Speech by SEC Commissioner:
Remarks Before the ABA Section of International Law
Commissioner Annette L. Nazareth
U.S. Securities and Exchange Commission
May 4, 2007
Good Morning. It is a pleasure to be here today. I always enjoy the opportunity to speak to such a well informed audience. But before I begin my remarks I must make clear that the views I express are my personal views and not necessarily those of the Securities and Exchange Commission or other individual members of the Commission or its staff.1
The principal legislation on which our securities regulations are based was adopted, as you undoubtedly know, in the 1930s and reflects the marketplace that existed at that time and the immediately preceding period. Consider what our securities markets were like in the early part of the last century. They were all floor-based markets, meaning that agents for buyers and sellers met in one physical location, called a "floor," to transact business. Certainly today the visual of a floor that comes to mind is that of the NYSE — that chaotic jumble of frenetic people and blinking computer screens that you see on CNBC. In the early part of the century, when telecommunications technology was in its infancy, exchanges operated in major U.S. cities all across the country, including places such as Kansas City and Cincinnati, to meet the needs of local business. Indeed, there were even some two dozen exchanges below Fourteenth Street in Manhattan before the 1900s.2 And while many of these eventually folded, a group of brokers — not members of the NYSE — gathered out-of-doors on Broad Street to trade securities of companies too new or too small to transact on the NYSE. Aptly named "curbstone brokers," this gathering flourished over the years, eventually moving indoors to a market that became the American Stock Exchange.
Over the years, advances in communication and technology have fundamentally shaped how exchanges organize themselves and trade securities. For instance, the invention of the telegraph in the early 1800s permitted "out-of-towners," as they were called, to place orders on Wall Street. But more importantly, the invention of the ticker machine, which provided quotation information on specific securities, greatly expanded business for brokers and provided current stock price information just about anywhere a ticker machine could be located. So too, the invention of the telephone in 1877 and development of long distance telephone service would eventually permit all parts of the nation to place buy and sell orders, and so, a mass market for securities ultimately developed in the early twentieth century.3
Further development of telecommunications may have contributed significantly to consolidation of the securities markets over time, as orders could be communicated from greater distances via telephone lines. But the floor-based market model prevailed well into the latter part of the century, when advances in both computer technology and telecommunications led to a virtual tectonic shift in the way securities markets operate. Today, the vast majority of securities markets, both in the U.S. and abroad are floorless, electronic markets in which buyers and sellers meet in cyberspace from their separate computer terminals. Indeed, electronic trading is no longer the wave of the future. It is our current reality, with markets competing on the basis of speed of trade execution as well as price, and with execution times of more than 300 milliseconds being considered a veritable pony express. Even the world's largest equities market in terms of dollar volume, the New York Stock Exchange, has coupled its famous floor-based market on Broad Street in lower Manhattan with electronic-based access through its new "Hybrid" market model.
Securities markets are traditionally national in that they are identified by their country of origin and subject to domestic market rules. But in a fully electronic trading world one can begin to appreciate the challenges of maintaining national standards in a borderless trading environment. One need only think of the virtually limitless expanse of the internet to appreciate the seamlessness of electronic communications.
The question, of course, is why do we care about maintaining our national standards? Why is applying our domestic market rules so important to us? The very simple answer is that we believe our regulatory regime has fostered the development of the finest securities markets in the world. There has been a longstanding concern that it will be extremely difficult to maintain our domestic regime if we permit regulatory arbitrage to exist between the rules applicable to our domestic players versus foreign participants. And perhaps it is obvious to a sophisticated audience such as this, but I will emphasize nevertheless that our national markets are absolutely vital to our economy. They play a critical role in capital formation in that they are the primary means by which investment is directed to its highest and best uses. The United States has the deepest and most liquid securities markets in the world. Our markets also enjoy the highest level of retail investor participation in the world. Indeed, today the number of U.S. households that invest in equities securities has tripled from 15.9 million to 56.9 million between 1983 and 2005.4 This is an extraordinary figure. America's investors have considerable confidence in our markets and with very good reason. The regulatory oversight that was established in the 1930s and that continues to evolve and adapt to changed circumstances has been a key factor in earning the confidence of investors and fueling the growth of our markets and the success of our economy.
