Speech by SEC Staff:
Remarks Before the FIA and OIC New York Equity Options Conference
Erik R. Sirri
Director, Division of Market Regulation
U.S. Securities and Exchange Commission
New York, NY
September 20, 2007
Thank you. It is a pleasure to join you today. I want to thank the Options Industry Council and the Futures Industry Association for inviting me to speak with you at this very relevant conference. Before I begin my remarks, let me remind you that the views I express are my own and not necessarily the views of the U.S. Securities and Exchange Commission, the individual Commissioners, or my colleagues on the Commission staff.1 Today I propose to discuss some recent developments in the securities markets, and how these events highlight the increasingly global nature of our work.
Subprime Mortgages and Credit Rating Agencies
The sharp rise in defaults by homeowners with subprime mortgages has reverberated through the financial markets. As default levels on subprime mortgages exceeded expectations, market participants began to question the value of a variety of financial products. And as valuations came into doubt, liquidity in these products fell sharply, which further complicated the task of valuing particularly complex instruments. As liquidity for structured products diminished, market participants needing to raise funds to meet margin calls and investor redemptions sold less complex financial instruments such as equities and municipal securities, placing downward pressure on prices in those markets. Overall, these dynamics have significantly impacted a wide range of market participants, from individual investors to systemically important financial institutions.
As you know, the Commission's mandate is to protect investors, maintain fair and orderly markets and facilitate capital formation. As the current events in the subprime mortgage business unfold, the Commission's role is several fold. I'll begin with an area that is receiving a lot of attention right now — the Commission's recently acquired authority with regard to credit rating agencies under the Credit Rating Agency Reform Act of 2006 (the Rating Agency Act) and the Commission rules adopted in June of this year.
The Rating Agency Act and its implementing rules require a credit rating agency that wishes to be treated as a nationally recognized statistical rating organization (NRSRO) to register as such with the Commission. An NRSRO must disclose a general description of its procedures and methodologies for determining credit ratings, and make public certain performance measurement statistics including historical downgrade and default rates within each of its credit rating categories. These disclosures are designed to assist users of credit ratings in assessing the reliability of an NRSRO's ratings over time, and will provide transparency with respect to the accuracy of an NRSRO's ratings in connection with structured finance products related to subprime mortgages.
As you are no doubt familiar, Moody's, S&P, and Fitch have each announced a number of ratings actions with respect to subprime residential mortgage-backed securities ("RMBS") and changes to their ratings methodologies with respect to these securities. Against the backdrop of recent forecasts of declining home prices, these agencies have linked their rating actions and changes in methodologies to revisions of their estimates in losses for, among other things, low or no documentation loans, highly leveraged borrowers, and the anticipated increase in loan modifications. However, some have criticized rating agencies for the accuracy of their ratings of certain structured finance products, especially RMBS. Critics fault the rating agencies for not taking rating actions sooner on those securities as the performance of underlying assets deteriorated, and for not maintaining appropriate independence from the issuers and underwriters of those securities.
Given recent events, Commission staff has begun a review of the stated procedures of NRSRO policies and procedures regarding ratings of RMBS, the advisory services NRSROs may have provided to underwriters and mortgage originators, their conflicts of interest, disclosures of their rating processes, the NRSRO's rating performance after issuance, and the meanings of the assigned ratings.
While the Rating Agency Act provides that the Commission may not regulate the substance of credit ratings or the procedures and methodologies by which any NRSRO determines ratings, the Commission does have authority to require certain disclosures and prohibit certain conflicts of interest. This new review should yield additional valuable information to the Commission with respect to whether the existing NRSRO rules will achieve the purposes of the Rating Agency Act and whether other steps should be undertaken to respond to issues identified by these events.
Additionally, the Commission and its staff are participating in a number of other domestic and international regulatory initiatives with respect to the role of credit rating agencies and the structured finance market. Notably, the President has asked that the President's Working Group on Financial Markets examine some of the broader market issues underlying the recent mortgage problems. The President's Working Group on Financial Markets is led by Treasury Secretary Paulson and is composed of Federal Reserve Chairman Bernanke, Securities and Exchange Commission Chairman Cox, and Commodity Futures Trading Commission Acting Chairman Lukken. The group will examine the role of credit rating agencies and how their ratings are used in lending procedures, and how securitization has changed the mortgage industry and related business practices.
Further, the International Organization of Securities Commissions ("IOSCO") has formed a credit rating agency task force to consider, among other things, the role of credit rating agencies in relation to the development of structured finance products.
