APJRBM Volume 2, Issue 1 (JANUARY 2011) ISSN 2229-4104

REDESIGNING THE CLEARANCE AND SETTLEMENT PROCESS IN THE INDIAN CAPITAL MARKETS

Preeti Goyal Visiting Faculty, Management Development Institute Gurgaon, India

Raj S. Dhankar Professor of Finance, Faculty of Management Studies, University of Delhi, South Campus, New Delhi-110021, India

Visiting Professor, Faculty of Business Administration, Lakehead University, Thunder Bay, Ontario, Canada E-mail: [email protected]

Abstract

Clearance and settlement process is at the core of the securities market infrastructure. This paper presents the importance of this process, describes the pre-redesign state of the Indian capital markets which was riddled with ineffective processes and regulations that led to a loss of investor confidence in the capital markets. In India the clearance and settlement process has been redesigned substantially due to various reasons including the integration of Indian capital markets with the global markets, growing trading volumes, various scams, and the need to boost investor confidence in the capital markets.

Introduction

The importance of financial services industry for emerging economies lies not only in channelling scarce capital for necessary economic growth and development, but also as an effective conduit for implementing monetary and debt management policies of the government. The clearance and settlement process is an important part of the infrastructure that is essential for the well functioning capital markets. With surging trading volumes and increasing globalization, this process has undergone various redesigns to make the process becomes efficient, effective, and transparent, that reduces risk for investors in a proactive manner. In the past few years, financial systems in emerging economies have become increasingly integrated with the global financial system. In India particularly, the motivation for the

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redesigns has been the need to increase investor protection and also to bring the infrastructure at par with the developed markets around the globe. The objective of this paper is to understand the reasons that made the redesign to the clearance and settlement process imperative. It presents the importance of this process, describes the pre-redesign state of the Indian capital markets which was riddled with ineffective processes and regulations, which led to a complete loss of investor confidence in the capital markets. With the liberalization of the Indian economy, the Indian capital markets became increasingly integrated with the global economies. Thus, a need to handle rapidly increasing trading volumes, globalization, and to increase investor confidence in the capital markets led to many significant changes in the clearance and settlement process in the capital markets.

Importance Of The Clearance And Settlement Process

Financial markets are an important conduit for channelling funds from the savers to the users of funds, as they are able to allocate capital to the most efficient uses. With growing trading volumes and integration of cross border processes, a well functioning clearance and settlement process becomes essential for the markets to operate efficiently. If not designed and operated appropriately, it has the potential to enable the manipulation of markets, leading to a loss in investor confidence in these markets. Three main entities depend on the securities markets. Of these, the government and corporates use the market to raise funds, and it is the households that invest their savings in the markets in the form of equity instruments, debt securities, mutual funds, etc. The household sector, thus, is an important source of funds. According to RBI data (Table 1), the household sector invests approximately 80-85% of its savings in fixed income investments, including deposits, insurance/ provident funds/ pension funds and small saving schemes. Its contribution to the securities market has been around 6-7%. Any manipulation of the financial system, impacts all investors, including households, whose savings have been invested in the financial assets. Table 1: Household Savings in Financial Assets

Financial Assets

96 97 98 99 (P) 03 (P) 04 (P) 05 (P) 06 (P) 07 # 08

------

1995 1996 1997 1998 2002 2003 2004 2005 2006 2007 Currency 13.4 8.6 7.0 10.1 8.9 11.2 8.5 8.8 8.6 10.9 Fixed Income 78.9 84.5 89.2 85.6 86.9 81.5 85.4 83.9 84.5 80.6 Investments Deposits 42.1 48.2 47.5 41.8 40.9 38.7 37 47.4 55.3 56.5

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Insurance/Provide nt/ 29.4 29.2 31.1 33.2 31.1 27.3 28.9 24.2 24.1 25.7 Pension/Funds

