Speech by SEC Commissioner:
The Current Role of Capital Market Regulation
Commissioner Roel C. Campos
U.S. Securities and Exchange Commission
CVM's 30th Anniversary: Assessing the Present, Conceiving the Future
Rio De Janiero, Brazil
September 5, 2006
Good morning. I'd like to thank Marcelo (Trindade) for inviting me to join you today in celebration of the CVM's thirtieth anniversary. It is an honor to be here and it is terrific to meet with and work with our regulatory counterparts. I have a special regard for Marcelo and the CVM. With Marcelo's leadership and those before him, the CVM has become an example of a splendid regulator that works closely with the financial industry and the Brazilian markets. Of course, an event like this cannot happen without the dedication and hard work of many people behind the leader. As such, I would specifically like to commend the hard work of Eduardo Manhaes Gomez and Aline de Menezes Santos of the CVM. Both have been particularly helpful to me on this trip. Of course, there are dozens of others who have contributed to this event at the CVM that I cannot mention. My sincere thanks to all of at CVM. Of course, Brazil and its great people continue to fascinate and impress me mightily. I only regret that I do not have time to see more than a glimpse of all it has to offer.
Before I begin my remarks today, I thought would share a couple of stories to set the tone. The first is about a broker dealer having a conversation with God. Securities regulators oversee broker dealers and we like to have a little fun at their expense at times. Of course, many broker dealers I know claim to receive direct input from God on a regular basis.
So, a broker dealer is having a conversation with God:
Broker Dealer: God, what does a million years feel like?
God: It feels like just a second.
Broker Dealer: Wow. God, what does a million dollars feel like?
God: Well, it feels like just a penny.
Broker Dealer, sensing an opportunity: God, may I have a penny?
God: Hmm, just a second!
The morale of this story may be that one should not seek to take advantage of a higher authority like the CVM.
Alright, since we are celebrating an anniversary, let me share this story:
A man and a woman were recently celebrating their thirtieth (just like the CVM) wedding anniversary. While cutting the cake, the wife noticed that her husband's eyes were filled with tears. The wife took his arm, and looked at him affectionately and said, "Darling, I never knew you were so sentimental," she whispered.
"No, No," he said choking back his tears, "That's not it at all. Remember when your father told me to either marry you or spend the next thirty years in jail?"
"Well, yes," the wife replied. "I remember it like yesterday."
"Well," said the husband with tears in his eyes and a choked voice, "Today, - I would have been a free man."
Marcelo, I think I can safely say that in Brazil none of the regulated industry, the public, or the markets feel the way that husband did. Members of all of those sectors are here today to honor you and the great institution of the CVM that has become a great partner for economic development in this country.
In fact, I have to note that two years ago, our own SEC could have celebrated its 70th anniversary. I don't think the idea occurred to anyone to have an anniversary celebration. Maybe that indicates that my SEC is not as beloved in the U.S. as your CVM is in Brazil.
Before I turn to my remarks, I'd like to take a moment to commend Brazil on a few of its recent capital markets initiatives. First, I congratulate you on your newest exchange, the Novo Mercado. The use of high quality financial reporting standards to improve pricing and liquidity sends a message to markets and companies around the world that investors value robust and reliable financial reporting. Second, I'd like to emphasize the continuing importance of the Inovar Project, whose purpose is to aid in the design of instruments for SME financing, especially venture capital. We have observed that the size of a primary market can impinge on the ability of SMEs to find suitable mechanisms in the traditional credit system to finance their growth. Consequently, sometimes governmental intervention is necessary for the development of the SME capital structure just that final plank in the bridge between companies and investors. So, kudos for taking and maintaining the necessary initiative.
Finally, I applaud the corporate financing efforts for SMEs undertaken by the National Development Bank (BNDES). Its unique manner of using international financing for SMEs within Brazil is the kind of creative thinking regulators should be employing everywhere. These and other programs employed by the Brazilians provide a fine example of how successful capital market regulation requires coming at a variety of issues from a number of different angles. The trick is to find the right regulatory balance to influence and guide innovation without losing investor protection
which leads me to the thoughts I'd like to share with you today.
Before I do, however, I must inform you that the remarks I give are my own and do not represent the views of the US SEC, my fellow Commissioners or the staff.
I wish to speak briefly about the U.S. regulatory framework and our own efforts to ensure that our regulation does not become a "stale marriage." I will also briefly review our recently revised National Market System (NMS), as well as the trends and my own forecast as to the evolution of the self-regulatory organizations, or SRO's, in America. I will also touch upon the situation with the global trend toward the consolidation of exchanges across national borders.
