Speech by SEC Commissioner:
Remarks Before the National Organization of Investment Professionals (NOIP)
Commissioner Paul S. Atkins
U.S. Securities and Exchange Commission
New York City
November 13, 2007
Thank you, David (Shields) for that kind introduction. It is an honor and privilege to be here today with you in New York. 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.
Given that yesterday we observed Veterans Day, it is important that we take a moment to reflect on our Nation’s veterans and what they have purchased for us by their sacrifices, including their lives. Today’s veterans have proved their dedication to the cause of defending our homeland and setting captive nations free, marching in the footsteps of prior generations who defended liberty when it was imperiled. Since the Revolutionary War, ordinary Americans have been called to extraordinary sacrifice for others. Whether at places called Bunker Hill, Brandywine, Bougainville, or Baghdad, the American soldier has always fought for freedom.
Now, our Nation and many nations in the West are at war with a shadowy enemy, who would destroy our freedoms. A heavy burden in that struggle has been borne by the people of New York; many people in this room lost colleagues, friends, and family members on 9/11. Just as today’s veterans share in a legacy of having served in forces that were once under the command of George Washington, the City of New York shares in the patrimony of liberty that has been handed down to us by the great city-state of Athens.
Two thousand four hundred years ago, Athens was locked in a military struggle that held grim consequences if it failed. Pericles was chosen to speak over the war dead at the Athens military cemetery, and he took the opportunity to remind the Athenians that there was more at stake for them than for others who did not enjoy their privileges. Pericles reminded his fellow citizens that
Our form of government does not imitate the laws of our neighboring states. On the contrary, we are rather a model to others. Our form of government is called a democracy because its administration is in the hands, not of a few, but of the whole people. In the settling of private disputes, everyone is equal before the law. Election to public office is made on the basis of ability, not on the basis of membership to a particular class….The way we live differs in another respect from that of our enemies. Our city is open to all the world. We have never had … laws to exclude anyone from finding out or seeing anything here… For our security, we rely not on defensive arrangements or secrecy but on the courage that springs from our souls, when we are called to action.
Despite a span of nearly two and a half millennia, the words of Pericles speak with clarity and power to everyone in this room. From an Athenian in the agora to a New Yorker at the Exchange, free men and women understand that there is more at stake than our enemies ever could. We are deeply grateful to America’s men and women in uniform and to those who served before them.
The men and women who work in America’s financial markets do their share to carry the torch of liberty to the rising generation. The funds with which they are entrusted represent the hopes and dreams of better lives for families and their descendants throughout the world. The members of the National Organization of Investment Professionals know that these investments are best protected by the same principles articulated by Pericles: treating everyone equally before the law, and keeping our markets open to the world.
Even though our principles remain the same, the structure of the marketplace is undergoing dynamic structural change, not just here in the U.S. markets, but in the international markets. Significant business and regulatory changes are also afoot.
- The NASD and NYSE Regulation have been busy transforming themselves into FINRA.
- The NYSE and Euronext have also merged, and will presumably now seek to capitalize on the potential efficiencies that the combination might offer.
- The NYSE is back in the bond trading business.
- NASDAQ has traded in the rains of London for the snows of Sweden, tempered by the heat of Dubai.
- On the domestic side, NASDAQ has shown an appetite for options with announced acquisitions of both the Boston and the Philadelphia exchanges and has reinvigorated 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.
- Exchanges and ECNs are considering whether and how to dip their toes into the liquidity of the “dark pools” that are multiplying around them.
All of these changes, along with the recent subprime problems, are happening at a time of concern about the competitiveness of the U.S. capital markets. This concern has been manifested, in part, in four major reports on U.S. competitiveness. The most recent, issued just last week, was produced by the Financial Service Roundtable’s Blue Ribbon Commission on Enhancing Competitiveness. Among other recommendations, the report called upon Congress to “enact Guiding Principles for Financial Regulation and authorize the President’s Working Group on Financial Markets to oversee the implementation of the Guiding Principles.” The report also had some more specific recommendations. For example, that the SEC “establish better lines of communication and coordination between the Office of Compliance, Inspections and Examinations (OCIE), and its nonenforcement divisions.” (I guess that it goes without saying that the coordination between OCIE and the enforcement division is already rather close.) A constant theme that runs through all 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.
The SEC would do well to look at the four reports, particularly at recommendations that appeared in all of them, including the following:
- fix the implementation of section 404 of the Sarbanes-Oxley Act — which I hope we now have done with the approval of Audit Standard 5 (although the jury is still out on that);
- use cost-benefit analyses in making rules; and
- work with the other financial regulators to bring transparency and predictability to the enforcement process.
These recommendations are not radical — they should be common sense measures that the SEC implements as a matter of course regardless of whether there is a documented link to U.S. competitiveness.
The markets have evolved. Times change, and we ought to review our rules to see if they need to change to keep up with the times. We need to ask ourselves the same question that Secretary Paulson has 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.
