Speech by SEC Commissioner:
Remarks Before SIFMA’s 40th Annual Seminar
Commissioner Paul S. Atkins
U.S. Securities and Exchange Commission
April 1, 2008
Thank you, Dan [Fitzpatrick] for your kind introduction. Before I begin, I must note that the views that I express here are my own and not necessarily those of the Securities and Exchange Commission or my fellow Commissioners.
I guess that I ought to start the morning with the big news, and I am not talking about Treasury Secretary Paulson's announcement yesterday of proposed reforms. In a little-noticed announcement made just before midnight last night, our Division of Trading and Markets issued a release pursuant to its delegated authority declaring that after all, despite the billions of dollars spent by the securities industry in an effort to comply with Regulation NMS and all the FAQs and speeches and seminars to explain the inexplicable and exemptions and exceptions to help implement the unimplementable, the staff has finally come to the conclusion that the trade-through rule of Regulation NMS must be consigned to the dustbin of history. The exigencies of the current market situation, competition from abroad, and the fact that there are in fact no trade-throughs have led to the inevitable conclusion that there are better ways for us to spend our time. Sorry for the inconvenience. For good measure, the Commission in this time of market turmoil has decided that it will adopt the views of the minority on the Seligman Committee and that market data fees for the past 7 years will be reimbursed, with interest.
Well, I should stop there. Because today is the first of April, I had to make sure that you are paying attention for your first session.
It is a particular honor to be with you all to mark forty years of the annual Compliance and Legal Seminar. In looking back over those forty years, it is important to consider what has changed and whether those changes have been for the better. We should also consider what has not changed, but should have. We clearly do not have time this morning to explore the transformations of the last four decades in detail. To be sure, discussion of the challenges of today can more than fill up the time.
Could any of us have envisioned just a year ago the events of the past several months, let alone the past couple of weeks? The demise of a large, well-capitalized investment bank in less than a week, basically through a run on the bank, or the complete evaporation of investor interest in whole classes of securities that had active markets just a few months ago?
History can help to put today's challenges in context. We have experienced turbulent periods like this before and have emerged from them with our economy intact and indeed stronger than when we went in. As Treasury Secretary Paulson remarked last week, "every period of prolonged turbulence seems to be the worst until it is resolved. And it always is resolved."1 The pessimists among us might respond that the economy is bigger and more complex than ever before, so its problems too are bigger and more complex than ever before. It is true that our economy has grown rapidly. Forty years ago, for example, at the time of the first Compliance and Legal Seminar, average daily trading volume had reached the then-astonishing amount of more than twenty-two million shares a day.2 The SEC's annual report of 1968 observed that the markets and regulators were "confronted with, and almost overwhelmed by, the sheer volume of activity."3 Wall Street itself came perilously close to shutting down because the antiquated back-office systems for clearance and settlement had not kept pace with growth of trading. Wall Street solved that problem, but some 20 years later in the wake of the 1987 market break, some scoffed at Dick Grasso's drive to prepare for a billion-share day. As a current combined Nasdaq-NYSE volume of over five billion shares illustrates, the market and its regulators did find ways to handle that volume and much more. So, while we may no longer fully appreciate the concerns of forty years ago, the capacity of the market to address them gives us a sturdy foundation for what we can expect from the future.
Of course, we need to be realistic about the problems that we face, but we also need to be realistic about the solutions that we consider. It is also fair to ask, as many are doing, whether our regulatory structure needs some updating. In answering that question, we cannot forget that we were asking that question long before the recent problems began. Treasury's Blueprint is one more important step in this process. We should also not forget that four well-researched studies have been published since November 2006 regarding the competitiveness of the U.S. capital markets and suggesting recommendations to improve our regulatory structure. Central to the issue of competitiveness is regulatory effectiveness and efficiency. Investors, ultimately, suffer the costs of lack of effectiveness and efficiency, not only through higher prices but also through constrained investment opportunities. In the end, that hurts them in their investment performance, because it means less opportunity for diversification.
And, no, competitiveness does not mean a race to the bottom, as some contend. Investors need and demand effective recourse to the rule of law and enforceability of contract. They rely on a system of integrity — that is what separates us from markets encumbered with insider dealings or lack of transparency. The SEC's mission to maintain the integrity of our markets is based on a rather simple premise: if investors have confidence that they will be treated fairly, they will invest their money and demand a lesser premium because of a lesser risk. This should yield a lower cost of capital, according to the same principle by which the market does not demand junk bond rates from the US Treasury. But, there also must be a balance. We also must not drive investors out of our markets by forcing them to bear the cost of burdensome, one-size-fits-all regulations. The actions of government by nature are coercive. Investors have no choice — it is they who pay for excessive regulation through lower returns, reduced growth, and diminished investment opportunities.