Regulation in the U.S.
Jeremy Cooper yesterday described the Australian system as one of "Twin Peaks," essentially a prudential banking regulator that is the central bank and a enforcement oriented regulator in ASIC. I suppose the U.S. system could be called a "Twin Peaks Plus." The two principal U.S. peaks are the prudential regulator that is our central bank the Fed or Federal Reserve and, separately, the Securities and Exchange Commission a federal regulator whose DNA is enforcement and deterrence as mandated by Congress. However, there are many other tall peaks as well in the U.S. regulatory landscape. In varying degrees capital market oversight is also shared with the Department of the Treasury, the Department of Justice, the Commodity Futures Trading Commission, and numerous other entities, particularly now, with increasing globalization. In fact, some have proposed a single regulator for the U.S. to replace this Twin Peaks Plus system, on par, for example, with the FSA model or the BAFIN. That topic alone is subject enough for a conference, so suffice it to say that increased coordination and sharing of expertise is of growing importance during this period of greater globalization.
The SEC's regulation also is supplemented by national securities exchanges, associations and other SROs. Working through a symbiotic relationship, the Agency and the SROs have attempted to divide up the regulatory responsibilities based on expertise, resources, and official mandate. But, as I will discuss momentarily, this 1934 model is in the midst of substantial modification as a result of regulatory and market forces.
Added to this mix of regulators are the 50 states and a handful of private oversight and standard setting boards (with Federal oversight). Plus, the industry, accountants, lawyers, trade groups and consumer advocates play their role in guiding, crafting and influencing the regulatory outcome. And, one cannot ignore the presence of politics and Congress in this stew. This combination of Federal, state and private regulation has worked reasonably well, adjusting to developments and innovations in the capital markets as they arise. The recent rapid pace of progress, however, is truly putting this system to the test and I hope we will rise to the challenge.
Generally, the US system of market regulation is accomplished through a blend of regulation, disclosure, enforcement, SEC staff guidance and interpretations, and best practices derived from coordination between the public, industry and regulators. As I see it, the idea behind regulation is to find the appropriate balance between the competing concerns of investor confidence and protection versus business interests. Rulemaking should never be undertaken simply for the sake of regulation. I wish sometimes that I could agree with some of the market ideologues who believe that, if left alone, market forces will always produce a solution. In fact, what I have found is that to avoid unfairness and destruction of smaller weaker players, the markets need a fair referee that gets involved only to make sure all are following a common set of rules that are fair to everyone. Many of our regulations are actually the product of requests from various parties (both from the business and the investor camps) to level the playing fields and provide a framework within which a healthy economy can thrive through competition, innovation, fairness, efficiency and confidence.
The recent modernization of the National Market System, carried out through Regulation NMS, is a prime example of this phenomenon. Driven in part by developments in technology, the evolution of trading, and the demutualization of exchanges, the Congressionally-mandated market structure from 1975 had become a hindrance to investor protection and efficient and effective trading. Accordingly, after several years and several proposals, the Commission adopted Regulation NMS as a consistent rules of the road approach across all US equity market systems. One of the primary principles underlying the regulation was to ensure that market consolidation could take place in a regulatory background that protects investors at the same time that it levels the playing field for competitors.
US Markets and Self-Regulation
A century ago, there were more than 100 local and regional stock exchanges in the US. They served the capital needs of companies and investors in their area by listing local companies for trading. The few survivors from the days of old are still called "regional exchanges" but they do not generally list local companies or serve local investors. Instead, they are competing parts of our national capital market that provide an alternative trading venue and a test zone for innovation and competitive services with the two primary US markets, the NYSE and the Nasdaq. The US market philosophy encourages the existence of these multiple trading venues even though natural forces tend towards consolidation of markets. For example, individual markets compete on the basis of size, because size offers greater liquidity for executing customer orders and are driven by economic and competitive forces such as the need to maximize economies of scale, reduce excess capacity, and, respond to technological developments.
Some have noted that there is always the concern that without some safeguards, too many trading venues can fragment liquidity, create a lack of transparency, and discriminate against certain market participants. Too many trading venues, it is also argued, can also create systemic risk because some market centers may not meet the standards of technical capacity and integrity reliability. We at the SEC, however, believe that this risk of multiple markets is outweighed by the benefits of competition. To the extent that markets compete to trade each others' listed securities, competition will be enhanced. Competition between markets forces markets to constantly improve, which is good for investors and for issuers. And so, we favor a model of market competition and order competition in the US. In fact the U.S. is the only jurisdiction where there is both market competition and competition for investor orders.
