4: New and Emerging Products and Services • Overview 

Overview of New and Emerging Financial

Products and Services

The Internet The Internet is a network of networks connecting millions of desktop

computers in homes, businesses, universities, and governments.

O nline

AMERICA

Microsoft

Explorer

Internete N

Netscape

Background

• The Internet began in the 1960s as a Department of Defense effort to link a

number of independent computer systems so that researchers around the

country could share a few super computers.

• The Internet is largely self-governing.

• The Internet is an open communications system with no built-in means to

protect privacy of information, such as a consumer’s credit card number.

Developments

The number of desktop computers connected to the Internet increased

dramatically in the mid-1990s as several developments made the Internet

increasingly useful and easy for nonexperts to use. These developments

are

• availability of simplified e-mail systems;

• establishment of the World Wide Web (WWW),1 a collection of documents

interlinked by a shared language, and

• development of user-friendly WWW browsers, programs designed to read

documents on the WWW.

1

Many people confuse the World Wide Web and the Internet. As stated earlier, the Internet refers to the

overall network of networks.

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Stored-Value Cards

Description and Use Recent developments in encryption, microchips, and computer network

technology have enabled consumers to make electronic payments through

the use of a stored-value card, a credit-card-sized device in which money

value is stored digitally.2

 Although stored-value cards resemble credit or

debit cards, transactions made with stored-value cards resemble

transactions made with currency or coin. For instance, users of

stored-value cards do not need a deposit account at a financial institution

nor do merchants have to verify a cardholder’s identity when purchases

are made. Stored-value cards are intended for repetitive, low-value

transactions too small for economical use of a credit or debit card, such as

payments for mass transit or fast food.

Stored-value cards have features that resemble traveler’s checks, in that

the card purchaser surrenders cash value in exchange for obligations of an

issuer, which may not be a financial institution. However, unlike traveler’s

checks, stored-value cards are designed for small-dollar value purchases

and can be used only with hardware devices equipped to accept payments.

The maximum dollar value that can be held on a stored-value card is

determined by the issuer. One industry representative predicted that this

amount would be about the same as the maximum withdrawal from an

automated teller machine (ATM).

Two types of multipurpose stored-value cards exist: disposable

stored-value cards, which are loaded with a fixed dollar value and are

discarded once all the stored cash is spent, and reloadable cards—such

as the Mondex card—which can be replenished by inserting the card in a

specially equipped ATM, a specially equipped telephone, or an electronic

wallet.3

 In the near future, individuals may be able to transfer funds to a

stored-value card using a personal computer connected to a network.

2

One type of stored-value card is the single-purpose card, e.g., a card used to pay for telephone calls

and transit fares. In this report, we will focus on general purpose cards that can be used to buy goods

and services from a variety of vendors.

3

A device that looks like a calculator and is designed to transfer value from one card to another.

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Stored-Value Cards

D Debit card

Stored-value card

E Electronic wallet

Encryption

A debit card is a bank card that draws funds directly from a consumer's 

checking or savings account. 

An electronic wallet is a small portable device that loads and reads storedvalue cards.

Encryption is the process of disguising a message (using mathematical formulas

called algorithms) in such a way as to hide its substance.

A stored-value card is a credit-card-sized device, implanted with a computer 

chip, with stored money value. A reloadable stored-value card can be reused 

by transferring value from an automated teller machine or other device. A 

disposable card cannot be reloaded. 

S

Key Terms

Basic Data General-purpose stored-value cards are still in the early stage of

development. Tests of disposable and reloadable stored-value cards are

being conducted in about two dozen countries, including the United

States. Banks, credit card companies, and technologically based

companies see the automation of small transactions as one of the frontiers

of payment technology. Table 4.1 describes a few of the most extensive

tests of stored-value cards.

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Stored-Value Cards

Table 4.1: Stored-Value Card Tests

Location Description

Swindon, England In July 1995, Mondex, a venture of two British banks, began

conducting a test of stored-value cards in Swindon, England, a

city with 190,000 residents. The cards and the merchant

hook-ups were provided free of charge.

• Swindon residents were offered reloadable cards to be used at

a majority of the city’s stores, parking meters,

pay phones, and buses. 

• 8,000 residents actually used the cards.

• 750 merchants out of the 1,000 in Swindon signed up

to accept the cards.

1996 Olympics in

Atlanta, GA

At the 1996 Olympics in Atlanta, VISA and the three largest

banks in the southern United States conducted the largest

experiment with stored-value cards. 

• About 2 million stored-value cards were made available in

denominations of $10, $20, $50, and $100.

• All of the 85,000 spectators at the opening ceremonies were to

be given $5 cards. 

• In July 1996, 198,000 transactions were made with VISA cash

 cards.

Manhattan, NY Chase Manhattan Bank, Citibank, MasterCard, Mondex, and

VISA announced an extensive pilot project on the upper west

side of Manhattan to begin in October of 1997. 

• Between 50,000 and 100,000 bank customers are to be offered

 reloadable cards that will be subject to

predetermined dollar limits. 

• The banks are expected to charge for the cards, although some

may be offered at a nominal cost or for free. 

• About 500 merchants are expected to accept the cards.

Source: GAO analysis of industry data.

Initial results of these pilots suggest that consumers will be slow to adopt

stored-value cards. According to press reports, in neither the Mondex nor

the VISA trials did the number of users meet issuers’ expectations.

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Stored-Value Cards

The economic viability of stored-value cards has yet to be proven. Since

stored-value cards cannot be read by existing ATMs or the card readers

attached to cash registers, an initial investment in card reader machines

will be required. These costs should decrease over time as the capacity to

read stored-value cards is incorporated into POS terminals and other

devices.

Processes Figure 4.1 illustrates how Mondex anticipates processing a transaction

using a Mondex stored-value card.

Example: A consumer purchases a stored-value card to make purchases.

After the consumer makes the purchase, using stored value as payment,

the merchant exchanges the stored value for a bank deposit.

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Stored-Value Cards

Figure 4.1: A Typical Mondex Card Transaction

Mondex originator

Assets Liabilities

$1M-gov't./

gov't backed

sec.

$1M-Mondex

value holders

Merchant C

NEMONDEX

ELECTRONIC CASH

WELLS FARGO MONDEX

Bank A

Bank A sells Mondex value to

consumers by transferring the

requested dollar value

to a Mondex card/terminal.

Consumer A purchases $50

in Mondex value, which is

loaded onto a Mondex

stored-value card.

Consumer A

2

3 Consumer A pays for $3.95

worth of purchases and transferrs

that amount of stored Mondex value

from his/her card to Merchant C's

terminal.

Merchant C's Bank

4 Merchant C

sends accumulated Mondex

value to its bank in exchange

for equivalent dollar deposits into

Merchant C's account.

5 Merchant C's bank sends

stored value back to the originator

in exchange for equivalent credit

to its account.

The Mondex originator

sells Mondex value to

Bank A, an issuer of

Mondex cards.

The Mondex originator

uses the money from Bank A

to purchase government/

government backed

securities.

1

Mondex originator Originator

Source: GAO analysis of industry data.

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Stored-Value Cards

Regulatory Oversight Nonbanks offering electronic cash, such as stored-value cards, are not

subject to the bank supervisory regime. Similarly, nonbanks are not

subject to any of the statutory and prudential limits that apply to banks.4

Banking institutions that issue such cards would be examined by their

respective regulators, such as the Federal Reserve or the Comptroller of

the Currency. Currently, there are no federal regulations that specifically

address the regulatory oversight of stored-value cards. There are, however,

regulations that may apply to stored-value transactions, such as the

Federal Reserve’s Regulation E.

Regulation E is intended to protect consumers in electronic funds

transfers. In March of 1996, the Federal Reserve Board proposed to amend

its Regulation E, “Electronic Funds Transfers,” to exempt from coverage

stored-value cards meeting specific criteria. Among other things, the

regulation requires that consumers be provided with a written record of

electronic transactions and generally limits consumer liability for

unauthorized electronic funds transfers to $50. The Board proposed to

exempt from Regulation E stored-value cards with a maximum value of

$100 or less and stored-value cards that are not linked to any central

database.5

The Economic Growth and Regulatory Paperwork Reduction Act of 1996

contained provisions instructing the Federal Reserve not to finalize any

amendments to the Electronic Funds Transfer Act (EFTA) for at least 9

months from the date of enactment (September 30, 1996). It also

instructed the Federal Reserve to conduct a study of electronic

stored-value products to determine whether the provisions of EFTA could

be applied to such products without adversely affecting the cost,

development, and operation of such products.

On July 16, 1996, FDIC issued an opinion describing what kinds of

stored-value cards could qualify for deposit insurance. Observers believe

that most stored-value cards will not be covered. FDIC observed that the

principles discussed in the opinion also would apply to stored-value

computer network systems that allow consumers to access stored-value

using personal computers.

4

See, for example, OCC interpretive letters regarding Huntington National Bank (Aug. 19, 1996) and

Wells Fargo Bank, et al (Dec. 2, 1996), giving national banks permission to invest in limited liability

companies that will operate stored-value card systems.

5

Like debit cards, stored-value cards that require online authorization at the time of transaction would

be subject to most Regulation E requirements. Certain off-line stored-value-cards—those with

balances maintained on a separate database—would be subject to only the initial disclosure

requirements of Regulation E.

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Stored-Value Cards

Risk and Risk

Mitigation

For purposes of this report, we discuss some of the most important risk

and risk mitigations associated with stored-value cards.

Table 4.2: Risk and Potential Risk

Mitigation for Stored-Value Cards Risk Risk mitigation

Credit risk Restrictions on issuers

Fraud risk Issuer security measures

Shaded cells indicate that mitigations are not in general use since stored-value cards are

still in the developmental stage.

Risk 1: Credit When people purchase stored-value cards, or when merchants accept

stored-value as payment for goods and services, they expose themselves to

the credit risk that the issuer of the stored-value card will be unable to

redeem the value stored on the card.

