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U.S. Securities and Exchange Commission

Speech by SEC Chairman:
More Efficient and Effective Regulation In the Era of Global Consolidation of Markets


Chairman Christopher Cox

U.S. Securities and Exchange Commission

Remarks to the Securities Industry and Financial Markets Association
November 10, 2006

Thank you, Micah [Green, Co-CEO of the Securities Industry and Financial Markets Association]. It’s a pleasure to be here at the first formal meeting of the newly created Securities Industry and Financial Markets Association. From all of us at the Securities and Exchange Commission, congratulations to all of you on your successful merger. I hope you’ll consider my presence here at this first meeting of the new organization to be my voluntary enlistment as an honorary charter member.

One of the participants here came up to me at breakfast this morning and asked, “Do you ever get nervous about speaking to big groups like this?” And I told him that’s not the problem when I speak to CEOs and industry leaders. Rather, it’s that being in front of the SEC makes them nervous.

So I hope you are all relaxed. The truth is, we can’t help but appreciate our surroundings on such a glorious morning in Boca Raton.

It’s been almost exactly a year to the day since we were here together for the last annual Securities Industry Association conference in Boca. And given all of the changes that have taken place since then, it’s worthwhile to reflect on what’s different now, and what’s remained the same. One of the things I hope won’t change is the way the Securities Industry Association and the Bond Market Association, over so many years, have provided the Commission with helpful insights into the operations of the securities markets and of your industry.

This morning is an excellent opportunity for me to express the SEC’s gratitude for your past advice, and to thank you in advance for the redoubled help I’m sure that this new organization will continue to provide. We’ve long worked together in your previous incarnations as the SIA and the Bond Market Association, and I very much look forward to working with you in your new and strengthened organizational form.

Today, as it happens, is the anniversary of the fall of the Berlin Wall. It was 17 years ago, on this day in 1989. So much has changed since then -- and we don't often stop to recall what our outlook on things was like before that historic event. Not that long ago, most people simply couldn’t imagine the wall coming down. I remember visiting the Berlin Wall when the Cold War was still raging. When I got back home -- this was about 1984 -- I was talking to a librarian and told her how a friend of mine had pulled out a piece of the wall to keep as a souvenir. She gave me a disapproving glare and said sternly, “Now what would happen if everybody did that?”

And of course (but not for that reason), the wall did come down -- and it was one of many events that led to the explosion of markets around the world in the 21st century. With today’s Germany in the thick of the competition surrounding the consolidation of the world’s securities exchanges, and with exchanges throughout the world beginning to offer serious competitive challenges to America’s own capital markets, it couldn’t be more clear how much has changed as a result of the continued spread of freedom and markets this last decade and half.

As you know, the changes in the marketplace aren’t limited to just the trading platforms. Old distinctions between products like options and futures, and even between equity and its derivatives, are also falling by the wayside. Your own merger into this new organization is itself an example of the blurring of traditional distinctions in the securities markets.

When we met a year ago at this same location, we talked about what these developments meant for the self-regulatory system that governs the securities industry. And now, with two trans-Atlantic exchange combinations already underway, and the prospect of still more global consolidation yet to come, it’s time to move beyond discussion about how the regulatory system copes with these changes, and to take positive, concrete steps to update our aging scheme of multiple self-regulatory organizations.

The very good news, as we meet here today, is that we're on the verge of historic changes that will simplify the current self regulatory structure. Instead of multiple and often redundant players, we may soon have a single self regulator for all firms in the securities industry. Instead of two rulebooks, two separate and uncoordinated regulatory staffs, and two completely different enforcement systems; instead of a menagerie of potentially conflicting schemes that can actually undermine the effectiveness of regulation and the efficiency of the securities markets -- we might soon be able to increase the effectiveness of regulation for the benefit of investors by eliminating the needless and often harmful duplication that interferes with that investor protection mission.

As Chairman of the Securities and Exchange Commission, I strongly support these efforts, which are currently well underway, to fold the member regulation functions of both the NASD and the NYSE into one regulatory body. I’m firmly convinced that, done properly, this can make our self regulatory system more efficient and more robust from an investor protection standpoint.