To that end, I am pleased to say that the SEC has already planned to take a hard look at two of the issues raised in the reports. Specifically, the SEC recently created an Advisory Committee on Improvements to Financial Reporting. The Committee, which is chaired by Bob Pozen and which met for the second time two weeks ago, is focusing on the following issues: (1) how financial accounting and reporting standards are set; (2) how we regulate compliance with those standards; (3) how investors get financial information; (4) what drives unnecessary complexity in accounting standards and reduces transparency; (5) the costs and benefits of existing accounting and reporting standards; and (6) any lessons that can be learned from the growing use of international accounting standards. That is certainly a full plate. I am very much look forward to hear the Committee’s advice about such an important set of issues.
Separately, Chairman Cox recently responded to a request from several congressmen and announced that the SEC will be organizing a formal roundtable to explore the topic of private securities litigation. This issue was discussed in each of the four competitiveness reports, and was uniformly noted to be a major problem affecting the competitiveness of the U.S. capital markets. I am greatly looking forward to this roundtable discussion, and I expect that we will hear an interesting and useful exchange of ideas. Private securities litigation can play an important role in helping to sort through financial fraud and even providing a deterrence against fraud, but a system that facilitates meritless litigation can impose tremendous costs on investors and deter innovation and productive economic activity. As the Financial Services Roundtable report noted, “The relationship between our existing rules-based system of regulation and litigation risk may be the greatest impediment to the implementation of a more principles-based approach in the United States.”1
Some nay-sayers reject not only the recommendations of these reports, but also the very need to examine our regulatory scheme. I encourage all of you to join with me in insisting that we heed the call to take a close look at the way in which we regulate our markets. Pay attention and be involved; these issues will directly affect your profession and the shape and strength of the American capital markets in the years to come.
In the end, companies are rational — they expect benefits of the public capital markets to exceed the costs. They owe their shareholders no less. 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. The same has been shown time and again in history — for example, in the 1960s when President Kennedy’s so-called Interest Equalisation Tax inadvertently got the Eurodollar market up and running as US issuers went abroad to sell debt. 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 Trading & Markets — 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 features prominently in the nightmares of securities operations professionals — the word is, of course, “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 involves the noun form of “fail,” as in fail to deliver. I am referring to the recent amendments to Regulation SHO, which were a very positive development. I am happy to report that the amendments we adopted should help reduce the number of aged fails to deliver. These amendments eliminated the now-notorious “grandfather” exception from Reg. SHO and limited the scope of the options market maker exception.
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. I could cite other examples, but looking at Reg NMS should suffice. 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. Its implementation process has further been characterized by a failure to meet the rule’s own timeline for effectiveness of its various components.
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 free competition. Over the years, competition in this field has 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 three years ago 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 old SRO/ITS trade-through rule — to see that the only thing “protected” by the rule was an outdated market structure. To make matters worse, the Commission dropped from the final rules a proposed opt-out provision that would have allowed market participants the ability to choose where to execute their trades and at what price.
Market participants do not need the “protection” offered by Reg. NMS’s trade-through rule. As the Security Traders Association of New York so aptly put it in their 2004 NMS comment letter: “there will be no need for a uniform trade-through rule if issues of connectivity, access, and automatic execution are adequately addressed.”2 Importantly, the comment letter then stated that “if the [NBBO] in every market is immediately available to ‘away markets’ then STANY believes broker-dealers’ best execution obligations would be sufficient to protect the interests of all investors and ensure that superior prices are sought.” I completely agree with this position. And so I am sorry to report that now — despite the fact that competition (not NMS) has driven the manual markets to automate — we 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. This feedback has been invaluable.
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, well over one year ago. As with other, less-important components of Reg. NMS, this deadline has been repeatedly and significantly delayed.
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.
Technology is only one aspect of the implementation burden. The SEC staff, using the extremely broad authority that the then-majority of the Commission so casually delegated in Reg. NMS, has provided several exemptions to facilitate the implementation of NMS, including significant exemptions from Rule 611-- the trade-through rule. One such exemption is for "Qualified Contingent Trades" — orders for a security and a related derivative or orders for related securities that are executed at or near the same time. These spread trades are enormously important to investors, and they are a substantial revenue source for broker-dealers. I am pleased that the SEC staff finally found the wisdom to exempt these trades from the trade-through rule. It would be a bizarre result indeed for market participants in a spread trade to have to seek out and satisfy “protected” bids or offers.
Another important exemption from the trade-through rule is the “print protection” exemption. According to the SIFMA exemptive request, print protection is the execution of ”a displayed order at a price that is better than a reported trade in the same security on a different market.” Sounds logical. Why should a rule prohibit a broker-dealer from improving the price, right? Well, that is where one of the trade-through rule’s unintended consequences comes into play. If a client’s order, say it is a buy order, is posted but not at the top of the book, it is possible that a sell order could pass over the client’s buy order and instead execute against a worse-priced bid. This happens when an Intermarket Sweep Order — itself an exception to the trade-through rule — is sent to take out the top-of-the-book quotes, missing better-priced quotes within the book.