Mitigation Restrictions on issuers. The major stored-value tests in the United

States are being conducted by nonbanks such as VISA, MasterCard, and

Mondex. These issuers’ operations are not covered by bank regulation, but

industry representatives believe that they could be covered by applicable

state regulations such as those governing nonbank “money

transmitters”—firms that issue “instruments for the transmission of

money,” such as traveler’s checks and money orders.6

 The state

regulations provide a number of safeguards for users of these nonbank

services. Issuers must generally be licensed and bonded, are required to

hold a minimum level of capital, may be required to hold reserves equal to

100 percent of outstanding value, and are also subject to periodic

examinations and audits.

6

According to the Federal Reserve, 44 states have enacted such laws, which industry representatives

believe would apply, or will be amended to apply, to multipurpose stored-value cards.

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Stored-Value Cards

Risk 2: Fraud Recognizing that stored-value cards could be attractive targets for

computer criminals, vendors have made security a high priority. Some

researchers assert that a flaw may make it possible to counterfeit certain

kinds of stored-value cards currently used in Europe and being tested in

the United States.

Mitigation Issuer security measures. Stored-value cards are constructed in such a

way that their chips are likely to be destroyed if an attempt is made to

tamper with them. Card issuers are studying sophisticated cryptographic

techniques to prevent fraud. Card issuers may also periodically replace

cards with new cards that offer alternative safeguards against fraud.

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Electronic Banking

Description and Use Advances in data communications and computer technology have enabled

depository institutions as well as securities brokerage firms and other

nonbank financial service providers—including commercial online

services—to offer electronic banking services.7

 Electronic banking

services may be delivered by means of automated teller machines (ATM);

specially equipped telephones, such as screen telephones;8

 and personal

computers equipped with modems and communication software.

Many consumers may choose one or more of these means to pay bills,

access information about account balances, transfer funds between

checking and savings accounts, and purchase mutual fund shares, among

other banking-related activities. Specific options available to consumers

vary by depository institution. Table 4.3 lists banking services accessible

through electronic means.

Table 4.3: Consumer Financial

Activities Accessible by Electronic

Means, 1996

Method of payment

Type of transaction ATM

Screen

telephones Telephones Computers

Pay bills Yes Yesa Yesa Yesb

Transfer funds between

personal accounts

Yes Yes Yes Yes

Inquire about account

balances

Yes Yes Yes Yes

Purchase Certificate of

Deposit (CD)

Noc No Yes Yes

Purchase mutual fund shares No Yes Yes Yes

Apply for loan No Yes Yes Yes

Obtain currency Yes No No No

aCapability to make payments is generally limited to certain preidentified businesses, such as

telephone companies.

bPayment of bills through home computers is generally accomplished using the services of a

third-party service provider.

cSome, but not most, ATMs offer opportunities to purchase CDs.

Source: GAO analysis of industry data.

7

Electronic banking is the use of electronic means to access banking services. Examples of electronic

banking include accessing an account balance via an ATM, transfer of funds between personal

accounts using the telephone, and payment of bills using a computer.

8

Screen telephones are telephones that have a small viewing screen attached and that may have a

keyboard. Some home banking services use these devices.

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Electronic Banking

Depository institutions and other financial service providers (e.g.,

nonbanks9

) compete in offering many electronic banking

services—including services for paying bills, purchasing CDs and mutual

funds, and processing loan applications. In addition, some foreign banks

are using the Internet to provide various services, including the sale of

securities.

C Commercial online service

E Electronic banking

Electronic funds transfer

A commercial online service is typically an integrated package of services

providing news, e-mail, special-interest forums, information resources, 

shopping, and other services accessed by consumer and business computer

users with proprietary software and a modem (e.g., America Online, 

Microsoft Network, CompuServe, etc.).

Electronic banking is banking activity accessed by electronic means.

Electronic funds transfer refers to any transfer of funds between accounts 

through an electronic terminal, telephone, computer, or magnetic tape, 

without the use of checks or other paper.

The Internet is an open, worldwide communication infrastructure consisting 

of interconnected computer networks that allows access to remote information 

and the exchange of information between computers.

I Internet

Key Terms

Basic Data Accurate data on electronic banking are difficult to obtain and interpret

because of both the rapidly evolving means of delivery and the varied

ways in which electronic banking can be done. One study suggests that

banks plan to reduce the number of traditional “bricks and mortar”

branches and replace them, at least in part, with alternative electronic

delivery means, including increasingly sophisticated ATMs that offer many

new services and products, such as the sale of mutual funds and

insurance.10 The study also estimates that telephone banking transactions

will grow by 50 percent by 1998. Finally, the study predicts continued

explosive growth in PC-based banking for the foreseeable future.

9

For purposes of this report we use the term “nonbank” to refer to any nondepository financial service

provider, including providers such as CheckFree.

10Creating the Value Network: 1996, American Bankers Association and Ernest & Young, 1996, p. 11.

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Electronic Banking

Processes Electronic bill payment is a service offered by banks and nonbanks. For a

fee, electronic bill payment services pay designated bills, after

authorization, on a consumer’s behalf. Bill payments may be made

electronically or by printed paper check. If the payee does not accept

electronic payment, the bill-paying service would print and mail a check

on behalf of the consumer. This type of payment system is not very

different from a customer writing checks. The only difference is that a

centralized computer system is involved in delivering the check to the

payee. A representative of Intuit, one of the electronic bill payment

services, told us that about 40 percent of merchants are equipped to

receive payment electronically, and only a fraction of those

merchants—about 20 percent—will accept payment without a guarantee

of the payment from the electronic payor. As a result, at least 60 percent of

all bills paid by this service are paid by paper check.

There are almost 1 million users of electronic bill payment services

provided by the two market leaders—CheckFree and Intuit. As of June 30,

1996, CheckFree had 729,000 users, and Intuit had approximately 200,000.

Both CheckFree and Intuit are nonbank financial service providers.

A bank may provide bill payment services in-house to its customers, or it

may contract with an outside electronic bill payment service to provide

the service for the bank’s customers. In addition, consumers may contract

independently with an electronic bill payment service; in such case, no

contractual relationship exists between the bank and the service.

The electronic bill payment process illustrated in figure 4.2 is that of a

nonbank providing the service to a consumer without a contractual

relationship with the consumer’s bank. The merchant in this case can

accept electronic payments. To communicate with the bill payment

system, the consumer uses a home computer equipped with a modem and

appropriate software. Messages are transmitted over a private

communication network (not the Internet).

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Electronic Banking

Figure 4.2: Illustration of an Electronic Bill Payment Process

Account of

ABC Billing System

Credit Debit

$500.00

1

3

To: ABC Billing Systems

From: Consumer A

Pay: Quick Start Mortgage

Date: 1/1/97

Term: Monthly

Amount: $500.00

Consumer A enters into an agreement

with ABC Billing Systems. Then, Consumer A

sends an electronic message by home

computer/modem to ABC Billing Systems

identifying the merchant, timing, and amount

of the payment. Additional information

affecting the timing of the payment (e.g.,

merchant's ability to accept electronic

payments) will be handled with the

identification information at this time.

2 Start of the billing cycle.

ABC Billing System sends the electronic

payment to Quick Start Mortgage's bank

(Bank B), through an

automated clearing house.

Through the ACH, ABC bill payment

system requests Consumer A's bank

(Bank A) to pay from Consumer A's

account the debt due for the payment it

made on Consumer A's behalf.

These processes happen within

moments of one another.

(a)

(b)

Bank B

Account of

Quick Start Mortgage

Credit Debit

$500.00

Bank A

Account of Consumer A

Credit Debit

$500.00

Bank B

Bank A

Bank A

Consumer A

(a)

(b)

Payments are

posted to the account of Consumer A.

Automated Clearing

House

To: Bank A

From: ABC Billing System

Pay: To the account of

ABC Billing System

Date: 1/1/97

Amount: $500.00

ABC Billing System Originator

(Figure notes on next page)

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Electronic Banking

Note: Electronic bill payment providers recommend that consumers schedule payments 3 to 4

days before they are due in case the payment has to be sent through the mail instead of

electronically and also to allow for settlement time for ACH.

Source: GAO analysis of industry data.

Regulatory Oversight Financial institutions that offer electronic banking services are regulated

by their respective regulators. Banks are regulated by OCC and the Federal

Reserve. Brokerage firms are regulated by their self-regulatory

organization. Businesses other than banks and brokerage firms that offer

electronic banking services are subject to investigation by the Federal

Trade Commission (FTC), which operates under a broad mandate to

regulate interstate commerce. FTC conducts investigations in response to

complaints, but it does not regularly and routinely conduct examinations

of entities under its jurisdiction because it is not concerned with the

financial soundness of those it oversees.

The specific electronic banking transactions are governed by the

Electronic Fund Transfer Act of 1978, and the Federal Reserve Board’s

corresponding Regulation E, which is intended to protect consumers

against losses due to unauthorized electronic funds transfers. A

consumer’s liability for unauthorized transactions involving an electronic

fund transfer generally is limited to $50 but can be as much as $500 if the

consumer fails to timely notify the institution that an access device was

lost or stolen. Regulation E also requires financial service providers to

inform customers of their rights in the event an unauthorized transaction

occurs. That disclosure must be made when an account is opened or

before the first electronic transfer is made. Additional disclosure must be

made periodically during the life of the account. Also, the customer must

receive a written receipt when an electronic transfer is initiated and

periodic statements describing each transfer.11

11The receipt requirement applies to transfers at electronic terminals but not to transfers initiated by

consumers over the telephone, such as home banking transactions.

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Electronic Banking

Risk and Risk

Mitigation

For purposes of this report, we discuss some of the most important risk

and risk mitigations associated with electronic banking.

Table 4.4: Risk and Risk Mitigation for

Electronic Banking Risk Risk mitigation

Fraud risk Use of mechanisms to provide

authentication, verification, and security of

information systems and message

transmissions

Security risk Regulatory review of computer security

Use of firewalls and other security

mechanisms

Shaded cells indicate that mitigations are not in general use. Unshaded cells indicate

mitigations in general use.

