Speech by SEC Staff:
Remarks Before the Investment Company Institute 2007 Operations and Technology Conference
Andrew J. Donohue1
Director, Division of Investment Management
U.S. Securities and Exchange Commission
October 18, 2007
Good morning. I am very happy to be here today and appreciate the Investment Company Institute's invitation to speak with you. Before I begin, however, I need to state clearly that my remarks here today represent my own views and not necessarily the views of the Commission, the individual Commissioners or my colleagues on the Commission staff.
Although I am a lawyer, the operations side of the fund business has fascinated me for some time. Having been in this industry for over 30 years now, I have watched as the fund business has truly evolved and developed. I am even at the point in my career, and I guess my life, where I often find myself saying "I remember back in the day when we used to do things X way, or Y way". More and more, the X and Y ways of doing things either don't exist or are largely unrecognizable. This is due primarily to advancements in technology. As you know, and as I continue to be amazed at, technology has been an incredible force in shaping the way the fund industry does business.
Although I noticed that I have been billed on the conference agenda to provide you an update on regulatory developments in the Division of Investment Management, and I will get to that, this morning I would first like to talk about something that has recently captured my attention. And that is the idea of operation risk. In today's fast-paced and increasingly complex financial marketplace, this area of risk management is becoming more and more important as we look at the intersection between technology and operations and its impact on the way business is conducted in the fund industry. On the one hand, technology has brought about tremendous benefits to our markets, which are more efficient and liquid than ever before. Access to information has never been easier. However, and this is where the lawyer and regulator in me comes out, in this incredibly fast-paced, complex, global marketplace, I can't help but wonder, how are firms keeping up?
In my past life, as general counsel of large fund complexes, I often marveled at (and often worried about) how our systems were able to handle the incredible volume of transactions that we saw in our markets every day. For example, at one fund complex, we priced as many as 18,000 securities each day - amazingly most of the time without a glitch! In fact, there have been relatively few reported cases of serious system glitches in fund complexes, which is remarkable considering that our markets and the fund business have continued to become increasingly fast and complex.
However, the incidents that have occurred indicate something alarming: In today's world, with our complex and highly interconnected systems, one small error, such as wrongly entering one digit of a code, can magnify to such an extent, and at such incredible speed, the results can be catastrophic. For instance, there have been examples, which you have most likely heard about, in which firms failed to send prospectuses to large numbers of customers as a result of a missed coding change. In other instances, firms failed to take necessary corporate actions as a result of clerical errors, such as account numbers that were not properly entered. Each of these small errors cost firms tens of millions of dollars in restoring customer accounts and in regulatory fines. With the precision of computers today, it is so easy to take them for granted and forget that they still rely on occasional human imprecision in our system processes. For this reason, when something does go wrong, we are often taken by surprise at how quickly it happens, and how quickly a relatively small error can multiply into disastrous results.
Of course I am not alone in my observations as to how and whether our risk systems are keeping pace in the complex financial world. In fact, across the financial sector as a whole, the risk management techniques we saw in the 90s have changed. Previously, risk systems primarily focused on measuring and monitoring market risk and then later in the decade, credit risk. Firms have now shifted their focus to the more amorphous area of operational risk. This includes the banking industry, as the Basel Committee has set forth a definition of this new area of risk focus as being "the risk of loss resulting from inadequate or failed internal processes, people or systems or from external events." Even with this definition, it is still difficult to nail down as to what it exactly entails. I also believe that its undefinable nature is what makes operational risk all the more daunting to manage. In fact, the Basel Committee's concern in this area has become evident recently, as it has focused much of its time, held forums and published reports on how the risks that fall into this catch-all category may be managed and how to avoid risks being transferred across different financial sectors.
Risk Management Systems
As the financial industry grapples with how to address operation risk within individual firms, it seems that a good place to start is to rethink how we approach risk management in general. In the current financial environment, it is becoming apparent that the old rules do not apply and that we need to approach how risk is managed from a different standpoint. For example, a common risk management approach among firms is to develop complicated algorithms to guide their systems and procedures. In developing these algorithms, firms take into account the details of past negative events and account for the circumstances that ultimately led to their occurrence. As a result, over the years these algorithms have become finely tuned to address the known risks and contingencies that have occurred over time.
To us in the fund industry, we approach the idea of looking backwards to predict what will happen with some skepticism. In fact, each fund prospectus discounts the idea, noting that "past performance does not guarantee future results". With respect to risk management, using an historical approach may have been appropriate in the past when the risks were narrowly-defined and generally known. But now, operational contingencies can't always be categorized. Losses can result from a complicated mix of events, making it hard to predict or model contingencies. To me, it seems that this way of approaching risk in today's markets, seems analogous to driving down a winding mountain road at top speed, with the car going faster and faster. However, rather than looking ahead of us out of the front window to see where are going and avoid the pitfalls, we are instead using the rearview mirror to guide us!