There are three key components of our regulatory framework as set out by Congress. We are charged with protecting investors, maintaining fair, orderly and efficient markets, and facilitating capital formation. Virtually all that we do at the Securities and Exchange Commission, and all that we mandate others who we regulate to do, are in furtherance of these three important goals.
Investor protection is perhaps the most easily understood goal. Generally, we require that exchanges operating in the U.S. and intermediaries who deal with U.S. customers register with us and be subject to U.S. regulation. All of our exchanges are also self-regulatory organizations, meaning that they have obligations to enforce their members' compliance with the federal securities laws. The rules of the exchanges cover a wide range of activities, including member conduct, sales practices, financial responsibility, supervision, disciplinary proceedings, education, and training. Exchanges are required to surveil vigorously their markets for inappropriate conduct such as manipulation and insider trading, oversee their members for violations of the exchanges' rules and the securities laws, and take appropriate disciplinary action. The SEC oversees the self-regulatory functions of the exchanges to ensure that they are properly supervising all of the activities of their members.
Every broker-dealer is required to register and to be a member of an exchange or a securities association. Broker-dealer registration allows the SEC and the self-regulatory organizations, for example, to review qualifications of a broker-dealer, conduct examinations, and ensure that broker-dealers maintain adequate competency levels, and enforce their policies and procedures for their particular business.
And when all of these best efforts at effecting appropriate conduct fail, we use our enforcement power to punish wrongdoing and to seek compensation for aggrieved parties.
We promote fair, orderly and efficient markets in a whole host of ways. For example, we mandate that the best bids and offers of every security offered on every exchange be made publicly available in real time so that all investors have immediate access to information on which to buy or sell securities. We approve and oversee how the markets handle customer orders to be sure they are treated fairly and do not disadvantage or discriminate against certain customers or orders. We also have rules that require brokers to obtain the best prices for customers that are reasonably available in the marketplace.
Finally, we have a regulatory program that encourages capital formation. We have perhaps the most robust transparency and reporting regime for public companies in the world. We have registration requirements for issuers that mandate disclosure for companies that raise capital in the public markets by offering securities. We also have periodic reporting requirements such as annual reports on Form 10-K to keep investors informed about the performance of the companies whose securities they own. These reports provide the market with current material information about the issuer that is reported in a consistent manner under GAAP.
Over the years our regulatory regime has been emulated by many foreign jurisdictions, but it is fair to say that no two jurisdictions have the same rules or identical investor protection regimes. Thus, we have heretofore required all markets operating in the U.S., including those that wish to place their trading screens here in order to access U.S. investors electronically, to be registered with the SEC. We apply the same rules to all regulated markets and intermediaries who operate here. Yet, not surprisingly, we are under increased pressure to permit foreign participation in our markets under more flexible terms. Our well informed, technologically savvy investors have an ever increasing appetite for investment products offered by foreign markets. There are many reasons for this. One is the desire to diversify their portfolios. Another is their interest in accessing the growth opportunities of other economies, particularly emerging markets. And clearly foreign issuers and foreign markets have a strong interest in directly accessing our broad investor base. We have relatively sophisticated and experienced investors with capital to spare and a high degree of confidence in our domestic markets.
Consider, for a moment, the growth in U.S. investment in foreign securities just over the last 25 years. Between 1980 and 2005, U.S. gross trading activity (purchases and sales) in foreign securities grew from $53 billion to $7.5 trillion.5 And gross foreign trading activity in U.S. securities has similarly grown from $198 billion in 1980 to $33 trillion in 2005.6 This reflects the broader expansion of equity ownership in the U.S. generally. And as I previously mentioned, since the 1980s, the number of households owning equities has tripled.7 This increase in equity ownership reflects several significant phenomena: a sustained period of economic growth, a record bull market, the baby boomer generation's need to prepare for retirement and the change in many employers' retirement programs to defined-contribution plans.