Before I drill down into exactly what kind of changes we hope to see, it’s worth considering the nature of the competitive, technological, and regulatory developments that have already transformed our nation’s securities markets, and that have brought us to this point.

First, and most obviously, our U.S. markets are operating in a much more competitive environment. That’s true not just domestically, but overseas as well. Both here at home, and abroad as well, our markets are facing increased competition -- not just from other exchanges, but also from electronic communications networks. And that, in turn, has prompted significant shifts in market share away from the primary markets. All of this competition has been a catalyst for innovation in a number of areas: in trading systems; in meeting the demands of customers; and in driving down costs, including the fees charged by the trading markets.

Another transformational change that has occurred in US markets is the conversion by a number of exchanges from member-owned organizations to for-profit entities. Some of our exchanges have even attracted investment from major securities firms. There’s little doubt that this move toward demutualization -- like all the other market developments we’ve seen -- is intended to help our markets to be more nimble and efficient in response to competition.

So with everything changing on the competitive landscape to a more responsive, cost-effective, global, and customer-driven model, it was inevitable that we would face this question: What is our regulatory system (the design of which is, after all, quite old) doing to be more responsive and cost effective in this new environment? And it has been the intense focus on this question by everyone in this room, by government policy makers, by industry professionals, and by academics, that has led to the current movement toward regulatory consolidation.

As all of you know, self-regulation has played a key role in protecting investors for a very long time. So as we consider tinkering with it -- or in this case, significantly overhauling it -- it’s worth taking a moment to consider its history.

The SRO concept itself is old as the Buttonwood Tree in Lower Manhattan in the 1700s. And it has stayed with us through passage of the Maloney Act in the 1930s, through every major securities law enactment in the 20th century, and now into the 21st. Today, just as always, SROs are helping to build and sustain the investor confidence that is indispensable to a healthy capital market.

As the New York Stock Exchange and other exchanges first developed during the early years of our nation’s history, they assumed responsibility for supervising the members’ activities. Over time, what began as trading conventions became formalized as exchange rules. Federal regulation of the exchanges followed -- not only as a response to the stock market crash of 1929, but also the failure of the NYSE to respond adequately to market manipulation.

When Congress formalized the SRO structure during the 1930s, it concluded that self-regulation of both the exchange markets and the over-the-counter market struck a reasonable balance. The government benefited by being able to leverage its resources through an oversight role. And the securities markets continued to be supervised by organizations familiar with the nuances of their operations. An additional benefit was that both the exchanges and the SROs had the ability to develop their own standards concerning equitable principles of trade, membership requirements, and business conduct.

It should be evident from going over this history that, while it is vitally important that our SRO system is modernized to keep pace with changes in the industry, the essential principles underlying the original SRO concept are just as valid today as they were 70 years ago. Strong, effective SROs are just as critical to healthy markets today as they have ever been.

Over the years, the SEC has made changes to the self-regulatory system based on our analysis of the extent to which SROs have succeeded in fulfilling their statutory obligations. The Congress has also periodically made legislative changes to strengthen the system. But these changes over the years have been incremental. There’s been no fundamental reevaluation of this system since its establishment.

Partly that was because almost everyone agreed that the SRO system has functioned effectively, and has served the government, the securities industry, and investors well.

But despite this general agreement, one feature of the system in particular has increasingly drawn the attention of reformers -- and that is its reliance on multiple, redundant regulators. A number of interested parties, including the SIA in its white paper titled “Reinventing Self-Regulation,” have urged the Commission to simplify the system.

And in response, in 2004, the SEC announced that the time had come for a major reassessment. The Commission cited, among the reasons for this willingness to think anew, “changes in the ownership structure of SROs,” by which we meant not just the change to for-profit status, but also the shedding of ownership of markets, which means that an SRO can now operate solely as a regulatory utility.

We also pointed to “increased competition among markets for listings and trading volume” as another reason that it is now time to consider major change. And we asked for comment on a number of possible ways that the self-regulatory system could be overhauled.

