Speech by SEC Commissioner:
Remarks Before the NYSE Regulation Second Annual Securities Conference
Commissioner Annette L. Nazareth
U.S. Securities and Exchange Commission
Grand Hyatt Hotel
New York, New York
June 20, 2006
Good afternoon. I am delighted to have been invited back this year to address the New York Stock Exchange's Second Annual Securities Conference. As you all well know, change is a hallmark of your industry, so fortunately there is never a shortage of new developments to discuss. I truly appreciate the challenges that all of you face as legal and compliance professionals. We are witnessing significant shifts in our industry from floor-based exchanges to more fully electronic markets, from fragmented national markets to potentially more consolidated international platforms and through it all, you are tasked with ensuring that our markets and our market intermediaries continue to meet their legal and regulatory obligations. Your presence here today is a fine example of the seriousness and professionalism that you bring to your roles. Before I begin, I must remind you that my remarks represent my own views, and not necessarily those of the Commission, my fellow Commissioners, or the staff.1
You are all quite familiar with the sea change we are witnessing at our domestic exchanges. Most of our exchanges have demutualized. They are now shareholder-owned, for-profit operations. Their members are the participants, or users, of their market, but they do not necessarily have an ownership stake in the exchange. Their stock provides the exchanges with a currency with which to make strategic investments in other businesses, including other markets.
We are also witnessing tremendous innovation in our domestic equity market structure, some of which was unleashed in response to our Regulation NMS. Nasdaq has merged with INET and the NYSE has merged with ARCA. The new regulatory framework has intensified competition between Nasdaq and the listed markets and has provided an impetus for exchanges to upgrade their systems and, in the case of NYSE, to introduce a hybrid market structure.
But the dynamic improvements domestic exchanges are making may now be eclipsed by the prospect of transatlantic combinations of exchanges. As you have all been reading in the press, NYSE has announced an intention to merge with Euronext and Nasdaq has acquired a significant interest in the London Stock Exchange. John Thain has described the historic move to consolidate with Euronext as the manifestation of a vision of building a truly global marketplace with great breadth of product and geographic reach that will benefit investors, issuers and shareholders alike. Our Chairman, Christopher Cox, has expressed his willingness to work with our regulatory counterparts across the globe to establish a cooperative approach to the proposed combination that will benefit investors of all the affected countries.
None of these developments should come as a surprise to any of us. Technology seems to only not have flattened the world, but also literally to have made it demonstrably smaller in many respects. Just think about something as commonplace today as telecommunications. All over the world, people are watching the World Cup matches in real time and sharing their views instantaneously. The same was true, of course, of the Summer Olympic games in Athens. I recall that summer not seeing the whites of my son's eyes for over a week. He explained that he was living on Athens time, watching the Olympic games well into our evening and sleeping when the Athenians slept. The world is truly a very small and interlinked place.
Technological innovation has spurred globalization. It has created a more tightly knit world in which cross border commerce can potentially occur in a seamless manner. It has unleashed the possibility that products and services might be offered across the globe at lower cost and with greater efficiency. On the securities side, these benefits could be reached through mergers of markets that operate from common technology platforms and that provide greater liquidity over a wider variety of products. These are clearly positive developments, and we should embrace the possibilities. Mergers of stock exchanges located in different jurisdictions may make business sense to shareholders of exchanges and to the investors they serve. We all know this type of progress challenges some of our traditional notions. I thought I would discuss today my views on how transatlantic mergers may develop, and the impact they may have on how national supervisory authorities regulate their markets.
