Speech by SEC Commissioner:
Remarks before the Securities Traders Association
Paul S. Atkins
U.S. Securities and Exchange Commission
Boca Raton, FL
October 7, 2004
Thank you, John, for that kind introduction. It is a great honor and pleasure for me to be here with the STA at your annual conference. Your organization has been a good, steady, knowledgeable voice for progress and accountability in the securities markets and market structure. Washington is a city where we see vested interests of all kinds coming through our doors with their special appeals. It seems to me that, particularly at this time in our history, you have a vested interest in helping to make the United States securities marketplace the best, most efficient, and most responsive in the world. That happens to align quite nicely with the interests of investors.
Before I go much farther, I must note, in order to keep my compliance folks happy, that the views I express here today are my own and do not necessarily reflect those of the SEC as an institution or of my fellow Commissioners.
One thing that we tend to do at the SEC, as many offices do as a morale booster, is to keep track of birthdays and anniversaries. This 71st annual conference of the STA just happens to be near to a rather gloomy anniversary in the lore of securities traders: October 24th, 1929. Two weeks from Sunday will be the 75th anniversary of Black Thursday, the beginning of the 1929 stock market crash. Much has changed in the markets in those 75 years, but surprisingly much is rather much the same.
Today, I would like to reach back into history to discuss the government's regulatory response to the 1929 stock market crash; the government's intrusive involvement in the markets during the Great Depression; and finally, the relevance of this historic period to the Commission's current rulemaking environment, including Regulation NMS.
The 1929 market crash followed one of the great boom periods in the history of this country. The mobilization and aftermath of World War I, with most of our trading partners completely defeated or exhausted, ignited our economy. Demand for American food products and manufactured goods was tremendous. Speculative hopes for the "New Era" hurled the stock market to new heights. In 1927, the Federal Reserve expanded credit, including lowering the discount rate and purchasing government securities in the market, at the request of England, France and Germany, to try to stop the flood of gold out of those countries into the U.S. This action stoked the speculative mania by providing "easy money" to investors for stock market speculation.
At this point, the train left the station. In those pre-Reg T days and without the information collecting tools as we know them today (even though ours are far from perfect), the Federal Reserve could not make sound judgments about bank retail lending policies for market trading, and market participants did not have an idea of the true margin overhang on the market. Margin loans of 80-90 percent were common. Instead, the Fed, nervous about the Wall Street exuberance, tried in 1929 to cauterize the flow of money into the stock market through public relations efforts, by telling member banks not to use the Fed's credit facilities for margin loans, and by raising interest rates.
The end result -- the stock markets continued rising, but real businesses suffered from the increased cost of money. The rising interest rates failed to stop investors from utilizing margin accounts because they could repay the high interest payments with the huge returns they received from the sale of their securities. Businesses, especially farmers, felt the squeeze and started failing.
Nonetheless, the investing public was hypnotized with irrational exuberance. Everyday citizens invested their savings in the market because they believed it would only continue to skyrocket. They acted on supposed tips and following what neighbors and colleagues did (some things never change). Diversification was not necessarily a common technique - and there were no tools for hedging or indexing. This is the time when Joseph Kennedy made his famous quip that you know it is time to sell when the shoe-shine boy tries to give you stock tips.
Investors did not know that their misperception of the market was buoyed and reinforced by the manipulative actions of Wall Street insiders. In reality, those playing inside baseball were manipulating the price of securities to induce investors into seeking easy riches. Investment pools worked in concert with specialists to pump up the price of securities in such a manner that would attract additional buyers to their web. Once trapped, the pool would sell its securities at the inflated price and share the profits. Large institutions also benefited from the investor hunger for more securities by developing and selling investment trusts to na´ve investors who did not understand the use of leverage and didn't care as long as the share price doubled over time.
In the late 1920s, P/E ratios had risen to a decade high of 26. Brokerage offices opened on cruise ships and at resorts to feed the masses' addiction to the ticker tape. Unrestricted margin accounts allowed these gamblers to roll the dice for higher stakes, and unfortunately, many were caught in the squeeze of the market avalanche.
Many economists argue that the government's monetary and economic policy exacerbated the markets' rise and heavy fall. And, many economists have shown that the stock market crash was not itself the cause of the Great Depression. They point instead to continued, flawed government policies after the Crash that exacerbated the business downturn and actually stifled the recovery that had begun.