Small Savings 7.4 7.0 10.6 10.6 14.9 15.5 19.5 12.3 5.1 -1.7

Securities Market 7.9 6.9 3.8 4.3 4.2 7.4 6.1 7.3 6.9 8.5

Mutual Funds 0.5 2.7 0.6 1.0 1.3 1.2 0.4 3.6 5.20 7.7

Government Securities 0.4 0.4 1.5 1.7 2.5 7.5 4.9 2.4 0.2 -2

Other Securities 6.9 3.8 1.8 1.6 0.4 -1.2 0.7 1.2 1.50 2.8

Total 100 100 100 100 100 100 100 100 100 100

P: Provisional Figures # Preliminary Estimates Source: RBI Annual Reports, Various issues

In the interest of economies to grow, and to keep investors interested and confident in the securities markets, it is essential that the markets be transparent, proactive, efficient and effective with minimal exposure to risk. This is possible when the underlying infrastructure acts as an enabler. The capital markets‟ clearance and settlement process is an essential part of this infrastructure. Globally, many changes to the clearance and settlement process have been made in the recent years. Specifically, in India the process has changed substantially due to various reasons including the integration of Indian capital markets with the global markets, growing trading volumes, liberalization of the Indian economy and scams in the capital markets.

State Of The Indian Capital Markets – Pre-Liberalization

Prior to liberalization, the regulatory framework of the Indian financial system broadly consisted of the Ministry of Finance, Government of India; (RBI); and the Securities and Exchange Board of India (SEBI). RBI is the central bank of the country, and is the centre of the financial and monetary system. It is fully responsible for the banking system of the country. The RBI regulates the government securities market and the money market. Prior to 1988, the Governing Board of the BSE regulated the stock market. At that time the brokers of the exchange elected other brokers to the board, thus, implementing regulations which went against the interest of brokers was almost impossible. The government nominated the executive director (ED) of the stock exchanges. But, since the ED

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reported to the board, even his powers were crippled. Therefore, regulation was the biggest casualty and implementing any stringent regulation was almost impossible. Subsequently, in 1988, the Securities and Exchange Board of India (SEBI) was set up to regulate the equity markets. SEBI, an autonomous body, was established through an administrative order, but became a powerful organization only after 1992. One of its mandates was to provide reassurance to investors that it was safe to undertake transactions in the securities market. In addition, it was responsible for regulating and promoting the development of the securities market. The early years of SEBI were not easy, since the reform program brought in by SEBI was resisted by the incumbent market intermediaries.

Established in 1875, (BSE) is Asia‟s oldest exchange. Following the BSE, the was setup in 1894. In the 20th century, 20 more regional exchanges were setup all over India. BSE, started as a voluntary non-profit making association, evolved into the country‟s leading stock exchange, boasting of the largest market share. Next in line were the Delhi and the Calcutta stock exchanges. BSE faced little competition, and came to be associated with various negative characteristics, such as vested interests, non-transparent dealings, callous attitude towards investors, and a rigid mind-set to change. This, usually, translated into higher costs for investors.

Prior to the setup of NSE, trading at the stock exchanges was done using an open outcry system. Prices quoted in the newspapers provided only the range of the price at which securities traded for the day. Due to the lack of automation and transparency, the actual cost of the trade could easily be hidden from the investors.

The market followed the account period settlement. Under this system, the trading cycle was a fortnight long and the clearing and settlement of trades took place a fortnight after the trade cycle ended. The long trading and settlement cycle made the settlement risky because of the possibility of any one of the parties to the transaction defaulting on the trade for reasons such as change in prices, availability of resources, etc. Subsequent to the settlement, it would invariably take a few months for the stock to be transferred in the name of the buyer with the registrar. Many problems faced in settlements were due to the physical delivery of share certificates, including forged/ damaged share certificates, fake signature, etc. This would often lead to bad deliveries.

Settlement was not guaranteed even at the end of the settlement cycle due to the existence of a settlement deferral product called badla. The badla system facilitated a badla trader to hold overleveraged positions, which potentially could create a payment crisis in the markets. Margin norms associated with badla were not adhered to, as practically no risk containment measures were put into place. In the absence of any effective regulation in place to monitor badla, it was very easy to misuse it, and to manipulate the whole system.

