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Speech by SEC Chairman: Remarks at the Society of American Business Editors and Writers (SABEW) Annual Convention

Chairman Mary L. Schapiro

U.S. Securities and Exchange Commission

Indianapolis, Indiana

March 15, 2012

Thank you, Peter. And thank you to SABEW for the opportunity to appear here today.

Three years ago, when I spoke to this conference in Denver, I had just become Chairman and the financial crisis was still very fresh in the minds of all Americans. There was a broad consensus that regulators and policymakers needed to identify how the system had failed and what reforms were needed to prevent another crisis from occurring.

There may have been disagreement among policy makers over the exact shape of reform, but there was little debate about the need for that reform.

SEC Reforms

At the SEC, we were already embracing reform inside and outside the agency. When I spoke in Denver, I emphasized the importance of having a federal agency whose primary mission is to protect investors. And during that same period, I spoke often about the need for the SEC to change and improve the way it operated.

The staff and leadership took these concerns to heart. And since then, I believe the change has been dramatic – both within the agency and across the regulatory landscape.

At the SEC, we completely restructured entire operations, including the two largest – enforcement and examinations. We removed a layer of management to put skilled attorneys back on the front lines, while giving them greater freedom to pursue investigations and negotiate penalties. We created specialized units to build and harness in-house expertise. And we broke down the silos that hampered effective operations.

We streamlined procedures to bring investigations more quickly and developed a risk driven examination program. We consolidated tips and complaints into a centralized database so information is more widely accessible, thoughtfully analyzed and carefully tracked. We built new technology, increased training programs, and brought in new skill sets. And we outsourced responsibilities that could be better handled elsewhere so as to preserve our resources and focus on protecting investors.

SEC Rulemakings

In addition to strengthening the agency, we also made tremendous progress in reforming the rules by which Wall Street plays – executing on an aggressive investor protection agenda. We passed rules to make money market funds more resilient. We strengthened the custody controls that investment advisers must have in place to protect investor assets; we adopted rules to end “pay-to play” practices by advisers to public pension plans and required better and more timely disclosure of material events related to municipal securities.

We required investment advisers to disclose more information about their qualifications and conflicts – and made that information easily accessible to the public.

We significantly improved the quality of the information in proxy statements so investors know about the qualifications of board members as well as corporate policies and compensation practices that encourage risk. And we gave shareholders a greater say on executive compensation, with “say on pay” rules.

Dodd-Frank Rules

As we were moving forward with our investor protection agenda, we were also supporting Congressional progress on what became the Dodd-Frank Act. Signed into law in 2010, the Act assigned the SEC a host of significant responsibilities.

As a result, we now have in place new rules requiring hedge fund and other private fund advisers to register and report important data to the public and systemic risk information to the regulators. We have required greater disclosure from the issuers of asset backed securities and begun to reduce investor reliance on credit ratings. And in short order, we established a new whistleblower program that is now producing high-quality leads and shortening the length of some of our investigations.

As I look around, I am impressed by what has been accomplished by the incredibly dedicated staff at the SEC. We launched one of the most productive rulemaking periods in SEC history, we have brought a record number of enforcement actions, and we have filed cases against almost 100 individuals and entities arising out of the financial crisis.

Avoiding Forgetfulness

While I can go on and on, I recognize that there remains much more to do – because the job of a regulator is constantly evolving.

Many of the initiatives currently on the SEC’s plate are there because of critical events – damaging to investors and to markets – that spurred calls for change. But as those events recede into history, the embrace of those reforms is becoming less sure.

We must not let the passage of time fog our memories, cloud our judgment, or diminish our resolve.

So today I would like to discuss a few areas where we cannot afford to lapse into forgetfulness – in particular, I’d like to talk about some of the lessons from three episodes: the Internet bubble, the financial crisis, and the Flash Crash.

Internet Bubble

Currently, Congress is considering a bill that would weaken investor protection by chipping away at the wall now in place between research analysts and underwriters employed within a financial institution.

That wall, among other things, limited communications between analysts and investment bankers and changed the financial incentives for analysts. It was put in place to prevent investment bankers from using the inducement of favorable research and of “buy” ratings to lure potential IPO and other clients to their firms for lucrative investment banking services, and from financially rewarding cooperative research analysts.

It was this practice that helped fuel the tech bubble of the late 90s, as research analysts gave positive ratings to companies they privately derided, driving up prices and misleading investors. Who can forget revelations that one prominent analyst was publicly giving “buy” and “strong buy” ratings to stocks that he was describing in private emails as “junk,” and “a disaster.”

The stock prices of companies like, Excite@Home and WorldCom soared on the recommendations of supposedly independent analysts, before the companies crashed into bankruptcy. The tech-heavy NASDAQ exchange peaked at more than 5100, before losing almost 80% of its value over the next three years.

