Speech by SEC Commissioner:
Remarks Before the Security Traders Association
Commissioner Paul S. Atkins
U.S. Securities and Exchange Commission
May 7, 2008
Thank you so much, John [Giesea], for your kind introduction. I am very pleased to be here with you today for your Twelfth Annual Washington Conference. Before I begin, I must tell you that the views that I express here today are my own and do not necessarily reflect those of the Commission or of my fellow Commissioners.
As you may have heard, my days of giving that disclosure are drawing to a close. I announced on Monday that I will be leaving the SEC after nearly six years as a commissioner. The past six years have consistently been interesting and challenging. The years admittedly unfolded in a way that I did not anticipate when I first agreed to take the job. Indeed, I doubt that anyone could have foreseen the combination of external events and internal policy debates that has marked the past six years.
I came on board just in time to work on the numerous rules that the SEC was required to promulgate under the Sarbanes-Oxley Act. That was just the beginning. After that came, to name just a few: Regulation NMS and its enormous costs and diversion from the real issues in the markets; the dramatic changes in the ownership, market share, and operation of exchanges; the late trading and market timing scandals in the mutual fund industry; the ill-fated mutual fund governance and hedge fund advisor registration rules; and now, of course, the subprime debacle and the related problems in the markets.
These are just a few of the matters that, one way or another, have found their way onto the SEC’s agenda over the past six years. We cannot predict now what the next six years will bring, but they are sure to be as interesting as the last six. On top of that, of course, we have a big election coming in November that will shape many things such as fiscal policy, trade policy, foreign policy, and federal spending priorities. All of that will surely affect the markets and your business more than any of the other issues of the past few years.
In confronting the challenges ahead, it is essential that the SEC, other regulators, investors, and other market participants apply the lessons learned from the past. Compiling a list of those lessons would take much longer than the time we have today, but I have several candidates for the list.
The most important lesson — and one that is worth reminding ourselves of at a time like this — is that our capital markets are resilient. As you all know, starting in the summer of 2007, the number of defaults by home owners with subprime mortgages — especially those with an adjustable rate mechanism, started to rise markedly. Two days ago, Federal Reserve Board Chairman Bernanke laid out the unpleasant statistics:
About one quarter of subprime adjustable-rate mortgages are currently 90 days or more delinquent or in foreclosure. Delinquency rates also have increased in the prime and near-prime segments of the mortgage market, although not nearly so much as in the subprime sector. As a consequence of rising delinquencies, foreclosure proceedings were initiated on some 1.5 million U.S. homes during 2007, up 53 percent from 2006, and the rate of foreclosure starts looks likely to be yet higher in 2008. … Nationally, as of the fourth quarter of 2007, the rate of serious delinquency, as measured by credit records, stood at 2 percent of all mortgage borrowers, up nearly 50 percent from the end of 2004.1
The problems have not confined themselves to the subprime market, but have spilled over dramatically into the rest of the financial market. Subprime defaults matter to the broader markets because of the fact that most mortgages now are securitized. Securitization of mortgages means that the effects of delinquencies in the mortgage market, such as we are now experiencing, are felt throughout the market. Even though the market has been affected, the number of defaults is still a small percentage of the total outstanding mortgages, which explains why most mortgage-backed securitized instruments are still performing. If you can buy and hold, you are sitting pretty these days.
Since last summer, we have seen significant deterioration of overall credit and liquidity conditions, both here and abroad. For example, the ramifications of the increased number of mortgage defaults quickly spread in the credit markets, especially in the critical time of mid-July to mid-August 2007: credit spreads increased dramatically and inter-bank interest rates rose to the point where there was little liquidity in the inter-bank market. The market was characterized by extreme risk aversion as participants developed heightened perceptions of counterparty risk. As valuations of asset-backed securities tumbled, financial institutions took large write-downs of their assets. Rumors flew about the financial stability of major market participants.
The most well-known casualty was, of course, Bear Stearns. What happened to Bear Stearns in March was unprecedented. The large, well-capitalized, eighty-five year-old investment bank experienced a crisis of confidence that denied it not only unsecured financing, but even short-term financing over-collateralized by high-quality agency securities. Counterparties would not provide securities lending services, and clearing services and prime brokerage customers moved their cash balances elsewhere. These actions fanned fear and concern, prompting other market participants to also reduce their exposure to Bear Stearns creating, in essence, a run on the bank.
While ceasing to transact with Bear Stearns in the face of a growing flurry of rumors may have been rational and, for those with fiduciary responsibilities to their own clients, prudent, the effect on Bear Stearns was ultimately devastating to its ability to stay in business. Its liquidity position rapidly worsened because of this sudden and unprecedented inability to obtain secured funding. Bear Stearns’ counterparties, clearing services, and secured lending sources included some of the biggest names on Wall Street. The actions of these regulated entities with which Bear Stearns did business ultimately delivered the final blow to the bank on that fateful weekend.