The NYSE/Euronext merger, as proposed, would appear to call for a common technology strategy but not a common exchange platform. It contemplates multilateral regulation similar to what is currently inherent in the Euronext structure. At base, this means that Euronext will not register as a U.S. exchange and will not offer its products directly in the U.S. Indeed, under this model, while the holding company for the markets will be under U.S. jurisdiction and the NYSE will continue to be a U.S. registered exchange, the non-U.S. markets will not. As a result, there would not be mandatory registration of the non-U.S. markets' listed companies in the U.S., nor would our federal securities laws necessarily apply to the non-U.S. exchanges. This would include, of course, the Sarbanes-Oxley Act (Sarbanes Oxley). Specifically, Sarbanes Oxley would not apply to any market not registered in the U.S., nor would it apply to companies listed on that non-U.S. market. So, joint ownership of a U.S. exchange and a non-U.S. exchange by a U.S. holding company does not alone trigger the application of U.S. securities regulation to the listing standards or trading rules of the non-U.S. exchange. U.S. regulation only applies to markets that transact business in the U.S. Mere affiliation with a U.S. exchange does not subject a non-U.S. exchange to U.S. law.
Just as we apply our standards to exchanges that avail themselves of our jurisdiction by transacting business here, our regulatory counterparts offshore do the same. All national regulators have a legitimate policy interest in maintaining high quality standards in their own jurisdictions.
That having been said, supervisory authorities have long recognized the inevitability of globalization. Thus, there have been a whole host of efforts to achieve cooperation among such authorities as well as to further the goal of consistent international standards. Ultimately, even greater synergies and efficiencies will be achieved in the marketplace as the differences among regulatory approaches give way to consistent, high quality standards that are internationally recognized. Many of these standards take the form of principles as opposed to specific rules. These principles provide the guiding compass on which national authorities base their rules. Of course, the essence of good regulation is achieving the proper balance between principles-based regulation and rules-based regulation.
Over the years, the Commission has participated in numerous international fora alongside foreign regulators, international markets, and their participants. Through our participation we have gained invaluable insights and close working relationships with our counterparts all over the world. We have engaged in joint efforts with supervisory authorities in many jurisdictions on regulatory and enforcement issues that have facilitated, among other things, cross-border securities activities while advancing market integrity and investor protection. With such experience under our belts, and having forged relationships with foreign regulatory counterparts and market participants, the SEC is extremely well poised to undertake a cooperative dialogue with regulators abroad on any issues relating to market consolidations. Within the SEC, our Office of International Affairs is dedicated to promoting international regulatory and enforcement cooperation and collaboration, and coordinates the expertise within the SEC to participate in programs that facilitate adopting high regulatory standards worldwide and providing technical assistance to strengthen regulatory infrastructure in emerging markets.
I thought I would mention just a few of the international fora in which we participate and discuss some of the efforts we are working on cooperatively with our international supervisory brethren. The SEC participates along with one hundred or so other securities regulators in the International Organization of Securities Commissions, or IOSCO. Indeed, our own Commissioner Campos is vice chairman of the Technical Committee, which is the group that develops international best practices, principles, and standards for securities matters. IOSCO has a long and successful history of promoting high standards of regulation that foster just, efficient, and sound markets. It provides an invaluable international setting to share information and cooperate on issues of common concern. IOSCO has been particularly effective in establishing best practices in a number of areas. For example, IOSCO issued a Credit Rating Agencies Code of Conduct that is now being used as a model in many member countries. IOSCO has also played an important role in bringing international standard setters together on such important issues as corporate governance, business continuity planning, and clearance and settlement issues.
International Cooperation in Enforcement
One area where there is a long and positive history of cooperation among supervisory authorities is enforcement. The SEC has been a strong advocate of engaging foreign regulators and negotiating arrangements to share information for use primarily in enforcement matters. Since the 1980s, the SEC has signed over 30 bilateral information-sharing arrangements, known as memoranda of understanding (MOU). These MOUs are the backbone of the international enforcement program and have provided crucial assistance to the Commission's enforcement staff in the investigation and prosecution of cross-border cases. Even without an MOU in place, the SEC frequently cooperates on an ad hoc basis with foreign regulators and uses a variety of other mechanisms to facilitate information sharing.
