Speech by SEC Commissioner:
Remarks Before the 34th Annual SIFMA Operations Conference
Commissioner Paul S. Atkins
U.S. Securities and Exchange Commission
April 30, 2007
Thank you for that kind introduction. It is an honor to be here today. Before I get started, I need to satisfy my own compliance people and tell you that the comments that I am about to make are my own and do not necessarily reflect official SEC policy or the opinions of my fellow Commissioners.
It is always nice to be speaking to a room full of securities professionals when the Dow is in record-high territory. But, record stock market highs in times, like this, of strong economic fundamentals are familiar to all of us. Less familiar are the numerous and varied changes affecting the securities markets today.
There are major market structure changes taking place here in the U.S. as well as in the international markets, some of which I will talk more about in a minute. Significant business and regulatory changes are also afoot. The NASD and NYSE Regulation are scheduled to complete their merger in June. The NYSE and Euronext have completed their merger and will presumably now seek to capitalize on the efficiencies that the combination provides. The NYSE is back in the bond trading business. NASDAQ is creating and/or buying an options market and is reinvigorating its PORTAL system for 144A securities; institutional trading firms like BATS, ITG, and GETCO represent a significant portion of the NYSE and NASDAQ trading volume. And, the way some other people have been talking — all around us, in the back alleys and in the unlit corners, "dark pools" are multiplying! Perhaps dark pools ought to be the subject for the next blockbuster horror movie — they could call it "The Dark Pool that Swallowed Manhattan!"
All of these changes are happening at a time of concern about the competitiveness of the U.S. capital markets. Three major reports recently have been published with recommendations, including some aimed at improving SEC rules and procedures. A constant theme in the reports is that excessive, overlapping, and unnecessary regulation in the U.S. is a major reason for our loss of market share in the global capital markets.
Although the perspectives and findings of each group are unique, there is a common thread of very important SEC-related issues among them. Three of them stand out: fix the implementation of section 404 of the Sarbanes-Oxley Act; use cost-benefit analyses in making rules; and work with the other financial regulators to bring transparency and predictability to the enforcement process. To tell you the truth, these recommendations are not radical — they are common sense measures that the SEC should undertake whether or not they affect U.S. competitiveness.
We at the SEC cannot and should not ignore these findings and recommendations. We must recognize and understand how the markets have evolved when we consider whether at least some aspects of our weighty regulatory precedent still make sense. Times change and we ought to review our rules to see if they still meet the purpose for which they were made in the first place. We need to ask ourselves a question that Secretary Paulson has recently posed: "Have we struck the right balance between investor protection and market competitiveness — a balance that assures investors the system is sound and trustworthy, and also gives companies the flexibility to compete, innovate, and respond to changes in the global economy?"2 The reports can help us answer this question.
I believe that the Commission is duty-bound to analyze, understand, and — if warranted — respond to each recommendation that pertains to us. As you might expect, not everyone agrees with the recommendations of these reports, or even of the necessity to examine our regulatory scheme.
So, let the debate begin! I encourage all of you to pay attention and to be involved, because this debate affects your profession and the shape and strength of the American capital markets in the years to come.
It is also good that this debate is taking place while market conditions are strong: the Dow has hit its all-time high, macro-economic fundamentals are strong, investor interest is healthy, and — as I am sure you all appreciate — the securities industry coming off a record-breaking year of profits.1 The strong U.S. capital markets continue to offer foreign firms many benefits, including deep liquidity, visibility to U.S. investors, transparency, and corporate finance and business strategy opportunities. But, at the same time, other markets have grown and liberalized during the past couple of decades, narrowing the advantages of our markets. This is ultimately for the good of all. As they say, "A rising tide lifts all boats."
But, as Benjamin Franklin is credited with saying, "A small leak will sink a great ship." In the end, companies are rational — they expect benefits to exceed costs. If that is not the case, they will go elsewhere or raise capital in the deep and flexible US private markets. This was proven true in 2006, when the value of Rule 144A unregistered offerings in the U.S. for the first time exceeded the value of public offerings. Our job as regulators is to examine the costs that we impose on market participants through our regulations to make sure that those costs do not exceed the benefits.
I am pleased to say that there have been recent glimmers of hope when it comes to the SEC's taking an economic view of rulemaking. Perhaps the best example of this is the review undertaken by the SEC's Office of Economic Analysis (OEA) regarding the effectiveness of the short sale rules. For many years, academics had been questioning whether the SEC's short sale price test, or "tick test," was needed. The tick test, which has been on the books for seventy years, restricts the prices at which short sales may be executed.
