Speech by SEC Commissioner:
Remarks Before the Security Traders Association's Annual Washington Conference
Commissioner Roel C. Campos
U.S. Securities and Exchange Commission
May 3, 2006
I'd like to thank John (Giesea) for inviting me to address you early this morning. It is always a pleasure to speak with the STA and we at the Commission truly value your insight and opinions on the various issues facing us. Of course, there's nothing like holding the 8:30am time slot, except, of course, having the post-lunch time slot. So, I thought I'd try to grab your attention with a little humor before diving into the substance of my remarks. Here goes nothing!
Shortly after receiving his big fat bonus, a young Wall Street banker drove his new Porsche into the parking lot of his penthouse apartment in uptown Manhattan. He parked in his usual spot. Barely had he gotten out of the car when a big truck slammed into the space next to him and crushed his car door. In a frenzy, he shouted at the truck driver, "Look what you've done! My brand new Porsche!" The truck driver came out, towering over the young lad, and said, "You Wall Street kids are so materialistic! Haven't you noticed that I ripped off your arm?" The young banker looked at his missing arm, horrified he screamed, "Oh my god! Where is my Rolex???"
Now that I've got your attention, I'd like to discuss two topics today: the new trading environment in which exchanges are all for-profit entities and, briefly, Regulation NMS.
Self-Regulation and For-Profit Exchanges
Now, I'd like to turn to self-regulation. The conflicts which arise in the context of SRO regulation generally are magnified in the world of for-profit exchanges. Consequently, we at the SEC must exercise heightened sensitivity to the rule changes proposed by the exchanges. We must assure that market quality and investor protection trump competition between market centers. Shareholder interests may guide the for-profit SROs but investor interests guide us.
As you know, originally, exchanges were private membership organizations subject to state law. Federal regulation of exchanges and their formal recognition as self-regulatory organizations came with the adoption of the Exchange Act, requiring exchanges to register with the SEC. Self-regulation was considered the best regulatory model available in 1934 to regulate the mutual or membership exchanges. It provided a balance between industry interests, the need to regulate the markets, and the available government resources to adequately and sufficiently carry out that task.
The self-regulation regime was endorsed again in 1975 when Congress expanded the SEC's regulatory authority over SROs to "significantly increase the regulatory options available to them to deal with perceived self-regulatory shortcomings." Congress stated that a principal reason for retaining a self-regulatory model was the "sheer ineffectiveness of attempting to assure [regulation] directly through the government on a wide scale," and that although the SROs had not always performed their role up to expectations, self-regulation generally was considered to have worked well and "should be preserved and strengthened."
Within the current model of self-regulation, the exchanges retain rulemaking and regulatory authority over their members, their markets and listed companies while the SEC maintains oversight authority. Essentially, this leaves the members of the exchange with the flexibility to control the price, quality and range of services offered by the exchange. They also participate in the governance and self-regulation of the exchange. Significantly, the only members of the exchanges are broker-dealers; no institutional or individual investors can be members.
The Commission's authority over an SRO also extends to these members, who ultimately control the SRO. The Commission can examine the books and records of an SRO, approve all SRO proposed rule changes, can add or change any existing SRO rule, and can impose limitations on the activities of, or deregister, an SRO. The Commission also has the authority to censure or remove any officer or director of an SRO. Controlling persons of an SRO are jointly and severally liable with an SRO and its officers and directors, unless such persons acted in good faith and did not induce the acts constituting a particular violation or cause of action. With respect to members, the Commission can examine their books and records, and it can sanction them and preclude them from being members of the exchange.
I think most would agree that the current system of self-regulation in the US has the following attributes: inherent conflicts of interest between SRO regulatory operations and members, market operations, issuers, and shareholders; costs and inefficiencies of multiple SROs, arising from multiple rulebooks, inspection regimes, and staff; challenges of surveillance of cross-market trading by multiple SROs; and funding and allocation of revenue for regulatory operations.
