Volume 16, No. 1 (Spring 2013)
ABSTRACT: Bank clearinghouse associations provided critical emergency services to their member banks during times of crisis. However, these associations, and the New York City Bank Clearinghouse Association (NYCHA) in particular, also provided critical intra-day liquidity to the security settlement process of exchanges such as the New York Stock Exchange (NYSE) through a process termed overcertification. Due to the risks involved, the NYCHA suspended overcertification during the Panic of 1873, forcing the NYSE to close for an unprecedented nine trading days. The NYCHA then began negotiations with NYSE officials concerning provision of liquidity, the NYSE’s clearing practices and who should bear the associated risks. Timberlake (1984) and Kroszner (1999) argue that bank clearinghouses evolved as private-sector solutions to serve as lenders-of-last-resort, and to constrain the risk taking of their members, particularly during crises. Our analysis shows that the NYCHA played a similar role in managing NYSE security settlement risks, and by encouraging the NYSE to adopt more efficient clearing processes.
KEYWORDS: bank clearinghouse, check certification, financial panics, New York Stock Exchange, stock trade finance
JEL CLASSIFICATION: G21, N21
Bernard McSherry and Berry K. Wilson1
INTRODUCTION
Two of the central banking roles of bank clearinghouse associations during the National Banking era are well documented (Timberlake, 1984; Calomiris and Gorton, 1991). Specifically, bank clearinghouse associations used suspension of convertibility and issuance of clearinghouse loan certificates to provide liquidity during times of crisis.2 In addition, bank clearinghouses played a central-bank-like regulatory role that included member audits, reserve requirements, deposit-rate ceilings, and disciplinary actions against violating members.
However, bank clearinghouse associations, such as the New York City Bank Clearinghouse Association (NYCHA), played an additional role of providing critical intra-day liquidity to the security settlement process of exchanges such as the New York Stock Exchange (NYSE). The NYSE required overnight settlement where trades were to be settled next day before 2:15 PM3 To finance the NYSE’s daily trade volume, New York City banks allowed brokers to draft checks far in excess of their outstanding balance through a process termed overcertification.
A bank creates a certified check by escrowing funds from a check writer’s account, and then endorsing the check to certify that the funds are in escrow. Certification substitutes the bank’s creditworthiness for that of the check writer. With overcertification, the endorsement by the bank was often for an amount far in excess of the broker’s deposit. A broker used the certified check to settle NYSE trades, and then cover the overdrafted check through a loan collateralized by the acquired securities. Repeating this process throughout the trading day created the large amount of financing needed to settle trades. An 1882 Comptroller of the Currency study found that certification averaged 105.48% of bank capital for New York City (NYC) national banks and 312.14% of bank capital for nine NYC “broker banks” on a daily basis.
As with suspension of convertibility, the overcertification privilege could be suspended. Indeed, in 1873 the NYCHA suspended overcertification, forcing the NYSE to close for an unprecedented nine trading days. The NYCHA was concerned with the heightened counterparty risk from broker defaults during the 1873 panic. The NYCHA then began negotiations with NYSE officials concerning the NYSE’s clearing practices and their impact on the risk exposure from check certification by the clearing banks. The NYCHA’s influence limited these risks, since few bank losses or failures were linked to overcertification, but also influenced the NYSE to eventually create its first securities clearinghouse.
This paper explores correspondence between the NYCHA and the NYSE, drawn in part from the NYSE archives. The correspondence started shortly after the NYCHA suspended overcertification in 1873, and then traces a period of negotiations leading to the founding of the NYSE’s first securities clearinghouse. Timberlake (1984) and Kroszner (1999) argue that bank clearinghouses evolved as private-sector solutions to constrain the risk taking and risk exposures of their members, particularly during times of crisis. Our analysis shows that the NYCHA played a similar role in managing NYSE security settlement risks, and by encouraging the NYSE to adopt more efficient clearing processes.