Oversight of CSEs
The recent events in the mortgage and credit markets also appear to have triggered a broader reassessment of risk appetite by a variety of market participants. As investors have limited their exposure to certain classes of instruments, financial institutions have been forced to hold, on their balance sheets, assets that a few months ago could have easily been sold or financed.
Commission staff frequently monitors the balance sheet liquidity available to the parents of the five securities firms the Commission supervises on a consolidated, or group-wide, basis. For these firms, the Commission oversees not only the U.S.-registered broker-dealer, but the consolidated entity, which may include other regulated entities such as foreign-registered broker-dealers and banks, as well as unregulated entities, such as derivatives dealers and the holding company itself. The Commission's CSE program provides holding company supervision in a manner that is broadly consistent with the oversight of bank holding companies by the Federal Reserve. This program's aim is to diminish the likelihood that weakness in the holding company itself or any unregulated affiliates would place a regulated entity or the broader financial system, at risk.
Under the CSE program, in addition to adequate capital, liquidity and liquidity risk management are a critical focus of the Commission staff's review of broker-dealer holding companies. Liquidity is essential to the viability of all financial institutions. The ability of a firm to withstand market, credit, and other types of stress events is linked not just to the amount of capital the firm possesses, but also to the sufficiency of liquid assets to meet obligations as they arise. Due to the importance of liquidity to the firms, Commission staff seeks to determine whether each CSE has adopted and follows funding procedures designed to ensure that the holding company has sufficient stand-alone liquidity and sufficient financial resources to meet its expected cash outflows in a stressed liquidity environment for a period of at least one year.
In light of the potential impact of recent events in the mortgage and credit markets on financial institutions, Commission staff is monitoring the liquidity available to the CSE parent with even greater frequency. All the CSE firms maintain pools of liquidity at the parent level, consisting of cash and highly liquid securities. Access to high levels of liquidity is particularly important in times of market stress; so we are monitoring CSE firms' access to their usual sources of both secured and unsecured funding. In addition, Commission staff is monitoring contingencies that might place additional strains on the balance sheets of the CSE firms. These include the potential unwinding of off-balance sheet funding structures, such as conduits. We also are monitoring the potential funding requirements for certain leveraged lending commitments made by the CSE firms, typically to fund corporate acquisitions or restructurings.
In addition to liquidity, Commission staff is engaged in ongoing review of the valuation processes at CSE firms. The CSE firms mark most positions to market, which is a critical governance and risk management process. At a result, the staff's focus on marking issues predates the diminished liquidity of recent weeks. But current market conditions have certainly increased the challenge of marking certain complex positions to market. We are reviewing the valuation methods used by each firm to determine whether they are robust and consistently applied across such firm's businesses.
The recent credit events in the market have re-emphasized the global nature of our markets. And, the impact of cross-border financial services and transactions on the markets, on investors, and on regulation compels us to think about financial services today from a global perspective. For this reason, one of my focuses at the Commission is centered on initiatives to facilitate a global market place.
U.S. investors continue to seek to diversify their portfolios through investment in foreign securities, and foreign investors have shown an increasing appetite for U.S. securities. In addition, developments in technology and reduced communication costs have driven the markets to become largely electronic — making geographic boundaries much less relevant. This, of course, has made it easier and less expensive for investors to conduct cross-border securities activity.
Financial participants worldwide have pursued alliances and mergers in order to more effectively participate in a global market place. In February of this year, the NYSE Group and Euronext merged their businesses. Nasdaq is currently pursuing an agreement to buy the Nordic stock-exchange operator, OMX. Further, Eurex has agreed to acquire the International Securities Exchange.
I have no doubt that the trend of cross-border alliances and mergers will continue, and that financial participants worldwide will continue to seek opportunities beyond their borders.
A Cooperative Approach
The Commission has begun exploring possible approaches to facilitate global market access. In June, the Commission hosted a roundtable, where distinguished representatives of U.S. and foreign exchanges, global and regional broker-dealers, retail and institutional investors, and others shared their views on the possible new approaches to facilitate our global market place. I am grateful for the sharing of ideas from the roundtable as Commission staff continues to press forward in developing a new approach.
Although the staff is still working to develope the details of a recommendation to the Commission, one possible approach could permit foreign exchanges and broker-dealers to provide services and access to U.S. investors, subject to certain conditions, under an abbreviated registration system. This approach would require that the Commission make certain findings relating to the public interest and the protection of investors, and would be conditioned on these entities being supervised in a "recognized" foreign jurisdiction that provides comprehensive regulatory oversight.