The Commission has periodically examined the self-regulatory systems and the extent to which SROs have successfully filled their statutory obligations, often finding the current regulatory framework lacking. Technological changes and industry changes, such as program trading and decimalization, also have raised the issue of whether the current model satisfies its mandate in the modern marketplace. Add to this demutualization and the for-profit exchange and the fox has been welcomed into the hen house.
The for-profit exchange dances to the tune of a new piper the shareholder. The shareholder adds new pressures to the operation and growth of exchanges in the form of returns. It is the path to providing those returns that magnifies the conflicts of interest inherent in the current self-regulatory regime. Vigorous self-regulation may suffer as the pressure to profit mounts. Exchanges may: underfund regulation to free up the resources for other purposes; minimize the value of a regulatory culture; fine and discipline traders as a means to collect revenue or to punish their competitors; raise listing company, trading and market data fees to maximize business; and, lower listing standards and surveillance parameters in order to generate or maintain revenue and encourage repeat business.
Aggressive competition to increase market share may result in increased use of incentive schemes that may run counter to the integrity of pricing and investor protection. Outsourcing of functions and expanding from core exchange business raise issues with respect to self-regulatory responsibilities and regulated activities. In addition, the Commission's oversight authority is called into question due to the unregulated status of shareholders.
Self-listing creates another basket of conflicts and concerns. As does the for-profit exchange's need to react quickly to business opportunities. This need imposes an obligation on the SEC to respond rapidly in dealing with regulatory approvals and inquiries from the exchange. While we at the SEC are not opposed to speed, despite what you might think, we must balance the desire for instant approval with our mandate to protect investors and seek public comment when warranted.
Without question, the current model of self-regulation is outmoded. The Commission needs to analyze, and act upon, the alternatives for a system of regulation that accounts for the developments in the marketplace and the changes in SRO ownership structures. There are three starting points for this process. First, the Commission needs to follow up on the concept release it issued on this subject over a year ago by reviewing the comment letters and exploring which alternatives have merit in today's marketplace. We should narrow down to two or three alternatives and explore them in detail.
I myself have been analyzing several of these models, seeking the thoughts of industry members, academics, and foreign regulators. In particular, I have been focusing on the independent regulatory and market corporate subsidiary model, the two hybrid models and the universal industry regulator. At this stage in my thinking, I tend to favor the hybrid model for its ability to eliminate regulatory duplication as well as some of the conflicts of interest engrained in our present SRO system. I am curious, however, as to whether separating out the member regulation is enough. Would such an approach ease regulatory questions when it comes to cross-border mergers, acquisitions, and common ownership structures?
The second starting point would be to act on the Commission's proposal regarding fair administration, transparency, governance and ownership of SROs. It's been so long, you may not remember the proposal; so, let me give you the highlights. You will recognize that many of these standards have been imposed on SROs informally already. First, the proposals would require a majority of the members of the exchange's or association's board of directors and key board committees to be independent. The proposals also would require exchanges and associations to establish policies and procedures to maintain a separation between their regulatory functions and their market operations and other commercial interests, and require that funds received from regulatory fines, fees, and penalties be used for regulatory purposes.
The proposals also impose ownership and voting restrictions, supplemented with reporting requirements, designed to strengthen SRO governance and administration while minimizing conflicts of interest. In addition, the proposals require a variety of electronic filings that target the SRO's governance, regulatory programs, finances, ownership structure, and other matters, thereby enhancing the Commission's oversight and surveillance of the SROs. Finally, SROs that self-list would be subject to certain requirements. While not a final solution to all of the questions facing us, the proposal surely provides us with the steps toward that end. Moreover, even if the Commission chooses to modify the specifics of the proposals, at least the Commission will be forced to focus on these issues in the near term.