THE COMPTROLLER AND THE MAGNITUDE OF THE OVERCERTIFICATION PRACTICE
Legislation was passed in March 1869 prohibiting national banks from overcertifying checks.4 , 5 , 6 By 1879, the Comptroller of the Currency John Knox threatened prosecution of banks pursuing the practice. However, the practice continued. The risk involved was the default of brokers, which occurred particularly during market panics. As NYSE trading increased over time, the certified check volume became a larger fraction of the NYCHA volume.
The 1882 Annual Report of the Comptroller of the Currency presents data from selective daily audits performed by the Comptroller, as reproduced in Table I. As the table shows, the ratio of daily certified checks to bank capital level increased sharply from a ratio of 60.18% (141.47%) on 6/30/1875 to 265.86% (901.55%) on Oct. 3, 1882 for NYC (nine “brokers banks”) national banks. This large daily turnover of liquidity was critical to support NYSE settlement, but created a large credit exposure for the clearing banks. Because the checks were certified, the NYSE security settlement risk was concentrated among clearinghouse banks, rather than among brokers.
Table 1. Certified Check Activity at NYC National Banks 1875–1882
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Despite the Comptroller’s concern for the risk exposure of national banks, few bank losses and failures were linked to the practice of overcertification. As well, despite the illegality of the activity, the Comptroller appeared to defer to the NYCHA to manage these risks, because of its critical role for the NYSE’s overnight settlement process.
The Wall Street view on anti-overcertification provisions was succinctly expressed by Frederick L. Talcott in the New York Times:7
The law is only another instance of the muddle into which politicians fall when the attempt to legislate in regard to the methods of financial transactions. The men who passed the banking law, or the great majority of them at least, know no more about the financial operations of this City than that apple woman in the corner…. In the 50 years that I have been in business I have known only one instance where a bank has suffered by certifying overdrawn checks, and a system which has been abused only once in 50 years is a pretty good system to stand by as things go in this world. Do you suppose that the shrewd men at the heads of our banks in this City do not know their customers? ...We don’t want a clearing-house. What we want is a repeal of that portion of the banking law which is stupid and which no financier would ever have inserted in the bill. We must open the eyes of Congress to the absurdity which has been committed in the framing and passage of this law, which operates as much to the disadvantage of merchants as of Wall-street. (New York Times Oct. 27, 1882)
THE ROLE OF THE NYCHA IN ESTABLISHING THE NYSE’S FIRST CLEARINGHOUSE
The NYCHA was acting in the interests of its member banks when check certification was suspended during the Panic of 1873 and the NYSE closed to trading for nine trading days from Sept. 20 to Sept. 30, 1873. Certification of brokers’ checks concentrated settlement risk among the NYCHA member banks. The NYSE was reluctant to internalize this risk itself and opposed creating a stock clearinghouse for various reasons.8 The issue was how financing for settlement would be provided, and which organization would bear the settlement risk.
The NYSE took threats of suspension of overcertification seriously. An NYSE letter dated Sept. 24, 1873 acknowledged the counterparty fear among the associated banks, and the bank run threat, and requested that the coordinated actions of the NYCHA banks be used to allow certification to continue.
The great obstacle we have to deal with in resuming the operations of the Stock Exchange is the mode of settling our transactions. As long as the banks on whom checks are drawn are distrustful of each other, so long will a condition of unreasoning panic continue, and the demand on all sides will be for “greenbacks” rather than for “certified checks,” which may turn out worthless within twenty-four hours after they have been accepted in payment. To reopen the Stock Exchange under this condition of affairs would simply, therefore, be the inauguration of a run upon the banks for legal tenders, with what results you are better qualified to judge than ourselves. The true plan, in the present emergency, in our opinion, is that those banks who are content to make clearances with each other, should, to the extent of their associated capital, guarantee the payment of checks certified by the banks allowed to enter the clearing house. It is necessary to have the moral courage to sacrifice the weak members of your present association, rather than to have all the banks of New York suffer the disgrace of a suspension of payments. (Sprague, 1910, p. 39)
The NYCHA responded citing the risks posed by overcertification and refused to resume the practice:
“…the banks… could not be expected to voluntarily guarantee the payment of checks of each and every bank without reference to the amount, especially when they could have no control over the actions of tellers, who might carelessly or corruptly certify to millions more than the customers could respond to; particularly when the associated banks, not having it within their power to foresee such action, could never have security in hand to indemnify them for such gratuitous hazard of their stockholder’s funds.…
Respectfully submitted,
JOHN E. WILLIAMS,
B.H. LOWRY,
WM. L. JENKINS
(New York Times, Sept. 28, 1873).