Interestingly, this sizable increase in global trading has occurred despite the current regulatory limitations placed on access by foreign markets to U.S. investors. Foreign broker-dealers are constrained in their ability to contact and transact with U.S. persons without registering in the U.S. For example, foreign brokers generally cannot solicit business in the U.S.; they can provide research reports only to certain institutional investors; and they can trade for certain institutional investors only through a U.S. registered broker or dealer.
Nonetheless, retail investors have numerous additional means of investing in foreign securities — through mutual funds, American Depositary Receipts, exchange-traded funds, U.S.-traded foreign stocks, or by direct investments in foreign markets. It probably will not surprise you that many mutual funds today are either focused primarily on investing in foreign securities or contain foreign stocks within a broader portfolio of securities. Mutual funds provide more diversification than most investors could achieve on their own. Many fund managers are familiar with international investing and have the resources to research foreign companies. This indirect ownership of foreign securities provides all the investment benefit to U.S. investors but spares them the challenges of dealing with foreign exchange issues as well as custody and settlement details.
Some investors invest in foreign companies by purchasing ADRs, or American Depositary Receipts, listed and traded on a U.S. exchange. ADRs are issued by U.S. depositary banks. They represent one or more shares of foreign stock or fractions of shares. The price of an ADR corresponds to the price of the foreign stock in its home market, adjusted to the ratio of the ADRs to foreign company shares. If you own an ADR, you have the right to obtain the foreign stock itself, but U.S. investors usually find it more convenient to own the ADR. A real advantage to ADRs is that you are trading in the U.S. market and so the trade will clear and settle in U.S. dollars.
Retail investors can also purchase foreign securities through their U.S. brokers, as many clearly have. Normally, the U.S. broker communicates the customer order to one of its foreign affiliates in the relevant country or to another broker with which it has a relationship in order to consummate the trade. Given the advances in technology, the communication by a U.S. person to his or her broker to purchase or sell a foreign security happens in a nearly seamless manner. What has been important from our regulatory perspective is that the entity that has the customer relationship with the U.S. person must comply with U.S. laws and regulations, including the array of safeguards and protections I mentioned earlier. That having been said, our restrictions on foreign exchanges to operate directly in the U.S. under any sort of mutual recognition approach has inhibited, to some extent, the growth of trading foreign securities in the U.S. One significant factor is the inability of foreign markets to solicit or advertise in the U.S. Foreign markets also argue that the costs of trading would be somewhat more efficient if some of the U.S. intermediation requirements were relaxed.
Certain foreign exchanges also argue that we should be more accepting of their regimes because they are substantially similar in terms of investor protection and market integrity. Indeed, it is fair to say that significant progress has been made through various international efforts to export high quality regulatory standards to several parts of the globe. Through IOSCO, the Joint Forum, and other international regulatory groups, progress has been made on many fronts, whether it be transparency, disclosure, or international accounting standards. Perhaps equally important, we have since the 1980s signed over 30 bilateral information-sharing agreements, known as memoranda of understanding (MOU). These MOUs are the backbone of the enforcement program and have provided crucial assistance to the Commission's enforcement staff in the prosecution of cases. 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 numerous securities regulators and the SEC was among the first signatories to the agreement. 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 and regulatory matters, and otherwise to keep shared information confidential.
We expect the interest of U.S. investors in trading foreign securities to continue to grow exponentially for a number of reasons. One recent catalyst is the cross-border consolidation of the markets. For example, the NYSE just last month completed its merger with Euronext, a European federation of exchanges. While the markets currently operate separately under a common holding company, it is only a matter of time, in my opinion, before business opportunities will compel these markets to argue for further regulatory easing of restrictions. The pressure from numerous foreign markets, even those not affiliated with U.S. markets, also continues to build as they see the potential for greater U.S. investment in their local companies. One thing is for certain. Technology, rather than being an impediment, is the fuel that is ultimately driving these changes in the marketplace.
