Speech by SEC Staff:
Luncheon and Keynote Address at NICSA East Coast Regional Meeting
Andrew J. Donohue1
Director, Division of Investment Management
U.S. Securities and Exchange Commission
October 6, 2010
Thank you very much for the kind introduction and for inviting me to join you today. I appreciate the opportunity to speak with you. Before I begin, I need to state the standard SEC disclaimer that my remarks represent my own views and not necessarily the views of the Commission, the individual Commissioners or my colleagues on the Commission staff.
As I will shortly be leaving my position as Director in the Division of Investment Management at the SEC, this will be one of my last opportunities to speak with representatives of the fund industry in my current position. I am grateful to have the chance to speak with you at this time as technology and fund operations have truly fascinated me since my days working in large fund complexes. In my role as general counsel back then, a large part of my responsibilities was to worry. There were plenty of things to worry about, but my focus was on what was happening in the fund industry, and our markets, and the incredible changes that technology was bringing to the way the industry operated. I was, and am, amazed at how fund operations were keeping up with all these changes — revolutionary changes in trading processes, the increasingly interconnected nature of our markets, greater use of sophisticated products and of course the speed of market activity.
The lightening fast pace of our current markets is indeed quite incredible, and the impact of technology is undeniable in this development. The use of algorithms for high-frequency trading now controls up to 70% of the equities market, according to current estimates. A “technology arms race” among firms is said to exist — a race for speed, among other things. I recently saw an article that talked about a firm that built a high-speed fiber-optic cable between Chicago and New York to use for sending trades between those two markets.2 The firm plotted the straightest route — as straight as the crow flies — to create a circuit that moves at a rate of 825 miles in 13.3 milliseconds. It was said that this rate shaves 100 miles and 3 milliseconds off of the time of the previous route. 3 milliseconds. Apparently, in our markets, 3 milliseconds is now considered an eternity as firms which use algorithmic trading, and which are not on this line and able to take advantage of its speed are, they say, at a significant disadvantage. 3 milliseconds! Things have really changed. The use of an open phone line for trading is now an antiquated approach, we have moved into dark fiber optics. What is next? It is mind-boggling and exciting to think about.
Technology has truly been an incredible force of change in the fund industry. However, what I have come to appreciate over my 30-plus years working in and with this industry is the importance of technology on a number of different levels. While I have spoken previously about my concerns of the new risks that technological changes present, specifically with respect to fund operations, what I would like to talk about today is the flipside of this: the amazing existing and potential benefits of technology, specifically as they relate to regulation of the fund industry and the protection of fund investors.
An appreciation of technology and how it can be used to improve the way we do things is especially important for me, as I am a lawyer and am well-aware of my limitations, especially regarding technology. You will note that I am not using any technology other than a microphone for my presentation today. During my time in the fund industry, if I was faced with developing a business proposition, I would consult those who worked with operations and technology and ask them how they would suggest getting from point A to point B. My intention was to do this consultation at the earliest stage. As lawyers, many believe our inclination is to say “no, you can’t do that,” while I have observed that frequently those working with operations and technology see the possibilities — the answer was seldom “no, we can’t do this,” but rather it was “here’s how can we do this,” or “here’s how can we do this better.”
Now I don’t mean to suggest that lawyers don’t have their roles, we do. But what I found very beneficial in the industry in the past — early collaboration among those with different areas of expertise — I also found very beneficial in the regulatory context. In particular, as a number of our regulatory initiatives in the Division of Investment Management had significant operations and technological aspects, learning about the impact of different regulatory approaches on fund operations was extremely helpful and I believe greatly assisted the Division staff in preparing balanced and effective rule recommendations to the Commission.
An example of how technology has been used in regulation, and how cooperation with the industry helped lead to a great result, is the Commission’s adoption of a mutual fund Summary Prospectus in 2008.3 This initiative, in my opinion, is one of the Commission’s most significant investor-oriented developments in fund regulation in recent years. And what is interesting is it would not have been possible until only a few years ago. The Summary Prospectus was designed to improve the disclosure framework for fund investors by providing information that is easier to use and more readily accessible. It does this by using advances in technology to address the length and complexity of mutual fund prospectuses. First, investors are provided key information they need to make informed investment decisions in a streamlined, summary format. The more detailed information about a fund is provided online in an interactive format which facilitates comparison of important information, such as expenses, across different funds and different share classes of the same fund.
