Speech by SEC Commissioner:
Remarks before the SIA Compliance and Legal Division Fall Compliance Seminar
by
Commissioner Paul S. Atkins
U.S. Securities and Exchange Commission
New York, NY
November 9, 2005
Thank you, John for the kind introduction. It is both and honor and a pleasure to be here today at the Compliance and Legal Division's Fall Compliance Seminar. Before I begin, I must remind you that the views I express here are my own, and do not necessarily represent those of the Securities and Exchange Commission or my fellow commissioners.
I would like to focus my remarks today on two topics. The first, which will make up the bulk of my comments, is - in the jargon of hurricane watchers - a Category 5 regulatory event that already should be firmly on your radar screen - Regulation NMS implementation. I will close with a few words about the status of our BD/IA rules.
Regulation NMS Implementation
I want to first commend SIA for the leadership role that it is playing in the Reg NMS implementation process. Following the adoption of the final rules, SIA quickly set up three Regulation NMS Implementation Working Groups on the major areas of the regulation, developed detailed issues lists, and began to engage the Commission staff on implementation issues. Just last week, SIA also held a well-attended symposium on Reg NMS implementation that gave the Commission and its staff a good deal to think about as we develop interpretive guidance on the rules. I encourage SIA to keep up the good work.
As you probably know, Commissioner Glassman and I dissented from the Commission's decision to adopt Reg NMS. While the goals sought to be achieved through the regulation were laudable, I believed - and continue to believe - that the final rules 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 those goals.
I also still believe that Reg NMS has the potential to do significant harm to our markets by unduly interfering with the operation of the competitive forces that over the years have benefited investors immensely by reducing trading costs and increasing market efficiency.
However, dissenting from the adoption of Reg NMS does not in any way make me less interested in the implementation process. Quite to the contrary, I intend to be fully engaged in the process to ensure that the rules are implemented in the least burdensome and most cost-effective manner possible and to limit their potential harm to our markets' competitiveness.
Turning to the implementation schedule, the first compliance date for the heart of the regulation - the new trade-through rule and market access requirements - is June 29, 2006, a scant nine months away. When you think of the many interdependent elements involved, the Commission has set a very ambitious timetable for the implementation of Regulation NMS. A lot needs to get done before the rules can take effect.
Specifically, the Commission needs to issue a great deal of interpretive guidance and take action on a host of SRO and NMS Plan rule proposals. SROs and the SIPs need to develop specifications and code changes to their systems. Broker-dealers need to revise their own systems and develop compliance policies and procedures. Industry-wide testing needs to occur to ensure that all the pieces work individually and together.
Industry participants also need some live working experience with new SRO rules, SIP processes, and concepts introduced by Regulation NMS, in particular the intermarket sweep order. On top of all this, the NYSE is proposing to introduce its hybrid market in the same time frame, itself potentially a sea change in how the listed markets operate.
The process is not going to unfold sequentially. I expect that many of the industry's issues with implementation will only fully emerge after the Commission puts out its initial guidance and firms' technology departments sit down to start writing specifications and coding systems for compliance with the rules.
If our experience with the implementation of the first two pieces of Reg NMS - the prohibition on subpenny quotations and the reduction in the Regulation ATS fair access threshold - are any guide, the implementation process will be a challenging one for the industry and Commission alike.
These first two pieces of Reg NMS were supposed to be the easy parts to implement, hence their original compliance dates of August 29, 2005. Mind you, these rules required minimal systems changes. Yet when market participants looked closely at the implications of the rules on their business processes, interpretive questions arose, which moved back the implementation of the Regulation ATS threshold a month and the subpenny prohibition until January 31, 2006. Will this be a harbinger of things to come?
The staff has since posted on the SEC website a list of frequently asked questions regarding the subpenny prohibition. The list is 18 questions long. The process so far does not give me much comfort at all that the remainder of the rule will be implemented without a hitch or on time.
Regulation NMS poses a fundamental implementation problem in that the rules themselves generally were written at an extremely high, almost aspirational, level, leaving a multitude of details to be worked out afterwards through a process of Commission and staff interpretation.