The NYSE reopened with limited trading on Sept. 30, 1873, and with the banks still refusing to overcertify broker checks. As monetary stringency eased, the banks resumed overcertification (Sprague, 1910, p. 40).
As the 1873 panic subsided, proposals were exchanged between the NYCHA and the NYSE. An Oct. 9, 1873 letter from the NYSE’s Committee on Clearances suggested creating a separate bank dedicated to clearing NYSE trades. The proposal acknowledges that the support of the NYCHA banks would be required.
The Committee on Clearances beg respectfully to report that to carry out a plan for clearing stocks in connection with a Bank where Brokers would be compelled by the New York Stock Exchange to keep an account, it would be absolutely necessary for the Bank to be represented in the Clearing House of the associated Banks of the City; for while the members of the Exchange could settle balances between themselves by checks on the Bank, parties carrying stocks would have to deposit large checks on the associated banks in the clearing house, on account of loans etc. and believing that a bank such as we propose would be cheerfully admitted to the Clearing House Association of the New York Banks we submit the following…. (NYSE archives).
In a Nov. 12, 1873 letter, the NYSE’s Committee on Clearances again suggested a separate clearing bank, in place of implementing a stock clearinghouse. Note that a stock clearinghouse would potentially involve the transfer of counterparty risk from the NYCHA banks to the NYSE itself.
The Committee on Clearances beg respectfully to report that in their opinion it is inexpedient to attempt the organization of a Clearing House at the present time; but are convinced that it is important to establish a Bank in accordance with the plan formerly presented by this Committee on October 9th, by which Money Clearances would be safely effected, and recommend that as soon as the capital can be obtained from the members of the Board for that purpose, the Bank be established and respectfully and earnestly urge upon your Committee to take all means within power to secure the necessary capital. The Committee urge this more particularly as the attempted arrangement by which approved certified checks on banks in the Clearing House would be received from depositors, as money without recourse has failed. The Committee respectfully asks to be discharged. (NYSE Archives)
The NYCHA banks continued to pressure for a stock clearinghouse,9 or the use of time options as an alternative to overnight settlement, as reflected in a Nov. 5, 1879 letter to NYSE President Brayton Ives from a special NYSE committee.
In accordance with your wishes that an informed conference would be held with certain bank presidents in relation to the subject of check certifications, with a view to ascertain whether anything was practicable in the methods of doing business at the Stock Exchange which would relieve the Banks as well as its own members of the necessity of using certifications of checks to the immense extent now requisite in the transaction of Stock business; the undersigned at your request met Presidents Fry of the Nat’l Bank of New York, Hays of the Union & Tappan of the Gallatin National Banks on the afternoon of the 31st of October.
Those gentlemen were quite seriously anxious in regard to the present aspect of the subject, while desiring to afford every reasonable facility for the transaction of the growing business of the Stock Exchange, the great increase in the number & amount of such checks was becoming a serious problem, especially as the National Banking Law prohibits certification beyond the balance at the credit of the dealer. They therefore had invited a conference with a view to elicit whether it was practicable for the Exchange to devise any system by which their business could be conducted without the use of the extraordinary numbers of certified checks now necessary.
A Clearing House for Stocks was freely discussed and fully considered. Your Committee represented that the Exchange had often, through Committee & otherwise, given serious thought and enquiry to that subject, but the practical difficulties in the way had prevented their coming to a satisfactory conclusion; the nearest approximation to such a system they had been able to agree upon was the adoption of a By Law authorizing dealings in Government Securities “For the Account.” This was done two years ago, but it had signally failed to secure the co-operation of the parties principally interested.
Your Committee are not prepared to pronounce that a satisfactory system for clearing stocks is impracticable, but they encounter such serious difficulties in considering the subject that they must reserve a conclusion upon it for the present.