The moral of the story is that the cause of the poor market performance and extended depression was not the result of the market's failure, but U.S. economic and regulatory policy. The government failed to recognize that its attempt to fix the economy by interfering with market forces first enhanced the stock market bubble, then sent the market into a whirlwind crash, and then prolonged the business depression.
Following the stock market crash, the government attempted to pull the country out of the depression by continued intervention with the economy. The government raised business and personal taxes, artificially controlled the valuation of the dollar, forbade private holdings of gold, supported an artificially high wage policy, tried to control prices, followed a very restrictive trade policy and an anti-free market domestic regulatory policy, and a host of other activities. This activity, according to economists, prevented the economy from stabilizing and rebuilding. Who would want to invest in such an environment?
The Great Depression that began after the Crash lasted ten long years and was finally broken by the Second World War. Luckily, our generation has not experienced the level of unemployment and poverty associated with the Great Depression. At the beginning of the 30s, Wall Street became the easy scapegoat for the economic deterioration within the United States. Politicians used a pen to punish those deemed responsible for the market crash by adopting remedial legislation. Congress adopted the Securities Act of 1933 and the Securities Exchange Act of 1934, after well-publicized, sensational hearings, to address the fraudulent and manipulative activity that Wall Street engaged in prior to the crash. The NYSE fought tenaciously to stave off the Exchange Act, claiming that self regulation alone could solve any fraudulent activity and that the exchange's independent pricing must be protected. The power struggle over the SEC's authority to oversee the NYSE ended for good the day NYSE President Richard Whitney was arrested for embezzlement.
Congress's enactment of the Securities Act of 1933, at the time, sought to provide more transparency in the market in the name of rebuilding public confidence in the markets. This legislation and the regulations that it spawned were mostly disclosure-based, as opposed to the reigning merit-regulatory philosophy in securities regulation at the time, as evidenced in the states' blue sky laws. The idea was that public companies and underwriters should provide enough information for investors to make a reasonable investment decision without imposing structural restrictions that would severely impede the capital raising process.
The Securities Exchange Act also empowered the SEC to prosecute manipulative activity in the purchase or sale of securities. This legislation gave the SEC oversight authority over the operations of the exchanges and specified its mission as ensuring that the market should operate in the investor's best interests.
Among other things, both Acts provided a basis for transparency and accountability needed to support the wide dispersion of ownership in U.S. corporations. Of course, legislation alone was not enough to revive the market's activity. The crash left the markets in a state of lackluster performance, and the Dow did not recover its 1929 height until 1954.
I apologize for the doom and gloom, but we must always review history to ensure that we do not make the same mistakes twice. The point is that governmental policy and regulation should not prohibit market forces from determining the appropriate prices for goods and services.
Now, most of you probably recognized early on in my talk today that a lot of the investor behavior displayed prior to the 1929 market crash reappeared during the high-tech bubble of the late 1990s. This tale of human gullibility is displayed throughout the history of investment: investors buying or selling on emotion, the herd mentality, overly rosy expectations, the feeling that somehow today is much different than yesterday, the bigger fool theory, and that somehow the normal rules of investing no longer apply.
The tech boom brought about our own generation's belief in the "New Era," or the "New Economy" as it was called in the 1990s. The advent of the internet; development of cheaper, more powerful computers; the growth of broadband; the automation of trading; and the concept of day trading brought direct market participation to the population as a whole. A seemingly never-ending pipeline of IPO's that were well-received by the market allowed investors to believe that they too could be rich by merely buying and selling these securities. Professional market participants would set their watch by the scheduled TV appearances of certain analysts who would send stock prices soaring due to the stampede of profitable order flow from unsophisticated investors.
Of course, the bubble of the 1990s burst in the spring of 2000. As in 1929, the economy headed into a recession in 2000. Then, the attacks of September 11 came in 2001, with another huge negative body slam to the economy. Airports were closed. Transportation was difficult, putting a great strain on business and the economy. The country girded for more attacks, and the U.S. counterattacked. Just as in the 1930s, deflation and deep recession loomed.
But, unlike the 1930s, the government this time acted quite differently. Rather than increase taxes, the government cut taxes for individuals and businesses to help the economy find its footing again. The economy rebounded by growing again, with many new jobs and increases in income for individuals and corporations. Clearly, we dodged the bullet of a 1930s-style economic situation.