As I mentioned earlier, to respond to the multitude of market and technological changes of the last decade, but maintain the philosophy of dual competition, the Commission adopted Regulation NMS. Founded on a belief that market forces and best execution should serve as the bedrock principles in the securities markets, NMS addressed many of the systemic issues that had arisen through the somewhat fragmented and hurried evolution of marketplace trading, stimulated by the rapid pace of technological developments. Specifically, the regulatory reforms of the rules for interaction between competing marketplaces and competing orders were modified by adopting clear and uniform trade-through protection in all listed stocks, limiting access fees and barriers to cross-market access, restricting subpenny quoting and bringing greater transparency to NMS Plan governance.
The best price principle embodied in the order protection rule underscores the principle that, no matter where a customer order is routed, it should receive the best price that is immediately and automatically available anywhere in the national market system. This principle promotes competition among individual market centers by ensuring that dominant markets cannot ignore smaller markets displaying the best price. It also ensures preserves multiple options for order executions, which explains why so many broker-dealers, market makers and institutional investors are part owners of the regional exchanges.
Moreover, investors, in particular retail investors, are protected because the rules assure that intermediaries act in accordance with the interests of their customers. In other words, the order protection rule functions as a backstop to a brokers' duty of best execution, violations of which can be difficult to prove and generally does not apply to retail orders on an order-by-order basis.
There was a very fine presentation yesterday on the subject of SRO's, so I will only make a few observations in this area.
SRO's in America during my tenure at the SEC have had a very mixed record of performance. There are cases of market SRO's failing in their basic responsibilities of surveilling the markets and appropriately disciplining their members. Many traders were found to have interpositioned themselves at the expense of customer orders at the NYSE, for example. Other markets have had equally troubling trading practices, which the SEC is aggressively investigating.
Undoubtedly, the current model of self-regulation needs modernizing, in particular given that the "for profit" structure is now the prevailing model in America. Further, in looking for the answers, we must be informed by the experiences of our counterparts in foreign jurisdictions. Most large foreign exchanges demutualized before the trend started in the US. In fact, by 2003, one survey noted that 42 out of 85 foreign exchanges were demutualized, 16 were in the process of demutualization, and 27 had no plans to demutualize. 18 out of the 42 demutualized exchanges were listed. Exchange and regulatory consolidation is not a new issue for our foreign counterparts either. The Euronext combination is one such examples of these models. The approaches taken by foreign regulators to the issues we are now facing in the US have varied and their lessons should be instructive.
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 during this period of change. In addition, our search for answers to the self-regulatory dilemma cannot be limited solely to the latest model for US exchange structures the demutualized exchange. We must consider the future. The new self-regulatory regime, whatever it may be, must take into account the reality of transatlantic market combinations.
It seems to me that SRO consolidation in America will occur in the near future. The benefits and the desires of the industry and members are too great for the separate SRO's to ignore. Moreover, several of my fellow Commissioners and I have been urging that consolidation occur and that talks progress between the two entities. This would be a huge positive that I have been encouraging for at least a year. A consolidated NASD and NYSE would effectively be a form of the so called hybrid model enhancing efficiency by eliminating inconsistent member rules, eliminating redundant infrastructure, and reducing conflicts of interest.
I am concerned that, as thinking about hybrid regulation progresses, the opportunity to address market surveillance will be neglected. In speeches and meetings, the SROs and some of their members continue to argue in support of the alleged value produced by the expertise and efficiencies of having market surveillance in house. If this view prevails, it will likely remain within the individual SRO structure. I believe that is both a regulatory mistake, as well as a business mistake on the part of the SROs. However, it may be that the market surveillance will be spun out at a later point in time.
International Market Consolidation
Many have asked me whether it is regulation that is driving the exchanges in America to seek consolidation with trans-Atlantic counterparts in Europe. My view is that the driving force has been the demutualization trend, which has resulted in profit oriented entities and CEO's that are driven to create new shareholder value. The CEO's of both NYSE and NASDAQ are using the time honored technique of seeking synergistic mergers. A CEO that can deliver value enhancing growth becomes a financial celebrity and will be highly rewarded as well.