I think the idea of where we are in terms of addressing operational risk becomes more clear if we look at some of the more recent crises that have been experienced in the financial markets. In the last few decades, each major financial crisis, with the exception of September 11, have generally not been triggered by events that we would expect to have caused such major disruptions, such as economic downturns or natural disasters. Rather, recent events in the financial marketplace left us scratching our heads and saying "who would have thought?" For example, who would have thought that, on Monday, October 19, 1987, with no expected warning signs, the market would experience its greatest single-day loss in continuous trading up to that point? On that one day, the Dow fell 508 points and lost over 20 % of its value. Then we had Long Term Capital Management. Who would have thought that a single Russian default could trigger a crisis that threatened the world's largest financial institutions? Similarly, just this summer, we saw this phenomenon with the subprime crisis. Who would have expected the ripple effect that we felt throughout the U.S. and world markets as these loans began to unravel?
Rather than being prompted by an event that we would expect to wreak havoc on the financial markets, the underlying causes of these events was the increasing complexity that characterizes the financial marketplace. This increasing complexity presents risks not only to the financial markets as a whole, but is a significant factor in how risk is managed within individual firms.
Developments in the Fund Industry
With respect to the fund industry in particular, what has kept me up at night, is thinking about how all the parts that make up our operational systems work together and coordinate the tremendous amount of information that they are required to process each day. In this regard, I look at individual fund complexes as being something like a young boy hitting a growth spurt. If any of you has a son who has gone through this, you know what it is like, or maybe you might recall yourselves - I certainly do, although mine were too infrequent. In any case, when children, particularly boys who tend to grow very fast in short periods of time, hit a growth spurt, often not all the parts grow at the same time. Instead, maybe the nose, or the feet grow first and the child can look a little awkward during this stage. Usually everything catches up and the awkwardness subsides. However, in some cases, the growth process doesn't go as smoothly, such as when the knees don't grow as fast as the legs, and as a result there may be some temporary pain.
In fund complexes, we should be thinking, are all the areas that need to grow and develop together keeping pace with each other? Or do we have some areas that are lagging behind that, if we don't recognize this fact, may result in some pain or a glitch that could be avoided?
Increasingly Complex Products
In this regard, one growth mismatch that comes to mind is fund firms' increasing investment in highly complex investment products, such as over-the-counter derivatives, and the capability of firms' back office operations to handle the processes that firms rely on to conduct these trades.
According to recently reported data, there was $34 trillion outstanding in credit default swaps at the end of last year, their value having grown 240% in 18 months. From a risk standpoint, a notable aspect of this incredible growth is that these complex instruments are becoming more widely-traded, with traditional long-only asset managers increasing their exposure to them. Firms' traders and portfolio managers may have the sophistication to invest in these products. However, a firm relatively new to this area may not have enough experienced personnel in other areas, particularly in back-office operations, to perform their necessary functions with respect to these trades. As a result, we are seeing operational risks arise as constraints in the back-office threaten the important functions, such as managing the documentation, settlement, valuation and confirmation processes, that this part of the firm performs.
In addition, the escalating trading volume of complex derivative instruments has also put tremendous constraints and exposed weaknesses in firms systems for clearing complex products. We have heard reports of huge backlogs in periods of particularly heavy trading, in one case confirmations had fallen as much as one week behind. The reason for this is an incredible growth and development mismatch within firms. The trading environment is characterized by some of the most highly complex and technologically advanced areas of operations. On the other hand, I am amazed at the significant amount of manual work that goes on behind the scenes getting trades ready for matching. For example, while credit derivative swaps are typically entered into over the phone between dealers and brokers, the trade data is then manually entered into internal systems, which may lead to errors. In one article, I read an estimate that 20 percent of electronic confirmations fail because the trade data had not been entered correctly.
Firm Structure - Vertical versus Horizontal
Some firms that do not have sufficient staff to deal with complex investments have addressed this constraint by restricting the number of these trades that can be executed. Another approach firms have taken is to outsource settlement and confirmation functions to third parties, such as custodian banks or fund administrators. However, this trend of outsourcing these as well as other critical functions has led to another operational risk deriving from firm structure.