Now, two years later, as the two major securities exchanges in this country are reaching across the Atlantic to combine with European exchanges, it is finally time to conclude that SRO regulation must change to keep pace. Unless we act now to remove unnecessary duplication and conflicts of interests in our regulatory structure, we’ll actually impair the ability of America’s capital markets to remain the world's strongest.

Our Concept Release clearly identified four main problems with the current system. Those problems are looming even larger now, with the dramatic changes currently underway in the marketplace.

First, there are inherent conflicts of interest between an SRO’s regulatory operations and the other interests of its members, its market operations, issuers, and shareholders. Rather obviously, SROs are responsible for making and enforcing rules that govern all aspects of their own members' securities business. If this basic conflict isn't properly checked, the result is weakened rulemaking, less rigorous examinations, and compromised enforcement actions and disciplinary proceedings involving members.

Just as important are the conflicts that can arise when an SRO’s regulatory obligations conflict with the interests of its own or its affiliate’s market operations. That is a potential source of conflict that is likely to grow as competition among markets continues to grow, and the markets that SROs operate continue to come under increasing pressure to attract order flow.

A second problem with the current system is the needless cost and inefficiency of multiple SROs that result from multiple rulebooks, duplicative inspection regimes, and redundant staff. It is investors who pay those extra costs in the form of both money and lost efficiency.

It goes without saying that multiple rulebooks aren’t just needlessly duplicative -- they're potentially conflicting as well. The same is true for rule interpretations and inspection regimes. They can conflict with one another just as easily. And the redundant SRO regulatory staff, along with the duplicative infrastructure across SROs, is just pure economic waste.

Of course, both Congress and the SEC have tried to reduce at least some of this regulatory duplication. The Designated Examining Authority program assures that only one SRO examines a firm for compliance with financial responsibility rules. The Exchange Act also permits multiple SROs, if they get Commission approval, to allocate to one SRO all regulatory responsibilities with respect to their common members. But these measures can only achieve so much. And as a result, a great deal of wasteful duplication remains today.

A third source of problems in the current SRO system that was cited in our Concept Release is that the increasing prevalence of cross-market trading that is making it ever more difficult for multiple SROs to conduct market surveillance. A fundamental characteristic of any market surveillance program is the need for adequate order audit trails at the SRO level. But now that trading routinely occurs across markets, crooked traders can cloak illicit activity more easily by dispersing their orders to various market centers. Simply put, multiple SROs make it harder to deal with this type of fraudulent activity.

The fourth concern that we identified is the question whether an SRO devotes sufficient resources to its regulatory operations. That issue has come into stark relief now that SROs have become for-profit entities. With the demutualization of SROs, their for-profit form of ownership raises the possibility that self-regulation will be viewed merely as a cost, and a net subtraction from the profitability of the enterprise. As we make our way forward to a better system, we’ve got to focus on mechanisms that can alleviate this tension, keep regulators at arm’s length from conflicting commercial interests, and assure adequate funding for the protection of investors.

Our Concept Release clearly outlined, as one alternative to today’s system, just the sort of hybrid model that the regulatory arm of the NYSE and the NASD are now considering. Such a system would regulate the members of both SROs with respect to membership rules (including rules governing a member’s financial condition), margin practices, the handling of customer accounts, registered representative registration, branch office supervision, and sale practices. It would be solely responsible for promulgating membership rules, inspecting members for compliance with member rules, and taking enforcement action against those members that fail to comply. This combined SRO would be market neutral.

Market operations and market regulation would remain separate -- that's the hybrid part. The strength of this approach is that it would minimize the inherent conflicts between the regulatory function, on the one hand, and market operations, on the other hand.

While this single regulator approach would completely eliminate today’s duplicate rulebooks, and the possibility of conflicting interpretations of those rules, at the same time it would retain one of the fundamental precepts that has characterized the SRO model since its inception in 1930s: the notion that regulation of the markets works best when the front line regulator is in proximity to the market. The government would continue to benefit by being able to leverage its resources through an oversight role; and the securities markets would continue to be supervised by organizations familiar with the nuances of their operations.