Risk 1: Fraud Electronic banking poses risks of financial loss due to unauthorized

transfers by electronic intruders. Both financial service providers and

consumers engaged in EFTs are exposed to this risk.

Mitigation Use of mechanisms to provide authentication, verification, and

security of information in electronic banking activity. Passwords,

PIN numbers, encryption, and other methods are commonly used to help

ensure secure management of financial information in electronic banking

activities.

In addition, several efforts are under way to legislate the legality and use

of digital signatures. Digital signatures are the electronic counterpart of

requiring a driver’s license or passport. They enable a person to verify his

or her identity for the electronic transfer of funds or some other

transaction.

Risk 2: Security Banking regulators have recognized that systems delivering financial

products and services face risks posed by individuals with a desire to

disrupt systems rather than to realize any financial gain. The damage from

viruses or other forms of attack could be significant. If a virus caused the

system of a bank to malfunction, for example, customers could lose access

to their accounts. Consumers’ computer systems are also at risk of viruses

and other forms of attack communicated through use of the Internet.

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Electronic Banking

Mitigation Regulatory review of computer security. The U.S. bank regulators are

required to perform extensive reviews of banks’ computer facilities as part

of their routine bank examinations.

Mitigation Use of firewalls and other security mechanisms in a security

strategy. Some financial institutions use firewalls and other methods of

filtering information coming from the Internet to computers to prevent

viruses and other malicious programs from damaging computer systems. A

firewall is a set of security procedures designed to block off intruders by

limiting the information that can pass to the server. Most firewalls involve

either looking at the “packets” of data individually or resending all data

destined for an organization through a single “gateway” or checkpoint.

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Financial Services Over the Internet

Description and Use An increasing number of merchants and financial service providers are

using the Internet as a communications infrastructure for financial

activities. In this section, we discuss purchases over the Internet with

payment by credit card and electronic money, and the use of the Internet

as an avenue for information and communication to facilitate trading of

government and corporate securities.

Many retail merchants have established World Wide Web (WWW) sites to

enable consumers to make online purchases using credit cards. In 1996, a

private research firm estimated that by 2000, the value of online purchases

by credit card will likely be more than $6 billion. The major difference

between a more traditional credit card transaction—whether by

telephone, fax, or at a sales counter—and a credit card transaction over

the Internet is in how the customer provides credit card information to the

merchant, including special procedures used to secure confidential

information.

For purposes of our discussion, the term “electronic money” includes a

wide variety of emerging strategies and mechanisms—many of them still

in a developmental stage—to enable a consumer to make online payments

on a cash basis without the use of physical cash, credit cards, or a

standard checking account.12 In Internet transactions, online merchants

would redeem electronic money for the appropriate value from the issuer.

Electronic money was not widely used in Internet transactions as of

October 1996. An attorney we interviewed, who has a practice dealing with

issues concerning electronic commerce and payment systems, told us that

over 20 electronic money systems were under development or operating as

of October 1996. A few of the versions of electronic money offered or

under development13 include the following:

• E-Cash: DigiCash was the first company to license the technology of

electronic money, which it calls e-cash. Its creators claim that e-cash

combines the speed of the present bank-based wire system with the

anonymity of cash. As of October 1996, e-cash was offered by one U.S.

bank, the Mark Twain Bank in St. Louis, MO. E-cash is a string of digits

that has been given the value of a digital coin by the issuing bank. These

digits are stored on the customer’s hard drive. The customer uses these

digits to pay for the transactions that he or she makes. In an e-cash

12This is referred to as online scrip in the June 1996 Congressional Budget Office study, Emerging

Electronic Methods for Making Retail Payments.

13The examples were selected for purposes of illustration only, without any intention to endorse any of

the featured products.

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Financial Services Over the Internet

transaction, when a customer pays for e-cash, the bank’s deposit liability

to the customer is reduced, and in its place is a new, e-cash liability for

that amount. After the customer transfers the e-cash to a merchant, when

the merchant deposits e-cash, the deposit reduces the e-cash liability and

increases the deposit liability. This means that there is a conversion from

e-cash to funds available for the merchant to withdraw.

• Electronic Money System: Citibank’s Electronic Money System (EMS) is

designed to provide secure, real-time transactions over any network,

including the Internet. EMS offers a blend of anonymity and disclosure.

According to a Citibank official, each electronic transaction would have an

audit trail that could be traced, but the identity of the parties would

remain anonymous.

In recent years, the Internet has also been used to provide information to

potential investors about exchange-traded government and corporate

securities. It has also been used by investors for communication of buy

and sell orders and even to create electronic bulletin-board-based trading

mechanisms for shareholders of off-exchange corporate securities. SEC has

also allowed a brokerage firm to use the Internet to establish a market for

qualified investors in private placement investments. As of October 1996,

securities transactions payments were not made over the Internet; such

payments were cleared and settled conventionally.

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Financial Services Over the Internet

A Authentication Authentication is the process of verifying the identification of the true sender 

of a message and also that the text of the message itself has not been altered.

Encryption is the process of disguising a message (using mathematical 

formulas called algorithms) in such a way as to hide its substance. Decryption 

is the restoration of encrypted data to its original text.

A payment processor or credit card association is an association dedicated

to the settlement and clearance of transactions using credit cards. Examples

of such associations are VISA and MasterCard.

Verification is the ability to positively identify and authenticate a particular

encrypted communication. 

P Payment processor or

credit card association

V Verification

E Encryption/decryption

Key Terms

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Financial Services Over the Internet

Basic Data While statistics on the total value of Internet transactions are not available,

many vendors offer merchandise that can be purchased online with a

credit card. With increased use and sophistication of home computer

technology and WWW services, Internet-assisted financial services are

expected to increase.

• In 1995 about a quarter of a billion dollars of credit card purchases were

made via the Internet.

• In 1995, one bank (The Mark Twain Bank of St. Louis, MO) offered

electronic cash that could be used to make purchases from a few vendors

equipped to take electronic payments.

• In 1996, more than 20 electronic money systems were available or under

development.

Processes Example: A consumer is planning to purchase an outdoor chair.

He or she decides to shop online by connecting to L.L. Brian’s WWW site.

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Financial Services Over the Internet

Figure 4.3: Credit Card Payments Over the Internet

1

2

Navigator

Name:

Password:

N

Consumer A

The consumer dials up his/her

Internet service provider and using

their browser software connects with

the World Wide Web.

Using the browser, the consumer

enters the Internet address of L.L.Brian

to call up its home page.

Online

Ordering

L.L.BrianR

Product

Guide

Free Catalogs

Park

Search

What's

New

Site

Search

Consumer A

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Financial Services Over the Internet

Place Your Order

Review final order and select payment method

John Doe, 1234 Anywhere, USA 12345

Description Qty Availability Cost

Adirondack Chair 1 Now $145.00

Total $150.95

Tax

Shipping $5.95

3 By clicking on pictures and

highlighted text, the consumer collects

information and decides to buy some

outdoor furnishings, which he/she

will pay for with a credit card.

Brian's Adirondack Furniture

Red

Outdoor Furnishings

Much appreciated for over 150

years for their simple lines and

sturdy construction... Assembly

required. Made in the U.S.A.

Chair Colors: White, Red, Green

TA 10452 $145.00 Order

Select Payment Method

Cancel

Purchase Purchase Now

Cardholder:

Account Number:

Expiration Date:

American

Express L.L.BrianVisa NOVUS

Brand Cards

VISA MasterCard Optima JCB

John Doe

1234 0043 2345

12/98

Consumer A

Consumer A

4 L.L. Brian's computer instructs the

consumer's browser software to

switch into "secure" mode. In this

secure mode, the consumer's personal

information and credit card number

are encrypted before transmission,

to ensure the privacy and security

of the transaction.

Source: GAO analysis of industry data.

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Financial Services Over the Internet

Regulatory Oversight Regulatory oversight for financial services on the Internet is determined

largely by the type of entity providing the service. Depository institutions,

brokerage firms, stock markets, and nonbank financial service providers

are subject to varying degrees of oversight by a variety of federal and state

agencies. The Internet itself is generally not regulated by the states or the

federal government.14

Depository institutions are subject to oversight by federal and state

banking agencies. They are regularly and routinely examined to help

ensure safety and soundness and compliance with consumer protection

and civil rights laws and regulations, including the Federal Reserve

Board’s Regulation E, “Electronic Funds Transfers,” which, among other

things, limit the amount of consumer liability for an unauthorized

electronic transfer of funds. Internet-transmitted activities in which

depository institutions are involved would not be exempt from the

scrutiny of federal examiners. Depository institutions issue credit cards,

distribute electronic money, and sell securities. Under certain conditions,

banks may also underwrite initial public offerings and assist in private

placement investments.15

14Domain names, the Internet addresses that are used to mark the network space of an institution, are

assigned by an organization known as the Internet Network Information Center (InterNIC). InterNIC is

a nonprofit organization. It currently subcontracts the actual business of domain registration to a

private contractor. A number of consortia, such as the World Wide Web Consortium, promote

uniformity in communication standards used on the Internet.

15Banks are allowed to conduct certain securities activities, such as brokerage services, within any

licensed bank. However, if a bank wishes to engage in securities underwriting, it may do so only

through what is known as a Section 20 affiliate. This institution is a subsidiary of the bank’s holding

company rather than the bank itself.

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Financial Services Over the Internet

Risk and Risk

Mitigation

For purposes of this report, we discuss some of the most important risk

and risk mitigations associated with financial services on the internet.

Table 4.5: Risk and Risk Mitigation for

Financial Services on the Internet Risk Risk mitigation

Security risk Encryption

Avoidance of the Internet for

transmission of sensitive informaton

Firewalls

Shaded cells indicate that mitigations are not in general use.