This problem is compounded by the current regulatory environment, in which the industry is extremely concerned of being second-guessed with 20-20 hindsight by regulators. As a result, the industry is looking for as much particularized guidance as possible on the various elements of Regulation NMS. While I am sympathetic to this request and believe that we should provide more complete guidance on the rules, I do remain concerned that the industry may well be tempted to accede to what it otherwise would consider to be unworkable, impractical, and costly standards in order to get the clarity and comfort it is seeking in this difficult environment.
A related and very real danger is that the Commission and its staff, in the process of providing the particularized guidance sought by the industry, will wind up micromanaging every aspect of market operation and interaction connected with the regulation. It thus falls on the Commission and its staff to exercise particular caution in providing interpretive guidance so as to insure that the rules are implemented in a cost-effective manner and do not impose any unnecessary burdens on innovation and competition.
Let me briefly touch upon some of the significant issues that are currently being considered by the Commission in the process of developing interpretive guidance on the trade through rule and the other elements of Reg NMS.
The trade-through rule is the part of Reg NMS that has received the most attention from the industry during the rulemaking process. It is no surprise then that this rule as adopted presents the most interpretive issues for the industry.
In providing interpretive guidance on any rule, the first step a regulator should take is to look at the policy objective behind the rule's adoption. The problem with applying this analysis to the trade-through rule - forgive me, but I would rather not call it the order protection rule as that is a complete misnomer - is that the supposed policy behind the rule continually morphed during the rulemaking process.
Initially, the rule was intended to protect displayed limit orders, then it was repositioned as increasing market depth and liquidity, and finally as reducing transaction costs for long-term investors and issuers. With those varied policy bases, the Commission granted the staff a great amount of leeway in providing interpretive guidance on the rule, for good or for ill.
For the trade-through rule, the two general areas where the clamor for interpretive guidance has been the loudest so far are: 1) how the various exceptions to the rule will operate; and 2) what are the compliance requirements generated by the rule.
With respect to exceptions, questions have primarily been raised regarding the use of the self-help exception, the operation of the intermarket sweep exception, and the content of the benchmark order exception.
The self-help exception is intended to allow trading centers to bypass otherwise protected quotations of automated market centers that are inaccessible for whatever reason, usually systems failure. Left unanswered in the adopting release is exactly when trading centers can avail themselves of the exception - for example, how many attempts do they have to make within what time frame before bypassing a particular quote? The Commission's pending interpretive guidance I hope will take into account market participants' existing practices in factoring non-responsive quotes into their order routing and execution strategies and provide sufficient comfort to market participants that they can use the exception as circumstances warrant.
The operation of the intermarket sweep exception is another area where firms are asking for additional guidance. The exception is critical to the operation of the rule as it allows trading centers to have assurance that their execution of any particular order does not result in a violation of the rule. As a result, intermarket sweep orders, or ISOs, will likely become the primary order type in the market place after the implementation of the rule.
That is certainly a curious turn of events, because the intermarket sweep exception was originally conceived as a work-around when it was acknowledged that a pure order-by-order trade-through rule would not work on a modern, market-wide basis.
It is crucial then that we tread extremely carefully in our interpretation of this exception and the parameters of this order type so as to not unduly interfere with the flexibility of trading centers to structure their operations in response to competition and customer needs.
The benchmark order exception is intended to allow for the continued execution of orders that are executed without reference to the current market price. While the release focused on VWAP executions as an example of a benchmark order, little else was said about other executions that could qualify for the exception. I would expect our interpretive guidance to provide a more expansive list of the type of executions that could be eligible for the exception.
A related question is whether the SEC will entertain any additional exceptions to the trade-through rule. I would hope that we can keep an open mind through the implementation process as to the need for additional exceptions as the industry works through the impact of the rule on the trading process. I also hope that we can act quickly to provide such exceptions if they are necessary.
The second major set of interpretive issues around the trade-through rule relates to the expected content of a trading center's policies and procedures to prevent trade-throughs of protected quotations and what are the necessary sufficient procedures to oversee their effectiveness. A threshold question here is whether firms should evaluate trade-throughs based on their own internal timestamps of quotations or use those of the SIP. Issues have been raised with the use of SIP data due to concerns such as latency, processing time, and clock drift.