From a historical perspective, we have been fortunate in this country with respect to the development of our capital markets. The United States emerged from the end of World War II with its capital, industrial and scientific structures intact. The rest of the industrialized world lay in ruins. Communism and socialist ideas then suppressed the formation of financial markets in many parts of the world. So, for many decades, these external factors contributed to the United States' place as the dominant financial marketplace in the world. Regardless of our regulatory costs, there were no other financial marketplaces with the size, liquidity, and depth of the United States — a position that we have continued to maintain to this day.
Through it all, American investors enjoyed an unparalleled investment environment — people from around the world have come here, on our terms, under our laws — to seek out our investment. As a result, Americans generally benefited from the protections of American laws and our court system. Now, with global investment opportunities increasing, that is changing. Many global competitive forces will continue to challenge the position of the United States, including the rise of liquidity pools and capital markets in Europe, Russia, China, India, and other places as well. Americans through technology have unprecedented access to these markets. E-Trade, for example, now offers its customers direct access to foreign markets with a click of a computer mouse. With burgeoning foreign capital centers and easy direct access of Americans to those markets, foreign companies no longer have to come here.
In a free market economy driven by innovation, our regulatory structure cannot remain static. We are in need of constant adjustments so that our markets remain the most attractive and competitive. The progress that people had made in thinking about those issues should not be cast aside in favor of a new regulatory framework hastily designed solely with only the current challenges in mind. In making changes, the problems that we face today should instead be taken into account along with the problems that had us considering regulatory modernization long before the current period of market uncertainty.
These themes were reflected in the Treasury's report on financial regulation that Secretary Paulson unveiled yesterday. The report was the product of many months of work and benefited from the input of many commenters, including SIFMA. Among the reforms that SIFMA favored and the Treasury is recommending are the unification of the SEC and Commodity Futures Trading Commission (CFTC) and a shift towards principles-based regulation. The latter would require radical adjustments by regulators and industry alike. The SEC would have to depart from its often very prescriptive approach to rulemaking. The financial industry would have to be weaned from its tendency to seek the protection that specific rules afford from later second-guessing and — if the rules serve as barriers to competition — from would-be competitors.
As to a possible merger between the SEC and the CFTC, I can only say that this is by no means a new suggestion. The CFTC was not even in existence in its current form as an independent agency forty years ago. Since then, the markets that the two agencies regulate have begun to meld into one another as financial futures contracts have greatly added to the CFTC's traditional regulatory portfolio. It is not surprising, then, that calls for a consolidation of the agencies have increased. Whether a merger ought to happen is a question for Congress and the Administration — it is certainly beyond my power as a Commissioner.
In the meantime, I am pleased to report progress in cooperative efforts by the CFTC and the SEC. Last month, the two agencies signed a memorandum of understanding (MOU) to recommit themselves to working together.4 Among the concrete outworkings of that MOU is the coordinated effort to approve two new products — one an option and the other a future — based on the Gold Trust Shares. These two products, I hope, mark the beginning of an end to the limbo in which products on which both agencies have a potential regulatory claim have too often found themselves.
Drawing lines between what belongs in one regulator's purview and what more properly fits in another's is difficult. Even within the SEC, there are questions about where one Division's work ends and another's begins. New products that are clearly within the SEC's purview have also gotten caught in regulatory limbo, a problem to which SIFMA referred in its comments to the Treasury. We now have a permanent regulatory liaison with the CFTC. We also need a new products czar, who would be responsible for project management of new products and shepherding them through the SEC process.
The silo mentality that sometimes roils the SEC was evident in our attempt to rationalize the investment advisor/broker-dealer regulatory schemes. As you all know, the solution that the SEC settled on did not pass muster in the U.S. Court of Appeals for the District of Columbia. So now we are back to the drawing board. This time, though, we have empirical data from the study that the SEC commissioned by the Rand Corporation.5 RAND's investor testing found widespread uncertainty about the differences between investment advisors and broker-dealers.6 Not surprisingly, investors are unlikely to read disclosures that explain what their broker or investment advisor does.7 Most of the investors surveyed said that they are satisfied with their own investment professional and the firm for which he works.8 Those who had worked with their investment professional for more than ten years were even more likely to be satisfied.9 The survey suggested that accessibility and attentiveness were the most important attributes of a financial professional, with cost a distant second.10
Whatever solution we settle upon, we must not unnecessarily disrupt relationships between investors and their advisors or brokers that are working effectively. We also need to be careful not to assume that all retail investors are identical and need identical financial services. A consumer in this country can choose between multiple varieties of soft drinks even within a single brand. How much more important it is for consumers to have choice in their financial service providers!