The government made various attempts to rid the market of the ill effects of badla, but without success. Badla was initially banned in 1969, which merely motivated badla users to let it exist as a surreptitious system. The government officially revived badla, wherein an open position could be carried forward for a maximum period of three months. Due to the lack of effective monitoring, the prescribed time frames were not adhered to, and the market remained exposed to the adverse effects of the badla system. Although, as a product, badla

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combined the facilities of stock lending, money lending, hedging and margin trading, but it was the insufficient regulation and ineffective implementation that allowed the misuse of badla.

Until the setting up of NSE, the Indian capital markets were characterised by opaque systems, manual processes, price manipulation by brokers, bad deliveries, duplicate stock certificates, and settlement deferral.

Securities Market Scams

Harshad Mehta, known as the original „Big Bull‟ of India, operated in both the Indian money market and the capital market in the late 1980s and early 1990s. Using fake bank receipts, he was successful in siphoning crores of rupees from the banking system, which, he then, invested in the equity markets. Using the badla system, he built large over-leveraged positions in the equity markets and was able to manipulate the prices in the stock markets. Due to the lack of effective risk management tools, he was not caught. The result was a phenomenal increase in stock market prices. The Sensex rose from 1000 in February 1991 to 4500 in March 1992.

It has been estimated that Rs 40 billion had been swiped from the banking system. The scam impacted several major financial institutions and individuals. Within a couple of months from the discovery of the scam, the equity prices crashed by 40%, with the Sensex dipping to 2500, wiping out investors‟ net worth by Rs. 1,000 billion. As per a study in Asia Money1: “By the time news of a stock market scam involving Mehta hit the headlines, and the subsequent collapse of the market in 1992, thousands of ordinary investors had lost their life savings.”

Another scamester is Ketan Parekh, who played hawked with the Indian stock markets in the late 1990s and early 2000s. He was able to procure loans from banks, which were way more than his creditworthiness. The money was then invested in the equity markets, what are now popularly known as the K-10 scrips. He improved upon Mehta‟s strategy of price manipulation and initially rode on the global mania in information technology stocks. The prices of the K-10 scrips were manipulated using circular trading and the badla system. The discovery of the Ketan Parekh scam resulted in the collapse of financial institutions involved in the scam.

Both Harshad Mehta and Ketan Parekh were able to take advantage of the lack of an effective clearance and settlement process, coupled with ineffective risk management systems, to manipulate the capital markets. Ultimately, the losers were the investors, with the scam costing them crores of rupees.

1 Asia Money (February 1 2001) Harshad Mehta: a legacy of fraud, http://www.asiamoney.com/Article/2057192/Channel/18853/Harshad-Mehta-a-legacy-of- fraud.html (accessed 23 October 2008)

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Liberalization Of The Indian Economy

As compared to the economies around the globe, since 1990, the Indian capital markets have witnessed phenomenal increase in market capitalization (Table 2), turnover (Table 3), and the number of listed domestic companies (Table 4).

Table 2: Market Capitalisation As % Of GDP

1990 2000 2002 2003 2004 2005 2006 High Income Countries 51. 120. 83.4 100. 108. 112. 126. 6 6 1 9 9 1 Middle Income 19. 41.2 35.3 44.5 43.7 49.5 74.2 4 Low & Middle Income 18. 38.7 33.3 43.5 43.8 50.1 73.3 8 East Asia & Pacific 16. 48.3 40.4 53.5 41.0 41.3 85.1 4 Europe & Central Asia 2.2 20.5 22.7 29.7 32.8 45.8 66.7 Latin America & 7.7 34.0 27.4 33.2 39.6 44.6 51.7 Caribbean Middle East & N. Africa 27. 34.8 26.1 47.3 37.1 49.1 48.9 4 South Asia 10. 27.0 22.7 39.8 48.7 60.4 77.2 8 Sub-Saharan Africa 52. 102. 47.3 105. 129. 137. 159. 3 3 9 6 0 9 Low Income 9.8 23.6 22.6 37.3 44.5 54.2 67 India 12. 32.4 25.7 46.5 56.1 68.6 89.8 2 World 48. 105. 74.6 89.7 96.3 99.6 113. 0 1 9 Source: World Development Indicators 2007, 2008 World Bank.

