By any measure, the United States has the most liquid, efficient and cost-effective capital markets in the world. The critical role that DTCC plays may not be well-known outside the financial services industry, but it fundamentally benefits everyone who participates in capital markets, ranging from the largest public companies to main street investors who rely on markets to help fund their retirements, raise capital to start a business, buy insurance or obtain loans to purchase a house or car.
In this three-part series, DTCC: Providing a Public Good, we’ll examine the market challenges that created the need for centralized clearing and the eventual creation of DTCC; review the key advances in clearance and settlement and how they have benefitted the markets; and illustrates how DTCC provides stability in times of crisis, from the terrorist attacks of 9/11, to the 2008 financial crisis and the global coronavirus pandemic.
Part I: History of Clearing in the U.S. and the Creation of DTCC
In the U.S., certificated securities have been issued since the 1700s, providing essential evidence of ownership of a security. The federal government issued the first major American publicly traded securities in 1790 to refinance federal and state Revolutionary War debt. In 1792, five securities began trading on what was to become the New York Stock Exchange (NYSE). Methods for buying and selling securities have evolved dramatically to meet the needs of market participants. As the financial markets have grown, so has the need for infrastructure that can help simplify, streamline and ensure the effective transfer of securities.
Initially, every transaction on the NYSE had to be paid for in full and the physical shares delivered within one business day. This meant that buyers and sellers had to exchange cash (or collateral if self-financed) and certificates.
To execute this, messengers delivered checks and certificates throughout lower Manhattan. As markets grew, increased trading strained the funding markets and trading infrastructure, spurring advances in clearing in the equity markets, including the introduction of netting to the settlement system. In 1920, NYSE established the Stock Clearing Corporation (SCC), which acted as a counterparty to every buyer and seller. This simplified the clearing process and reduced demands on the funding markets. Firms could now pay or receive money from SCC rather than having to issue checks to all its counterparties in a transaction. In other words, the clearinghouse could net down purchases and sales conducted on the exchange among participants, greatly reducing the need for funding. Many manual processes, however, remained in the clearing system, and physical securities still had to be moved from the sellers to buyers.
As markets grew, increased trading strained the funding markets and trading infrastructure, spurring advances in clearing in the equity markets, including the introduction of netting to the settlement system.
In the 1960s, the increased volume of securities trading overwhelmed the complex and largely manual processes of the settlement systems. Deliveries to customers of cash and securities were frequently late, and stock certificates often were lost (i.e., “settlement failures”). Consider, in 1967, trading averaged 10 million shares per day—and just three months later that number doubled to 20 million shares per day. The sheer volume buried workers in paper and resulted in hundreds of thousands of transactions remaining unsettled every day. The exchanges had to cease trading on Wednesdays, shorten trading hours on other days, and extend settlement by a day to trade date plus five business days (T+5) to catch up on the backlog of paper. The result was a loss of investor confidence in the reliability of the securities markets.
Industry and Regulator Collaboration
To address settlement failures and restore confidence in the markets, the securities industry—in partnership with Congress, state and federal regulators—created the foundation for the clearing and settlement system that exists today. In the 1960s and early 1970s, the industry established several new central securities depositories (CSDs) and clearinghouses. NYSE established a CSD for storing stock certificates that eventually was spun-off in 1973 to become The Depository Trust Company (DTC), an industry-owned and governed utility. DTC allowed custodian banks to join as participants, thus including securities transacted by institutional investors. All printed certificates were deposited in a DTC vault, and also were “dematerialized”—meaning they were recorded in electronic form to make processing transactions faster and simpler. Instead of having someone run printed stock certificates up and down Wall Street, participants’ accounts could be debited and credited to reflect transactions (e.g., “book-entry settlement”). In 1976, the industry moved to address trade failures by combining several clearing facilities to create the National Securities Clearing Corporation (NSCC), which provided clearing, settlement, risk management, and other services, including continuous net settlement of trades and payments, to its participants.
Throughout the 1980s and 1990s, the industry experienced a wave of consolidation. By the late 1990s, the other regional CSDs in the U.S. were consolidated into DTC to become the U.S. national CSD, and the NSCC was the largest clearing agency in the United States. Eventually DTC and NSCC merged into DTCC to enable U.S. equity clearance and settlement to take place in a single industry-owned and governed entity.
DTCC has a market neutral horizontal framework that allows all marketplaces registered with the U.S. Securities and Exchange Commission (SEC) to have open access to clearing. As investors were given the ability to trade into a position on one exchange and out of it on another—with both trades clearing and settling via the same system—the entire equity market could be thought of as a national market system. This market neutral open access model enables innovation in trading and drives down the costs of trading for all market participants.
Throughout these market developments, Congress and the SEC took steps to help bring greater oversight to this evolving piece of the market. Congress passed the Securities Acts Amendments of 1975 as the basis for the creation and oversight of a national system for the clearance and settlement of securities transactions. The implementation of these amendments, along with consolidation in the industry, helped pave the way for the eventual formalization of exchange competition via the SEC’s Regulation National Market System (NMS).