Our economists conducted a pilot test on approximately 1,000 securities to investigate whether removing the price tests would make stocks more susceptible to patterns associated with downward manipulation. They did not find evidence to suggest that pilot stocks are more likely to be manipulated downward than other stocks. Based on the results of the pilot, the SEC proposed last December to eliminate the tick test across the board. I commend the ingenuity of the staff — both in OEA and the Division of Market Regulation — in formulating this approach, and I look forward to seeing similar empirical methods used in the future.
Other recent rulemakings by the SEC can be neatly described by a single, four letter word that is the source of many nightmares for securities operations professionals — the word is "FAIL." Fail is an especially appropriate word to describe the substance of one of these rulemakings, and the process and theory of others. The first rulemaking is the pending proposal to amend Regulation SHO, and thus relates to the noun form of the word "fail" — as in a "fail to deliver." I am happy to report that the amendments under consideration by the Commission would, if adopted, help reduce the number of aged fails to deliver. These amendments would eliminate the now-notorious "grandfather" exception from Reg. SHO and would limit the scope of the options market maker exception.
The decision to propose the amendments to Reg. SHO was based upon a thorough and extended review of empirical data on fails collected by the SEC staff after implementation of Reg. SHO in 2004. In a time when the SEC has come under intense scrutiny for shortcomings in our rulemaking processes, this thoughtful, coordinated approach was truly a breath of fresh air. It exemplifies the expectations of Congress when it placed on us the burden to consider whether our actions will "promote efficiency, competition, and capital formation."
Unfortunately, proactive regulatory thinking does not characterize all that the SEC does, and that is where the verb form of the word "fail" comes in — as in the SEC failed to do its job properly and was slapped down by the courts. These are mainly the regulatory missteps that the SEC made before the arrival of Chairman Cox. During that time, a majority of the Commission — when I found myself in the minority — promulgated several rules that did not satisfy the cost/benefit analysis and other procedural requirements for our rulemakings — including the not trivial requirement that the SEC act within the authority granted it by Congress. Two of these rules, the hedge fund registration and mutual fund independent director rules, were challenged and defeated in federal court. A third, and the most relevant to this crowd — Regulation NMS, has so far successfully escaped court review and is in the process of a much-delayed implementation process. In Reg. NMS, the SEC failed to establish a need for rulemaking, failed to conduct a meaningful cost/benefit analysis before promulgating the rule, and failed the U.S. markets by adopting the rule.
In a nutshell, Reg. NMS rules fall into four categories: (1) the trade-through rule (it is an understatement to say that the sweet-sounding appellation "Order Protection Rule" is a misnomer); (2) the access rule; (3) the sub-penny rule, and (4) the market data rules. Some of these rules are much more problematic than others.
In my view, Reg. NMS represents a massive regulatory intrusion into our secondary trading markets that was completely unwarranted, given the lack of evidence of market failure and the availability of substantially less-intrusive means to advance the purported goals. Reg. NMS has the potential to do significant harm to our markets by unduly interfering with the operation of competitive forces. Over the years, these forces have benefited investors immensely by reducing trading costs and increasing market efficiency. Whatever its justification, Reg. NMS is a carte blanche for unsupervised meddling by the SEC staff in the marketplace for years to come.
The most problematic component of Reg. NMS is the trade-through rule. Based on the trade-through studies I read during the rulemaking process, I did not see a need for trade-through "protection." Protection from what? The freedom to choose how you want your trade executed? Does the government know better than investors how trades should be executed? I don't think so. And, one need only look at the precedent for this sort of rule — the SRO/ITS trade-through rule — to see that the only thing "protected" by the rule was an outdated market structure. Market participants did not need protection — the duty of best execution, coupled with the rise of electronic trading centers, would have ensured that investors got satisfactory executions. So I am sorry to report that now — despite the fact that competition has driven the manual markets to automate — we will soon have a trade-through rule and at the same time no assurance of best execution compliance for orders sent to some of these automated markets.
My opposition to the adoption of Reg. NMS does not in any way make me less interested in the implementation process. Quite to the contrary, I have been fully engaged in the process to ensure that the rules are implemented in the least burdensome and most cost-effective manner possible and in a way that limits their potential harm to our markets' competitiveness. I am grateful that market participants have been providing crucial feedback to the SEC on Reg. NMS implementation.