These conflicts led to a 2003 settlement between the SEC and other regulators and a number of the largest financial institutions, which agreed to significant structural reforms.

Unfortunately, the House bill would begin chipping away at that wall, eliminating reforms designed to ensure that investors receive objective analysis.

We should not walk backwards here. Collusive behavior between analysts and bankers cost investors huge sums, shattered confidence in the integrity of research, and damaged the markets themselves.

Financial Crisis

Money market funds

The second memory that I want to refresh arises from the more recent financial crisis.

In September 2008, the Reserve Primary Fund held just over 1 percent of its assets in commercial paper issued by Lehman Brothers. When Lehman declared bankruptcy, the fund took a hit and declared that it could not return to investors the full dollar per share that they had put in. This phenomenon – known as “breaking the buck” – triggered a run on the fund and, in short order, a run on other money market funds as well.

This happened, in part, because most investors treat money market mutual funds like bank accounts – where customers are guaranteed to get at least one dollar back for every dollar they deposit. However, these products are, in fact, not bank accounts, but investment vehicles whose value can on occasion slip below or move above a dollar.

Following Lehman’s bankruptcy, investors redeemed $40 billion, or roughly two-thirds of the Reserve Fund’s total value, in just two days.

And, then the fear began to spread.

Within the week, investors had withdrawn $310 billion from prime money market funds – 14 percent of those funds’ total assets, with some firms hit much harder than others. This helped freeze short term credit markets, resulting in the loss of short-term financing that businesses and institutions needed for operations.

The run stopped, but only after the government stepped in with a taxpayer-funded Treasury guarantee that reassured investors and calmed the market – and that also left the American taxpayer implicitly on the hook for $3 trillion in money market fund shares.

That event vividly underscored the need to tighten liquidity and risk requirements. And so the SEC, in 2010, adopted new rules that for the first time imposed robust liquidity requirements on money market funds. The reforms also required higher-quality credit, shorter maturity limits, and periodic stress tests, making money market fund portfolios stronger and more resilient.

But, when we passed these reforms, I clearly stated that we needed to do more – that those reforms were just a first step. Because, despite changes in the assets they hold, money market funds remain susceptible to a sudden deterioration in quality of holdings and consequently, remain susceptible to runs.

The companies that manage money market funds often go to great lengths to avoid breaking the buck. They have been quick to infuse their own capital to prop up the value of money market funds, and over the past two years they have waived investor fees in order to prevent fund values from falling below $1.00. SEC staff provided no-action assurances that allowed more than 100 money market funds to enter into capital support agreements with their parent companies in 2007-2008. Without these capital infusions and other support, these funds might have broken the buck, kicking off other destabilizing runs. These numbers underscore the fact that the Reserve Primary Fund’s collapse should not automatically be regarded as an isolated incident.

Because Congress eliminated the possibility of another Treasury guarantee, there would be little regulators could do to manage or stop such a run.

Indeed, money market funds remain particularly vulnerable to exogenous shocks, like a sovereign debt crisis in the Euro zone or a natural disaster across the globe. A 2010 Moody’s study identified nine financial incidents that kicked off multiple sponsor interventions in the U.S. and Europe, not including the financial crisis. These range from the Orange County default in the mid-90s to the collapse of individual insurance companies, to the California energy crisis of the early 2000’s. In addition, as recently as November 2011, the sponsor of some money market funds bought out securities of a Norwegian bank that was downgraded to non-investment grade status.

Whenever there is an unexpected shock to the financial system, or a natural disaster with market moving implications, the staff knows that the first thing I will ask is: “what is the related money market fund exposure?” Money market fund investors are historically very risk averse and are motivated to pull their money – and get their dollar – in advance of any deterioration of value.

To avoid the likelihood of another money market fund run, there are two serious options I am hoping that the SEC will propose: either float the net asset value, so that a money market fund’s value goes up and down like any other mutual fund, or impose capital requirements, combined with limitations or fees on redemptions.

These proposals are designed to, respectively, desensitize investors to the occasional drop in value or make it less likely that the funds will not be able to absorb a loss and cause a run.

In the post-mortem of the financial crisis many have argued that regulators sat silent on the sidelines rather than raising alarm bells. As a regulator who saw the damaging effects of the 2008 run on money market funds, I find it hard to remain on the sidelines despite calls to declare victory on this issue.

While many say our 2010 reforms did the trick – and no more reform is needed – I disagree. The fact is that those reforms have not addressed the structural flaws in the product. Investors still have incentives to run from money market funds at the first sign of a problem.

OTC Derivatives

Another piece of unfinished business highlighted by the financial crisis is the creation of a transparent, efficient market for derivatives currently traded over the counter – one that will make it less likely that credit default swaps and other OTC derivative products can propel risk throughout the financial system.