As in the 1930s, there was a strong legislative and regulatory response to the burst bubble and the bad practices that were brought to light. After the corporate scandals of Enron and WorldCom came other revelations about analysts saying one thing and thinking another, the governance issues of the New York Stock Exchange, and the self-dealing practices of specialists.
Part of the political reaction, of course, was the Sarbanes-Oxley Act of 2002. To implement Sarbanes-Oxley, the SEC has recently completed the largest rulemaking initiative since Congress adopted the Securities Act of 1933 and the Securities Exchange Act of 1934. We have been true to history in that the government has responded to the latest crises by adopting regulations to address activities that are perceived to have initiated the crisis.
As in anything, the danger is that politicians and regulators will go too far in their quest to try to tame public unease by enacting regulations that supplant the market's judgment. As some of you may find this weekend, if you swing your golf club too far in an effort to hit the ball harder, you risk overshooting the green. Regulation, like golf, requires careful and precise strokes to achieve the intended results.
How are those careful strokes achieved? Well, just as in golf, through empirical analysis and study of your swing to target the problems, keeping in mind your physical and mental limitations. Unless you are the one-in-a-million natural athlete, gut instinct will lead more to sore muscles and over- or undercompensation than to a correct swing and perfect placement of the ball. Then, if you understand the "funnel rule" of Total Quality Management as Dr. Edwards Deming used to teach, the more you tinker without understanding and analysis, the farther you get from the ideal situation.
Unfortunately, we as regulators at times have not realized our limitations and have failed to look to empirical evidence as a guide to our rulemaking efforts. In that vein, I should note that we are now subject to a challenge to our new rule requiring independent chairmen for all mutual funds.
Fortunately, the timing of the recent business and market scandals means that market structure reform will happen. Unfortunately, it may mean that the issue of market structure will be caught up in the remedial political rulemaking momentum. The call for market structure reform began before I joined the SEC over two years ago and prior to the surfacing of the bad conduct on the floor of the exchanges. I supported the initial concept of providing for regulatory certainty, removing barriers to competition, and leveling the playing field between market participants and market centers. Since that time, the SEC issued proposed Regulation NMS, which is intended to modernize the established market system in the U.S.
I expressed my concerns with proposed Regulation NMS during the Commission's public meeting to approve its release. I specifically pointed out that the proposed rule structure inserts a firm governmental hand into the operation of the U.S. markets. I am still reviewing the comment letters and have not come to any firm conclusions regarding this rule proposal. But, one central question that needs to be addressed is basically a philosophical one: when is it appropriate for the government to intrude into the marketplace, and specifically, into the pricing of securities?
I fully support market transparency. Transparency allows buyers and sellers to find one another and it provides the market with the ability to develop an effective pricing mechanism. The SEC's adoption of the limit order handling rules is an example of regulation that increased the transparency for buyers and sellers. It was one of the major achievements of Arthur Levitt's time as chairman of the SEC.
This increased transparency provided the investing public with better information about the true demand for and supply of liquidity. Since that time, competition flourished and the innovation within the Nasdaq market created true competition between order execution centers based upon order execution quality. The adoption of Rule 11Ac1-5 created further transparency and provided brokers routing orders with the quantitative information necessary to determine the execution quality of each market center.
The Nasdaq market is now fully automated and it recently adopted further improvements to its market structure by developing an opening and closing process that brings orders together at a single price. The limit order handling rules, by furthering the goals of market transparency, created the right incentive to promote competition and innovation.
On the other hand, the proposed trade-through rule outlined in regulation NMS is not a disclosure rule or a transparent form of regulation. In fact, it dictates how market participants must behave and interact with each other. When does dictating behavior become micromanagement of market forces? What sort of as-yet unknown, unintended consequences will we see? How difficult will it be for the SEC to enforce?
Furthermore, we have not really taken the step of studying the overall impact of an enforced trade-through rule on liquidity and in the pricing of securities. Going back to the golf swing analogy, we have not really seen a good test of the application of an enforced trade through rule. ITS certainly has not provided an adequate test.
I have not yet heard a convincing explanation as to how the proposed trade-through rule will be implemented in a non-standardized automated market. The technical problems associated with the timing differences between electronic data flows and order routing systems seem to create a labyrinth of issues. A truly effective trade-through rule might only be possible in a standardized, centralized market.