The third starting point is to have the Commission assist in the harmonization project undertaken by the NYSE and NASD, as aided by the industry, to produce one rule book for member regulation. As a part of the Commission's approval of the NYSE/ARCA merger, the NYSE committed to work with the NASD and securities firm representatives to eliminate duplication and inconsistent regulation of broker-dealers within their existing regulatory framework within one year. Breaking the rules into four categories, thus far, the NYSE has established committees composed of NYSE, industry and NASD members, although the NASD has yet to designate its participants.
It is my understanding that the committees have had initial meetings and are developing their timeline for action. The staff of the Division of Market Regulation also has been consulted. I would encourage their regular and active participation in the meetings to both keep this project on the fast track and provide a counterbalance during the review process so as not to lose any of the protections afforded by the existing rules. The idea is to consolidate and conform the rules, not to eliminate them. Corporate governance, market access, and many of our investor protection rules are written into the SRO rules.
Consolidation cannot be far behind harmonization. Accordingly, I see harmonization as a step along the road to modernizing the self-regulatory framework. The question will be how to consolidate, not if to consolidate. Will it be a hybrid model or a universal regulator? Who will own what and who will control what? But those are questions for another day. For now, let me make it clear that we at the Commission are acutely aware of the problems presented by for-profit SROs operating under an outdated regulatory regime. We are closely monitoring the SRO rule filings to ensure that investor interests are not eclipsed in favor of business interests.
The final topic I'd like to address is Regulation NMS. Obviously, there is great concern regarding the upcoming July compliance date. In this regard, the STA, for example, has consistently favored a phased approach in which the Commission would mandate connectivity and access between market centers before going further. Even after the Commission adopted the top-of-book proposal instead of the STA proposition, the STA has continued to urge a phase-in approach within the construct of the adopted rule. Others have urged various phase-in timelines too.
Reg. NMS was approved in June of 2005 and there should have been no surprises regarding the July compliance date. So, theories aside, what is the reality of the situation? With the looming date, broker-dealers have expressed frustration with the inability to complete programming of their systems while they wait for final rules from the SROs. Vendors, trading centers and broker-dealers also must wait for the SIP and NMS Plans to finalize market data functionalities before they can program. Surveillance systems must be implemented and tested based on the ultimate rule sets and systems modifications. Undeniably, there are a number of hurdles that must be met before the proverbial "switch" can be flipped if we are to have a smooth transition into the new trading environment. Like falling dominoes, these events must be completed in sequence. Thus, it should come as no surprise that the staff will recommend that the Commission extend the compliance date. The only "unknowns" will be the dates along the timeline for the phase-in and the consequences of failure to meet those dates.
The Division of Market Regulation has been speaking with the industry to determine meaningful and realistic dates for the phase-in of Reg. NMS. I will tell you that I do not look lightly upon an extension because I fear that people will move NMS to the back of their to-do lists, counting on future extensions if, again, they are not ready by the compliance date. Practical realities, however, dictate an extension. The changes required by Reg. NMS are revolutionary and, therefore, time consuming. Just be aware that an extension is not an opportunity to focus your efforts elsewhere. When the time comes, those who are not ready will have unprotected quotes; in other words, they will be left behind.
As far as the timeline itself, the first step will be to complete the notice, comment and approval process of the SRO rules regarding Automated Quotations, ISO orders and IOC orders. This will need to be followed by the SROs' publication of their final specifications. This will allow for the beginning of the NMS Access Linkage, wherein the firms will have programmed their systems in response to the SROs' systems. The operation of the SRO systems, other than those providing order protection rule protection, will commence next. The final step will be compliance with the order protection rule for the stocks. The goal will be to provide sufficient time between these last two steps of implementation in order to allow for experience with the new conditions and necessary systems tweaks. As we move through the hurdles in this timeline, I encourage industry participants to come to the staff early and often with any problems that arise. Only then can we provide guidance to ensure that everyone is able to adhere to the schedule.
As I see it, each delay is a strike at the investor.
On that note, I will thank you for your attention. I believe you will be hearing from my colleague next, Annette Nazareth, but I would be happy to answer any questions if time permits.