Thomas Ruggiero, TCS Financial Solutions

Lottery processing in US for partial calls brings out a set of challenges in allocating affected positions under an Omnibus account structure for a DTCC participant. The Short Positions and Loaned Positions are not considered in the Lottery process run by the participants, which results in short holders having to cover an increasingly illiquid security and long holders potentially missing out on “in the money” redemption payments. This leads to the question if the current partial call allocation methodology is still the most efficient in a world of ever more complex trading strategies and derivative products.

Current Lottery Process and Related Issues:

The current allocation methodology employed by DTCC is a computerized impartial lottery that allocates using a
call increment, random starting point, and a security number assigned to each lot the participant holds based on the denomination of the product. Once the called bonds are identified, they are segregated at DTCC in the participant’s account and intimated to the participant on the called quantity.

The DTCC participant, who could be a broker/custodian, will also run a lottery internally based on the ‘Called Quantity of Security’ to identify the affected positions.

The allocation of the called quantity is done across all of their long client and firm accounts, with client accounts being given priority over firm accounts. Because the lottery only affects long positions, this means that short positions are not called. Long positions that are loaned as part of a repo or stock loan contract are not called, unless the recipient was holding the security at DTCC in lieu of covering shorts. (Buying back borrowed securities in order to close an open short position. Short covering refers to the purchase of the exact same security that was initially sold short, since the short-sale process involved borrowing the security and selling it in the market).

Further, NYSE rule 217 and FINRA rule 11530 make called securities ineligible for delivery, which presents a problem for the seller if part of the security is called prior to settlement. It requires either a difficult negotiation with the buyer or purchasing additional securities to cover those called to make whole on the delivery.

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