Operating behind an opaque curtain, these transactions were not visible to regulators or other market participants. But, as revealed during the crisis, firms that entered into derivative transactions, sometimes to reduce their market risk, found that they had only transformed this risk into something else perhaps more insidious: counterparty risk.

The result was that, as more and more derivatives were transacted across the system, an elaborate network of trading contingencies emerged in which firms were subject not only to the credit risk of their own counterparties, but also to the credit risk of their counterparties’ counterparties, and so forth. This type of cross-firm connectivity has the ability to greatly magnify the systemic shocks of a default by any single firm.

While it would have been difficult to have imagined the sheer size or impact of this market when these products first became popular in the 1990s, regulators appreciated the need to get a better handle on what was going on behind the curtain. Unfortunately, at that time, the industry strenuously objected to any regulation -- and, in 2000, Congress specifically excluded most derivatives transactions from regulatory oversight.

When the credit crunch materialized in 2008, the hundreds of trillions of dollars worth of derivatives in the system magnified the crisis.

Today, the SEC is working with the CFTC to write rules that will address shortcomings in the derivatives market and further strengthen the stability of our financial system.

It’s a system we’re building literally from the ground up. When complete, the system will:

  • Clearly define which key market participants must register, establish standards for their business conduct, and lay out their capital and margin requirements.
  • Make clear what trade information market participants must report and to whom.
  • Set up regulated trading markets that operate according to established duties and core principles to provide greater transparency to market participants.
  • Establish regulated clearing houses to act as middlemen between the parties and to assume the risk should there be a default.
  • Create data repositories – or centralized record keeping facilities – to allow regulators to see what’s going on.
  • Include tough anti-fraud rules for all.

Our progress in this area has been deliberate, and we are beginning to transition from proposing rules to adopting them. As the next step, I expect the Commission will shortly finalize rules that further define who will be covered by the new derivatives regulatory regime and what will constitute a security-based swap.

Beyond this, the staff is developing a plan for putting the rules into effect. I expect it to be a plan that appropriately phases in those rules so as to avoid short circuiting the system as it comes on line. And I expect that, at all stages of implementation, those subject to the new regulatory requirements will be given adequate time to comply.

Today, there are some who say that the rules should not apply to certain types of entities or swaps – or who say “let’s re-propose everything” – or who argue that we should wait for foreign governments to catch up to us. When I hear these arguments, I have to wonder if they remember what we went through just four years ago.

Flash Crash

Finally, we cannot forget the painful lessons of the May 6, 2010 Flash Crash, when – in a roughly five-minute period – the S&P 500 plunged a full 5 percent, only to recover that loss a few minutes later. Following that event, we approved a series of measures to help reduce the likelihood of another similar event, including imposing circuit breakers and banning naked access to the markets. But we must continue to push for a fast and reliable way to rapidly reconstruct unusual market events as well as to investigate suspicious trading activities.

Unfortunately, as with the financial crisis, memories of the Flash Crash are fading – and I worry that we risk becoming complacent, resigned to using existing tools. But these outdated tools both limit our ability to identify fraud and make it impossible to swiftly analyze trading behavior.

Despite the measures now in place that will reduce the chance of dangerous volatility like we saw in May 2010, future anomalous events are inevitable, and regulators will need to reconstruct transactions rapidly in order to limit damage, reassure investors and act to prevent similar events.

In 2010, notwithstanding round-the-clock efforts, it took SEC and CFTC staff almost four months to figure out precisely what had happened – longer than investors, markets and regulators should ever have to wait.

That was one of the reasons that, in May of that year, we proposed rules that would create a consolidated audit trail enabling us to track trading data across all equity and equity option trading platforms. The complexity of the undertaking has necessitated a detailed and extended rulemaking process, including a thoughtful review of the many comments received. And at this point, the contours of the staff recommendations are being finalized and I expect that the regulations will soon be considered by the full Commission.

The consolidated audit trail would seek initially to track only orders and trades in the equity and equity option markets, but I believe this is just a first step and that the system should be expanded in the future to fixed income, and other markets.

For now, the most important thing is to get a structure in place so that the heavy lift of working through the technical nuances of the system can begin.

But again, just because we have done much to help prevent another Flash Crash, does not mean we have done enough.


It is tempting, given that some financial reform is already in place, and given the brightening economic horizon, to declare victory and go home.

But there is important work yet to do.

We don’t know what the next shock to the system will be. Few saw the meltdown of the subprime mortgage market or the European debt crisis coming. But we do know that when the next shock comes, if the regulatory regime has not been strengthened, financial markets will be vulnerable to severe disruption.

We cannot lose sight of the past. We cannot be lulled into a sense of complacency just because our economic forecast is brighter or the market has rebounded. And, we cannot be coaxed into thinking that, because we have taken many important steps, our journey is complete.

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Modified: July 28, 2014