Risk: Security Intruders using advanced programming techniques may be able to break

into a computer system over the Internet and obtain information they are

not authorized to have. The security of the systems is of particular concern

because a break-in could result in an immense amount of

information—such as credit card numbers—getting into unauthorized

hands. Further, if information is not secured before transmission over the

Internet, an intruder could obtain a copy of the information being

transmitted or change the message. A report published by the Bank for

International Settlements (BIS) on the security of electronic money has

recognized security concerns and noted that “. . . no single security

measure or set of measures . . . can be said to be sufficient for a particular

product. It is a combination of measures, together with the rigor with

which they are implemented, that will serve to reduce the risk most

effectively.”16

Mitigation Use of strong encryption systems. Systems that transmit credit card

information and electronic cash generally use encryption systems to

prevent electronic intruders from obtaining information—such as credit

card numbers—that could be used to make an unauthorized transfer of

funds. Two major secure-communication protocols have been used in the

Internet/WWW commerce market: Secure Sockets Layer (SSL) and Secure

HyperText Transfer Protocol (S-HTTP). Information Law Alert describes the

difference between SSL and S-HTTP as similar to the difference between an

armored car, which protects the channel, and an envelope, which secures

the specific data being transmitted.

16BIS is an organization of central banks based in Basle, Switzerland. It is the principal forum for

consultation, cooperation, and information exchange among central bankers.

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Financial Services Over the Internet

On February 1, 1996, VISA and MasterCard announced their support for a

new set of technical standards—to be known as Secure Electronic

Transaction (SET)—for making secure credit card purchases over open

networks such as the Internet. SET is to include universally accepted

standards for encrypting credit card numbers and verifying their use; the

standards are to be incorporated into Internet-related software—most

notably software browsers widely used to access the WWW. Among other

things, SET would help prevent merchant misuse of credit card numbers.

Instead of receiving an encrypted credit card number to be decrypted by

the merchant, the merchant would receive and pass the encrypted credit

card number to the credit card association, which would then decrypt the

number and transmit an authorization code to the merchant. This standard

was not expected to be operational until early 1997.

Mitigation Avoidance of the Internet for transmitting credit card numbers.

Some firms allow shoppers to make credit card purchases over the

Internet without transmitting their credit card information. One firm, for

example, will take a shopper’s credit card information over the telephone

and then act as an intermediary between the shopper and the Internet

seller.

Mitigation Use of firewalls and other security mechanisms in a security

strategy. Some financial institutions use firewalls and other methods of

filtering information coming from the Internet to computers to prevent

viruses and other such malicious programs from damaging computer

systems. The firewall attempts to block off intruders by limiting the

information that can pass to the server. Most firewalls involve either

looking at the packets of data individually or resending everything

destined for an organization through a single gateway or checkpoint.

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Section 5: Issues 

Issues Related to Payments, Clearance, and

Settlement Systems

In this section, we highlight issues we identified in doing our work on

payments, clearance, and settlement systems. As discussed in the scope

and methodology section of this report, many of these issues were raised

by payments system users, providers, and regulators. In addition, we

identified some issues from our review of documents, data, and other

materials. Some of the issues relate to specific payments systems; others

are broader in nature. We did not seek to evaluate or resolve any of these

issues in this report.

Issue: the Safety of

Traditional Retail

Payment Transactions

Retail payment transactions are generally small-value, large-volume

payments, such as paper checks for consumer purchases, paychecks,

Social Security fund transfers, and other payments made via an automated

clearing house (ACH). Individually, these types of payments represent a

fairly low level of risk. However, to the individual expecting to receive an

electronic payment, the failure to receive the payment could become a

potentially serious problem. In addition, when retail payment mechanisms

are used for large-dollar transactions, risk can escalate. Thus, proposals

have been made to enhance the safety of retail payment systems.

The Use of ACH to

Transmit Large-Dollar

Payments

In general, use of an ACH network involves considerably more risk than the

use of more secure payments systems such as Fedwire. Unlike Fedwire,

ACH payments are provisional in nature until final settlement, which can

occur as many as 2 days after payment instructions are received.

As previously mentioned, ACH networks have largely been used for

small-dollar payments in which the dollar-value risk if a payment were to

be returned unpaid would be correspondingly small. Also, the price for an

ACH transaction is much lower than that for a Fedwire transaction. The

price differential can be as great as $0.01 for an ACH transaction versus

$0.45 for a Fedwire transaction. Thus, there is a price incentive to use ACH

for increasingly larger dollar-value transactions. Currently, the ACH format

does not allow any ACH transaction greater than $100 million. However,

some industry officials told us that this dollar cap has been circumvented

in cases when the originator of the ACH transaction cuts a large value ACH

payment into several smaller ACH payments to remain under the

$100 million cap for each individual payment.

Some industry officials have expressed concerns about ACH being used for

any large-dollar transactions, even those substantially below the

$100-million cap. One industry official has suggested that the ACH dollar

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Issues Related to Payments, Clearance, and

Settlement Systems

cap should be as low as $100,000. Moreover, these officials told us that the

failure of several large-dollar transactions could expose counterparties to

risks that go beyond those borne by the individual originating institution.

However, other industry officials we spoke to said they did not believe in

the necessity of imposing such dollar limits. They argued that the risk is

borne by the individual financial institution that chooses to use an ACH for

large-dollar transfers.

Same-Day Settlement

Finality of ACH

Transactions

Risks in using an ACH arise from the time lag between payment instructions

being issued and final settlement being made. For example, if a customer

making an ACH payment through his or her bank fails to fund the payment

on the settlement day, the originating institution could suffer a financial

loss.

Some industry officials say that the period of risk could be shortened if the

Federal Reserve adopted same-day settlement finality for its ACH

processing. The Federal Reserve reserves the right to reverse credits to

banks until some time in the night following provision of these credits to

banks. A Federal Reserve official told us that there are several obstacles

that would need to be overcome before same-day settlement finality could

be achieved. For example, ACH transactions are provisional payments with

the presumption, but no guarantee, that the originator of the transaction

will fund its ACH obligations. If same-day finality were established for ACH

transactions, then some sort of guarantee—such as collateral

requirements—would need to be established to ensure that the depository

institutions had sufficient funds to settle their ACH transactions.

Issue: New and

Emerging Financial

Products and Services

New and emerging financial products and services present many legal and

regulatory challenges. Some areas of regulatory oversight, such as the

Community Reinvestment Act (CRA) and credit access, are currently

directed toward the geographical location of the bank, market, or product

being supervised. And consumer protection laws and regulations have

generally been written with the current, predominantly paper-based,

processes in mind. With the growth of electronic commerce, such as

electronic banking, electronic cash, and use of the Internet to purchase

securities, regulators are likely to face increasing complications in

applying existing laws and regulations to these new products and services.

Several task forces are already under way to look at some of the consumer

protection and compliance issues. In addition, the current regulatory

structure is likely to be tested further as nonbanks increasingly offer these

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new services and products. Such developments, already under way, are

likely to raise anew issues related to the extent to which there is a “level

playing field” between banks and nonbanks.

Consumer Regulations The Federal Reserve’s Regulation E governs electronic funds transfers

(EFT), among other things. Currently, Regulation E provides that

consumers must be given a paper receipt at the conclusion of any

electronic transaction conducted at an electronic terminal. For this

reason, an ATM is to issue a receipt each time a customer uses it. This

provision may be a problem for new financial products such as

stored-value cards.

Geographical jurisdictional issues may arise in a number of areas. CRA

requires a bank to delineate the territory it serves and take steps to meet

the credit needs of that territory. Electronic access to banks and banking

services, which provides consumers with opportunities to bank far from

the communities in which they live, clearly complicates the task of

delineating a community by geographical boundaries. Banks offering

services over the Internet as one alternative to those offered at their

traditional “bricks and mortar” branches may be able to continue to satisfy

CRA requirements using these traditional branches. However, at least one

bank is now offering its services exclusively over the Internet, soliciting

customers nationwide. As Internet banks increase in number, regulators

are likely to face a difficult challenge in defining the territory of service for

these banks for CRA purposes. Another jurisdictional concern related to

investor protection is raised by offerings of securities over the Internet.

The use of stored-value cards will likely raise additional issues related to

legal and regulatory oversight. Currently, stored-value cards are being

issued by banks and nonbanks. Questions have arisen about the

applicability of deposit insurance to amounts contained on the cards

issued by banks. Recently, FDIC issued an opinion having the effect that,

with the types of cards anticipated to be most widely used, the funds paid

for them will not be covered by deposit insurance. Only in cases in which

the value is actually held in the cardholder’s account at the financial

institution until payment is authorized would deposit insurance for the

cardholder be available. Consumers may not be aware of this and also may

not be aware that, unlike similar-looking credit cards, stored-value cards

generally offer no dollar limit against theft or loss.

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When fully implemented, stored-value cards may be issued from a provider

in any location to a consumer who uses the card in a completely different

location. Because of these issues, some bankers have suggested that only

banks be permitted to issue stored-value cards. However, these cards are

already being issued by nonbanks.

Consumer Rights and

Access Protection Versus

Financial Innovation

At a U.S. Department of the Treasury conference on the role of

government with regard to electronic money and banking,1

 several federal

policymakers and representatives of the financial services industry

emphasized that governments wishing to foster financial innovation must

be careful not to impose rules that inhibit it. However, these conference

speakers also acknowledged that governments should seek to ensure that

effective risk management systems are in place in the private sector.

Recognizing that transactions over the Internet ultimately create demands

for universally accepted standards for protection of customers, one federal

legislator suggested that private-sector interests may wish to join forces in

developing an electronic commercial code of conduct and standards for

such protection.

Escheatment Most states have laws that allow them to “escheat,” or take custody of

abandoned property, such as bank accounts that have been inactive for

some period. Given the potentially large sums involved, states with

escheatment laws might not allow issuers of stored-value cards and

electronic money to keep abandoned funds for their own accounts. But

several issues must be resolved. For example, there is an issue of which

state would have escheat jurisdiction, particularly if issuers of stored-value

cards and electronic money do not keep records of purchases and

customers’ addresses.

Banks Versus Nonbanks A broader question likely to receive increased attention because of the

emergence of these new products and services is whether or not banks

and nonbanks are operating, or should be made to operate, on a “level

playing field”—that is, that they receive equal regulatory treatment. This

question has been debated by bankers and other providers of financial

services for some time; however, the entry into the market of so many new

nonbank providers of such services as electronic banking, stored-value

1

Toward Electronic Money & Banking: The Role of Government, U.S. Department of the Treasury

Conference, Sept. 19, 1996.