This has contributed to an increased burden on the clearance and settlement process, due to which substantial changes had to be made to the process. At the same time, the two major capital market scandals led to a loss of investor confidence in the financial markets. To bring back the investor confidence, and to improve the quality of the process, various risk management tools were incorporated in the functioning of the capital markets. Financial systems in emerging economies are now increasingly integrated with the international financial system. In order for India to compete globally, and to make the Indian capital markets attractive globally, it became a necessity to possess infrastructure which is at par with developed markets. This process was led by the forging of links with the major

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financial centres. Indian companies have been permitted to raise resources from overseas markets, and foreign firms are allowed to tap the Indian capital markets. Table 3: Turnover Ratio (%)

1990 2001 2003 2004 2005 2006 2007 High Income Countries 59.4 129.9 137.9 110.1 114.0 122.2 150.2 Middle Income 78.3 84.9 44.1 60.9 41.6 75.3 94.5 Low & Middle Income 70.7 90.1 57.8 72.4 53.7 78.2 94.3 East Asia & Pacific 118.1 149.9 72.7 103.5 50.0 123.1 163.5 Europe & Central Asia -- 83.1 53.6 37.9 59.0 68.5 64.1 Latin America & Caribbean 29.8 26.9 21.7 22.0 26.1 29.2 34.8 Middle East & N. Africa -- 22.3 19.6 64.4 16.5 27.0 28.3 South Asia 54.0 161.6 180.3 131.2 120.6 108.7 101.3 Sub-Saharan Africa -- 22.5 23.7 39.3 27.6 32.6 30.1 Low Income 53.8 121.3 139.6 130.5 107.6 96.6 93.3 India 65.9 191.4 14.1 115.5 93.6 96.4 95.9 World 57.2 122.3 123.0 72.4 53.7 78.2 94.3 Source: World Development Indicators 2007, 2008, World Bank.

Table 4: Number of Listed Domestic Companies

1990 2001 2003 2004 2005 2006 2007

High Income Countries 17,747 25,548 23,097 27,594 28,001 28,733 30,016 Middle Income 4,231 15,364 13,307 14,456 14,117 11,141 13,195 Low & Middle Income 7,677 23,097 20,629 22,444 20,873 17,263 20,106 East Asia & Pacific 774 3,486 3,132 3,582 3,794 3,525 4,080 Europe & Central Asia 110 8,220 6,781 7,776 7,023 4,490 6,070 Latin America & 1,734 1,567 1,381 1,468 1,525 1,342 1,509 Caribbean Middle East & N. Africa 817 1,596 1,585 1,803 1,627 1,078 1,443 South Asia 3,231 7,159 6,839 6,909 6,000 5,954 6,089 Sub-Saharan Africa 1,011 1,069 911 906 904 874 915 Low Income 3,446 7,733 7,322 7,988 6,756 6,122 6,911 India 2,435 5,795 5,644 4,730 4,763 4,796 4,887 World 25,424 48,645 47,576 50,038 48,874 49,946 50,212 Source: World Development Indicators 2007, 2008, World Bank.

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Global development banks have also been involved in the development of the Indian capital markets. Asian Development Bank (ADB) being one such bank. According to an Asian Development Bank (2004)2 report, “three factors were essential for this market to develop (a) competition, which forced good market standards of fairness; (b) transparency and efficiency, through an improved clearing, settlement, and depository system, which allowed dematerialized trading and better market regulation; and (c) sufficient supply and demand to foster market depth and liquidity. The derivative market has played a key role in this aspect of market development”. In November 1995 a loan of $250 million was approved for the Government of India (GOI) by ADB for the Indian Capital Market Development Program. It was disbursed in two tranches of $125 million each, and was linked to the successful completion of pre-defined activities. The ADB report also reveals that reforms from this program included “(i) implementing an integrated national market system; (ii) introducing an automated trading, settlement, clearing, and depository system; (iii) introducing competition in capital market sectors; (iv) enhancing private sector participation and reducing government crowding out of private investments; (v) liberalizing mutual funds and stock brokerage industries; (vi) improving the efficiency of primary and secondary markets, and establishing mechanisms to enhance market liquidity; and (vii) enhancing the regulatory and supervisory powers of SEBI as the capital market's sole regulator”. The transfer of regulatory and supervisory powers fully to SEBI through legislation, was a core condition for the release of the second tranche of the ADB loan. As part of the changes, NSE was created for competition, depositories were created for paperless trading, clearing corporation was created for reducing risk, and the Indian stock markets, which previously followed a account period settlement cycle, gradually switched to a rolling settlement cycle (T+5) which was reduced to T+3, and further to T+2, to bring the process in line with international practices. Thus, increasing of trading volumes, manipulation of the capital markets, and the increasing integration of Indian capital markets with global markets has put pressure on the capital markets infrastructure to become more effective and efficient. As a part of the reforms, the clearance and settlement process has been redesigned to bring it at par with developed economies. Globalization