An interesting outgrowth of the MOU process occurred in 2002, when IOSCO created a Multilateral Memorandum of Understanding (MMOU). This is the first global multilateral information-sharing arrangement among securities regulators, and I am proud to note that the SEC was among the first signatories to the agreement. There are now 30 other securities and derivatives regulators admitted to the MMOU, with many other regulators seeking to become signatories.
Under the MMOU, signatories agree to provide certain critical information (including information related to bank and brokerage records), to permit use of that information in enforcement matters, and otherwise to keep confidential such shared information. Membership in the MMOU requires a showing of a jurisdiction's legal authority to comply with the key provisions which IOSCO verifies through the application review process.
I cannot over-emphasize how much this MMOU has enhanced the SEC's enforcement program by increasing its ability to obtain information from a growing number of jurisdictions worldwide. That so many jurisdictions participate has also created an impetus for non-members that lack the legal ability to engage in effective information sharing to use the application process for the MMOU to effect change in their domestic markets, for example, by hastening the enactment of the necessary legislation. IOSCO recently announced its goal of having all its members join or commit to join the MMOU by 2010.
Certainly another area where extensive efforts are underway to converge regulatory standards is accounting and auditing standards. The EU is now attempting to forge a single capital market across 25 different countries with widely varying financial cultures, legal traditions, and disclosure standards. Accounting standards are just one part of a much larger project. Recognizing that regulation has global implications, and knowing that embracing a common set of high quality accounting standards bolsters investor understanding and confidence, foreign and U.S. regulators have increasingly coordinated over the years to achieve, where possible, regulatory convergence. One area where coordination has yielded great results is auditor regulation, where the Commission and the Public Company Accounting Oversight Board (known as "PCAOB") and their European counterparts have worked diligently together to reduce regulatory overlap and divergence. Related to this is the project to converge two sets of accounting standards: U.S. Generally Accepted Accounting Principles (U.S. GAAP) and International Financial Reporting Standards (IFRS).
For the past several years, the Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB), the respective standard setters for U.S. GAAP and IFRS, have been engaged in a project to converge the two accounting standards. The SEC staff has been very supportive of this project. Last year they issued a "roadmap" describing the preliminary objectives that would be necessary in order to eliminate the U.S. requirement that financial statements prepared under other standards, including IFRS, be reconciled with U.S. standards in the financial disclosures of foreign companies selling shares in the United States. Among other things, the staff's roadmap states that eliminating the reconciliation requirement will require that the two standard setting boards have a robust process for convergence in place, and that a faithful and consistent application, interpretation, and enforcement of IFRS will emerge across all jurisdictions that use IFRS.
The SEC has taken several important steps to facilitate the transition to IFRS by a growing number of SEC-registered foreign companies. In particular, the SEC has adopted amendments to provide a one-time accommodation for foreign private issuers registered with the SEC that prepared financial statements for the first time under IFRS. The accommodation permits eligible foreign private issuers for their first year of reporting under IFRS to file two years rather than three years of statements of income, changes in shareholders' equity, and cash flows prepared in accordance with IFRS, with appropriate related disclosure.
Last year, Chairman Cox met with Arthur Docters van Leeuwen, the Chairman of the Committee of European Securities Regulators (also known as "CESR") to discuss IFRS, and other potential areas for joint collaboration, such as developing common licensing exams for industry representatives. Then, this past February, Chairman Cox and EU Commissioner McCreevy reviewed the progress on and affirmed their commitment to eliminating the need for reconciliation between IFRS and U.S. GAAP. Chairman Cox reaffirmed the Commission's commitment to the staff's "roadmap" to eliminate, by 2009 at the latest, the SEC requirement for foreign private issuers to reconcile IFRS-based financial statements to U.S. GAAP. We have just reached a milestone in this regard, with many foreign private issuers beginning to file with the SEC IFRS-based financial statements reconciled to U.S. GAAP. Together the SEC and CESR are formulating a work plan to review and analyze the financial statements of these issuers and to inform one another of their analysis of the reconciliations made and to work together to avoid conflicting interpretations.