They are however glad to invite the attention of the Exchange to a distinct proposition made by the President of the Continental National Bank to test the practicability of a Clearing house by trying it in respect to one or more active Stocks. We deem this proposition worthy of the serious considerations of the Stock Exchange.
There is a suggestion they will venture to make, which if adopted by members generally would result in largely diminishing the number of checks drawn & certified, under the present mode of doing business. The speculative transactions of the Stock Exchange are now largely conducted by borrowing & lending stocks from day to day, involving extraordinary numbers of certified checks. A return to the old fashion of dealing in buyers and sellers options, for short or long periods, would undoubtedly not only relieve members of many daily anxieties & troubles & perhaps have the effect, at some time, of averting serious embarrassments likely to occur to them out of the excitements often attending these daily settlements of stock loans. (NYSE Archives)
An additional proposal was to create a clearinghouse within the NYCHA, where the NYSE member brokers would jointly guarantee the checks used by brokers to clear trades, thus obviating the need for bank certification of such checks or the need for a separate stock clearinghouse.
I respectfully beg to offer the following suggestion as a substitution for the certification of checks—and the Stock Clearing House.
That the members of the Stock Exchange shall make an agreement with each other to guarantee the payment, through the New York Clearing House, of all checks issued by the several parties thereto- and authenticated under the said agreement…. This plan, a clearing house within a clearing house would not change the present routine of business, as a collective guarantee it would have the same value as Bank certification, and would be more economical than a Stock Clearing House.
(Nov. 1, 1882 letter from G. Ellis to the NYSE’s
Governing Committee, NYSE Archives)
A related proposal was to create a safety fund within the NYSE that would insure the checks of member brokers.
The same committee published a series of goals for the new clearing plan, one of which was “Secrecy, safety and a minimum of labor, with the perfection of system to insure clearing in times of panic, and to place any liability or loss where it belongs…. To prevent any block or trouble in times of panic by reason of a default, a moderate sum can be deposited with the Treasurer of the Board by each member, making a Safety Fund from which the Superintendent of the Committee can temporarily pay any differences on stock sold out under the rule, such fund to be afterward reimbursed by the adjustment of the matter with the party having the contract with the defaulting member, this will seldom, if ever, occur, for if a member was solvent and settled all differences in the morning, he is not likely to fail to receive stock in the afternoon and the Clearing Department Fund will be augmented constantly by the profits of the Clearing Department, until it reaches a very large amount. No circumstances could arise when any serious loss could come to the department….
(Dec. 2, 1884 letter from the Joint committee to
obtain and examine into plans for relief from the
present system of settlement of stock contract,
NYSE Archives)
The pressure for a stock clearinghouse continued, and the NYSE finally agreed to found its first stock clearinghouse, which began operations May 17, 1892. Francis L. Eames, founder of the NYSE Clearing House, reflected back on the pressure from the NYCHA banks:10
Early in 1892, it became known that many of the banks were alarmed at the immense certifications necessary for stock brokers. It also became known that a resolution was to be introduced in the Clearing-House of the banks, to restrict the volume of certifications for brokers, and it was thought that the resolution would be carried. (NYSE archives)
Somewhat ironically, the stock clearinghouse established by the NYSE in 1892 was not a central counterparty. That is, it did not guarantee the settlement of trades of member brokers. Rather, the stock clearinghouse netted trades between brokers, which in the process greatly decreased the amount of certification required and thus eased pressure on NYCHA banks.
This outcome is reflected in Table 2, which shows the annual clearing results for the NYSE’s stock clearing corporation. For each year: 1892–1897, the stock clearinghouse was able to net over 90% of the NYSE’s trade volume, leaving a greatly reduced volume for clearing through the traditional (pre-clearinghouse) mechanism. Thus the banking sector continued to bear the risk of overcertification but at a greatly reduced level of certification.