As most of you know, the original compliance date for the trade-through rule and market access rules — which together are the heart of NMS — was June 29, 2006, almost one year ago. As with other, less-important components of Reg. NMS, this deadline has been repeatedly and significantly delayed. The first extension, which the Commission approved last May, replaced the 2006 deadline with a complicated phase-in schedule. I said last year that I doubted that the industry could meet even these more generous timeframes. So, it was no surprise this January when the New York Stock Exchange requested a further extension of the February 5 trading system deadline. The Commission approved a one-month extension of that deadline, even though the additional one month period was not enough time for the NYSE to remedy its inability to route orders to the ADF and ISE! The Commission also extended the start date for industry compliance for 250 stocks from May 21 to July 9, and the date for full industry compliance from July 9 to August 20. Since these are the first dates that affect everyone in this room, you should note that the 20th of August falls conveniently into the heart of summer vacation season. On behalf of the Commission: You're welcome. The October 8 deadline remains in place — at least for now! I guess the "NMS" in Reg. NMS will never stand for "No More Stalling." I would welcome your feedback on the feasibility of these deadlines.
Why all of the delays and extensions? The difficulty in the creation of new, electronic trading systems by the exchanges was undoubtedly one reason for the extensions. However, the truth of the matter is that the unduly complex and burdensome nature of the rules themselves made the extensions necessary. The implementation process already has been a rude awakening for many, and we have not even gotten to the broker-dealers yet!
Technology is only one aspect of the implementation burden. The SEC staff, on its own by authority delegated in Reg. NMS from the Commission, has provided several exemptions to facilitate the implementation of NMS, including a significant exemption from Rule 611 for "Qualified Contingent Trades." Exemptions are necessary to tailor an inappropriate, "one size fits all" rule to the needs of a dynamic marketplace. At bottom, however, these exemptions, along with the implementation delays, are the clearest sign that NMS was unworkable as proposed — and remains so today. Should you have any lingering doubt about the workability of Reg. NMS, keep in mind that the staff has issued over 50 "Responses to Frequently Asked Questions" for Rules 610, 611, and 612. And, you will see more FAQs — the Responses to previous FAQs have actually generated questions of their own!
I will continue to watch carefully the implementation of Reg. NMS and hope that its consequences turn out to be a non-event — other than the thousands of hours and multiple millions of dollars spent in an effort by market participants to implement it. The trouble is that the real consequences for our markets will not be known for years, after the damage has been done and after trading patterns have shifted in unpredictable ways and perhaps to other venues. There will be more exemptions, more questions, and maybe even more delays before this is over. I implore you and your firms to provide us with feedback as we continue to slog through the NMS quagmire!
I can't leave the topic of "fails" without touching on one more highly important issue currently facing the Commission. This goes back to the meaning of "fail" as a noun. The SEC has recently been involved in a very proactive (some might even say prudential) exercise with respect to the issue of fails in the OTC derivatives markets. In response to reports of widespread documentation problems in those markets, the SEC has joined forces with other regulators, most notably the Federal Reserve Board and Britain's FSA, to encourage OTC market participants to clean up years of incomplete and inaccurate trade documentation. The need to act was clear. From all reports, the backlog of unconfirmed trades, which essentially are fails, and the widespread and unchecked use of novations in the credit derivatives markets had crippled risk management efforts and set the stage for a massive meltdown in certain default scenarios. Given the multi-trillion dollar aggregate notional amounts of the contracts involved, it was easy to see that the OTC derivatives dealers and their counterparties had created an operational problem similar in scope to the late 1960's back-office crisis on Wall Street.
In September 2005, the Federal Reserve Board and other regulators including the SEC called together 14 major OTC derivatives dealers to address these operational issues. The focus at that time was on OTC credit derivatives. Of course, the SEC does not necessarily have jurisdiction over OTC credit derivatives, but the firms subject to SEC supervision through our Consolidated Supervised Entity program are dealers in that market, and so it was important for the SEC be involved in overseeing the cleanup process. In addition, the SEC does regulate OTC equity derivatives, which were affected by many of the same operational maladies suffered by credit derivatives.