For example, the Commission could consider under what circumstances foreign broker-dealers that are subject to an applicable foreign jurisdiction's regulatory standards could be permitted to have increased access to U.S. investors without need for intermediation by a U.S.-registered broker-dealer. The Commission also could consider under what circumstances foreign exchanges could be permitted to place trading screens with U.S. brokers in the U.S. without full registration.
Some key issues in developing this approach involve the types of investors and securities, and the standards that the broker-dealer's or exchange's home jurisdiction would need to meet. While such an approach could reduce frictions associated with cross-border access, it would not address the significantly greater custodial and settlement costs that are incurred today when trading in foreign markets.
To satisfy the Commission's mission of investor protection and fostering capital formation, any exemptions from registration would depend on whether the foreign exchange and the foreign broker-dealer are subject to comprehensive regulation in their home jurisdiction. To make this determination, the Commission likely would need to engage in detailed conversations with the regulator(s) in the foreign jurisdiction to explore the regulatory regime, considering whether it adequately addresses aspects currently part of the U.S. regulatory scheme including general investor protection principles, such as prohibitions against fraud and manipulation, the vigor of the inspections and enforcement regime, and the effectiveness of the clearance and settlement system.
I envision the process as a flexible and collaborative approach by which the Commission would engage in an assessment of the foreign regulatory regime in advance of exemptions being sought by interested broker-dealers or exchanges.
Other limits also could be appropriate. For example, trading could be limited — at least initially — to foreign securities, so as to address concerns about the impact of this approach on U.S. market activity. Similarly, exemptions could be limited to trading with market professionals and certain large sophisticated investors, who could be expected to more fully appreciate the risks of trading directly with foreign markets and intermediaries.
In addition, the staff is contemplating a recommendation that the Commission update and modernize the requirements under Rule 15a-6. Specifically, the staff is exploring possible modifications to Rule 15a-6 that would permit foreign broker-dealers, with limited intermediation by U.S.-registered broker-dealer, to engage in transactions with certain large institutional investors involving foreign securities and U.S. government securities. This relief would entail a reduction in the level of intermediation presently required by U.S.-registered brokers or dealers for these types of transactions. We also may consider whether recommending to the Commission new exemptions or revisions to any current exemptions under Section 12 of the Exchange Act would be appropriate.
Global financial services initiatives may very well promote competition and efficiency of cross-border capital flows, and thus have the potential to benefit the markets and investors in the U.S. and abroad. A core mission of the Commission is to protect investors. So, as the Commission approaches these difficult global regulatory issues, it must be vigilant in its efforts to ensure adequate disclosure and regulatory oversight for investors in the U.S. or that trade in U.S. securities or on U.S. markets. At the same time, another core mission of the Commission is to facilitate capital formation, and the Commission is mindful of the fact that today capital increasingly is being raised internationally. I believe the Commission recognizes, however, that it can do more to reduce the costs and frictions of trading foreign securities in the U.S. without jeopardizing the protection of U.S. investors.
In my view, greater competition that could result from increased cross-border capital flow should benefit markets overall. The Commission must ensure, however, that as competition increases it remains fair. There would be disparities in the standards applicable to US registered exchanges and unregistered foreign exchanges. For example, in the U.S., exchanges must file their rules with the Commission under our statute. Around the world, many — in fact, most — exchanges do not have the same kind of rule filing requirements that are placed in our statute. The Commission is cognizant of that, and, as these exchanges come into the U.S., the Commission will face increased pressure to streamline its rule filing process. Accordingly, the staff is pursuing ways the Commission could use to streamline the rule filing process for U.S. exchanges with respect to trading rules, new products, and certain other areas. Among other things, this would help level the regulatory playing field between U.S. exchanges and their foreign counterparts.
Markets' Response to Heightened Competition
Perhaps the most distinguishing characteristic of the U.S. securities markets, particularly when compared with securities markets internationally, is the intense competition for order flow among multiple venues trading the same products. In this battle for order flow, the various trading venues have continually sought to develop new technologies, trading rules, order types, and fee structures that will give them an edge on their competitors. Clearly, investors benefit when markets have powerful competitive incentives to innovate. Often, however, innovations may spark controversy and claims such as unfair competition or discrimination. These claims generally wind up with the Commission for review in one form or another, such as in the context of an exchange's proposed rule change. The Commission strives to resolve market structure issues in a manner that promotes competition and innovation, while maintaining the investor protection and public interest goals of the securities laws.