When firms retain their critical functions internally, they maintain control over all aspects of operations - there are no gaps. As such, in this all-in-one vertical structure, coordination among all the parts of the operational process is easier to achieve and responsibility is clear. With the trend toward a more horizontal structure, where critical functions are increasingly contracted to third parties, gaps are created within the operational process and perfect coordination becomes more difficult. For this reason, the processes and controls that firms put into place must take into account the relationships among each contracting party to determine whether they are effective. Also with the more horizontal structure, how do you ensure that necessary communication between the interconnected functions occurs? For example, if a computer program in one area is updated, all affected functions need to be aware of the change - if not, necessary information may not flow evenly throughout the firm creating a risk that operational glitches may occur.
These are just some examples. In the mutual fund area, I think we are just at the beginning of seeing growth mismatches of these types as technology continues to drive and reshape the fund industry as we know it. In many ways it is a very exciting time and we are in a sense witnessing almost a revolution in terms of the capabilities of technology to affect how funds do business and how the financial marketplace operates. Thinking of it this way also underscores how important it is to evaluate how we approach risk in this changing environment. I appreciate the opportunity to have discussed some of these considerations with you this morning.
I would now like to shift gears and move from the esoteric world of risk management, to an area that is a bit more concrete and discuss with you some of the current initiatives we are working on in the Division of Investment Management.
When talking about updating operations and business procedures to match what is happening in the marketplace, we in the Division have a similar responsibility to evaluate the SEC's rules to determine if they are relevant and whether they are achieving their intended purpose. One of my top priorities this year is to do just that with regard to rule 12b-1. This rule, adopted in 1980, was intended to stem the problem of net redemptions, spur fund growth, and reduce overall shareholder expenses. However, as you know, in many cases 12b-1 fees now are used primarily as a substitute for sales loads and for servicing. With these uses, it is not clear whether this rule continues to serve the purpose for which it was originally intended.
To discuss the issues surrounding rule 12b-1, the Commission hosted a Roundtable in June this year. The Roundtable consisted of panels addressing the historical circumstances that led to the promulgation of Rule 12b-1 and the rule's original intended purpose. The Roundtable also discussed how the uses of 12b-1 fees have evolved and the rule's current role in fund distribution practices.
The Roundtable was very successful and a number of regulatory approaches to rule 12b-1 were raised by the panelists. These included revising the factors that directors must consider in their annual approval of 12b-1 plans to make them better conform with the reality of the way 12b-1 fees are used and requiring funds to disclose in shareholder account statements the actual amount of distribution-related expenses that each shareholder paid. It was also suggested that the Commission treat 12b-1 fees as account-based fees, assessed directly on individual investors, rather than at the fund level.
In addition to the Roundtable, the Commission also requested public feedback on the issues surrounding rule 12b-1. In response to the request, the Commission received over 1400 comments. Many of the comments presented very thoughtful ideas, arguments and perspectives on rule 12b-1, underscoring strongly held views people have about this rule. The staff is now busy going through the comments, reviewing the suggestions raised at the 12b-1 Roundtable and generally considering the best policy in this area. We are currently preparing a recommendation to the Commission regarding rule 12b-1.
Disclosure Reform and Interactive Data
The next initiative I would like to discuss fits in very well with this conference as it epitomizes how technology can be used in a positive way for the benefit of fund investors. This is the Commission's disclosure reform and interactive data initiative. In fact, this initiative has the potential to change entirely the way fund shareholders obtain and use information. To that end, the initiative has two interconnected components - prospectus improvement and interactive data.
For the prospectus improvement component, the Division is formulating a recommendation to the Commission that would permit funds to offer securities using streamlined disclosures that would be provided directly to investors, with more detailed information available on the Internet or in paper upon request. The streamlined disclosure initiative is designed to enhance the current prospectus/SAI regime by providing investors with key information in plain English in a clear and concise format. This information may include investment objectives and strategies, costs, risks, and historical returns. The more detailed information in the current forms would continue to be available to investors and others who desire it, including in an easily accessible electronic form.
This concept represents an effort to make use of technologies available today to enhance the mutual fund disclosure regime. However, it also represents an acknowledgment that many fund investors currently are overwhelmed with paper - they need and deserve a disclosure system that better meets their needs and is consistent with the manner in which Americans increasingly retrieve and process information in the 21st century.
Further enhancing the disclosure regime is a technological infrastructure the SEC has been working on for the past two years that would make an interactive disclosure regime possible in the form of data tagging. Data tagging uses standard definitions (or data tags) to translate text-based information into data that is interactive, that is, data that can be retrieved, searched, and analyzed through automated means. Tags are standardized through the development of taxonomies, which are essentially data dictionaries that describe individual items of information and mathematical and definitional relationships among the items. Tagged information can help investors, analysts, and other users to mine the wealth of information contained in detailed disclosure documents, providing users with the ability to access precisely the information in which they are interested and to analyze and compare that data.