The staff has made preliminary statements that trading centers can rely on internal time stamps to determine compliance with the rule, but they also may consider suggesting that firms periodically measure their trade-through rates against the SIP timestamps as a means of assessing the reasonableness of their procedures. Given the inherent limitations of SIP data, I would be interested in your views on the utility of such an exercise.
As for surveillance procedures, firms have expressed concerns that they might be required to maintain a database of every quotation change, whether trade-throughs have occurred and whether an appropriate exception applied. I would hope that our interpretive guidance would clarify that firms would be considered to have appropriate compliance procedures if they reasonably sampled trading activity for compliance with the rule and maintained such records.
I understand the staff preliminarily has said much the same already. I do also understand that the industry has concerns that many months later regulators may make requests for time periods outside of those sampled by firms. I invite your thoughts on the appropriate way to keep compliance with this rule from becoming overly burdensome for firms while still giving regulators the necessary flexibility to conduct their oversight obligations.
We ultimately have to acknowledge that the marketplace has a wonderful means of policing itself, which was the flaw of the original Commission rulemaking when the majority ignored actual data and any meaningful cost/benefit analysis. Because the statistics prove that trade-throughs probably occur at a very minor rate already, it makes absolutely no sense to burden market participants with yet more costs through unrealistically strict interpretations of the rule.
While the trade-through rule has received the lion's share of attention so far in the process of spotting issues and developing interpretive guidance, there is much more to Reg NMS. The regulation also encompasses locked and crossed market prohibitions, access fee restrictions, market access requirements, and a new market data revenue allocation formula. I will very briefly mention some initial impressions on the implementation issues involved with each.
With respect to locked and crossed market restrictions, I have heard some in the industry voice concerns that they will be subject to materially different rules and compliance demands on the various SROs through which they conduct business. It is my current understanding that the staff is encouraging the SROs to take a largely uniform approach to this rule and to submit similar proposed rules restricting locked and crossed markets.
While such an approach may reduce the likelihood that firms will be subject to widely differing regulations and compliance requirements, the Commission also will have to be careful that in dispensing final interpretive guidance it is not forcing markets' operations into a one-size fits all approach. This type of approach could very well have adverse effects on innovation.
Another observation worth making here is that it would benefit the SROs to make their Reg NMS implementation plans known to their membership as early as possible to eliminate potential confusion and to allow members to get on with their own implementation efforts.
As for access fees, Reg NMS limits the fee charged with respect to the execution of an order against a protected quotation or the best bid or offer of an exchange, Nasdaq, or NASD to $0.003 for NMS stocks priced above $1.00. I have not heard much at all from the industry so far about implementation issues related to the access fee restriction, but I assume it is due to other matters taking precedence. I have no doubt that issues will arise regarding this restriction.
Nasdaq's pending proposal to prohibit ECNs from directly charging an access fee on its market raises the question whether prohibiting access fees would implicate the Exchange Act prohibition on SROs fixing their members' commissions. The Commission avoided the question in approving Nasdaq's existing $0.003 access fee cap by stating that since access fees could be charged at any rate below three mils, the proposal did not fix a particular commission rate. The result reached in the Nasdaq rule proposal could have implications for how access fees are charged and collected in a Reg NMS environment.
On the market access requirements, it appears that the current ITS Plan participants are working on a stop-gap measure to utilize the ITS infrastructure (without the ITS governance provisions) as a voluntary means for routing orders among the listed markets once Reg NMS goes into effect. It will be interesting to see how the volume transacted through this proposed interexchange linkage will compare to the volume through ITS today. And, I will be interested to see whether private linkage systems will be as prevalent in the listed space as in the Nasdaq space once automated access is available across the markets trading listed stocks.
In a backhanded defense of its market data revenue sharing formula, the majority made the odd statement that while the formula is complex, only a few people actually need to understand it. I find it somewhat amusing to note then that at least one SIP, definitely one of the people who need to understand the formula, reportedly engaged a consultant and an auditor to assist it in implementing the new formula. The only other observation to make with respect to the formula is that while its intent was to eliminate gaming opportunities, one can only wonder what gaming opportunities arise out of the new formula. This is particularly true with respect to the quote credit calculation, as it allows SROs, and consequently their members through revenue sharing arrangements, to gain market data revenues by displaying quotations at the NBBO with a minimum duration of one second.