This challenge has not gotten any easier in recent years as evolving communications and processing technologies have transformed all aspects of the trading process, including order generation, order routing, order execution, and post-trade analysis. These changes are evident in both the stock and options markets. Moreover, the reduction in minimum pricing increments to one penny has further heightened the need for automated solutions to address the need to trade at many price points and in smaller sizes. We have all watched over several years as market participants have adapted to penny increments in stock, and I expect to see similar changes in options.
I briefly will note two recent manifestations of the current competitive landscape in the U.S. securities markets. They are, first, the increasing use of order types that offer hidden liquidity and, second, the efforts by exchanges to attract and sustain dedicated market makers willing to accept responsibility for maintaining the quality of markets on the exchange. The two manifestations are worth noting not only because they reflect the current state of competition, but also because they highlight the Commission's statutory role in regulating exchanges and market structure.
The increasing use of hidden orders is but one of many effects of expanded automated trading tools and reduced pricing increments. Efficient order entry and small increments enable market participants located both on and off an exchange to step ahead of displayed trading interest at a relatively small economic cost. We have begun to see an interest in exporting to the options markets order types commonly seen in our equity markets, particularly those that allow for non-displayed price or size. Although stepping ahead of displayed orders can produce much narrower quoted spreads, it clearly disadvantages those that otherwise might display their trading interest in size.
Not surprisingly, the increased opportunity to step ahead has prompted a counter-reaction by those market participants that wish to trade in size without revealing too much of their trading intent. Among other things, this counter-reaction has taken the form of hidden liquidity and, particularly in the equity markets, can be seen in the numbers of new dark pools that have been much discussed in the press. What may be less recognized is the extent to which the public markets, including exchanges, also have a "dark" component that closely interacts with their displayed trading interest. In particular, many exchanges have order types that allow their customers to submit trading interest that is entirely undisplayed, typically at prices inside the best displayed prices. They also offer order types that allow the submitter to display some part of trading interest at a price, while keeping the rest of the size hidden in reserve.
I believe that a not insignificant percentage of liquidity on some equity exchanges could be of the "dark" variety. Consequently, these exchanges could in fact operate the largest dark liquidity pools in the U.S., not some of the ATSs that have been highlighted in the press recently. The increased use of hidden liquidity across all markets has prompted some concern that price transparency and market efficiency could eventually be harmed if the trend continues.
More efficient trading technologies also are the driving force behind another manifestation of competition among markets — the efforts by exchanges to attract and sustain dedicated market makers. Exchanges want dealers that are willing to accept responsibility for market quality by supplying liquidity on a consistent basis, in good times and bad. Exchange market makers, however, face increasing pressure from active traders located off the exchange. Despite being located off the exchange, improved trading technologies enable these active traders to trade in enormous volume at low transaction cost. These off-exchange competitors may not be registered as broker-dealers, much less as exchange market makers with responsibilities for promoting market quality.
In general, the Exchange Act prevents exchanges from offering their market makers special trading privileges beyond those necessary and appropriate to promote a fair and orderly market. In addition, exchanges often accord the orders of public customers particularly favorable treatment in relation to the orders of exchange members or other broker-dealers. As the distinction between professional traders on an exchange and professional traders off an exchange continues to blur, however, exchanges are seeking to assist their own market makers in an effort to keep their business models viable. This phenomenon is evident in both the options markets and the equities markets, particularly with the well publicized challenges facing NYSE specialists in an automated trading environment. One type of exchange response has been a proposal to create a class of "professional" orders that do not receive the same favorable treatment as public customer orders, even if they are submitted by persons other than registered broker-dealers. Such proposals often prompt claims of unfair discrimination.
In assessing these two manifestations of market competition, there is an important distinction. The professional order designation proposes to treat market participants differently based on their trading patterns. In contrast, while the increasing use of hidden orders may be troubling, at least potentially, because they could detract from price transparency, the order types typically are available to all types of market participants on the same basis.
When competitive innovations are presented for Commission review, I do not believe that the Commission's proper function is to select or promote any particular business model. Rather, the Commission must be concerned with the Exchange Act goals of protecting investors and the public interest and promoting fair competition. The Commission's review should focus on the likely effect of proposed innovations on market quality as it affects investors, including such quantitative indicia as effective and quoted spreads, market depth, and transitory price volatility. For example, proposals to give particular privileges to exchange market makers in relation to another type of market participant should be justified by a showing that the result would not merely be to promote the interests of the market maker or the competitive interests of the exchange, but would improve market quality on that exchange.
Thank you for the opportunity to share with you some of my thoughts on our ever-increasingly global financial market.