Without a doubt, our current system of two rulebooks, two separate SRO staffs, and two separate enforcement regimes is undermining the effectiveness of regulation, and by extension, the efficiency of our capital markets. Reducing unnecessary regulatory costs, while increasing regulatory effectiveness, will help the United States continue to attract the capital necessary for our nation’s economic growth. And most important of all, ending unnecessary duplication and the dangerous lack of coordination in our regulation across markets will offer the best protection to investors.

As regulators, our mission at the SEC is to serve and protect investors with the most efficient, fair, and forward-thinking system of regulation possible. Quite simply, I believe that the time has come to put an end to the duplication, conflicts, regulatory costs and competing rules we all live with today. We can do better -- for investors; for the 5,100 firms competing in a constantly changing marketplace; and for everyone who relies upon the strength and integrity of our capital markets.

The significant restructuring of the current SRO model that is now underway has been long in the making. For the last decade, both the NYSE and NASD have been working to reduce burdens on their member firms by coordinating oversight and examination efforts. Under a 1995 Memorandum of Understanding, they’ve been holding quarterly planning meetings to coordinate schedules for routine exams. More recently, the NASD and NYSE have also agreed to coordinate their examination programs. During the coordinated examinations, examiners from both SROs would share their findings, and if necessary, change the focus of the examinations. And when the examinations are completed, the NASD and NYSE would share examination reports. Working together with the SEC, the NASD and the NYSE have also established means to reduce the possibility of overlap in examinations of broker-dealer branch offices.

And in February of this year, in connection with the Commission’s approval of the rules implementing the merger between the NYSE and Archipelago, the NYSE undertook to work with the NASD and industry representatives to eliminate inconsistent rules and duplicative exams. They agreed to submit to the SEC proposed changes that would harmonize inconsistencies in the two rulebooks, as well as report to us on which of the rules haven't been reconciled. Following up on that agreement, a broad review of the rules was undertaken by representatives of several compliance advisory groups, member firms, and the SIA. Various subcommittees studied rules governing matters such as testing and education, sales practices, and supervision. They noted the areas where differences exist, and whether the NYSE approach, the NASD approach, or a blend of the two would be preferable.

As we meet here this morning, all of that hard work has essentially been completed -- and the resulting recommendations are even now being reviewed internally at the NYSE and NASD. As a result, I expect that we will soon see proposed rule changes filed with the SEC for the purpose of harmonizing the NYSE and NASD rules. I applaud this work as an important step in reducing regulatory costs to the securities industry and improving investor protection.

But even conforming the rulebooks in this way won’t address the broader problems of conflicting enforcement and interpretations, or the potential for duplicative examinations, that result from having multiple SROs. That is why I am so firmly of the view that much more can, and should, be done. Without a joint regulatory entity, we’ll undoubtedly continue to make progress -- but as before, it will only be incremental.

I know both the NASD and the NYSE are committed to the broader objective of a single self regulatory organization. I won’t predict timing, but I know the momentum is there.

We all realize how important this is. The time to act is now. I’m very excited about these opportunities to increase consistency and efficiency in our SRO system, because in ushering in these changes, we’ll be improving America’s capital markets, and making our nation more competitive.

It's easy to forget the significance of what we’re talking about when we’re caught up in the details of SRO structure. But the fact is, nothing that we do in our country impacts more people, or offers a greater opportunity to serve our fellow citizens, than the improvement of our capital markets. That’s because they’re the wellspring of support for our entire free enterprise system. And they touch the lives of almost everyone.

Back in Joe Kennedy’s day, our first SEC Chairman could marvel that “one person in every ten” owned equities. But today, our financial markets encompass the investments, the hopes, and the dreams of half of all households. Some 57 million Americans now own stocks -- and the median income for shareholders is a very middle-class $65,000.

Our market economy, better than any other system in the world, enables the poor to rise from poverty, and enables the vulnerable and marginalized to be protected -- because after all, wealth must be produced before it can be shared. So to all of you, whose vocation it is to power this amazing engine of wealth creation with your imaginations and your willingness to take risks, thank you for what you do. Thank you for what you give each day for your fellow men and women, for your country, and for our world. We’re on the threshold of exciting changes. And the SEC is honored to be your partner.



Modified: 11/10/2006