Thus, we are working at the SEC to provide an appropriate response — one that eases access to foreign securities and markets, but that does so in a manner that maintains our high domestic standards of market integrity and investor protection. I believe a new cooperative approach should be forged — one that offers the possibility of foreign exchanges that are deemed to have comparable exchange regulation and oversight standards to be permitted to operate in the U.S. under some sort of conditional exemption to full U.S. registration. The Commission has the authority under amendments to the Exchange Act that were passed in 1996, to exempt any person from any provision of the Exchange Act and to impose appropriate conduct on their operations. This provision gives us the necessary flexibility, combined with our ability to facilitate a national market system, to craft a cooperative framework for foreign access. Fundamental to any approach would be that the jurisdiction cooperates with the SEC in assuring investor protection, as well as other statutory requirements. We would need to make a finding that such an approach is in the public interest and is consistent with the protection of investors. I believe we should consider a framework that contains certain conditions. For example:
Comparable Regulation — The foreign exchange should be subject to comparable regulatory oversight in its primary jurisdiction that protects investors and the integrity of the securities markets in areas including: fair markets; fraud; manipulation; insider trading; current trade reporting; issuer disclosure standards; surveillance and enforcement. In the interest of comity, the foreign jurisdiction should provide regulatory relief to U.S. markets that is at least as extensive as that provided by the SEC to foreign markets.
Notice to Investors — Investors should be notified that their trading is being done in a foreign marketplace, which may not offer the same protections afforded to them in the United States. Investors may need better disclosure concerning those differences.
Foreign Securities Only — An exemption should be limited to accessing foreign securities only. This would maintain existing investor protection standards for exchange trading of U.S. securities, and serve to limit the problems associated with different regulations applying to trading in the same securities in the U.S.
U.S. Membership Limited to Broker-Dealers — The foreign exchange should not provide direct access to U.S. persons other than registered U.S. broker-dealers.
Access Only to "Qualified Institutional Buyers" — We should consider as an initial matter having the end users limited to sophisticated investors. This limitation would help to ensure that investors are familiar with foreign market practices and have the sophistication to bear the risk of dealing with a broker dealer than is not regulated in the U.S.
Fair Access — An exempt foreign exchange would not be permitted to discriminate unfairly among U.S. broker-dealers in granting access to services.
MOU — The SEC and the non-U.S. exchange's home regulator would need to coordinate their oversight in a manner designed to assure effective regulation in both jurisdictions and should coordinate inspections, and regularly share information regarding the exchange.
Recordkeeping and Reporting — The SEC should be able to obtain access to clearly identifiable audit trail data regarding transactions executed on the foreign exchange by U.S. members and have access to trading information involving U.S. investors.
With regard to foreign broker-dealers, a similar cooperative approach could apply to foreign brokers dealing with large institutional customers. This would have the effect of easing our current Rule 15a-6 requirements for foreign brokers that are subject to comparable regulation in their countries of origin. There are certainly more details to be considered here, but the opportunities for cooperative approaches apply in this area as well.
Just as we apply U.S. legal standards to issuers, exchanges and brokers that avail themselves of our jurisdiction by transacting business here, likewise our regulatory counterparts offshore do the same. National regulators have a very 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 and the natural tension that arises when the rule sets of numerous jurisdictions meet. I've mentioned some of the efforts to achieve cooperation among regulators as well as to further the goal of consistent international standards. Ultimately, I believe 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. And as regulatory approaches become more consistent, the decision to move to greater recognition of other regulatory regimes becomes ever-more inevitable. I look forward to meeting this challenge in the years to come.
Thank you very much.