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U.S. Securities and Exchange Commission

Speech by SEC Staff:
Remarks before The California ’40 Acts Group


Erik R. Sirri

Director, Division of Market Regulation
U.S. Securities and Exchange Commission

Washington, D.C.
January 26, 2007

Thank you. I am delighted to have been invited to the meeting of The California ’40 Acts Group. I myself am a native Californian: I grew up in La Canada, and went to College near here at Caltech and UCLA, so it is good to be home. I actually went down to have breakfast at The Pantry this morning. There’s something I like about that place—it never changes—but I think it’ll kill you if you eat there too often. Based on life in Washington, I actually didn’t know they had securities attorneys, let only ’40 Act folk, this side of the Rockies. It was especially nice to see Paul Roye again, with whom I worked at the SEC when he was head of the Division of Investment Management. At the outset, let me remind you that the views I express are my own and not necessarily the views of the Commission, the individual Commissioners, or my colleagues on the Commission staff.1

The last few years have been tough on the fund industry in many ways. But let me begin by saying that the investment management industry should be proud of the contributions to the development and growth of new products available to investors. While new products inevitably present regulatory challenges, I welcome responsible innovation and encourage your creativity. As the market place evolves, I continue to evaluate market-driven practices and consider whether regulatory enhancements are desirable to increase integrity and efficiency in the market place.

Growth of Exchange Traded Funds

One area of rapid innovation is in exchange-traded funds (ETFs). As you know, ETFs were first introduced in 1993 and in their early incarnations resembled index-tracking mutual funds. Many new ETFs that have emerged in recent months are expanding the traditional scope of ETFs. Approximately 135 new ETFs were issued last year, and investors can now trade over 300 ETFs, with $400 billion in assets, according to a report by Morgan Stanley last November. ETFs were originally built around broad, well-known passive indexes, such as the Standard & Poor’s 500-stock index, the Dow Jones Industrial Average, and the small-company Russell 2000. Today, markets accessible through ETFs include U.S. and international equities, fixed-income, commodities, and currencies.

Last month, for example, trading began on an ETF based on an index of companies that own the most valuable patents relative to their book value, another on an ETF that tracks companies spun-off from larger companies, and a third ETF constructed from publicly traded global real estate securities outside of the U.S. – to name a few.

This month, so far, the New York Stock Exchange has announced eight new ETFs that track the price and yield performance of specific benchmark indexes representing segments of the U.S. bond market, and five ETFs that track groups of companies concentrating on treatment innovations in cancer, infectious diseases and cardiology, among others. The American Stock Exchange likewise has announced the launch of new ETFs, including seven new commodity-based ETFs that track price movements in everything from gold and silver to base metals, an ETF that tracks the performance of a float-adjusted market capitalization index designed to measure the combined equity market performance of developed and emerging market countries (excluding the U.S.), and an ETF that provides short or magnified exposure to small capitalization indexes. Investors now can trade seven major currencies, with another currency – the yen – on the way. And finally, there was a recent launch of an ETF last summer that tracks the Goldman Sachs Commodity Index.

Increased Listing Competition

The proliferation of product offerings is coupled with increased competition among SROs for primary market listings of ETFs. Last month, for example, several iShares ETFs transferred from the American Stock Exchange to NYSE Arca. There is a natural competitive goal for an exchange to strive to become the dominant exchange for listing and trading ETFs. This drive should be coupled, as I believe it is, with a commitment to the highest level of market quality and investor protection.

Regulatory Challenges

These products, and others that are on the drawing boards of creative firms, often present regulatory challenges. The breadth of products offered to investors depends not only on the creativity of the sponsors of ETFs, but also on novel approaches by exchanges seeking to list ETF shares. It is reasonable to ask what the Division of Market Regulation’s concern is in this process. After all, these products appear to be more the purview of the Division of Investment Management. There are two chief concerns when evaluating new products offerings: (i) whether the product is a security, and if so, (ii) whether the Commission should approve the listing of the product.

A threshold question is whether the product is a security: exchanges have the authority to list and trade “securities” as defined under the Exchange Act. Thus a new product based on a commodity, such as corn or wheat, may be an example of an instrument that can potentially pose issues in this regard, even if it is a useful and viable financial product.