The Commission currently permits companies, including mutual funds, to voluntarily submit financial statement information in a tagged - or XBRL - format. Early this year, the Investment Company Institute released for public review a draft taxonomy that it developed for tagging certain disclosure data contained in the risk/return summary of the mutual fund prospectus, including investment objectives and strategies, costs, risks, and historical performance. In June, the ICI's risk/return summary taxonomy was recognized as an acknowledged XBRL taxonomy by XBRL International.
Also last June the Commission adopted rule amendments expanding the current interactive data voluntary reporting program to enable mutual funds to submit exhibits to their registration statements containing tagged risk/return summary information. We are now at the beginning of this program and I am hopeful we will achieve broad voluntary participation that will allow us to test the interactive tagging system's usefulness to investors, third-party analysts, mutual funds, and the marketplace.
Another very important initiative that the Division is developing concerns soft dollars. In 2006, the Commission issued an interpretive release that, among other things, provided guidance with respect to what qualifies as execution and research services that may be purchased using soft dollars under section 28(e) of the Securities Exchange Act. As a next step, the Division staff is currently working to provide a recommendation to the Commission that would provide guidance to assist mutual fund boards in their oversight responsibilities in this area.
Again, in line with the theme of this conference, soft dollars is a great example of how technology has impacted business practices in the fund industry. For example, firms are increasingly employing new technologies in their brokerage practices, such as the increased use of electronic trading platforms and execution systems. These new technologies are making it easier for advisers to more accurately determine the cost of best execution and as a result more precisely value the cost of the research and brokerage services obtained with soft dollars. Additionally, the use of new technologies has created increased transparencies and is allowing greater opportunities for "virtual unbundling" of research and execution services. We are also seeing potentially favorable current market trends such as an overall decline in commission rates and increased internal reporting of meaningful information on trading practices to fund boards.
In addition, U.S. firms are reacting to new regulatory requirements in other jurisdictions, such as the FSA's requirements in the UK that research and execution be unbundled. Thus, the area of soft dollars has become a fast moving target. In order to get the lay of the land in this area, we are speaking with advisers of all sizes, independent directors and directors' counsels to make sure we get our recommendation right. Our goal is to provide fund boards with helpful guidance to assist them in monitoring the conflicts of interest inherent in soft dollar arrangements, while being careful to avoid recommending guidance that will adversely affect the evolution of the trading markets in an unintended way.
We expect to provide the Commission with a recommendation in this area shortly.
The Division is also busy working on regulatory initiatives related to exchange-traded funds. Following the launch of the first ETF in 1993, these products, which now have more than $485 billion in assets, have become an increasingly popular and important component of our financial markets.
The form of ETFs has also continued to evolve. Although all current ETFs are index-based, the indices on which they are based are becoming increasingly narrow. Additionally, we have seen recently the introduction of so-called leveraged ETFs - the first ETFs to seek a multiple or inverse multiple of the return of various indices -- and the first ETFs based on affiliated indices. We also have seen recently the introduction of high yield bond ETFs.
Because ETFs were not envisioned when the Investment Company Act was enacted, ETFs do not fall neatly within the traditional categories of investment companies and as a result must obtain exemptive relief to operate. Currently, this is done on a case-by-case basis through an application process. Shortly, the Division intends to recommend that the Commission propose a rule to codify the exemptive relief ETFs require to operate. This would eliminate the need for ETFs to obtain specific relief before beginning operations.
Books and Records
The final initiative I would like to discuss this morning is the revision of the books and records requirements for both investment companies and investment advisers. Although we have talked a lot about technology today, in terms of regulation, I don't think its impact is any more obvious than how it relates to books and records. The rules governing recordkeeping requirements under both the Investment Advisers Act and the Investment Company Act have not been updated in a comprehensive fashion since they were adopted in the 1960s. At that time, paper records were the norm and electronic records were the exception. Of course, the reverse is clearly true today. For this reason, the Division is taking a fresh, comprehensive look at requirements in this area.
In developing our recommendation in this area, the Division is actively exploring how to reconcile the rules with the desire for electronic record retention. This includes the extent of obligations to retain electronic communications such as e-mails and text messages.
Again, I appreciate your attention this morning. The impact of technology on operations in the fund industry is a fascinating and truly relevant area to focus on over the next two days. The ICI has put together a program that I am sure you will find extremely interesting and educational. I hope you enjoy it. Thank you.