I would like to close my remarks on Reg NMS implementation by sharing some of my expectations for the Commission's conduct during the implementation process. First, it is imperative that the SEC coordinate internally. We need to ensure that our staff is speaking with a single voice in providing interpretive guidance to the industry and that the various divisions and offices maintain a uniform approach to the interpretation of the rules as time goes on, especially as the rules become part of the examination process.
As an aside, I think that we need to give serious consideration to a thought I first shared aloud last year - whether an independent Office of Compliance Inspections and Examinations is the best way for the Commission to organize and utilize its examination resources. Would it make more sense for the Commission to reintegrate examiners into the Divisions? Doing so could help the Commission provide a more consistent message to the entities and individuals we regulate. An integrated structure could allow for interaction and exchange between the people who write and interpret rules and those who are on the frontlines interacting with registrants and assessing their compliance with our rules. An integrated structure could also alleviate any inefficiencies introduced into the Commission's processes that have grown out of inadvertent organizational barriers between the two functions. It would also eliminate the potential for "mission creep" to occur. This is a topic worthy of further serious discussion among the Commissioners.
Returning to today's topic, I hope that the SEC will coordinate closely with the SROs to ensure that firms are not subject to differing interpretations of the same rules by various regulators, or that the examination processes used by different regulators do not result in unnecessary compliance burdens for the industry.
Third, the Commission and its staff must work with the industry to assure that the interpretive guidance is provided in a way that allows the rules to operate in the most practical way possible, with a view towards having the least disruptive effect on the markets, limiting costs imposed on the industry, and allowing the most room for continued competition and innovation in our markets.
Finally, I would encourage all of you - not only through the SIA, but also as individual firms - to engage the Commission, its staff, and the SROs early and often with your issues and perspectives on the Reg NMS implementation and the interpretive guidance provided by the Commission and the staff. I am concerned about informal rulemaking behind closed doors. We must strive to have a transparent process however this develops.
BD/IA Rulemaking
Before I close my remarks, I would like briefly to say a few words about a completely different topic. Last April, the Commission, after an extraordinarily long period of inactivity, adopted the BD/IA rule to provide some guidance about where the line lies between activity that will be subject to regulation under the Advisers Act and activity that is exempt from the Advisers Act because it is solely incidental to brokerage services. The rule, which we adopted in April, has sparked considerable controversy, including a lawsuit. As adopted, the rule provided a framework within which broker-dealers, without being subject to regulation as investment advisers, can offer fee-based brokerage accounts to customers for whom such accounts would be appropriate. The rule requires the inclusion of specific language on account documents to warn investors that these are not advisory accounts and encourages customers to ask questions about their rights and brokers' obligations.
The rule also provides guidance about activities that would not qualify as "solely incidental" to a broker-dealer's brokerage business and hence would trigger the Advisers Act. Specifically, a broker-dealer provides advice that is not solely incidental if it (1) charges a separate fee for or separately contracts to provide the advice, (2) holds itself out to the public as a financial planner or as providing financial planning services, or (3) exercises investment discretion over the account.
You and others have raised excellent questions about how this guidance is meant to work in the context of real customer relationships. The rulemaking will do more harm than good if it results in duplicative regulation, dissuades people from becoming financial planners or obtaining advanced certifications, or scares brokers away from making necessary suitability determinations. We are working with you and others to answer the questions that were raised by the release. In the meantime, we have extended the compliance date for the "solely incidental" portion of the rule until the end of January.
This is an area in which we have provided murky guidance to no one's satisfaction. Rather than perpetuating this turbidity, would we not be better served by getting this right even if it takes a little longer? Whatever we do should be by Commission action after all affected parties have a chance to weigh in through the notice and comment process.
In the longer term, as we determined in the adopting release, we need to conduct a study that takes a broader look at issues related to the relative obligations and regulatory schemes for broker-dealers and investment advisers. Whatever shape this further study takes, and that should be determined in the near future, I hope that you will get involved. It is crucial that we have the benefit of the input of people who are actually working with customers on a daily basis.
Thank you for your time and attention. My phone and office are always open to you. Please call or stop by if you are in Washington if you have any comments or concerns.
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