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cards, and Internet-supplied financial transactions will likely serve to

increase and sharpen the debate.

Brokerage houses provide deposit accounts similar to those of commercial

banks. But they do not receive the same regulatory oversight as

commercial banks do. Nor are they required to hold noninterest bearing

reserve accounts at the Federal Reserve. In addition, bankers feel that

other regulatory requirements imposed on depository institutions, such as

CRA requirements, impose additional regulatory burdens on their

institutions, which place them at a competitive disadvantage when

competing against nonbanks.

On the other hand, banks have certain advantages that are derived from

their bank charters. For example, the ability to offer deposit insurance to

customers may give banks a competitive advantage over nonbank financial

service providers. Furthermore, reserves enable banks to clear and settle

obligations. And although undergoing safety-and-soundness examinations

may impose regulatory burden on banks, it also allows banks to provide a

measure of assurance to customers that their deposits are being

well-handled.

However, industry observers believe that nonbanks could fall under

applicable state regulations, for instance, those governing nonbank

“money transmitters”—firms that issue “instruments for the transmission

of money,” such as traveler’s checks or money orders.2

 The state laws

generally provide a number of safeguards for users. Issuers typically must

be licensed and bonded, are required to hold a minimum level of capital,

may be required to hold reserves equal to 100 percent of outstanding

value, and are also subject to periodic examinations and audits.

Issue: Security and

Protection for New

and Emerging

Financial Products

and Services

Electronic technologies now in place or under development, such as the

use of the Internet for financial transactions, electronic cash, and

stored-value cards, hold great promise for increasing consumer choice in

payment methods. However, such technologies also provide additional

means for abuse and illegal activity. Law enforcement officials have

expressed concerns about the possibility of individuals using these new

products and services for illegal purposes such as money laundering.

Some fraudulent schemes involving securities transactions over the

Internet have already been uncovered. Because of the newness of these

2

According to the Federal Reserve, 44 states have enacted such laws, which industry representatives

believe would apply, or will be amended to apply, to general-purpose stored-value cards.

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products and services, approaches to making such products and services

more secure and less vulnerable to illegal use are still under development.

The Security of Internet

Transactions

Through the Internet, customers now have access to credit card payment

systems, electronic banking, and other financial services in a way that was

never before possible. Such services bring to the consumer an array of

new, convenient methods for doing financial transactions. However,

because of the nature of the Internet—the fact that it is basically an

unsecured means of transmitting information—customers, merchants, and

other service providers have increasing concerns about the safety and

security of their transactions. For example, if an intruder could

successfully attack a credit card association, customers could lose access

to their accounts, or in the worst case, the credit card payment system

would grind to a halt.

Firewalls and other methods of filtering information coming from the

Internet to computers can be used, in part, to increase the security of

Internet transactions. A firewall is a method that attempts to block

intruders by limiting the information that can pass to the merchant’s or the

financial institution’s internal network. Use of encryption is another

means by which the security of Internet transactions could be increased.

However, neither firewalls nor encryption provides a guarantee of safety

for Internet transactions. To the extent that financial transactions over the

Internet remain vulnerable to intrusion or capture by unauthorized parties,

consumers may be reluctant to dramatically increase their usage of the

Internet for their financial business, and any major successful attacks

would likely affect the public confidence in electronic commerce in

general.

In addition to the issue of the basic security of the Internet, the Internet

also provides a new means for criminal elements to perpetuate fraudulent

schemes against consumers. Such schemes pose risks to consumers

because the Internet provides relatively easy and cost-effective access to

millions of individuals. Pennsylvania securities regulators we interviewed

described several illegal schemes conducted over the Internet, including

sales of nonexistent bonds. Law enforcement agencies are stepping up

their efforts to identify and stop such schemes, but it remains to be seen

whether these efforts can keep pace with the rapid growth of the use of

electronic commerce and the Internet for such illicit purposes.

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In addition, new technologies, such as the use of the Internet for financial

transactions or stored-value cards, are likely to provide additional avenues

for money laundering.3

 Law enforcement officials are especially concerned

with systems that allow person-to-person transfers, which would include

stored-value cards and Internet transfers. Financial institutions offering

accounts over the Internet are not limited to domestic U.S. institutions.

Foreign, off-shore banks, which may not be regulated by U.S. bank

supervisory agencies, are now offering U.S. customers accounts and

financial services. In at least one case, an off-shore bank is advertising its

services over the Internet as a tax haven for U.S. investors. Stored-value

cards may enable individuals to move illegal money from a bank account

onto a stored-value card, where it will be untraceable when used.

However, because stored-value cards generally are designed for

small-value purchases and many have low limits, such as $500, for the

amounts that can be stored on them, they may not be very efficient

vehicles for laundering large amounts of cash.

Legal Status of Digital

Signatures

To deter forgery, a person wishing to cash a check is usually required to

provide a signature and some type of identification—such as a driver’s

license or passport—to verify that the signature is actually his or hers. A

digital identification, or digital certificate, is the electronic counterpart of

requiring a driver’s license or passport. It enables a person to verify his or

her identity for the electronic transfer of funds or some other transaction.

A digital identification allows individuals to sign, or “authenticate,” digital

transactions. For example, a person wishing to make an electronic money

payment over the Internet could verify that the party requesting the

payment was actually the generator of the request and not an

impersonator.

If digital signatures are to substitute for handwritten signatures, they must

have the same legal status as handwritten signatures—i.e., they must be

legally binding. The legal status of digital signatures is not well defined.

For example, banks are required to acquire a signature card for every

customer, but none of the banking regulators has ruled on the validity of

digital signatures.

Several efforts are under way to legislate the legality and use of digital

signatures. In 1995, Utah became the first government entity to adopt a

3

Money laundering is the disguising or concealing of illicit income to make it appear legitimate.

Although precise figures are not available, federal law enforcement officials estimate that between

$100 billion and $300 billion in U.S. currency is laundered each year.

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comprehensive statute allowing electronic commerce using digital

signatures. Similar legislation is under consideration in some other states.

Issue: Mitigation of

Settlement Risks in

Wholesale and

Foreign Exchange

Transactions

The emergence of the global marketplace has rapidly increased the speed

and volume of wholesale financial transactions. With this growth has come

the potential for increased risk and the call for new mitigation strategies.

As explained in the section on foreign exchange transactions, Herstatt risk

exists because the two sides of a contract are not settled simultaneously;

therefore, if a participant defaulted after receiving its side of a contract but

before making the payments due to the other party, all the payors could

lose up to the full value of the contracts, which might be sizeable.4

Participants in the foreign exchange market might seek to diminish this

gap between payment and receipt by delaying payments, but this could

create gridlock; that is, if payments were delayed, the intended

recipients—even though solvent—might be unable to make their own

payments to others, thus spreading the same problems to still other

participants. In addition, within the United States, the growth in wholesale

transactions could place the Federal Reserve and the taxpayers at

increased risk, in part because of the provision of daylight overdrafts.

A variety of proposals have been made for mitigating various risks in

wholesale payments. Some of these address Herstatt and gridlock risks in

foreign exchange transactions. These proposals include establishing

simultaneous payment arrangements, known as payment-vs.-payment

(PVP), and creating a clearing house as a counterparty. Other proposals are

concerned with domestic wholesale payments in the United States. Some

of these proposals include (1) increasing the fees banks are charged for

incurring daylight overdrafts and (2) fully funding each Clearing House

Interbank Payment System (CHIPS) transaction rather than allowing debit

and credit positions to accumulate until end-of-day settlement.

Timing of Payment Release A committee of major banks involved in foreign exchange trading has

opposed delaying payments until late in the settlement day. Its “best-case”

settlement assumption is for payments to be made at opening time on

settlement day to ensure adequate liquidity for counterparties.5

 We are not

aware of any regulatory proposals for standards for payment release.

4

Herstatt risk can exist within the same time zone, as long as settlement of one currency occurs before

settlement of the other. Time zone differences obviously can increase the length of the time gap

between the two settlements.

5

The New York Foreign Exchange Committee, Reducing Foreign Exchange Settlement Risk, Oct. 1994.

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Simultaneous Payment

Process or PVP

Herstatt risk in foreign exchange transactions could be eliminated by

procedures to make payment of each currency leg dependent on payment

of the other; as mentioned earlier, the process for allowing simultaneous

payment is called PVP. To enhance the potential for PVP in foreign exchange

transactions, the Federal Reserve has announced plans to extend the

opening hours of Fedwire in 1997. By the end of this year, Fedwire is to be

open from Monday through Friday 12:30 a.m. to 6:30 p.m. ET, thus ensuring

that it will be possible to process dollar final settlements during hours

when payment systems in major foreign countries are also open.

Expanded Fedwire hours should make simultaneous payments possible.

PVP does not automatically follow from overlapping payment system hours:

expanded Fedwire hours should make simultaneous payments possible,

but realization will depend on private-sector actions. In that regard, a

group of major banks in the industrial countries, calling themselves the

Group of Twenty, have an objective of bringing about a private-sector PVP

system by 1999.

A concern of market participants is that any risk-mitigation measures

should not be so costly or cumbersome as to interfere with the ability of

the markets to function effectively. To that end, proposals for clearing

houses and PVP are being examined in terms of the amount of liquidity that

may need to be tied up as collateral. The central banks’ G-10 committee

raises the question as to whether some proposed PVP schemes might

heighten the potential for transmission of problems from one country to

another by increasing links between them. Yet another consideration is the

degree to which a proposed measure would allocate costs to those

institutions that bring risk to the system, thus retaining incentives on each

institution to manage risks prudently.