The development of the summary prospectus involved a commendable collaborative effort among the Commission, the fund industry and fund investors. This effort included a Commission roundtable in June 2006 with participants representing a wide range of different areas of expertise. At the roundtable, participants discussed the potential benefits of increased Internet availability of fund disclosure documents. These benefits included facilitating fund comparisons and replacing one-size-fits-all disclosure with disclosure that each investor could tailor to his or her own needs. Participants also suggested that advances in technology offer a promising means to ensure that access to the full wealth of information about a fund is immediately and easily accessible, and provide the means to present all information about a fund in an interactive online format. In this way, technology could be used to assist investors in sorting through the overwhelming number of investment choices by having ready access to key fund information in a usable format.
As disclosure is a key element of investor protection in the mutual fund regulatory scheme, the Summary Prospectus represents a true advancement in this area — a result I believe we arrived at by taking into account input from a variety of disciplines representing differing expertise and viewpoints. With the success of the Summary Prospectus, the Division staff has been evaluating this idea of providing streamlined, user-friendly information with a technology component in other areas, such as shareholder reports and the variable annuity prospectus, each of which can be long and dense, but yet contain information of vital importance to investors. I hope that again, the industry and fund investors can play as positive a role in the staff’s consideration of these very important initiatives as they did for the Summary Prospectus.
Another regulatory initiative where input from the fund industry, particularly fund operations, was critical to achieving a balanced result was the Commission’s recent proposal to reform rule 12b-1.4 The proposal is designed to modernize regulation of the way that mutual funds and their investors pay for the costs of promoting and selling — or distributing — fund shares.
Over 30 years ago, when rule 12b 1 was adopted, one of the main purposes for 12b-1 fees was to pay for advertising and promotion. Today they are used mostly to pay for investor services and to compensate sales personnel for selling fund shares — essentially functioning as a substitute for a front-end sales load. Rather than paying for new investors to invest in the fund, 12b-1 now involves existing investors essentially paying for themselves. The reforms proposed by the Commission, if adopted, would regulate the distribution fees that serve as a front-end load substitute. They would do this by limiting the cumulative sales charges paid by individual fund investors (whether up-front or over time), improving the disclosure of distribution fees in fund prospectuses, shareholder reports, and transaction confirmation statements, and providing a more appropriate role for fund directors in reviewing and approving these fees. The proposal would also, for the first time, allow funds to choose to offer a class of shares that could be sold with sales charges that are established by broker-dealers, rather than by funds to promote price competition and as a result provide a new alternative means for investors to purchase fund shares at potentially lower costs.
In preparing its recommendation for reform of 12b-1, the staff took into account significant input from fund investors, fund directors, mutual fund managers, and other regulators. The consensus among this diverse group was that the 30-year-old rule needed to be updated to better reflect modern distribution practices. However, the staff considered various routes towards achieving this goal when developing its recommendation. Through the staff’s meetings with the many groups representing different views and disciplines, we were able to better understand the various options and how we could leverage current technology and operational capabilities to achieve the regulatory goals while minimizing the burdens on firms. As with many of our regulations that entail changes to fund operations, learning of the different options and possible alternatives to avoid unnecessary operational retooling and costs, was a key component in developing this recommendation. As the staff considered the various alternative methods, we realized some could involve a significant cost. Through the help and suggestions of many of you and your firms, I believe the Commission’s proposal reflects the current practices of many funds and fund transfer agents, which we anticipate would reduce costs associated with complying with the proposed rules.
In this regard, I want to note that the comment period on the proposal ends November 5th. I encourage you to submit your comments and suggestions. The staff takes the comments on Commission proposals very seriously and they are a vital part of the regulatory process. Your expertise, your knowledge in the practical sense of what works and what does not, and your understanding of how the proposal will impact funds operationally, are especially helpful to the staff in developing a final recommendation to the Commission. I urge you to approach this important proposal from your “can do” perspective and offer us assistance in crafting the best recommendation for adoption.