The problems of today loom large, but history reminds us that these are not the first troubled economic times, nor will they be the last. The delinquency problems in the retail mortgage market, the liquidity drought, and the collapse of Bear Stearns are certainly noteworthy, but these kinds of market situations — uncertainty regarding valuation, integrity of counterparties, or looming regulatory action — are not unprecedented. We also must keep in mind the relative size of the subprime market. It is approximately $1 trillion of securities outstanding — relatively small compared to the total size of the US Treasury market of approximately $30 trillion, much less as compared to the global debt market.
Markets periodically go through difficult times — they cannot always rise. Indeed, according to one estimate, there have been thirty-two full business cycles — expansion and subsequent contraction — since 1854.2 Frankly, our current experience is mild in comparison to some of these prior events. Knowing that market cycles are inevitable, does not necessarily make the difficult times easier, but it reminds us that we can rationally anticipate improvement.
Basically, in the past four years market participants mispriced risk. We are going through a learning process and correction. The increasing complexity of securities had outstripped the risk management systems of financial institutions around the world. New investors had entered the market for these complex securities looking for higher returns. That additional demand affected prices. Many relied too much on ratings and did not do their own due diligence. Some failed the first rule of investing: diversification. The painful process of repricing risk and taking one’s lumps is proceeding, and I hope that we are closer to the end of the process than the beginning, as Treasury Secretary Paulson intimated yesterday.
Contrary to what some are saying, securitization is not a bad thing and it certainly is here to stay. It is safe to say that the market will now demand more transparency, simpler structures, and perhaps increased standardization of products. That may mean, for liquidity’s sake, a greater resistance to OTC products and more of a demand for exchange-traded derivative products.
A second lesson that the past teaches is that we ought not devise regulatory solutions before we have identified the problems. Regulation NMS has taught us just how costly regulatory solutions to non-existent problems can be. The so-called “Order Protection Rule,” at the center of Reg NMS, by its very name suggests that it was needed to solve a pressing problem of unprotected orders. As Commissioner Glassman and I noted in our dissent from the rule, it was difficult to see how the “minimal trade-through rates” evident in the data “indicate that investors are not obtaining best execution, that their orders are being unfairly treated, or that investors are otherwise suffering economic harm.”3 Since the rule was adopted, a series of exemptions has been necessary to make it workable.
The third lesson that follows from this think-first, then-act lesson is that the regulator must be particularly careful in times of turmoil. At such times, there is inevitably pressure from many corners to do something to respond to the turmoil and to do it fast. Solutions might be demanded even before the sources of the turmoil are identified. The STA, in the white paper that it just released, cautioned: “Consequences, especially the unintended consequences, are easier to identify in stable markets. Changes enacted in politically charged times or during financial market upheaval tend to be overreactions which have many more unintended consequences than changes that have been deliberately debated in times of stable markets.”4
A fourth lesson that we can draw from the past is that decisions must not be made within regulatory silos. Co-operation across regulators is important in assessing and solving problems that extend beyond any one regulator’s purview. Even within the SEC, all too often, one division acts without adequate involvement from other divisions that might have an interest in the action. Sometimes the result is that new products stall as they await SEC approval; they bounce from one division to the next, meeting new obstacles in each, without any central co-ordination. It can be even more difficult when there are multiple regulators involved. When the SEC mandated registration for hedge fund advisors, for example, it did not take into account concerns from other regulators about the effects on hedge funds’ provision of liquidity. Nor did it try to work with other regulators to fill the information gap about hedge funds that it claimed was one of the reasons that a registration mandate was necessary.
Events such as the collapse of Bear Stearns remind us that establishing strong relationships between regulators before crises occur is extremely important. The President’s Working Group on Financial Markets, which includes the Treasury Department, the Federal Reserve, the Securities and Exchange Commission and the Commodity Futures Trading Commission, is an important forum for this cross-regulator co-operation. Last month, for example, in response to a call from the President for an exploration of the causes of the market turmoil, the PWG released a Policy Statement on Financial Market Developments. The PWG made a number of recommendations that are intended to achieve: “improved transparency and disclosure, better risk awareness and management, and stronger oversight” with an eye towards “mitigat[ing] systemic risk, help[ing to] restore investor confidence, and facilitat[ing] economic growth.”5 None of these objectives can be met without co-operative work between regulators.
