Speech by SEC Staff:
|INVESTOR HOLDINGS OF FOREIGN SECURITIES, BY COUNTRY (BY PERCENT)9|
Given these investor trends, when combined with certain regulatory and business-model changes, cross-border mergers of stock exchanges seem more a response to a changing market environment than a cause of it.
Fundamentally, a stock exchange is just a place where a buyer meets a seller. Until the 20th century, technological limitations meant stock exchanges were mostly local or regional affairs, even where international investors were present. Originally, these exchanges were extremely local — in the New York Stock Exchange's case, first a clearing under a buttonwood tree, and then a coffee house, where brokers and dealers would gather to trade government bonds. Later, of course, technology would allow markets to become national. In a few countries (including the United States), technology and regulatory changes would even lead regional exchanges to compete with each other for issuers and investors. However, legal restrictions such as capital controls and other regulatory requirements effectively isolated markets within the confines of national borders.
Changes in legal, regulatory and business models over the past several years have brought down many of these national barriers and allowed — or in some cases, forced — exchanges to respond to the changing demands of investors and other market participants. Ironically, given some recent concerns about the "competitiveness" of US markets, it was the United States that led the way internationally in making stock exchanges more competitive with each other and more responsive to the needs of investors and issuers.
The traditional floor-based exchange is not just local, but also physically restrictive — as a practical matter, only so many people can fit on a trading floor at one time. As a policy matter, historically many exchanges also restricted the number of members as a way to limit competition. However, in 1975 Congress, concerned that separate, unconnected exchanges were leading to trading fragmentation and poor customer executions, directed the SEC to facilitate development of a national market system. As a result, the SEC required exchanges and market makers to publish their quotes and trade reports. As telecommunications technology improved, broker-dealers and others developed electronic communications networks ("ECNs") which reduced costs and added features that investors sought. Later, following evidence that Nasdaq market makers were themselves engaged in anti-competitive behavior, the SEC approved new order handling rules and promulgated Regulation ATS, which greatly enhanced the abilities of ECNs to compete with more traditional exchanges.
Today, in part as a result of these regulatory and technological changes, US exchanges and ECNs offer the most competitive order-execution services in the world. Greater competition among US stock exchanges has not only spurred even greater technological innovation, but has also led to a change in exchange business models. Rather than seek to restrict the number of members that trade on it, as exchanges historically have done, upstart ECNs and new electronic exchanges often wish to place their terminals and trading screens with as many broker-dealers, in as many locations, as possible. With electronic trading, liquidity no longer exists in a single location. Faced with this fact, the traditional member-run exchanges have encountered greater competitive pressure, as these new trading systems potentially offer investors better trade execution, at less cost. And anything that attracts investors tends to attract issuers.
In response to this new competitive environment, many exchanges around the world have demutualized. Some argue that, as for-profit corporations responsible to shareholders, demutualized exchanges may be better situated to raise capital, modernize, and compete in the global economy. But in shedding their guild-like traditional structures for the trappings of a modern company, exchanges have come under the same market logic that most other firms now face. The desire to expand market-share and attract issuers and investors has led these newly competitive exchanges to pursue mobile capital, mobile issuers and mobile liquidity wherever they can be found. Since exchanges are nodes in a rapidly expanding global capital market network, and nodes are only as powerful as the number of linkages they offer other members of the network, this competition has led exchanges to seek out alliances across borders, and, in some cases, merger partners.
Today the SEC faces a very different market environment than it did 70 years ago when it was created. Issuers operate in a global market and seek capital globally. The market intermediaries the SEC regulates also operate in multiple jurisdictions and, frequently, are also regulated abroad as well. But, perhaps most importantly, today capital is both widely dispersed and mobile. More Americans than ever before invest in our capital markets and, increasingly, these investors also trade on foreign markets and invest in foreign securities.
This global capital market presents both promises and challenges to the SEC's mandate to protect investors, ensure fair, orderly and efficient markets, and facilitate capital formation. The promises include greater competition in the market for financial service providers, to the benefit of investors and issuers alike; an opportunity for investors to diversify their portfolio risk across borders more effectively and at less cost; and the ability of issuers to seek the lowest cost of capital wherever it might be. All things being equal, modern economic theory suggests such investment diversity is wise.
Of course, not all things are equal. Investing abroad entails additional costs. Under current regulations, foreign financial service providers cannot solicit US investors or offer advice unless they are registered with the US Securities and Exchange Commission. Many of these foreign firms are reluctant to do so because they are already subject to a full set of regulations at home. The result is that, when investing abroad, US investors often pay commissions twice — once to their US broker, and then again to the foreign firm that actually executes the trade. Countries also vary in the degree protection they offer investors and, perhaps most importantly, in their enforcement philosophies. Making matters worse, the same technologies that allow retail investors to look abroad for investment opportunities also allow fraudsters to look across borders for victims.