Money Market Funds
One more initiative I would like to discuss is the Commission’s adoption, in February this year, of amendments to reform rule 2a-7, the rule that governs money market funds.5 The reform of rule 2a-7 is another example of how regulation may use technology to achieve greater investor protections, and also require common industry practices to encourage investor confidence in our markets. Again, learning from the industry what will work and how different policy approaches will play out was invaluable in preparing an effective and balanced recommendation in this area, particularly as technological advancements and capabilities played a role in a number of the new requirements under rule 2a-7. For example, the amendments require the board of directors of a money market fund to adopt procedures to provide for periodic stress testing of the fund's portfolio under different scenarios, such as a sudden increase in interest rates or the default of issuers of securities held by the fund. The requirement to provide stress testing follows what we learned from the recent market crisis in which a widely-held money market fund for the first time “broke the buck” and various facilities were enacted and other government programs were created to provide stability and additional liquidity to money market funds. The requirement to provide stress testing, along with the other requirements adopted in the 2a-7 reform, were aimed at improving the ability of money market funds to withstand the financial stresses that they may experience and make money market funds a more safe investment.
In addition, under the new rules, money market funds must disclose portfolio information to the public each month on their web sites. This disclosure will equip investors with information they can use to evaluate the risks of investing in particular funds. The funds must also file more detailed portfolio reports each month with the Commission. With the technology of today, the Commission will be able to use this data — to aggregate and analyze it to better oversee the $3 trillion dollars invested in money market funds and help ensure their safety. Twenty years ago the Commission likely would not have been able to handle this amount of collected data and use it as effectively as it will be able to today.
The same thing may be true with respect to data the Commission has been authorized to collect under the Dodd-Frank legislation, such as information from private fund advisers, regarding their private funds. Some of that data may be used, for the first time, to analyze the potential systemic risks of hedge funds in our markets. Due to technology, the types of analyzes — the aggregation, manipulation — of that data that we and other regulators can now do, that we couldn’t do before, is astounding. In this way, technology, on the one hand has created a more complex market system with new potential risks and benefits, but it also is providing us with increasing tools and capabilities to enable us to do our jobs better and more effectively. These are certainly interesting and exciting times to be in the fund industry and to be at the Commission.
In conclusion today, I would like to reiterate how important your engagement in the regulatory process is, and I encourage your participation. You provide the staff with an important reality check. You help us understand how things may be done, and how they may be done better, with the least amount of unnecessary costs and burdens. You also help us better approach the impact on your operations of our proposals — what is the cost and benefit of adjusting your systems to accommodate a certain requirement? How long may it take for you to reasonably implement the requirement? For example, with your assistance we learned of the difficulties money market funds may experience in implementing the requirement under the new rule that funds be able to process sales and redemptions at a net asset value per share other than a dollar. With this information, the Commission established a compliance date more than 20 months after adoption. There are many other examples. In my experience, I feel the regulatory process was greatly enhanced through the input of a variety of sources and perspectives and facilitated more effective and balanced recommendations from the Division.
Now, in looking to the future, I imagine your assistance will be appreciated that much more. Technology, at the incredible rate it is developing, is showing no signs of slowing down. Quite the contrary. How do you and we solve problems using this technology? How can technology provide a better way? How can developments in technology benefit investors, particularly fund investors? I believe these questions will continue to be the focus of regulation in the fund area, and ones to which I believe, with the benefit of your insight and expertise, you can truly help us find the best answers. Thank you for listening.
1 The Securities and Exchange Commission disclaims responsibility for any private publication or statement of any SEC employee or Commissioner. This speech expresses the author's views and does not necessarily reflect those of the Commission, the Commissioners, or other members of the staff.
2 See Christopher Steiner, Wall Street’s Speed War, Forbes, Sept. 27, 2010
3 See Enhanced Disclosure and New Prospectus Delivery Option for Registered Open-End Management Investment Companies, Investment Company Act Release 28584 (January 13, 2009)
4 See Mutual Fund Distribution Fees, Investment Company Act Release 29367 (July 21, 2010) (Proposed Rule)
5 See Money Market Fund Reform, Investment Company Act Release 29132, February 23, 2010