Table 2. Stock Exchange Clearinghouse Transactions: 1892–1897
EPILOGUE CONCERNING THE STOCK CLEARING CORPORATION
Overcertification continued to grow as NYSE trade volume grew with economic growth, despite the netting of trades by the NYSE clearinghouse. On Nov. 3, 1913 the U.S. Supreme Court ruled that National City Bank and other banks were not entitled to redress losses incurred through overcertification of checks, related to the 1911 failure of brokerage firms: Lathrop, Haskins & Co. and J.M. Fiske & Co. As a result, the New York banks finally moved to end overcertification. The NYSE was able to forestall this action until an alternative plan could be formulated. After some deliberation, the Stock Clearing Corporation (SCC) was incorporated by the NYSE on Jan. 9, 1920 as a wholly owned subsidiary of the NYSE. The SCC began clearing all stocks on Sept. 15, 1922, and Rogers (1926, p.25) estimated that SCC operations reduced needed settlement funds from $139.911 billion to $21.429 billion over the period October 1922 to December 1926.
Losses due to overcertification continued to be very limited. S.F. Streit, Chairman of the Stock Clearing Corporation, in an April 10, 1918 letter to the Governing Committee estimated “the loss on the part of New York banks from certification in the past thirty-five years has been considerably less than $1,000,000.”
CONCLUSIONS
The NYCHA banks provided critical intraday liquidity to the NYSE’s overnight settlement of security trades through the overcertification of broker’s checks. Check certification transferred the settlement risk from the brokers to the banks. The NYCHA managed these risks among its members and thus suspended overcertification during the 1873 panic, which forced the NYSE to close its operations for an unprecedented nine trading days. The 1873 panic was the last time that the NYCHA suspended overcertification, but thereafter undertook a dialog with the NYSE concerning settlement and risk management practices. A review of documents in the NYSE archives and other sources shows that pressure from the NYCHA banks was instrumental in affecting changes in NYSE clearing practices, and with influencing the establishment of the NYSE’s first stock clearinghouse.
REFERENCES
Calomiris, Charles W. and Gary Gorton. 1991. “The Origins of Banking Panics: Models, Facts, and Bank Regulation.” In R. G. Hubbard, ed., Financial Markets and Financial Crises. University of Chicago Press, Chicago, pp. 109–173.
Chamberlin, Emerson. 1905. “The Loan Market.” In E. C. Stedman, ed., The New York Stock Exchange. New York: Stock Exchange Historical Company.
Emery, Henry C. 1896. “Speculation on the Stock and Produce Exchanges of the United States.” Studies in History, Economics and Public Law 7, no. 2: 282–512.
Facciolo, Francis J. 2005. “A Broker’s Duty of Best Execution in the Nineteenth and Early Twentieth Centuries.” Pace Law Review 26, no. 1: 155–185.
Gibson, George R. 1889. The Stock Exchanges of London, Paris, and New York: A Comparison. New York: G.P. Putnam’s Sons.
Kroszner, Randall S. 1999. “Can the Financial Markets Privately Regulate Risk?: The Development of Derivatives Clearinghouses and Recent Over-the-Counter Innovations.” Journal of Money, Credit and Banking 31, no. 3, Part 2: 596–618.
Myers, Margaret G. 1931. The New York Money Market. New York: Columbia University Press.
Nelson, Samuel A. 1907. The Consolidated Stock Exchange of New York, Its History, Organization, Machinery and Methods. New York: A.B. Benesch Company.
Noyes, Alexander D. 1893. “Stock Exchange Clearing Houses.” Political Science Quarterly 8, no. 2: 252–267.
Pratt, Sereno S. 1903. The Work of Wall Street. New York: D. Appleton and Company.
Rogers, James H. 1926. “The Effect of Stock Speculation on the New York Money Market.” Quarterly Journal of Economics 40, no. 3: 435–462.
Sprague, Oliver M.W. 1910. A History of Crises Under the National Banking System. National Monetary Commission. Washington, D.C.: U.S. Government Printing Office.
Timberlake, Richard H. 1984. “The Central Banking Role of Clearinghouse Associations.” Journal of Money, Credit and Banking 16, no. 1: 1–15.
- 1Bernard McSherry (bernardmcsherry@aol.com) is an assistant professor at New Jersey City University, and Berry K. Wilson (berrykwilson@gmail.com) is an associate professor at the Lubin School of Business, Pace University. The authors would like to thank Dr. Joseph Salerno for encouraging this topic, and an anonymous referee for helpful comments.
