The US paper crunch, 1967-1970

1 September 2008

(Extract from pages 83-95 of BIS Quarterly Review, December 2007)

The current information management issues related to OTC derivatives transactions bear some resemblance to the US paper crunch in the late 1960s, when the back offices of US securities brokers were not able to handle the sharp increase in trading volumes. The number of "fails", ie failures to deliver securities on the settlement date, soared in consequence, and so did losses from errors at brokerages. Some firms tried to resolve the problems by abruptly switching to computerised systems, with generally disappointing results. Ironically, instead of providing relief, the fall in volumes that accompanied the decline in stock prices in 1969 and 1970 added to the burden on already weakened firms. Declining revenues at a time when costs continued to rise resulted in the failures of many brokerage houses. According to Seligman (2003), approximately 160 members of the New York Stock Exchange failed during that period, and roughly the same number were either taken over or disbanded.

The Securities and Exchange Commission (SEC) initially reacted to the back office problems by shortening the trading day in August 1967 and in early 1968, but with little effect. In the 1970s, the SEC imposed a compulsory surcharge on the commissions paid on small trades in order to prop up the income of brokerages, but even so expenses of the leading securities firms substantially exceeded income and sizeable backlogs remained. In the end, the back office problems seem to have been "resolved" by private investors shunning the stock market for a variety of reasons, including bad experiences with back office procedures. A 1973 report by the New York Stock Exchange found that three out of 10 investors had experienced lost or late-delivered securities.

Notwithstanding the similarities between the paper crunch and the current situation in the OTC derivatives markets, there are also notable differences from today's backlogs. First, the back office problems of the late 1960s concerned broker-dealers which were organised as partnerships and were by an order of magnitude smaller and less sophisticated than the large banks that dominate the OTC derivatives markets today.2 As a consequence, the broker-dealers of the 1960s had much less financial muscle to fund an overhaul of their back office procedures. Second, operational risk was arguably much less well understood in the 1960s than today, which resulted in less willingness to address such risks. That said, the paper crunch of the 1960s serves as a reminder that weak back office procedures could have serious implications not only for market efficiency but also for the financial health of firms active in the market.

1The discussion is based on SEC (1971) and Seligman (2003).
2The discrepancies were also very large relative to their capital base. For example, SEC (1971) reports that the number of untraceable securities owed to customers exceeded capital by a factor of two at several firms!