If the new product is a security, then the Commission determines whether it is proper to list the product on an exchange. In 1998, the Commission summarized the regulatory framework for Commission approval of SRO listing standards for derivative securities products. Some of the relevant factors considered include the exchange’s surveillance, transparency of the pricing information about instruments of which a new product is based, and the potential for disparate and unfair access to information by some market participants. The Commission continues to use these standards as guidance for approving the listing and trading of such derivative products.

In light of the increased pace of innovation, the Commission adopted generic listing standards, which have helped to speed up the regulatory process required in launching new ETFs by reducing the burdens on issuers and exchanges. For example, the Commission has previously approved generic listing standards for ETFs based on indexes that consist of stocks listed on U.S. exchanges. Innovation is not static, and neither is the Commission. Recently, the Commission has taken steps to facilitate the introduction of new ETFs by expanding the expedited exchange listing procedures available for U.S. stock based ETFs to cover ETFs that invest in international securities. The Division hopes to have generic listing standards out for debt-based ETFs, both foreign and domestic, in the first half of this year.

Where products pose novel issues, however, the listing exchange must still adopt rules to cover these new ETFs that do not fit squarely under their generic listing rules. The listing exchange must determine that each new derivative securities product meets the criteria for: design and maintenance of the instruments or index underlying the new derivative securities product; customer protection rules; surveillance of the component securities; and the potential market impact of the new derivative securities product. The Commission requires SROs to have a surveillance program adequate to monitor for abuses in the trading of a new derivative securities product. The Commission also considers relevant the availability of real-time public pricing information with respect to the underlying instruments. Such information is important to minimize the potential for manipulation.

The principle of real-time public pricing information can be a problem in the case of actively-managed ETFs. These are new products that aim not to passively hold a fixed portfolio of securities but rather to allow for the active management of those securities, while at the same time trading continuously on an exchange. The problem, of course, is that because the composition, and thus the pricing, of the underlying portfolio is not known, traditional arbitrage mechanisms commonly used in ETFs are problematic. These actively-managed ETFs have proposed various solutions to this problem, based on varying degrees of pricing transparency. One can ask the question, how bad would it really be if you only know the composition of the portfolio once per month, and the pricing of the underlying portfolio once per day? Mispricing might occur over the course of the trading day, but this would likely be bounded. More to the point, if investors understand the potential for mispricing, they might be willing to tolerate the error provided that prices weren’t systematically biased one way or the other. From our perspective, if we want these instruments to trade on an exchange, we are going to have to evaluate the relative importance of the principles I have just enunciated: pricing transparency vs. competition.

Pricing transparency can also be a challenge, for example, where the underlying instrument trades in an over-the-counter market (such as the OTC gold market), where participants are not required to report their quotes or trades. Also, derivative products based on securities that are not listed on a U.S. securities exchange, where real-time quote and trade information is publicly available, pose challenges in assessing whether sufficient public price information is disseminated. In some circumstances, the Commission has recognized that there exist numerous sources of pricing information from which market professionals could price the derivative shares. Today, for example, gold-linked trust shares are listed on the American Stock Exchange and the New York Stock Exchange.

Product innovations enhance competition in the market, offering a wider array of investment options for investors, which I believe should be encouraged. Different types of products can generate equivalent economic exposures. For example, ETFs SPDRs and S&P500 open end mutual funds, or a share of IBM stock, a total return swap, or a single stock future on the same underlying are all examples of equivalent exposures. I believe that the development of competition between such products is ultimately beneficial to investors as competition will ultimately lead to better products and lower prices. Yet this is often not a simple path. Product design issues and jurisdictional questions make this a difficult for the Staff, especially because the industry understands these issues and often designs products that press the boundaries of our zone of comfort for many of these products. This is as it should be, and it is incumbent on us to work out these concerns with firms, exchanges, and other regulators.