A related lesson is that regulators ought to draw on the experience of the industry that they are regulating. As you well know, the landscape changes fast. Market participants with financial incentives to keep up with all of the changes have trouble enough doing so. Regulators, who are one step removed, have even more difficulty in keeping pace with the change. As a result, the regulatory structure might lag so far behind the marketplace that it hinders the market’s ability to serve investors. In recent years, the markets have changed dramatically. We now see a marketplace dominated by for-profit exchanges. In order to sharpen their competitive edge, these exchanges are consolidating with their foreign and domestic peers. Market share has shifted rapidly to new entrants and towards electronic platforms. Market makers and specialists are seeing their roles redefined. Alternative liquidity pools are thriving. Interestingly, though, the share of total trade volume of the so-called dark pools has hovered around twenty percent for the past three years.6 That lack of growth calls into question the fears that some have expressed about dark pools and their potential effect on transparency. There has been a tremendous increase in quote traffic and market data, which is attributable largely to Reg NMS, but nevertheless is a noteworthy development. Is this extra noise productive for the market and price discovery? Keeping up with all of these changes poses challenges for regulators.
That is where another lesson comes in — economic data are useful in understanding the changing market. The SEC used economic data to demonstrate that the tick and bid tests were neither necessary nor effective given the way in which the market had evolved. The STA’s white paper notes that “it would be extremely difficult to reestablish and regulate a ‘tick test’ or a ‘bid test’ in the current market structure,” but urges the SEC to “aggressively and rigorously” enforce Reg SHO’s locate rule and delivery requirements in order to combat manipulative short selling.7 The market is already at work on this problem, including Lendex, a new platform to facilitate securities lending and borrowing. Efforts like this will make it easier to locate securities.
To this end, the SEC proposed a naked short selling antifraud rule earlier this spring. The rule would highlight the liability of short sellers who deceive others, such as broker-dealers and purchasers, about their intention or ability to deliver securities in time for settlement and that fail to deliver securities by settlement date. The rule proposal, as you might expect, has drawn a lot of comment. Many of the commenters called for a restoration of the uptick rule. It is my hope that we can use economic analysis to assess whether price tests are an appropriate answer to the concerns raised by these frustrated commenters.
A sixth lesson is that regulators sometimes have trouble accepting that we cannot substitute ourselves for the market. Furthermore, in trying to do so, we can actually do more harm than good. Reg NMS is one example of this phenomenon. As the Security Traders Association of New York remarked before Reg NMS was adopted:
STANY believes that there will be no need for a uniform trade-through rule if issues of connectivity, access, and automatic execution are adequately addressed. If the [NBBO] in every market is immediately accessible 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. Additional regulation, in the form of a trade-through rule, is both unnecessary and anticompetitive.8
I do not have to tell you that this plea fell on deaf ears; the SEC went ahead anyway with Reg NMS. Consistent with STANY’s analysis, the STA’s recent white paper included the following post-implementation assessment of the trade-through rule:
a marketplace without [the rule] would be superior to enforcing the current [rule] with its approximately seventeen exemptions (and possibly more to come). While this position would appear “anti-investor,” it is not. … STA has long held that competition will serve investors seeking both quality execution and desired liquidity. When markets are connected and monopolistic barriers are removed, market participants will trade where they can get the best execution. Price, speed, liquidity and efficiency are all factors in the equation, but it is up to the participants to weigh each one. Competition and innovation will create a framework for satisfying best execution.
Of course, market participants have adapted and will continue to adapt under Reg NMS. Nevertheless, I cannot help but wonder how the money spent in complying with the rule would otherwise have been spent. The market has a sensitivity to investors’ needs that the SEC and other regulators cannot duplicate. By interfering in the market on behalf of investors, regulators can make it less likely that investors will get what they want.
This points to the further lesson that, to the extent possible, regulators should encourage the private sector to develop solutions to problems. The STA’s white paper, for example, calls for the development of a set of best practices to govern exchanges’ opening process.9 Presumably these best practices would be designed to preserve the discipline that competition among venues has brought to the opening process, while addressing the investor confusion that has resulted from having multiple opening prices.
History also reminds us that sometimes the issues are a lot more basic than we think. We cannot allow our efforts to be diverted to devising complex solutions to non-existent problems while neglecting the fundamental infrastructure that enables the markets to work smoothly. Neglect is obvious in the state of documentation in the over-the-counter derivatives markets. For example, in the failure of one hedge fund not long ago, it took a couple of hundred people weeks to sort through the OTC derivatives documentation issues. One of the primary difficulties has been the lack of standardized documentation, which has often resulted in lengthy confirmations. Commissioner Nazareth, whom you honored last night, and I called for attention to this issue years ago. Just last week, Assistant Treasury Secretary Tony Ryan remarked upon the fact that “infrastructure development has lagged innovation” in the OTC derivatives market.10
In response to reports of widespread documentation problems, the SEC joined forces more than two years ago with other regulators, most notably the Federal Reserve Board and England’s FSA, to encourage OTC market participants to clean up years of incomplete and inaccurate trade documentation. There has been much progress. The most recent report on that progress came at the end of March, when the so-called Operations Management Group, made up of OTC derivatives dealers, buy-side firms, ISDA, MFA and SIFMA, reported significant progress in cleaning up the situation in the credit and equity derivatives markets. The OMG also laid out promising goals for 2008, including implementation of electronic platforms for confirms and novation requests, central settlement, and timeliness and accuracy goals for credit derivatives.11 In addition, new enterprises, such as Markit Group’s SwapsWire, have entered the market to provide centralized, automated trade processing. Competition should encourage innovation in this area. As successful as the public/private partnership has been in cleaning up the problems with OTC derivatives documentation, there is more that the SEC can do to facilitate efficiency and competition in the equity and credit derivatives markets.
