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Market Contingency Preparedness

Audit Report No. 200
February 9, 1995

EXECUTIVE SUMMARY

Between September 1993 and September 1994, we evaluated Commission preparations for responding to unusual market events and operational difficulties. Our evaluation emphasized two Commission guides: the Market Volatility and Contingency Guide (MVCG) and the Quick Understanding of Industry Contingency Controls (QUICC) Guide.

We found that over the last several years, the Commission significantly enhanced its capabilities for responding to market events, and further enhancements were planned. In addition, we found that the MVCG and the QUICC Guide were generally accurate and useful.

Overall, the Commission appeared to have made adequate preparations for responding to unusual market events, to the extent such events can be reasonably foreseen. It has shown a willingness to continually improve its preparations, based on its experience to date. We commend the Commission for its efforts.

We are recommending that the Commission implement its planned enhancements, make certain changes to its contingency guides, and schedule periodic training on market events for senior officials. Generally, the Division of Market Regulation concurred with our report; its comments are attached. We have revised the report to reflect the Division's comments.

SCOPE AND OBJECTIVES

Our overall objective was to evaluate the adequacy of Commission preparations for responding to unusual market events and operational difficulties. In particular, we evaluated the accuracy and usefulness of the Market Volatility and Contingency Guide and the Quick Understanding of Industry Contingency Controls Guide.

During the audit, we interviewed Commission and Self-Regulatory Organization staff, reviewed available documentation, and observed operations and communications in the Market Watch room. We also conducted a survey of Commission staff.

The audit was conducted between September 1993 and September 1994, in accordance with generally accepted government auditing standards.

BACKGROUND

Following the market breaks of 1987 and 1989, the Commission took steps to enhance its capability to respond to such events. / For example, the Division of Market Regulation established a Market Watch room to serve as the focal point for information gathering. It installed dedicated phone lines to the exchanges there, as well as numerous securities data bases (e.g., Reuters, Dow Jones).

The Division also prepared two guides for Commission staff: the Market Volatility and Contingency Guide (MVCG) and the Quick Understanding of Industry Contingency Controls (QUICC) Guide. It has periodically updated and enhanced the guides based on its experience using them.

The MVCG describes the responsibilities of Commission staff during periods of market volatility (i.e., extreme price swings, particularly declines). The staff are expected to gather information from the markets, communicate this information to the Chairman and the other Commissioners, and disseminate information and regulatory decisions from the Commission to the markets, governmental entities, and the public.

The QUICC Guide describes responses to major system (i.e., ADP) operational contingencies that significantly degrade or interrupt the functioning of a market, a broker-dealer, or a clearing agency. It is intended to provide guidance, not definitive answers, in the event of an operational contingency.

The two guides do not provide detailed plans outlining responses to specific contingencies, because of the complexity and inherent unpredictability of market contingencies.

AUDIT RESULTS

We found that over the last several years, the Commission significantly enhanced its capabilities for responding to unusual market events, and further enhancements were planned. Communication and working relationships between the Commission and the exchanges were good, and the MVCG and the QUICC Guide were accurate and useful. The Commission response to several instances of market volatility we observed was diligent and appropriate.

Our observations of the Market Watch room indicated that its staff continually monitored the markets, and they were aware of their responsibilities. During periods of market volatility, we noted increased presence of key officials in the room. As discussed below, improvements to the Market Watch room are planned.

Our survey of Commission employees indicated that they felt that the Commission has enhanced its preparedness for responding to market conditions. Generally, they believed that the MVCG and QUICC Guide were adequate.

Overall, the Commission appeared adequately prepared to deal with market volatility and operational contingencies, to the extent that such events can be reasonably foreseen. Of course, future events are inherently unpredictable, especially in such a highly complex and dynamic system as the capital markets. Future market contingencies and risks may differ from prior events; e.g., much recent attention has focused on possible risks to the markets from the extensive use of derivatives.

The Commission's flexible and evolving approach to responding to contingencies seems reasonable. It emphasizes the judgement of well-trained staff; good working relationships and communication links with the markets and other government agencies; general guidance for its staff (the two guides); and access to information resources (the Market Watch room), among other elements.

We commend the Commission for its efforts. We are making several recommendations for further enhancements, as described below.

Changes to Guides

The Guides do not provide sufficient information on why certain steps are appropriate. This information would help train staff, and make the Guides more complete. Also, the Guides do not clearly state that the Office of Public Affairs has the primary role in responding to the press.

The QUICC Guide, which was developed more recently than the MVCG, does not contain certain beneficial information, including an overview; a detailed description of responses needed to various operational contingencies, as well as who is responsible for those responses; and a description of the likely impact on the markets from the contingencies.

The most recent version of the Guides, issued in November 1994, incorporated two of our suggestions during the audit:

o expanding information on international matters, including a list of international regulators (this issue was highlighted by a recent incident involving the assassination of a Mexican presidential candidate /), and

o numbering the Guides to enhance accountability over these non-public documents.

Recommendation A

The Division of Market Regulation, in consultation with other affected offices and divisions, should revise the MVCG and the QUICC Guide as explained above.

Planned Enhancements

Senior officials in the Division of Market Regulation, by memorandum of July 11, 1994, requested numerous enhancements to the Market Watch room. They wish to expand the room, staff it better, and acquire additional equipment (e.g., telephones, computers, faxes) and data resources (i.e., improved access to financial news). We concur with the request, which will need to be reviewed by the Office of the Executive Director.

Recommendation B

As budget resources permit, the Division of Market Regulation should implement its planned enhancements to the Market Watch room.

Training of senior officials

Several Commission staff indicated that periodic training on market contingencies would be helpful for senior officials. Currently, the Commission does not have a systematic training program for these officials. Scheduled training would help ensure that they are able to act quickly and effectively in response to market events when necessary.

The training could cover an overview of the MVCG and QUICC Guide, as well as discussion of possible market contingencies. Training would be especially appropriate for officials new to the Commission.

Recommendation C

The Division of Market Regulation, in consultation with affected divisions and offices, should develop and implement a training program for senior Commission officials.