The economies around the world are more integrated than ever before. Major economies are no longer isolated from the happenings in other economies. Amidst all this, globally financial systems are undergoing many changes. These include the changes in the underlying processes. The national level financial systems are no longer immune to the events around the globe. Financial markets in particular are becoming more integrated than ever before. During the period, July 1990 to July 2007, the Nifty shows significant correlation with many of the world‟s leading indices (Table 5). Integration of global markets makes it imperative that market infrastructures at a national level be at par with the global markets. In the case of European Union (EU), the post trade services for securities transactions have been identified as the most important barrier in

2 Asian Development Bank (ADB), 2004, The Performance Audit Report on the Capital Market Development Program (Loan 1408-IND) in India, Asian Development Bank

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making the EU ambition of a single capital market a reality (Cruickshank, 2001). Henry (2006) advocates expediting the process of formulating regulatory measures to facilitate access to clearing and settlement which are flexible enough to deal with a versatile and fast moving sector. Despite some recent consolidation, the still fragmented nature of the systems and the associated high costs of cross-border settlement hamper international securities trading, and make accessing the market by foreign institutions and investors difficult. According to Freixas, et. al., (2004), further consolidation will be necessary in due course, and it remains to be seen whether it will have to be imposed or it can emerge through market processes. Table 5: Correlation of Global Markets (July 1990 to July 2007)

Nifty Singapore Taiwan Nasdaq Hang Nikkei FTSE S&P CAC Dow 50 TAI Seng 225 100 500 40 Jones Nifty 1.00 Singapore 0.19 1.00 Taiwan 0.12 0.27 1.00 TAI Nasdaq 0.05 0.16 0.09 1.00 Hang 0.18 0.62 0.24 0.14 1.00 Seng Nikkei 0.14 0.38 0.24 0.13 0.38 1.00 225 FTSE 100 0.11 0.29 0.12 0.36 0.31 0.25 1.00 S&P 500 0.03 0.14 0.07 0.84 0.12 0.12 0.42 1.00 CAC 40 0.12 0.29 0.14 0.38 0.30 0.25 0.77 0.43 1.00 Dow 0.03 0.15 0.06 0.71 0.13 0.12 0.41 0.94 0.43 1.00 Jones Source: Indian Securities Markets: A Review, 2007, page 3

The need for efficiencies in international capital markets has led to increased international co- operation among standard setters and capital markets regulators. The reduction of trade barriers, internationalization of companies, deregulation of capital markets, and growth of co- operative ventures have led to an increased awareness of the inefficiencies arising from the diversity in standards across countries. There is acknowledgment that the legal and risk management issues raised by cross border settlement need to be appropriately reflected in the approach towards regulation of the service providers. Also, the regulators need to co- ordinate their supervisory activities to ensure that any problems in cross border clearing and settlement can be understood and managed aptly (Hills and Young, 1998). Recognizing the importance of cross border issues, the G10 central banks have created a disclosure framework for securities settlement systems, which requires the systems to describe their operations, and the risks involved for participants, including the risks involved in linking the systems (Hills and Young, 1998). Thus, increasing integration of markets around the globe mandates that the financial infrastructure in these markets got to be integrated.