- 2During 1863–1914 there were four major instances of suspension of convertibility (1873, 1893, 1907, and 1914), and six instances of the use of clearinghouse loan certificates (1873, 1884, 1890, 1893, 1907, and 1914).
- 3Overnight settlement was in force since the earliest days of the NYSE, but prior to 1857 most trades were settled by buyer’s and seller’s options (time contracts), which allowed negotiated delayed settlement. Time contracts allowed traders to trade in and out of positions before settlement was required. However, broker failures and time-contract defaults during the Panic of 1857 curtailed their use, and overnight settlement became preferred to limit settlement risk.
- 4Congressional investigation into the Gold Panic of 1869 found that overcertification provided leverage to speculators seeking to inflate asset prices. “With the great revenues of the Erie Railway Company at their command, and having converted the Tenth National Bank into a manufactory of certified checks to be used as cash at their pleasure, they (Jim Fisk and A.R. Corbin) terrified all opponents by the gigantic power of their combination, and amazed and dazzled the dissolute gamblers of Wall Street” (41st Congress, 2nd Session, House of Representatives Committee on Banking and Currency, 1870, p. 7).
- 5Overcertification could be legally pursued by state banks and trust companies, and, although illegal, continued among national banks. This was similar to the legal limbo of the suspension of convertibility and the issuance of clearinghouse certificates.
- 6By 1868 it was estimated that three-fourths of the checks going through the New York Clearing House were certified checks issued in advance of deposits (Myers, 1931, p. 282).
- 7Frederick L. Talcott was a 50-year veteran of Wall Street who wrote with some frequency for the New York Times. Apparently, he was also known as the “cotton king.”
- 8One was that NYSE members were reluctant to divulge confidential trading-position information to clearinghouse clerical staff. As well, there were concerns that contracts settled through netting might not satisfy a legal requirement that such transactions include an “intent to deliver” (Gibson, 1889, p. 118; Noyes, 1893, p. 266; Pratt, 1903, p. 131; Chamberlin, 1905, p. 425).
- 9 Indeed, the Philadelphia Exchange had implemented a stock clearinghouse earlier. In a letter written Oct. 28, 1879 W.H. Tevis, a Philadelphia Stock Exchange member, expressed his distaste for the Philadelphia Clearing House, but admitted that during times of stress it reduced the use of checks. “You may depend upon it that a ‘scrimmage’ in the market would lead to endless trouble that might provoke a panic… You may tell Mr Ives that a number of us try to get along without using the C.H. whenever we can but when it comes to the traders in millions of shares at hundreds of dollars differences they all rush to the C.H. as a happy delirium from plunking down bank due bills (which are our certified checks).”
- 10An additional pressure came from the Baring Panic of 1890 and from the NYSE’s competitor, the Consolidated Stock Exchange, whose clearinghouse had reduced financing needs and also lowered counterparty risk and broker defaults (Gibson, 1889, p. 115; Nelson, 1907, p. 49; Facciolo, 2005, p. 173). Emery (1896, p. 86) comments on this confluence of events: It was the borrowing panic of 1890 and 1891 that brought forcibly home to the Stock Exchange the impossibility of further continuing the cumbersome method of cash payments. This method necessitated a vast amount of borrowing and a cash settlement of all loans. When the stringency came at that time, many failures resulted from the impossibility of procuring the necessary loans. On the other hand, on the Consolidated Stock Exchange of New York, a young and less important exchange, the failures were comparatively few. This difference was ascribed by Bradstreet’s solely to the fact that one institution attempted to carry on its business by old fashioned methods, while the other was equipped with a modern clearing system. The explanation is easily accepted with the comparative ease with which the Stock Exchange has weathered similar troubles since the clearing house was adopted. It is not hard to imagine that the NYSE Governing Committee, concerned that its rival exchange might attract business due to its lower counterparty risk, decided to mimic much of the Consolidated Exchange’s successful system. The Consolidated Exchange’s clearing system had been introduced in June 1886, and the NYSE adopted a very similar system in May 1892 (Noyes, 1893, p. 259; Myers, 1931, p. 303).