Given the trends noted earlier, some of the risks that a globalizing capital market poses are not necessarily different from the risks the Commission is grappling with under a changing domestic market environment. For example, to some extent, the effects of greater exchange competition have been felt in the United States for several years now, independent of any foreign competition, and the SEC is keenly aware that US markets must be monitored for anti-competitive behavior among various market participants. In fact, the SEC is considering a proposal by the NYSE and NASD to consolidate their self-regulatory functions in a way that would effectively insulate the new combined SRO from the business pressures of the exchanges and market intermediaries.
Other issues, however, are unique to the international environment. For many years now the Commission has been aware that the growing globalization of the world's securities markets poses unique enforcement risks where unscrupulous individuals take advantage of this US investor interest in foreign markets to defraud US investors. Historically, pursuing securities law violators when evidence has been located abroad presents challenges. It has been even more challenging for the Commission to repatriate defrauded investor assets if those assets have been secreted to another jurisdiction. In some cases, an entire industry has developed to assist those who commit securities fraud to move assets overseas and hide their activities behind shell companies.10
Likewise, issuers and market intermediaries operating in more than one jurisdiction may face unique costs in the form of different, overlapping, and sometimes even contradictory regulatory requirements. For several years now, the Commission has worked with its foreign counterparts to develop a converged regulatory approach that would minimize cross-border regulatory costs by creating an international consensus around a single set of high-quality standards. One example of this is the SEC's support for the accounting standards convergence project between the US Financial Accounting Standards Board and the International Accounting Standards Board. This convergence project has advanced so far that the Commission has just proposed a rule that would eliminate the requirement that foreign private issuers using International Financial Reporting Standards (IFRS) reconcile their disclosure statements to US Generally Accepted Accounting Principles.
Finally, cross-border exchange and market intermediary mergers themselves raise unique regulatory concerns because of the different regulatory systems that may apply to each merger partner. On one hand, as with issuers, the overlapping regulation may be inefficient and costly to the firms involved, without any real corresponding investor protection benefit. On the other, the resulting regulatory oversight may not be overlapping enough — there may be gaps in the oversight of the various national regulators, and conceivably these gaps could result in systemic problems should something go wrong.
All of these factors can work to make the global market a scary place. Where fraud is widespread, investors become wary, and issuers are forced to pay more for their capital. If regulators are not careful, borders can become one-way valves, letting the bad guys in but keeping the good guys from pursuing wrongdoing abroad. When this happens, the resources a regulator might put into protecting investors can be wasted, since criminals might easily evade our efforts. For regulators, this presents a dilemma: we cannot effectively close our markets to the outside world, but openness could threaten our efforts to protect our market's integrity.
A tempting option might be to just give up. Regulations impose costs on issuers and financial firms. Ideally, these costs are more than offset by the benefit to investors — a benefit that accrues to issuers and firms in the form of lower capital costs and a greater willingness of investors to trade on our markets. Yet, if borders make combating fraud difficult, it can undermine even the best regulatory system, and regulations are left providing little corresponding benefit for the costs they impose on the law-abiding. When this happens, a regulator might be tempted to invoke caveat emptor.
However, the SEC's mandate makes this impossible. The SEC is charged with three overarching goals: protecting investors, making sure our markets are fair, orderly and efficient, and promoting capital formation. Closing our markets to outsiders and keeping our investors locked at home does not achieve any of these goals. Yet protecting investors from fraud while assuring them that they are getting the best investment opportunities available, and the best information upon which to base their choices, is a challenge. Meeting this challenge will require much greater coordination among the world's securities regulators than is now the case.
For the past two decades, the SEC has been at the forefront of building relationships throughout the world to better protect investors. These relationships have developed to the point where the next step may be possible — forging an alliance of like-minded regulators. While countries vary in their approaches to securities regulation, there are other jurisdictions that share the SEC's passion for investor protection and market integrity. The protections these markets offer investors mirror our own. If the SEC and its counterparts can build mechanisms that make our oversight and enforcement systems seamless, I believe that foreign financial service providers operating in the US should be able to substitute compliance with their home jurisdiction's regulations for compliance with our own through a system of selective mutual recognition.
Reciprocal and selective mutual recognition would end duplicative regulation and lower the cost of capital for US companies, but, more importantly, it would also increase investment opportunities while enhancing US investor protection and the SEC's ability to pursue securities law violators abroad. But before such an alliance is possible, certain bridges must be built. The SEC's investor protection mandate is ironclad, and the Commission must be confident that foreign partners share the same legal powers and regulatory philosophy. This assurance might take the form of a "comparability assessment" by which the SEC and a potential partner trade information about their regulations and how those regulations are enforced, to help ensure that our objectives and philosophies are the same. It might also include enhanced enforcement and prudential information-sharing arrangements to help ensure that, if fraud should occur, each will help the other prosecute the offenders and seek redress for defrauded investors.
This is a departure from past policies, but one I believe is worth taking. Our current regulatory approach is based on a model built when markets were local affairs. Now, the majority of US investors also look overseas for investment opportunities. The SEC's duty as the investor's advocate requires nothing less than that we face up to this new reality.
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