It is only natural — and maybe even compelled by the duty of best execution — that a broker-dealer would want to fill its customer’s order after it had been passed over for a worse price. It may seem unbelievable, but that would not have been possible without the print protection exemption, because such trades could have resulted in a trade-through violation. In approving this exemption, the SEC staff, again using delegated authority, noted that “[p]rint protection . . . can improve the execution of depth-of-book quotations and thereby promote price discovery.” If you untwist the SEC staff’s logic, the real message is that the trade-through rule can impair executions of depth of book quotations and thereby impair price discovery. Thus, the need for an exemption.
There are other, important exemptions, such as the sub-penny and error correction exemptions. There are also the nine exceptions that are “built in” to the trade-through rule, such as the benchmark, ISO, and stopped-order exceptions. Each of these exceptions is further detailed and nuanced in sixty or so FAQs so far, and we probably have not seen the end of the FAQs yet. If you get lost in all these details, just take a look at the SEC website under “Spotlight on Regulation NMS.” All the extensions and exemptions and FAQs are nicely catalogued there.
So now you have it. We have had to resort to a slew of exemptions, exceptions, and FAQs to tailor an inappropriate, “one size fits all” trade-through rule to the needs of a dynamic marketplace. At bottom, however, these carve-outs, along with the implementation delays, are the clearest sign that NMS — the trade-through rule in particular -- was unworkable as proposed. As we dissenters said at the time of adoption, we have no way of knowing what innovations will be stifled by this rule. Just look at how long and how hard the industry has had to work to get these changes approved.
So, the inevitable has come to pass: without ever having really seen the light of day, the trade-through rule is mortally wounded. It has suffered a thousand cuts, but it is finally close to lifeless. The trade-through rule has been eviscerated by the carve-outs demanded by a dynamic market system, and all that is left is the still-too-burdensome, unneeded husk of a bad idea. The reality of the situation has not been lost on market participants — let’s just say that I have heard this same thing from numerous anonymous sources. Now, mind you, some at the SEC do not agree with this assessment and are still searching for vital signs. Nonetheless, the exceptions and exemptions have already eaten the rule! I am not holding my breath for a formal declaration of surrender, but the following quote from a recent New York Stock Exchange filing creating a “Do Not Ship” order type illustrates that reality finally hitting Washington is not too far away:
The Exchange states that . . . orders that are routed away to other market center(s) in compliance with Reg. NMS may cause the market participant to incur multiple fees because the customer has to pay a separate fee each time the order is routed to other market center(s) during the course of its execution. The DNS order enables a market participant to control the costs associated with order execution by limiting the execution of the order in whole or in part, to the Exchange.3
What does this mean? New York filed this rule change because other exchanges had already implemented it. So, we are now at a point where a customer can effectively opt out of the NMS trade-through rule and can direct his execution to the exchange where he wants it to go for the price that he wants. We have come full circle after a huge detour and several hundreds of millions of dollars of implementation costs.
It took the SEC only three years and countless hours of industry time to circle back — in a Rube Goldberg way — to the basic premises of the opt-out rule that we originally proposed in 2004. I continue to believe that an opt-out provision is a much-needed addition to Reg. NMS. It would certainly be a more straight-forward approach. The problem is that, taken together, the exemptions and exceptions lack the simplicity and breadth of the opt-out provision. It would also eliminate the need for the industry to seek piecemeal exemptions. I have heard some rumblings that obtaining such exemptions is harder now that the grim reality of Reg. NMS’ impaired state is coming to light. Perhaps it is time for the Commission to look reality in the face, return to first principles, and simply adopt an opt-out provision.
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. These efforts and hours devoted to Regulation NMS could have been directed instead towards the innovations that have made our financial markets the envy of the world. 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.
One aspect of the NMS process that I will be monitoring — and this is where I will rely on all of you for help — is how our examiners will inspect for compliance with Reg. NMS. An improper approach to inspections could make a bad rule much worse. OCIE should be looking for reasonable policies and procedures reasonably implemented and should avoid engaging in a trade-by-trade “gotcha” exercise. Broker-dealers must ensure that if they meet the definition of “trading center,” they have appropriate policies and procedures in place.
I have enjoyed my time with you today and thank you for the opportunity to share my perspectives on the complex issues that we face at the SEC, and the sometimes poor decisions we make as a body.
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 so that we can make our markets as free and fair as they can be. Thank you again for your very kind invitation to speak with you today.
1 The Financial Services Roundtable, The Blueprint for U.S. Financial Competitiveness at 23 (Nov. 7, 2007) (available at: http://www.fsround.org/cec/blueprint.htm).
2 Comment Letter of The Security Traders Association of New York (June 30, 2004) (available at: http://www.sec.gov/rules/proposed/s71004/stany063004.pdf).
3 Securities and Exchange Commission Release No. 34-55768; File No. SR-NYSE-2007-24. May 15, 2007