This brings us to the final lesson. It is a basic one, but one worth remembering: we must not lose the forest for the trees. Regulatory solutions to specific pressing problems must be developed with a sound appreciation for the overall regulatory picture. In addressing the current subprime market problems, regulators must also be cognizant of other, longer-term challenges that face our capital markets. The longer-term issues include concerns about whether our current regulatory framework is preventing U.S. capital markets from performing efficiently, whether we are spending our resources wisely to protect investors, and whether we need to make changes to maintain the international competitiveness of our capital markets. Of course, a strong regulatory structure that is designed to ensure fairness, predictability, and efficiency is a crucial prerequisite for any healthy capital market. Investors need and demand effective recourse to the rule of law and enforceability of contract. They rely on a system of integrity. If, however, we get the balance wrong, lower market effectiveness and efficiency will harm investors through higher prices and through constrained investment opportunities.
The Treasury’s recent regulatory reform blueprint does a good job of reminding us not to lose the forest for the trees. It forces us to focus on big picture issues of regulatory structure, even as we also consider the short- and medium-term recommendations that the Blueprint includes. The Blueprint recommends short-, medium-, and long-term steps to address regulatory issues in the financial markets, including a long-term reordering of the regulatory structure in the United States. This would involve a shift to an objectives-based regulatory approach, in which regulatory authority would be allocated according to regulatory objective rather than industry segment.
The Blueprint identifies three broad categories of regulation: market stability regulation, prudential financial regulation, and business conduct regulation. Treasury envisions an optimal regulatory structure in which the Federal Reserve would be the market stability regulator. A newly created Prudential Financial Regulatory Agency would oversee capital adequacy, impose investment and activity limits, and supervise risk management at institutions that enjoy government guarantees. Finally, business conduct regulation, including most current SEC and Commodity Futures Trading Commission functions, would be carried out by a new Conduct of Business Regulatory Agency. I look forward to the debate on the Treasury proposals, which, given the multiplicity of potentially affected parties, will be both interesting and long.
So there are some candidates for inclusion in a list of lessons from the past that ought to guide us in the years to come. Organizations like the STA have valuable contributions of their own to make to that list. I suspect that all of you, with your invaluable day-to-day experience, have your own candidates for the list. I know that I stand between you, lunch, and Chairman Cox, but if we have a few minutes, I would like to hear your ideas. Thank you very much for your attention.
1 Remarks of Benjamin Bernanke, Chairman, Board of Governors of the Federal Reserve, before the Columbia Business School’s 32nd Annual Dinner (May 5, 2008) (available at: http://www.federalreserve.gov/newsevents/speech/
Bernanke20080505a.htm#f1) (citations omitted).
2 National Bureau of Economic Research, Business Cycle Expansions and Contractions (available at: http://www.nber.org/cycles.html#announcements).
3 Dissent of Commissioners Cynthia A. Glassman and Paul S. Atkins to the Adoption of Regulation NMS, at 10 (June 9, 2005) (available at: http://www.sec.gov/rules/final/34-51808-dissent.pdf).
4 STA White Paper at 3.
5 Memorandum from Henry Paulson, Secretary of the Treasury, to President George Bush (Mar.13, 2008) (available at: http://www.treasury.gov/press/releases/reports/
6 Erik R. Sirri, Director, SEC Division of Trading and Markets, Remarks at the SIFMA Dark Pools Symposium (Feb. 1, 2008).
7 STA White Paper at 18-19.
8 Comment Letter of The Security Traders Association of New York (June 30, 2004) (available at: http://www.sec.gov/rules/proposed/s71004/stany063004.pdf).
9 STA White Paper at 10-11.
10 Anthony Ryan, Assistant Secretary of the U.S. Treasury, Remarks at SIFMA’s “Wall Street to Washington” Conference (May 1, 2008).
11 Letter from the Operations Management Group to Timothy Geithner, President, Federal Reserve Board of New York (Mar. 27, 2008) (available at: http://www.ny.frb.org/newsevents/news/markets/2008/an080327.pdf).