The dealers agreed after the 2005 meeting to develop processes for reducing the operational risks associated with the documentation backlog, and established a timeline that would allow regulators to track their progress. At a follow-up meeting in early 2006, the dealers reported significant progress in cleaning up aged unconfirmed trades, and committed to future deadlines for further reductions. The dealers also committed to objectives for increasing the electronic settlement of eligible trades, and began to work with DTCC to build upon its Deriv/SERV platform by establishing a "Trade Information Warehouse" to automate and standardize post-trade processes and to store copies of each contract. I understand that new enterprises, such as Swapswire, have entered the market to provide centralized, automated trade processing, and I assume that such competition will encourage and drive innovation in this area.
Today, due in large part to the increased use of electronic settlement systems and standardized contracts, the number of aged unconfirmed OTC credit derivative trades at the CSE firms supervised by the SEC has been reduced by approximately 90% since the September 2005 high. That is truly a success story, and I applaud both the principled regulatory approach and the tremendous efforts of the market participants.
In the Fall of 2006, attention turned to documentation failures in the OTC equity derivatives markets. According to a recent report by the Office of the Comptroller of the Currency, the notional amount of OTC equity derivatives held by banks in the fourth quarter of 2006 was just shy of $2.3 trillion dollars.2 Amazingly, that figure pales in comparison to the $9 trillion dollar notional value of credit derivatives — and the $131 trillion dollar aggregate notional value of all derivatives held by banks in that same period. But, despite a relatively small notional value, equity derivatives represented almost one-third of the banks' trading revenues. And these figures only represent a small slice of the world markets for OTC derivatives. According to a March 2007 report by the Bank for International Settlements, the global notional amount of OTC equity and credit derivatives were approximately $7 trillion and $20 trillion dollars, respectively, at the end of June, 2006.3
As with the credit derivative documentation cleanup, the process for equity derivatives is being overseen by regulators but implemented by the dealers. Although the equity derivatives markets have experienced documentation problems similar to those of the credit derivatives markets, it appears that the problems are not as severe. However, inherent differences in the credit and equity derivatives markets have made some aspects of the cleanup effort for equities derivatives more challenging.
One of the primary difficulties has been the lack of standardized documentation, which has often resulted lengthy confirmations. The problems arising from a lack of standardization are exacerbated by the fact that, unlike with credit derivatives, the majority of equity derivative transactions are dealer-to-client instead of dealer-to-dealer, and thus the number of counterparties is much larger. I understand that efforts to date have been productive, but much more work is needed to match the successes experienced in the credit derivatives process. If one were asked to cite just one major systemic threat to our financial system, the answer would have to be the non-standardized documentation of OTC derivatives.
I am very pleased with the public/private partnership employed to cleanup the OTC derivatives documentation problems. I assume that these efforts will yield great results. But, I believe there is more that the SEC can do to facilitate efficiency and competition in the equity and credit derivatives markets. I am a firm believer that, as a general rule, market forces will — if allowed — quickly cure or kill inefficient practices.
To allow the full measure of market efficiencies in the derivatives markets, the SEC and other regulators cannot stand in the way of new product development and dissemination. As you may know, both the CME and the CBOE have recently proposed new exchange-traded credit derivative products. These exchange-traded products will provide market participants with important benefits that OTC products simply cannot. The products are substantially similar to OTC products, but they would bring with them all of the efficiencies inherent in exchange traded products — they are standardized, centrally-cleared and settled, and transaction and quotation information would be transparent. Despite the concerns that OTC dealers may raise, I doubt that the exchange-traded credit derivatives will have a major competitive impact on the OTC markets. In fact, it wouldn't surprise me if both markets grew at similar rates. But I fully expect that the availability of exchange-traded products will increase the pressure on the OTC markets to streamline their processes and provide increased transparency. That, in turn, will allow for better risk management and increased confidence for regulators and market participants.
In my view, the SEC should not allow jurisdictional issues — a.k.a. "turf wars" — to stymie the growth of exchange-traded credit derivative products. I hope and expect that the Commission will work closely with the CFTC to establish a rational, predictable, and timely approval process for these products.
And while we are at it, the SEC and the CFTC should also work together to quickly eliminate the barriers to a fully-effective, single account portfolio margining system. Jurisdictional squabbles should never impede innovation and holistic risk management practices.
You have been a very patient audience, and I appreciate your attention. I welcome your active involvement in the issues I discussed today, and all of our issues. My phone and office are always open to you. Please call or stop by if you have any comments or concerns. Thank you again for your time and attention.