Of course, an undertaking such as this requires near Herculean efforts and would not succeed if a single regulatory authority or standard setter operated in isolation or tried to achieve convergence on a jurisdiction by jurisdiction basis. This endeavor to harmonize two accounting standards depends fundamentally on trust and open communication among regulators. I must commend CESR for its essential work in implementing IFRS in the European Union member states. CESR will also continue to support IFRS implementation by coordinating dialogue on the application of IFRS in the member states.
Consolidated Supervision, CRMPG II, Basel II
Another area in which globalization is already having an impact on how we regulate and how we coordinate with our international counterparts relates to our Consolidated Supervised Entity program. The days when broker-dealers were independent entities, raising their capital from a relatively small group of partners are long past. Today, the largest broker-dealers are a part of public holding companies whose business operations span the globe, and who have a range of activities that cut across the entire financial services space. These structures combine activities that are functionally regulated in various jurisdictions with other activities that are conducted outside of regulated entities.
We, as well as our regulatory colleagues in Europe, have acknowledged this new reality through a variety of measures. The European Union promulgated its Financial Conglomerates Directive, effectively requiring internationally active financial institutions that do business in Europe to be supervised on a consolidated basis beginning in 2005. Under this approach, the authority of a consolidated supervisor extends beyond any functionally regulated entity or set of entities, such as broker-dealers, banks, and insurance companies, to the holding company itself and any unregulated entities within the group. The Commission acted in 2004, by introducing a voluntary consolidated supervision regime available to certain U.S. investment banks that were not regulated by the Federal Reserve as bank holding companies. To date, five investment banks, Bear Stearns, Goldman Sachs, Lehman Brothers, Merrill Lynch, and Morgan Stanley have opted into this prudential supervision regime, which entails Commission oversight of risk management and control systems as well as Commission examination of unregulated entities within the group.
This prudential regulatory regime focuses on the financial and operations conditions of the holding company and aims to ensure that financial weaknesses in the holding company or affiliate do not destabilize a regulated entity. Through a prudential approach to regulation, with a single consolidated supervisor monitoring the holding company, the international financial institutions avoid considerable regulatory duplication and expense that they otherwise would incur by responding to the inquiries of numerous regulators that oversee a particular regulated subsidiary in their jurisdiction.
In its role as a consolidated supervisor, the Commission must work on a day-to-day basis with other regulators in Europe and around the globe. Each of the five investment banks supervised on a consolidated basis by the Commission, sometimes referred to informally as consolidated supervised entities or "CSEs," has large and important affiliates that are functionally regulated in other jurisdictions. While we are responsible for the U.S. broker-dealer, the holding company, and its unregulated affiliates, we recognize the concerns of the supervisor of, for example, the U.K. broker-dealer in each of the groups. The U.K. Financial Services Authority ("FSA") in this case, as the primary regulator of the U.K. broker-dealers, has a clear interest in understanding the overall financial and operational condition of the holding company, and gaining a level of comfort that the U.K. entity will not be imperiled by events elsewhere in the group. This requires a high level of cooperation between the U.S. and the U.K. authorities. We are deeply committed to this process, meeting formally with the U.K. FSA quarterly and speaking informally at the staff level on an almost daily basis.
The market for credit derivatives, including plain vanilla single-name credit default swaps and more complex structured credit products, posed a test of the international regulatory community's ability to cooperate during 2005. By any metric, the market for such over-the-counter derivative products has exploded over the past five years, and the infrastructure necessary to process the trades had not kept up with the growth in volumes. The result by mid-year 2005, when the downgrade by rating agencies of the U.S. automobile sector prompted another spike in credit trading, was a substantial backlog in confirmations at all fourteen major dealers. The problem was not only a lack of back office resources at the dealers, but also the need to engage the entire trading community in solving the problem, including the dealers' customers on the "buy side" of the market.