Both the NYSE and Nasdaq have used their new flexible, demutualized, for-profit-structures to pursue follow-on public offerings to quickly raise additional capital for their ventures. We are all familiar with the Nasdaq's effort to acquire the London Stock Exchange. In several stages, the Nasdaq has purchased a total stake of 25.1% of the LSE. This stake gives the Nasdaq a "blocking" or "controlling" interest in the Exchange, but Nasdaq cannot assert another bid in the LSE until October. Likewise, the NYSE bid for Euronext is no surprise. In making its bid, the NYSE stated its intention to pursue domestic and international acquisitions and strategic alliances to further strengthen and diversify its business, enter new markets, and advance its technology.
But both exchanges have met with some resistance to their overtures. Nasdaq's indicative offer last March was rebuffed, prompting its approach of buying a controlling interest in the LSE. The NYSE continues to fight a public battle from the Deutsche Bourse for the coveted Euronext. Moreover, not one to pass up opportunities, Euronext has been courted by the Italians, Tokyo and other potential merger partners while the final shareholder vote on the NYSE offer remains pending.
The proposed merger between the NYSE and Euronext will utilize a holding company structure, where the holding company will be a U.S. Delaware corporation, with two wholly-owned subsidiary exchanges operating separately in each jurisdiction in accordance with local regulations. This structure will essentially allow both exchanges to operate in almost exactly the same manner as before. This structure might also include a special trust to own the license of the European Euronext exchanges. One detail will be that regulators on both sides of the Atlantic will need to assure their supervisory authority over the holding company in the State of Delaware in the U.S.
What is clear is that the proposed combination of the NYSE and Euronext will produce no exportation of U.S. regulation - Sarbanes Oxley, for instance, to Europe. No European issuer will subject itself to U.S. regulation unless it voluntarily chooses to operate directly in America. Moreover, the European and American regulators have set up working groups to assure that the merger process, if it occurs, goes smoothly and without surprises, and that no unintended regulatory creep occurs from the U.S. to Europe.
In both the Nasdaq and NYSE scenarios, the exchanges have also focused on the cost savings and other efficiencies that a union could produce by eliminating duplicative functions and coordinating sales and marketing activities efficiencies that would accrue to the benefit of the investor.
For example, NYSE and Euronext project that they can achieve $375 million in merger benefits, of which $275 million would come from savings, primarily from reducing technology spending by cutting the number of trading systems to two from six. the remaining $100 million would stem from added revenue derived from combining their businesses in equities, listings and derivatives. The unified trading platform of Euronext boasts similar cost synergies. On its face, this holding company structure would not result in the imposition of the US regulatory regime on the European exchange. I would direct you to the Commission's fact sheet on cross-border exchange mergers for further confirmation of this position.
That is not to say that longer term strategies of integration would not result in a different regulatory outcome. I believe that it is inevitable that a combined trans-Atlantic exchange organization will some day request the regulators on both sides of the Atlantic to cooperate in approving a common set of trading rules. Given the differences in America and Europe (e.g., the unique NMS features discussed earlier), achieving this will not be easy. I do believe that at some point in the future, some type of regulatory mutual recognition will be negotiated between the SEC and European regulators, assuming of course that the current trends toward the convergence of standards continue.
Another personal observation, in seeking to see beyond the horizon, is that the combined exchanges themselves will become one stop shopping center for many services. This may create a new type of competition for brokerage and other services that their former members provide. It may be a very different world.
While it is imperative that regulators explore the implications of all possible combinations, we must keep business interests in mind too and remember not to put the cart before the horse. We must quickly and thoroughly address the regulatory implications of the proposed models while also preparing to respond to modifications that may be presented down the road. Some combination is inevitable. The question is when will this take place?
At a minimum, the existence of a cross-border exchange will serve as a catalyst to achieve regulatory harmonization or convergence at both a domestic and international level. The bottom line is that companies across the world are seeking access to capital. This must be facilitated by the markets, wherever they may be. The result is competition for listings which translates into competition in the quality of trading and services that are offered to lure issuers to a particular market. Our goal as regulators is to ensure the fair and efficient operation of these markets while protecting investor interests.
Going back to my story about the wedding anniversary, regulation must adapt to the changes in the economy and the pressures of globalization to avoid a stifling marriage with market participants. Regulation needs to be engaged in a healthy partnership, protecting capital and investors, while at the same time allowing fair competition among the financial providers and the markets.
As you can imagine, that is no small task. We must avoid mediocrity and keep standards high as that will continue to attract capital and investors to our markets. Moreover, as I said at the beginning of my remarks, the operation and regulation of the stock markets is just one small piece of the puzzle that is capital markets regulation. Sharpen your pencils because there is much to be done!
Well, I could go on but I'd like to save some time for my fellow panelist and for discussion so I'll stop now. Thank you for listening. Luiz...