As new products move beyond indexes or U.S. equity securities, U.S. exchanges must monitor the risk that certain market participants may take advantage of inside information or manipulation the market. This may be particularly challenging where the derivative is based on a commodity or instrument that primarily trades in a foreign jurisdiction. For example, in response to the rapidly growing credit derivatives market, the Chicago Board Options Exchange and the Chicago Mercantile Exchange each plan to begin trading new products based on credit default of a company, one crafted as an option and the other to fit within the category of a futures contract. As a policy matter, the Division’s staff focuses on the application of the securities laws – and in particular insider trading prohibitions – to products that could be used improperly to profit from such insider information.

Last summer also saw the launch of new innovative ETFs designed to make it easier for investors to establish a short exposure to an index. ETFs that short stocks present different – and potentially greater – risk than long-only ETFs. That risk is intensified when the ETF is leveraged. For example, shorting a stock directly or using leverage is prohibited in retirement accounts, and though a relatively small number of traditional mutual funds do exist that pursue some of these alternative strategies, they're not always available through retirement accounts. However, such ETF products come with benefits as well. By providing built-in leveraged short exposure to the indexes, these ETFs make it much easier for retail investors to execute sophisticated investment strategies involving hedging or risk-shifting. Investors no longer have to go through the process of setting up margin accounts, they simply can trade ETFs. It is notable, however, that whereas a retail investor who makes use of a margin account receives disclosures statement that discusses the operation and risks associated with trading on margin prior to or at the opening of a margin account, no such disclosure is provided to an investor who buys a levered or levered-short ETF in the secondary market, or if it is provided, it occurs after the fact with the trade confirmation.

The brisk pace of innovation in exchange-traded funds means that many retail investors, including retirement-account investors, are getting easier access to broader investment strategies, from short-selling stocks to betting on currency and commodities.

Innovation Coupled With Investor Protection

For myself, I believe our mandate here is clear. We must strive to strike the appropriate balance between a flexible environment that fosters the development of new and useful financial products on the one hand with a clear sense of the obligation of responsible product design and investor protection on the other. More can be done to speed the introduction of new securities products, but it must be done in a manner consistent with investor protection.

While I recognize the benefits of the number of increasingly complex products that are being introduced, some of these products have unique features that may not be well understood by investors or registered persons.

Market participants should take a proactive approach to implement and update their procedures for developing and vetting new products. The NASD has recommended best practices for reviewing new products which may be a useful reference. In addition to SRO guidance, I expect that the Commission will continue to bring enforcement actions whenever new products are used to harm investors. For example, the Commission recently brought an enforcement action in a matter involving inverse floaters – highly complex, risky, and volatile type of mortgage-backed security derivatives – which were sold to retail investors for whom they were unsuitable. The registered representative sold inverse floaters to retail customers with conservative to moderate investment objectives for whom they were unsuitable investments, and made material misrepresentations and omissions to these customers when doing so.


The approach to new products can therefore be summed up as having three parts. First, we should strive to facilitate the creation of new and useful financial products. This can be done by focusing our attention on those aspects of the new product that implicate the core aspects of our regulatory program. Industry’s role in such an approach is to bring to us only those products that are responsibly designed in light of our regulatory concerns and surveillance realities. Second, we should strive to get multiple products with the same economic exposure trading at the same time. Then advantage is one of a potentially lighter regulatory touch, with a concomitant improvement in product quality and pricing. Third and finally, the advent of these new products highlights the need for responsible selling efforts on the part of brokers who distribute these products.

Through new products, investors gain a wider array of investment options from which they may diversify their investments, maintain liquidity, and access foreign markets, commodities, and other products through our markets via a mechanism of registered U.S. advisers and broker dealers, and using U.S. currency. That is true value. For our part, we in the Division of Market Regulation, and I know I speak for Buddy Donohue in the Division of Investment Management, will strive to work constructively with you as you develop new product offerings. Congress has charged us to be mindful not just of investor protection, but also of competition, efficiency and capital formation. Given my background in finance, those words are not empty, and I look forward to working constructively with the industry. The Division will continue to evaluate the efficiency and effectiveness of the regulatory program with regard to new products, and I encourage you to join us in this effort.

Thank you again for inviting me here today.



Modified: 02/02/2007