Apparently, no single dealer was prepared to "get tough" on confirms with its buy-side trading partners, unless it was confident that the other thirteen would do the same. If only one dealer were to refuse to trade further with counterparties that had outstanding confirms, the fear was that business would just migrate elsewhere in the dealer community. The effect would be the same if a regulator responsible for only a subset of the fourteen major dealers were to try to act unilaterally. The result was what the economists would term a "prisoner's dilemma," or collective action problem.
Under the leadership of Tim Geithner, President of the New York Fed, the fourteen major dealers along with their consolidated supervisors from four nations convened in New York early last Fall. The industry was encouraged to propose solutions to a number of confirm-related issues, which all fourteen dealers quickly endorsed. The results since September have been terrific: the backlog of outstanding confirmations fell at each dealer by at least 30 percent by January 2006 from September levels. And almost all dealers have now met a second target established for June 2006 of reducing the backlog relative to September 2005 by 70 percent. We find this now demonstrated ability of the regulatory community to act in concert to solve collective action problems of this sort extremely reassuring but I must note, this result required the commitment and participation of domestic and international supervisors to jump start a plan of action.
Another critical component of all global consolidated supervision regimes is the Basel II Standard, known more formally as the 2004 "Revised Framework for International Convergence of Capital Measurements and Capital Standards" published by the Basel Committee on Banking Supervision. The Basel II Standard seeks convergence on multiple dimensions. It is intended to hold all internationally active institutions to a common capital adequacy standard. But at the same time, the underlying philosophy is clearly to align regulatory capital calculations with internal risk measurement and control systems by permitting the most sophisticated institutions to use internally developed models in computing capital adequacy.
A key challenge in implementing Basel has been to ensure that the standard is practical, relevant, and provides appropriate incentives for a variety of institutions. The original 1988 Basel Standard was developed largely for application to commercial banks. In general, commercial banks have risk management and accounting practices that are distinct from those at investment banks. A 1997 Market Risk Amendment to the original 1988 standard was intended to deal with the sort of trading activities that predominate at investment banks by defining a Basel "trading book" for which regulatory capital is computed using an institution's internally-developed value-at-risk models.
But by the time that the Basel II Revised Framework was published in 2004, the distinctions between the trading book and the traditional commercial and retail banking activities of the Basel banking book had blurred. For example, new over-the-counter derivatives products, notably credit default swaps, allowed risk to be repackaged in a way that could move it from the Basel banking book to the Basel trading book. The potential undesirable results of such innovation in light of the traditional Basel dichotomy between trading book and banking book included disparate capital charges at institutions of different types and regulatory arbitrage opportunities for institutions with both banking and trading books.
In 2005, Commission staff joined with regulatory colleagues around the globe to deal with these significant issues. A joint Basel Committee-IOSCO working group was tasked to review the ramifications of the proliferation of over-the-counter derivative instruments and their possible inclusion in the Basel trading book. In July 2005, this working group published a paper proposing approaches to the most critical issues, notably ensuring that investment banks would compute regulatory capital in a manner consistent with their internal risk management practices while reducing opportunities for regulatory arbitrage for institutions with both Basel banking and Basel trading books. In December 2005, the results from this effort were formally incorporated into the Basel II Standard and have been embraced by the industry.
All of the foregoing examples are intended to illustrate that the Commission, as well as many of its international regulatory counterparts, are old hands at earnestly sharing information, cooperating in enforcement matters, and working toward regulatory convergence through the creation of high quality standards on which we can all agree. Financial services firms and their supervisory authorities share a common interest in having a regulatory environment that supports economic development and growth, financial stability, investor needs, and investor protection. As capital markets continue to grow globally, cooperation must become the rule if the needs of investors are to be well-served and the capital markets are to flourish. I look forward to working with my regulatory counterparts and market participants around the world as we enter a new era in global trading.