Should we not look for a simpler solution? Competition among markets will drive innovation and progress, so long as there are no artificial barriers to competition. Investors acting rationally and purely out of self-interest will prefer the best price available, but only if all other factors are negligible. The bottom line is that there will always be people for whom other factors do matter. For whatever business or personal reasons, they will pay more to get exactly what they want when they want it. Arguably, the trade-through rule removes investor choice, and more importantly, interferes with the broker's fiduciary obligation to provide best execution to all of his customers. Does our proposed rule, without an opt-out provision, just replace the investor's choice with the government's choice?
History demonstrates repeatedly that governmental involvement in market pricing, perhaps even tangentially, can have serious overall consequences for the economy as a whole. Government involvement in price-setting distorts the market by depriving buyers and sellers of critical information for their transactions. A market economy functions best when buyers and sellers can make their preferences clear. The government is not well-suited to do so, since it can only guess as to their preferences.
The concept of a trade-through rule appears on the surface to be benign and perhaps even commonsensical. It seems hard to argue against ensuring that investors receive the "best price" and that limit orders be adequately protected. But, we must stand back and look at the big picture: does this rule call into question the fundamental goals of our capital markets?
One thing is certain for me: It is clear that when Congress created the National Market System, it did not intend to nationalize the market system. Does this rule wed us to the quasi-centralization of the markets? Are we saying that that fragmentation of the markets, or in other words competition, is unacceptable regardless of the innovation in technology that brings those markets together?
If we again turn to history, the SEC's track record with centralized plans has not produced favorable results. Here, I am thinking in particular of the market data regime.
In the 1970s, the markets, at the behest of Congress, developed a system to distribute quote and last sale information. The SEC supported the development of a single processor system that provided the market centers with a monopoly over the generation and distribution of market data. At that time, the Department of Justice submitted a letter to the SEC noting its concerns about developing a single processor system in the United States.
Now, almost thirty years later we can see that some of those concerns have proven to be well-founded. The SEC, which has aimed (particularly after 1975) not to be a rate setter, has nonetheless over the years allowed - even required - the distribution of market data at arguably inflated prices. This situation becomes more troubling given the devaluation of individual quotes represented in the National Best Bid or Offer following the implementation of decimalization. Brokers must now spend additional money to obtain depth of book market data in order to make reasonable order routing and execution decisions.
The excess rents collected from this sale of data have led to market distortions addressed in proposed Regulation NMS, including locked/crossed markets, wash sales and market data rebates. Other problems associated with this unchecked system include a lack of accountability for the use of the excess revenues.
Our proposed solution to these problems in Regulation NMS involves further micromanagement through an unbelievably complicated reshuffling of the revenue distribution between the market centers. We do not even address the real problem, which is the price charged for the market data. Our proposal justifies the existing rate structure by arguing that SROs need the money to fund their regulatory functions. Why not instead encourage the the SROs to charge an upfront fee for regulatory services? That is called a user fee, and it is much more transparent than the current system. Instead, our proposal assumes that the government should support inflated pricing for a public good in order to cross-subsidize the operating functions of entities that are quickly becoming public companies. Consumers of these data, especially those required to purchase these data, ought to demand that the SEC be accountable for granting and protecting a monopoly.
I would be interested in learning whether allowing competition within the market data realm might lead to technological enhancements and allow the markets to create the appropriate incentives for increasing the transparency of liquidity in the market. I am concerned that further substitution of the government's judgment for the appropriate interactions between market participants will only increase costs and create inefficiencies, thereby hurting investors instead of protecting them.
In closing, let me thank you all for all of your work that you are doing, individually and collectively, through the STA, your various committees, firms, and also as individuals in helping us at the SEC develop policy. Your commentary and involvement in the process is vital and helps build a better product. As consolation to those of you who think that you might be talking into air with no effect or response - good, bad, or indifferent - let me just say that none of these issues ever seems to die away. Whatever happens to the NMS proposal, there will be more rounds of it in the future. So, your comments all have an effect in helping to shape current and future policy. So, please keep up your work. My door is certainly always open. I love to talk about these issues and invite you to contact me directly (preferably not all of you at once!).
Thank you for your attention and I wish you a successful conference.