Clearing House Becomes

Counterparty

One approach to reducing Herstatt risk in foreign exchange contracts

involves the creation of a clearing house, which would become the

counterparty—and thus guarantor—of all the trades among members. If

such an institution had sufficient collateral or other backing available to

be used in case of potential payment failures by one or more of its

members, a clearing house could reduce credit risk. With reduced

concerns over credit risk, there might be less incentive to withhold or

delay payments, thus lessening the risk of gridlock. Exchange Clearing

House (ECHO) is a clearing house based in London, which had 13 member

banks as of May 1996. Multinet International Bank, once in operation, is to

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be a clearing house that becomes counterparty to trades initially in U.S.

and Canadian dollars among its members.

U.S. Treasury OFAC

Powers Over Assets of

Non-U.S. Companies

Under the Emergency Economic Powers Act, the President can prohibit or

regulate transactions relating to the interests and assets of any foreign

country or foreign national. Using this authority, the President can, among

other things, prohibit (1) any transactions in foreign exchange;

(2) transfers of credit or payments between, by, through, or to any banking

institution, to the extent that the transfer or payment involves any interest

of a foreign country or national thereof; and (3) the importing or exporting

of currency or securities.6

 Regulations implementing Presidential Orders

under the act are promulgated by the Office of Foreign Assets Control

(OFAC) within the Department of the Treasury. OFAC powers are exercised

under laws intended to thwart terrorism or crime. OFAC powers are to be

exercised on payments flowing across Fedwire or CHIPS, even if the

payments are legal in the payor’s country. Presently, all major players in

global finance are heavily dependent on these two payments systems.

Foreign financial institutions might want to divert their payments outside

the United States. Some officials raise the concern that if international

payments flows are pulled out of the U.S. payments systems, this action

might affect the ability of the Federal Reserve to monitor financial flows

and risks.

Pricing and Provision of

Daylight Overdrafts

Some private-sector officials believe that the Federal Reserve is

significantly underpricing daylight overdrafts. They argue that the rate

charged for daylight overdrafts should be equal to the costs of providing

those same funds to banks at the federal funds rate, which recently has

been around 600 basis points. The Federal Reserve told us that they

strongly disagree that daylight overdrafts are underpriced. Federal

Reserve officials do not believe that daylight overdrafts fall within the

meaning of a “new priced service” being offered under Monetary Control

Act and, thus, Federal Reserve officials believe that cost recovery is not

required. Instead, officials told us that the Federal Reserve’s position is

that charging fees for daylight overdrafts is a risk control mechanism as

opposed to a charge for a priced service. Further, they argued that to raise

6

50 U.S.C. §§ 1701-1706. The act authorizes such action in cases in which the President has declared a

national emergency because of an “unusual and extraordinary threat” to the U.S. national security,

foreign policy, or economy, “which has its source in whole or substantial part outside the United

States.” The President has used this power to issue “freeze” orders against the assets of Iraq (1990),

Panama (1988), Libya (1986), Iran (1979), South Vietnam (1975), and other countries. See Rachel R.

Gerstenhaber, Comment, Freezer Burn: United States Extraterritorial Freeze Orders and the Case for

Efficient Risk Allocation, 140 U. Pa. L. Rev. 2333 (1992). See 31 C.F.R. §§ 575.101-575.901.

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daylight overdraft fees precipitously would likely cause disruptions, e.g.,

causing a substantial volume of large-value payments to be shifted to less

secure payments systems, thereby increasing payment system risk.

Regardless of the level of pricing of daylight overdrafts at the Federal

Reserve, it is recognized that they pose credit risks to the Federal Reserve.

If the bank receiving an overdraft fails before it repays the overdraft, there

could potentially be a loss experienced by the Federal Reserve. However,

the institutions at the highest risk of failure are not permitted to incur

daylight overdrafts. In addition, virtually all daylight overdrafts that are

attributable to Fedwire securities transfers, and by extension the majority

of daylight overdrafts, are collateralized. In this regard, it is noteworthy

that some major European central banks either do not provide

uncollateralized daylight overdrafts or plan to require full collateralization

for central bank, real-time gross settlement systems in the future. A

Federal Reserve official said that provision of Federal Reserve intraday

credit in the Federal Reserve’s payment system was indispensable in

maintaining the liquidity of the Treasury market, which underpinned the

smooth functioning of other financial markets in this country and abroad

as well.

CHIPS End-of-Day

Settlement

On an average day, over $1.2 trillion of large-dollar payments are made

among CHIPS’ participants. These payments are netted among the members

during the day, but the participants’ net credit/debit positions are not

settled until the end of the day. Individual participants could fail, at cost to

their creditors; hypothetically, if enough participants were to fail, then

end-of-day settlement would not occur; in the latter case, there would be

systemic disruption to payments in this country and elsewhere.

Regulators and industry officials pointed out that the CHIPS system had

rigorous controls over payments and debit positions and had access to

collateral that would cover the largest failures. They added that the netting

system helps maintain liquidity in the markets since the huge amount of

daily payments that are sent over the system only require an average

settlement amount of $5 to $10 billion each night.

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Issue: Appropriate

Role of the Federal

Reserve in the

Payments System

Several issues concern the role of the Federal Reserve in the payments

system. Currently, the Federal Reserve serves as both a regulator and

provider of certain payment system services and, as such, is in

competition with private payment-service providers. The Monetary

Control Act of 19807

 (MCA) required the Federal Reserve to price, on a

basis comparable with private business firms, all the payment services it

offered at the time the law was enacted and any other services it

developed after that date. Private-sector providers and others have raised

questions about the Federal Reserve’s ability to fully adhere to this law;

others see an inherent conflict in the Federal Reserve’s dual role as

regulator and service provider.

Potential Conflict Between

Federal Reserve’s Role as

Both Service Provider and

System Regulator

The Federal Reserve is currently the largest single provider of priced

payments services—e.g., check clearing, ACH services, and wire funds

transfer services—in the nation. Yet, the growth of private check clearing

houses, such as the Chicago Clearing House Association (CCH), and the

California Bankers Clearing House (CBCH), all of which directly compete

with the Federal Reserve, has been a principal reason that the Federal

Reserve’s volume of checks cleared has declined in recent years. MCA

placed the Federal Reserve in a unique position—competing actively with

private-sector institutions in providing services, such as check clearing, on

the basis of price and quality of service, even though it has supervisory

authority over these competing institutions and has responsibility for

ensuring that the nation’s payment system functions properly.

Some private-sector service providers have expressed the concern that the

Federal Reserve faces a potential conflict of interest in being both a

provider of services and a regulator of payment systems. These private

sector providers fear that the Federal Reserve could be unfairly competing

with them in two ways: first, by writing the regulatory rules so as to favor

its own services; and second, by underpricing its services so as to retain a

larger market share.

Federal Reserve officials told us that they have taken steps to ensure they

are competing fairly with the private sector in providing payment services.

For example, any proposed change in the Federal Reserve’s operations

must undergo an impact analysis to assess the impact of the proposed

change on private-sector competition.

7

Monetary Control Act of 1980, Pub. L. No. 96-221, Title I, 94 Stat. 132 (codified as amended in

scattered sections of 12 U.S.C.).

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Potential Conflict Between

MCA and Federal Reserve’s

Future Check Clearing

Role

The Federal Reserve, in providing its check clearing services, operates

under two potentially conflicting requirements. First, under MCA, the

Federal Reserve is required to recover all the costs of doing business that

it would incur if it were a private business. The second requirement is that

the Federal Reserve be the “clearer of last resort.” This means that the

Federal Reserve is required to provide check clearing services, regardless

of the costs it incurs, to any financial institution that needs to use its

services for this purpose.

The large private clearing houses have an advantage in that they, unlike

the Federal Reserve, need not provide check clearing services to small and

unprofitable depository institutions. For example, private check clearing

houses often only cover certain geographical areas or handle only certain

types of payments, such as those for large-dollar amounts. If the private

clearing houses increasingly attract the most profitable business, leaving

the most costly business for the Federal Reserve, the Federal Reserve may

eventually be unable to meet its legal requirement to recover its costs of

doing business. In addition, with the financial industry’s move toward

interstate banking, larger banks will be clearing checks within their own

banks, and possibly exchanging checks among their organizations.

Possible Inefficiency in the

U.S. Payment System

There are many estimates of the share of gross domestic product devoted

to the U.S. payment system. For example, the Federal Reserve estimates

this share to be below 0.5 percent of gross domestic product. One

economist has estimated this share to be higher—between 1 percent and

1.5 percent, or in dollar terms, between $72 billion and $109 billion in 1995.

Because electronic payments, such as ACH, credit cards, or stored- value

cards, are estimated to cost only one-third to one-half that of payments by

check, a shift from paper checks to these electronic systems could lower

financial costs in the economy. In that regard, the usage of paper check

payments in the United States is considerably higher than that in other

industrial countries.8

 The federal government should be making fewer

check payments by 1999 under the Debt Collection Improvement Act of

1996. Nonetheless, because federal government checks only account for

about 1.3 percent of all U.S. checks written, this decrease in check

payments should have little impact on the total U.S. volume of check

payments.

8

In 1993, 80.4 percent of the volume of noncash payments in the United States was checks; among 9

other industrial countries, the share of checks in noncash payments averaged 25.6 percent, ranging

from a low of 3.3 percent to high of 58.7 percent.

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Appendix I 

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the Federal Reserve System

Note: GAO comments

supplementing those in the

report text appear at the

end of this appendix.

See comment 1.

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See comment 2.

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See comment 3.

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See comment 4.

See comment 5.

See comment 6.

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See comment 7.

See comment 8.

See comment 9.

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Comments From the Board of Governors of

the Federal Reserve System

The following are GAO’s comments on the Board of Governors of the

Federal Reserve System’s letter dated April 16, 1997.

GAO Comments 1. The Federal Reserve acknowledged that we had incorporated a number

of the comments they provided on earlier versions of the draft report.

However, they expressed disappointment that many of their substantive

comments were not addressed.

While the Federal Reserve was reviewing our draft, we were in frequent

contact with staff regarding technical comments. We incorporated their

suggested changes where appropriate. In addition, officials responsible for

operating many of these payment systems or developing new products,

such as CHIPS, GSCC, and Mondex, reviewed sections of the report and

commented on its accuracy. We made a number of changes to these

sections based on their comments. Because our presentation of the issues

did not include evaluation or conclusions, we did not incorporate the

Federal Reserve’s detailed comments on the issues if, in our judgment,

their comments were evaluative in nature. However, their comments on

the issues are presented in their entirety in the Board of Governors’ letter.