Of course, if consumers are to have choices, they must also have good information about those choices. The challenge is to provide the information in a form that investors will read. The effort to encourage investors to read disclosure documents is not a new one. Four decades ago, an SEC Study Group working under the supervision of Commissioner Francis Wheat to conduct a comprehensive review of disclosure policy, was discussing the possibilities of summary '33 Act prospectuses in plain English.11 Likewise, now the SEC has a proposal out for summary prospectuses for mutual funds in plain English. Proposals for disclosure reform are more promising today when we have the Internet, than forty years ago, when microfiche was the promising disclosure technology. The SEC will have to consider, of course, whether changes are necessary to ensure that the summary prospectus is actually used, as SIFMA and ICI suggested in a joint comment letter.12
Some of the actions that have been taken in the name of retail investors have actually harmed retail investors. An example of this is, of course, Regulation NMS, to bring up the subject a second time, this time seriously. Implementation of Reg NMS, although unquestionably time-consuming and technologically challenging, has been aided by a series of exemptions from the trade-through rule, with more likely to come soon. It is good that we are flexible enough to grant exemptions and interpretations where they are needed, but we have not always granted that relief when it is needed. Oral assurances from the staff that a particular practice will not be deemed to run afoul of Reg NMS are better than nothing. But oral relief is cold comfort to the firm facing questions from a FINRA examiner without anything concrete to which it can point. As an example, requests for a written exemption for non-convertible preferred securities and an expansion of the qualified contingent trade exemption are pending. I hope that, in the future, as issues arise, exemptions and interpretations will be granted more promptly than they have been to date. As a general principle, however, it is better to refrain from adopting rules that we know at the outset will require massive exemptions to function.
The Reg NMS exercise not only has taken up a lot of your time, but it has consumed a lot of SEC hours that could have been spent on other matters. Our attempts, rejected by the courts as either ultra vires or procedurally improper, at reforming mutual fund governance and mandating that advisors to hedge funds register are additional examples of the SEC's diversion in recent years from issues that really matter. In all of these cases, the SEC focused its attention on designing solutions for non-existent problems, and using questionable reasoning and contortions of statutes in order to do so.
Here is a thought experiment for you this morning: What if the SEC had instead focused its staff and rulemaking resources more fully on documentation problems in the over-the-counter (OTC) derivatives markets? Commissioner Nazareth and I called for that years ago. In response to reports of widespread documentation problems in those markets, the SEC joined forces more than two years ago with other regulators, most notably the Federal Reserve Board and the UK's FSA, to encourage OTC market participants to clean up years of incomplete and inaccurate trade documentation.
The need to act was clear — from all reports, the backlog of unconfirmed trades -which essentially are fails- and the widespread and unchecked use of novations in the credit derivatives markets had crippled risk management efforts. The fear was what would happen in the case of a large default of a major institution? Indeed, what role did that fear play as recent events played out? Given the multi-trillion dollar aggregate notional amounts of the contracts involved, it was easy to see that the OTC derivatives dealers and their counterparties had created an operational problem similar in scope to the late 1960s back-office crisis on Wall Street. For example, in the failure of one hedge fund not long ago, it took a couple hundred people weeks to sort through the OTC derivatives documentation issues.
In September 2005, the Federal Reserve Board and other regulators including the SEC called together the fourteen major OTC derivatives dealers to address these operational issues. The focus at that time was on OTC credit derivatives. Of course, the SEC does not necessarily have jurisdiction over OTC credit derivatives, but the firms subject to SEC supervision under our Consolidated Supervised Entity (CSE) program are dealers in that market, and so it was important for the Commission to be involved in overseeing the cleanup process. It is an important risk management issue. In addition the Commission does regulate OTC equity derivatives, and those contracts were not immune from the same operational maladies suffered by credit derivatives.
The dealers agreed after the 2005 meeting to develop processes for reducing the operational risks associated with the documentation backlog, and established a timeline that would allow regulators to track their progress. In the ensuing years, they have shown great progress. The so-called Operations Management Group, made up of OTC derivatives dealers, buy-side firms, ISDA, MFA and SIFMA, recently reported significant progress in cleaning up the situation and laid out goals for 2008, including implementation of electronic platforms for confirms and novation requests, central settlement, and timeliness and accuracy goals for credit derivatives.13 In addition, new enterprises, such as Markit Group's SwapsWire, have entered the market to provide centralized, automated trade processing, and I assume that such competition will encourage and drive innovation in this area.