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Current Financial Crisis

The current global financial crisis has its roots in the subprime mortgage crisis that was triggered by increasing number of foreclosures and mortgage delinquencies in USA. In the later years of the 1990s, many housing loans were given to subprime borrowers in the US. The subsequent decline in the housing prices in 2006-07 was accompanied by a dramatic rise in the mortgage delinquencies and foreclosures. As a consequence, the securities backed with subprime mortgages, held mostly by financial firms, lost most of their value resulting in a significant decline in the capital of many banks and US government sponsored enterprises. Its impact was soon apparent on banks and financial markets around the globe. The crisis became prominent in September 2008. Beginning with the failures of large financial institutions in the United States, it quickly evolved into a global credit crisis. In lending to non-creditworthy individuals both regulators and banks inaccurately assessed the risk in the financial markets. The case of Citigroup is significant - Citigroup has always been under Federal Reserve regulation, and its near collapse exposed the in effective regulation and the US government‟s gross underestimation of the severity of the crisis even after it began. Citigroup was not alone in not being able to fully understand the risks it was taking. Besides, host of other reasons, it also happened because both the international bond rating agencies and bank regulators accepted some complex mathematical models which theoretically "showed" the risks to be much smaller than they actually proved to be in practice3. Furthermore, "The super-boom got out of hand when the new products became so complicated that the authorities could no longer calculate the risks and started relying on the risk management methods of the banks. Similarly, the rating agencies relied on the information provided by the originators of synthetic products. It was a shocking abdication of responsibility"4. The crisis has brought to the forefront the inherent weaknesses in the global financial system and lack of regulation in financial industry. So far, the crisis has resulted in not only the collapse of major banks and financial institutions, but also in a loss of millions of jobs around the world. With the loss of market capitalization, many investors have lost substantial part of their savings. Though the current crisis may not be directly attributable to the clearance and settlement process in capital markets, but it reflects the magnitude of the impact; the failure of regulation system, and the lack of risk management process, it is capable of creating. Conclusion

Clearance and settlement process is an important part of the capital markets infrastructure. If this process does not function in the desired manner, it can lead to an ineffective and inefficient system, as is evident from the scams in Indian capital markets and the current crisis in the global financial system. Additionally, if the process is such that it is possible to use it to manipulate the financial markets, then, not only, do the investors loose confidence in the markets, but also, it shows the ineffective management of the process by both- the regulators and the participants. Harshad Mehta and Ketan Parekh scams exposed the risk inherent in the Indian capital

3 Floyd Norris, 2008, News Analysis: Another Crisis, Another Guarantee, The New York Times, November 24, 2008 4 George Soros, 2008, The worst market crisis in 60 years, The Financial Times, London, January 22 2008 Sri Krishna International Research & Educational Consortium http://www.skirec.com -53-

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markets regulation and infrastructure. Infrastructure and regulation form an essential vehicle for the implementation of risk control mechanisms. The integration of the global markets and liberalization of the Indian economy has led to various changes to the underlying processes such that the investors are exposed to minimal risk. Specifically, with the setting up of NSE, many changes have occurred in the securities markets. With it came various risk control measures that would detect market manipulation and reduce risks in the market.

References

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18. Shah A., Thomas S., 1997, Securities Market, India Development Report, Edited by K. Parekh. 19. Shah A., Thomas S., 1999, Developing the Indian Capital Market, in Hanson and Kathuria: India, A Financial System for the 21st century, Oxford University Press. 20. Shah A., Thomas S., 2001, The Evolution of the Securities Markets in India in the 1990s, Seminar on “Ten Years of Economic Reforms” at Indian Council for Research on International Economic Relations. 21. Shah A., Thomas S., 2003, Policy Issues in Indian Securities Markets, In Anne Krueger and Sajjid Z. Chinoy, editors, Reforming India‟s External, Financial and Fiscal Policies, Stanford Studies in International Economics and Development, page 129– 147, Stanford University Press. 22. Shah A., 1999, Institutional Change on India‟s Capital Markets. Economic and Political Weekly, XXXIV(3–4). pp. 183–194. 23. Singhal, R., 2004, Financial Sector Reform in India: Is There a Grand Design?, Occasional Paper Number 16 July 2004, Center for the Advanced Study of India, University of Pennsylvania.

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