2. The Federal Reserve stated that our discussion of the clearance and

settlement in the U.S. government securities market only focuses on a

portion of the market, the GSCC members and the securities clearing banks.

The Federal Reserve believes this leaves the reader with the erroneous

impression that these organizations represent all of the clearance and

settlement activity that occurs over Fedwire.

We have added a footnote to our discussion of Treasuries stating that we

focused only on GSCC’s process, which is one mechanism for clearing and

settling U.S. government securities. See page 58.

3. The Federal Reserve commented that our discussion regarding the risk

that ACH debit transactions will be returned should be deleted because this

risk relates to the finality of the underlying payment, not to the finality of

the settlement of the transaction.

We have deleted our example of the ACH debit transaction in our

discussion of same-day settlement finality of ACH transactions. See page

158.

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4. The Federal Reserve commented that it is not clear why the report

discusses the problems associated with providing receipts for stored-value

cards in the context of privacy concerns, when such concerns have not

been raised with respect to debit or credit card transactions.

We deleted our discussion describing the problems associated with

providing receipts for stored-value cards in the context of privacy. See

page 159.

5. The Federal Reserve commented that our report was incorrect in stating

that brokerage firms and other nonbanks that provide accounts similar to

demand deposits are subject to Federal Reserve reserve requirements.

We have clarified our discussion of banks versus nonbanks to remove the

mistaken impression that brokerage firms and other nonbanks that

provide accounts similar to demand deposits are subject to Federal

Reserve reserve requirements. See page 160.

6. The Federal Reserve stated that our report was misleading in that it

implied Herstatt risk is only an intraday risk and results primarily from the

different time zones of the settling currencies.

We state in the report that intraday risk could accumulate to the sum of 2

or 3 days’ trading volume. See page 44. We have added language to the

report recognizing that Herstatt risk can exist within the same time zone.

See page 164.

7. The Federal Reserve commented that if GAO includes a discussion of the

G-20 initiative, it should do so as part of its discussion of PVP, rather than

in the “clearing house becomes counterparty” section.

We have moved the discussion of the G-20 initiative in foreign exchange

transactions to the section discussing simultaneous PVP. See page 165.

8. The Federal Reserve believes that our discussion of the issues in the

report fails to give the reader an appreciation of the differing perspectives

and associated considerations. For example, with regard to the potential

conflict between the Federal Reserve’s role as service provider and system

regulator, the Federal Reserve believes the report would be more balanced

if it included a discussion of any actual evidence of unfair competition by

the Federal Reserve. In addition, the Board provided information in its

Page 177 GAO/GGD-97-73 Payments, Clearance, and Settlement
Appendix I 

Comments From the Board of Governors of

the Federal Reserve System

letter and in its discussion of other issues on efforts it has made to

minimize the potential conflict between its two roles.

We raise the issues of the potential conflict in the Federal Reserve’s dual

role because many private-sector individuals and organizations expressed

such concerns. We do not present any evidence that would either

substantiate or refute the contention that the Federal Reserve is actually

competing unfairly with its private-sector competitors. We have, however,

incorporated where appropriate additional information the Board has

given us about its efforts to minimize the potential conflict between its two

roles. For example, we acknowledge that the Federal Reserve said that

when it is considering any proposed change in its payment system

operations, it conducts an analysis to assess the impact of the proposed

change on private-sector competition. See page 168.

9. The Federal Reserve stated that our report overestimated the share of

gross domestic product devoted to the payments system and offered an

alternative estimate.

Recognizing that there are many different ways to measure possible

inefficiencies in the U.S. payment system, we have included the Federal

Reserve’s estimate. See page 169.

Page 178 GAO/GGD-97-73 Payments, Clearance, and Settlement
Appendix II 

Major Contributors to This Report

General Government

Division, Washington,

D.C.

Nolani T. Traylor, Evaluator-in-Charge

Tamara E. Cross, Senior Evaluator

Nancy Eibeck, Evaluator

Robert Pollard, Economist

Charles Kilian, Advisor

John Treanor, Banking Advisor

Desiree W. Whipple, Reports Analyst

Kim Wheeler, Publishing Advisor

Hazel Bailey, Evaluator (Communications Analyst)

San Francisco

Regional Office

Abuid Amaro, Evaluator

Linda Chu, Evaluator

Office of General

Counsel, Washington,

D.C.

Paul Thompson, Senior Attorney

Page 179 GAO/GGD-97-73 Payments, Clearance, and Settlement
Glossary

ACH Operator/Processor An ACH operator/processor is a central clearing facility that receives

batches of ACH credit and debit transactions from originating depository

institutions; edits, sorts, and distributes the transactions to receiving

depository institutions; and facilitates the settlement among participants.

Authentication Authentication is the process of verifying the identification of the true

sender of a message and also that the text of the message itself has not

been altered.

Back Office The back office of a financial institution is made up of employees

responsible for (1) recording and maintaining the official records of the

financial institutions and (2) processing transactions entered into by the

financial institutions or its customers.

Batch Processing Batch processing is the transmission or processing of a group of payment

orders and/or securities transfer instructions.

Bond A bond is a debt security representing a loan by the buyer to the

corporation or government issuing the bond; it may pay interest, or it may

be discounted in price from the value at maturity.

Book-Entry System A book-entry system is an accounting system that permits the transfer of

assets (e.g., securities) without the physical movement of paper

documents or certificates.

Browser A browser is a computer program that facilitates locating and displaying

information on the World Wide Web (e.g., Netscape Navigator or Microsoft

Explorer). The browser could work on the Internet or through internal

information management systems called Intranets.

Call Option A call option is a contract that gives one the right, but not the obligation,

to buy a specified amount of an underlying asset, such as stocks or

currency, at a specified price by a certain date.

Cash Letter A cash letter is a group of checks, accompanied by a listing of the checks,

which is sent to a clearing house, a correspondent bank, or the Federal

Reserve for collection.

Check A check is a written order from one party (the payor) to another party (the

payee) requiring the payor to pay a specified sum on demand to the payee

or to a third party specified by the payee.

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Glossary

Check Clearing Check clearing is the movement of a check from the depository institution

at which it was deposited back to the institution on which it was written.

The funds move in the opposite direction, with a corresponding credit and

debit to the involved accounts.

Check Truncation Check truncation is the practice of holding a paper check at the bank at

which it was deposited (or at an intermediary bank) and electronically

forwarding the essential information on the check to the bank on which it

was written. A truncated check is not returned to the writer.

Class of Options A class of options consists of options that are of the same type and style

and cover the same underlying asset.

Clearance Clearance is the process of transmitting, reconciling, and in some cases,

confirming payment orders or security transfer instructions prior to

settlement, possibly including the netting of instructions and the

establishment of final positions for settlement. In the context of securities

markets, this process is often referred to as clearance.

Clearing Agent Banks Clearing agent banks are Fedwire participants that are regularly engaged

in the business of providing clearing services in eligible securities for

members and GSCC.

Clearing House A clearing house is a voluntary association of depository institutions that

facilitates the exchange of payment transactions such as checks,

automated clearing house transactions, and large-value funds transfers

and the settlement of participants’ net debit or credit positions.

Clearing Members Clearing members are firms that are determined by OCC to be qualified to

interact with OCC on behalf of market participants.

Commercial/Merchant Server A commercial/merchant server is a computer and/or computer program

that provides information in response to requests by other computer

programs. Some servers are capable of sending and receiving secure

messages.

Commercial Online Service A commercial online service is an integrated package of services providing

news, e-mail, a special-interest forum, information resources, shopping,

and other services accessed by consumer and business computer users

using proprietary software and a modem (examples include America

Online, Microsoft Network, CompuServe, etc.).

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Glossary

Comparison Members Comparison members are primarily government securities broker-dealers

and clearing agent banks that are capable of interacting with GSCC

operations.

Corporate Payments Corporate payments are payments that are used by businesses to pay

other businesses for goods or services.

Correspondent Bank A correspondent bank is a bank that—by arrangement—holds the deposits

of another bank and provides payments and other services for that bank.

Credit Card Company A credit card company is a company that owns the trademark of a

particular credit card and may also provide a number of marketing,

processing, or other services to the members using the card services.

Credit Line A credit line is the maximum amount of credit available in an open-ended

credit arrangement, such as a bank credit card, which the lender may

change at any time. The credit line is disclosed in the credit card

agreement.

Currency Option Currency options are options that represent the right to buy or sell foreign

currency at a particular price within a specified period.

CUSIP CUSIP stands for the Committee on Uniform Securities Identification

Procedures. Each type and issue of security will have its own unique CUSIP

number.

Daylight Overdraft A daylight overdraft is an intraday loan that occurs when a bank transfers

funds in excess of its reserve account.

Depositary Bank A depositary bank is the bank at which a check is first deposited.

Direct Participants Direct participants are financial institutions that are permitted to transact

with the clearing organization, and all customers come to the clearing

organization through them. The term usually refers to institutions that

interact with NSCC.

Dual Trading Dual trading occurs when an individual (or representative of a firm) trades

on behalf of customers and also trades for his or her own or the firm’s

proprietary account.

Decryption Decryption is the restoration of encrypted data to their original text.

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Glossary

DVP System A delivery vs. payment (DVP) system is a system that ensures that the final

transfer of one asset will occur if, and only if, the final transfer of another

asset (or other assets) occurs.

Electronic Banking Electronic banking is a banking activity accessed by electronic means.

Electronic Funds Transfer

(EFT)

EFT is any transfer of funds between accounts using an electronic terminal,

telephone, computer, or magnetic tape and that does not use checks or

other paper.

Electronic Data Capture (EDC) EDC is a point-of-sale terminal that reads the information encoded in the

magnetic stripe of bank cards. These terminals electronically authorize

and capture transaction data, eliminating the need for a paper deposit.