Today, due in large part to the increased use of electronic settlement systems and standardized contracts, the number of aged, unconfirmed OTC credit derivative trades at the CSE firms has been reduced by more than ninety percent since the September 2005 high. That is truly a success story, and I applaud both the principled regulatory approach and the tremendous efforts of the market participants.
In the Fall of 2006, attention turned to documentation failures in the OTC equity derivatives markets. According to a recent report by the Office of the Comptroller of the Currency, the notional amount of OTC equity derivatives held by banks in the third quarter of 2007 was about $2.8 trillion.14 Amazingly, that figure pales in comparison to the $14 trillion notional value of credit derivatives — and the $172 trillion aggregate notional value of all derivatives held by banks in that same period.15 As high as these figures are, they do not reflect the change in the market of which you all are very keenly aware: for example, trading revenues for cash and derivative activities of all commercial banks fell from $6.2 billion in the second quarter of 2007 to $2.3 billion in the third quarter.16
As with credit derivative documentation cleanup, the process for equity derivatives is being overseen by regulators but implemented by the dealers. Inherent differences in the credit and equity derivatives markets have made some aspects of the cleanup effort for equities derivatives more challenging.
One of the primary difficulties has been the lack of standardized documentation, which has often resulted in lengthy confirmations. The problems arising from a lack of standardization are exacerbated by the fact that, unlike with credit derivatives, the majority of equity derivative transactions are dealer-to-client instead of dealer-to-dealer, and thus the number of counterparties is much larger. I understand that the efforts of the major banks through ISDA have been productive, but much more work is needed to match the successes experienced in the credit derivatives process. This lack of standardization of OTC credit derivatives continues to be a major systemic threat to our financial system.
As successful as this public/private partnership has been to clean up the problems with OTC derivatives documentation, there is more that the SEC can do to facilitate efficiency and competition in the equity and credit derivatives markets.
The SEC and other regulators cannot stand in the way of new product development and dissemination. As you may know, both the CME and the CBOE proposed exchange-traded credit derivative products last year, and I understand that they would like to bring many more of these products to market. These exchange-traded products will bring market participants important benefits that OTC products simply cannot. The products are substantially similar to OTC products, but they would carry with them all of the efficiencies inherent in exchange traded products- they are 100% standardized, they are centrally cleared and settled, and transaction and quotation information would be transparent. Despite the concerns that OTC dealers may raise, I doubt that the exchange-traded credit derivatives will have a major competitive impact on the OTC markets. In fact, it would not surprise me if both markets grew at similar rates. But I fully expect that the availability of exchange-traded products will increase the pressure on the OTC markets to streamline their processes and provide increased transparency. That, in turn, will allow for better risk management and increased confidence for regulators and market participants.
In my view, the SEC should not allow jurisdictional issues — a.k.a. "turf wars" — to stymie the growth of exchange-traded credit derivative products. I hope and expect that the Commission will work closely with the CFTC to establish a rational, predictable, and timely approval process for these products. Indeed, I believe that timely consideration and approval of these products will be a major test of the commitments set forth in the MOU with the CFTC.
In light of the current problems in the U.S. markets, some people have suggested that we turn our attention inwards and put on hold efforts to improve the integration of the international marketplace. Unplugging the U.S. economy from the international one is not a way to solve our problems, but rather to exacerbate them. We ought instead to forge ahead with our cooperative efforts with other nations. Many of you in this room have worked hard to build up relationships outside the United States. The SEC, for its part, has worked with its fellow regulators to build stronger international markets. To date, our efforts have included the reaching of memoranda of understanding regarding enforcement cooperation, technical assistance, and investigatory collaboration with more than thirty foreign jurisdictions.
In a continuation of our efforts, last week, the SEC announced upcoming plans for mutual recognition. The SEC's plans include long-overdue amendments to Rule 15a-6 in order to make it easier for U.S. investors to deal directly with foreign broker-dealers and thereby trade foreign securities. If the rule is amended, some of your firms could see demand for their chaperone services essentially eliminated. The impracticalities of chaperoning makes it time for a change, and the change should serve investors well. Along with reforms to Rule 15a-6, we will be working with foreign jurisdictions to conduct comparability assessments of one another's regulatory regimes. I laud the push to reduce or eliminate unnecessary barriers to entry. I am concerned, however, that this comparability undertaking might become an unworkable cycle of rule-by-rule comparison followed by a cumbersome series of individual firm-by-firm exemptions. I hope that instead the Commission can formalize a focused, transparent process that will recognize the merits of alternative regulatory structures.
A conference like this is an excellent opportunity for all of you to compare notes and exchange ideas. I hope that after doing that, you will feel free to stop by when you are next in Washington, D.C. to let me know what the SEC can learn from your experiences. Thank you all for your attention.