Encryption Encryption is the process of disguising a message (using mathematical

formulas called algorithms) in such a way as to hide its substance, a

process of creating secret writing.

Equity Index Option An equity index option is an options contract that covers the price of a

diversified stock portfolio that matches a designated stock-index (a

statistical indicator used to measure changes in stock groupings).

Equity/Stock Equity or stock is a financial instrument that represents ownership in a

company.

Exchange An exchange is an organized market with transactions concentrated in a

physical facility with participants entering two-sided quotations (bid and

ask) on a continuous basis.

Exercise Exercise means to make use of the “rights” in a contract. For instance, a

buyer of a call option may exercise the right to buy the underlying asset at

a particular price agreed upon when the contract was purchased.

Federal Funds Rate The federal funds rate is the rate charged by a depository institution on an

overnight sale of federal funds to another depository institution. The rate

may vary from day to day and from bank to bank.

Federal Reserve Account A federal reserve account is a noninterest-earning account that a

depository institution maintains with a Federal Reserve Bank. The balance

in this account is maintained for purposes of (1) satisfying the Federal

Reserve’s reserve requirements and/or (2) settling payments cleared

Page 183 GAO/GGD-97-73 Payments, Clearance, and Settlement
Glossary

through the Federal Reserve. The balances in these accounts play a central

role in the exchange of funds between depository institutions.

File A file is a group of entries transmitted by originating institutions or to

receiving institutions by ACH operators. A file may contain one or more

batches of entries.

Finality Finality is an irrevocable and unconditional transfer of payment.

Float Float is checkbook money that appears on the books of both the check

writer (the payor) and the check receiver (the payee) while a check is

being processed.

Floor Broker A floor broker executes trades for customers and may also execute trades

for their personal or employer accounts.

Floor Trader A floor trader executes trades only for their personal accounts. A floor

trader is also referred to as a “local.”

Futures Commission Merchant

(FCM)

An FCM is a firm that buys or sells futures contracts and accepts payment

from or extends credit to those whose orders it accepts.

Hedging Hedging is engaging in financial transactions to protect against potential

adverse changes in the values of assets, liabilities, or off-balance-sheet

activities.

The Internet The Internet is an open, worldwide communication infrastructure

consisting of interconnected computer networks that allow access to

remote information and the exchange of information between computers.

Liquidity Liquidity is a quality that makes an asset easily convertible into cash with

relatively little loss of value in the conversion process.

Locked-in Trades Locked-in trades are transactions that are matched by a computer, usually

at the place of the trade, before being sent to a clearing organization.

Market Maker Market maker is a dealer that makes bids and offers at which he/she will

trade.

MICR-Line Information MICR-line information refers to the data characters at the bottom of a

check. The magnetic ink character recognition (MICR) line at the bottom of

Page 184 GAO/GGD-97-73 Payments, Clearance, and Settlement
Glossary

a check includes the routing number of the payor bank, the amount of the

check, the number of the check, and the account number of the customer.

Mortgage-Backed Securities MBS are securities that are backed by mortgages in which investors

receive payments out of the interest and principal payments made on the

underlying mortgages.

Multilateral Netting Multilateral netting is an arrangement among three or more parties to net

their obligations, which may arise from financial contracts, transfers of

funds, or both. This type of netting normally takes place in the context of a

multilateral net settlement system.

Net Debit Cap A net debit cap is the quantitative limit placed on the debit position that

participants in a funds or securities transfer system can incur during the

business day. Under the Federal Reserve’s policy, institutions are subject

to two caps—a daily cap and a 2-week cap.

Net Settlement Net settlement is the settlement of a number of obligations or transfers

between or among counterparties on a net basis.

Netting Netting is an agreed upon offsetting of positions or obligations by trading

partners that can reduce a large number of individual obligations or

positions to a smaller number.

Netting Members Netting members are primarily government securities broker-dealers and

banks that are capable of participating in the netting services through

GSCC.

Novation Novation is an agreement to replace one party to a contract with a new

party. The novation transfers both rights and duties and requires the

consent of both the original and the new party.

Offsetting Offsetting is liquidating a purchase of contracts (e.g., futures contracts) by

the sale of an equal number of contracts with the same delivery month,

thus closing out a position.

On-Us Check An “on-us check” is a check payable from funds on deposit at the same

bank where it is presented for collection.

Open Outcry Open outcry is a form of trading whereby buyers and sellers trade by

shouting their orders and using hand signals.

Page 185 GAO/GGD-97-73 Payments, Clearance, and Settlement
Glossary

Opportunity Costs Opportunity costs refer to the present value of income that could be

earned (or saved) by investing in the most attractive alternative to the one

being considered.

Options on Futures An option on a futures contract gives an investor the right but not the

obligation, in exchange for a price (called a premium), to buy or sell a

specified futures contract at a specific price (called the exercise price)

within a specified period.

Order-Book Official An order-book official is an exchange official who accepts and executes

limit orders from customers—orders to buy or sell when the market

reaches a certain price.

Originating Depository

Institution

An originating depository institution is a depository institution that

initiates and warrants electronic payments processed through the ACH

network on behalf of its customers.

Originator An originator is the person or organization that initiates an ACH entry.

Paying Bank A paying bank is the bank at which a check is payable and to which it is

sent for payment or collection.

Payment Processor or Credit

Card Association

A payment processor is an association dedicated to the settlement and

clearance of transactions using credit cards. Examples of such

associations are VISA and MasterCard.

Payments System Payments system is a collective term for mechanisms (both paper-backed

and electronic) for moving funds, payments, and money among financial

institutions throughout the nation. The Federal Reserve plays a major role

in the nation’s payments system through distribution of currency and coin,

processing of checks, electronic transfer of funds, and the operation of

automated clearing houses that transfer funds electronically among

depository institutions; various private organizations also perform

payments system functions.

Premium A premium is the amount that the buyer of an option pays the writer or

seller of the option.

Presentment Fee A presentment fee is a fee that a bank receiving a check may impose on

the bank that presents the check for payment.

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Glossary

Proprietary Trading Proprietary trading is the buying and selling for the trading institution’s

own account, in contrast to the trading the institution does on behalf of its

customers.

Put Option A put option is a contract that gives one the right, but not the obligation, to

sell a specified amount of an underlying asset, such as stocks or currency,

at a specified price by a certain date.

Real-Time Gross Settlement Real-time gross settlement is a system that processes each transaction as

it is initiated rather than processing it in a batch. Gross settlement means

that the system settles each transaction individually.

Receiver A receiver is the individual or organization that has authorized an

originator to initiate an ACH credit or debit transaction entry to the

receiver’s account with the receiving depository institution.

Registered Options Trader A trader that trades on the exchange floor but has an obligation to make

markets similar to that of specialists.

Repurchase Agreement A repurchase agreement is an agreement between a buyer and seller

(usually) of U.S. government securities, whereby the seller agrees to

repurchase the securities at an agreed-upon price and, usually, at a stated

time.

Respondent Bank A respondent bank is a bank that regularly buys check processing and

other services from a correspondent bank.

Return Item A return item is a transaction that has been returned by a receiving

depository institution because it cannot be posted.

Securities Securities refer to a financial instrument that represents a share of

ownership in a corporation—a stock; a loan to a corporation, government,

or governmental body—a bond; or conditional rights to ownership, e.g., an

option.

Self-Regulatory Organizations Self-regulatory organizations are industry organizations and associations

responsible for enforcement and practices in their market.

Series of Options Series of options are all options of the same class that also have the same

unit of trade, strike price, and expiration date.

Page 187 GAO/GGD-97-73 Payments, Clearance, and Settlement
Glossary

Server A server is a computer that stores information that is retrieved by other

computers.

Settlement In banking, settlement refers to the process of recording the debit and

credit positions of two parties in a transfer of funds. Also, it is the delivery

of securities by a seller and the payment by the buyer.

Settlement Banks Settlement banks are banks that maintain the settlement accounts for

clearing members whereby payments and deposits are made.

Specialist A specialist is a member designated by an exchange to be the sole market

maker for a particular stock.

Speculation Speculation is the assumption of risk in anticipation of gain but

recognizing a higher than average possibility of loss. The term speculation

implies that a business or investment risk can be analyzed and measured,

and its distinction from the term investment is one of degree of risk.

Stock/Equity Option A stock option gives one the right to purchase or sell a certain number of

shares of stock at a particular price within a specified period.

Stored-Value Card A stored-value card is a credit-card-sized device, implanted with a

computer chip, with stored money value. A reloadable stored-value card

can be reused by transferring value to it from an automated teller machine

or other device. A disposable card cannot be reloaded.

S.W.I.F.T. The Society for Worldwide Interbank Financial Telecommunication is an

international financial payment cooperative organization that operates a

network that facilitates the exchange of payment and other financial

messages between financial institutions throughout the world.

Systemic Risk Systemic risk refers to the risk that the failure of one participant in a

transfer system (or financial markets generally) to meet its required

obligations will cause other participants or financial institutions to be

unable to meet their obligations when due.

Trade Comparison Trade comparison is the receipt, validation, and matching of data on the

long (buy) and short (sell) side of a transaction and the reporting of such

match.

Treasury Security A Treasury security is a negotiable debt obligation of the U.S. government,

backed by its full faith and credit, and issued with various maturities.

Page 188 GAO/GGD-97-73 Payments, Clearance, and Settlement
Glossary

UCC The Uniform Commercial Code (UCC) is a set of model laws governing

commercial and financial transactions.

Value Added Networks Value added networks refer to a third-party service provider that manages

data communications networks for businesses that exchange electronic

data with other businesses.

Verification Verification is the ability to positively identify and authenticate a

particular encrypted communication.

Writer (Option) An options seller is called a writer of options, a “covered” writer if owning

the underlying asset and a “naked” writer if not. The writer of an option is

obligated to sell, in the case of a call option, or buy, in the case of a put

option, a specified amount of the underlying asset at a predetermined

price when the buyer or holder exercises the option. The writer earns a

premium paid by the buyer.

(233483) Page 189 GAO/GGD-97-73 Payments, Clearance, and Settlement
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