Opening Statements by SEC Chairman:
December 15, 2004 Open Meeting
Chairman William H. Donaldson
U.S. Securities and Exchange Commission
December 25, 2004
Asset-Backed Securities Rules
The first item on our agenda relates to recommendations from the Division of Corporation Finance to adopt a package of proposals the Commission issued in May regarding registration, reporting and disclosure for asset-backed securities. As I noted when we proposed these rules, in less than 25 years, the market for SEC-registered asset-backed securities has grown from its infancy into a large and important segment of our fixed-income capital markets. Asset-backed securities issuance is hitting new records and indeed, according to some sources, is on pace to exceed corporate debt issuance.
Existing Commission reporting and disclosure requirements, which are designed primarily for corporate issuers, do not always fit well with the information that is material for most asset-backed securities transactions. Over time, Commission staff, through no-action letters and filing reviews, have developed a framework to address the different nature of asset-backed securities reporting and disclosure. However, the current accumulated guidance is not as transparent as we would like. This decreases efficiency and can lead to uncertainty.
As proposed, the components of today’s package of recommendations include:
- updating the Securities Act registration requirements for asset-backed securities offerings;
- consolidating staff interpretive positions that allow modified Exchange Act reporting more suitable for asset-backed securities;
- adopting rules that provide disclosure requirements relevant to asset-backed securities; and
- codifying and streamlining existing staff interpretive positions that permit use of additional written communications in a registered offering of asset-backed securities.
The market has long expressed a desire for a defined set of regulatory guidance, and commenters on the proposal applauded the initiative. The commenters also provided thoughtful and helpful input to refine the details. Feedback from both issuers and investors was extremely important and very much appreciated.
Because this initiative addresses the entire registration, reporting and disclosure process for asset-backed securities under both the Securities Act and Exchange Act, the resulting release to adopt the proposals, like the proposing release itself, is necessarily long. However, like the proposals, the recommended final rules are designed primarily to codify current staff position and industry practice, with incremental changes in certain areas, as well as revisions in response to comment.
I applaud the staff for its work on this project. As a result of your efforts, no longer will participants in this market be forced to review and assimilate a stack of no-action letters and other staff positions to understand the regulatory framework for asset-backed securities transactions. Instead, you have recommended a system that is more efficient and transparent and should lead to increased certainty and compliance – for the benefit of the entire market.
For this, I want to recognize Alan Beller and the staff from the Division of Corporation Finance who developed this recommendation – including Paula Dubberly, Jeff Minton and Jennifer Williams. I know that the team also received crucial support and insight from the Division’s Operations Group headed by Max Webb, as well as many others throughout the agency, including the Divisions of Investment Management, Market Regulation and Enforcement and the Offices of Information Technology, Chief Accountant, Economic Analysis and General Counsel. Thank you all as well.
The next item on our agenda is a recommendation from the Division of Market Regulation that the Commission re-propose Regulation NMS for a 30-day public comment period.
Regulation NMS is the product of more than five years of study and hard work by the Commission and its staff to modernize the national market system for the trading of equity securities. Our review has included multiple public hearings and roundtables, an advisory committee, three concept releases, the issuance of temporary exemptions intended in part to generate useful data on policy alternatives, and a constant dialogue with industry participants and investors. Building upon this groundwork, we proposed Regulation NMS in February of this year, and in the ten months since we have engaged in an intensive dialogue with investors large and small, with the marketplaces, with the broker-dealer community, with the academic community and with members of Congress and other public officials.
We held a public hearing in April and invited a wide cross-section of industry participants to express their views on the February proposal. Following that hearing we issued a supplemental request for comment on some of the intriguing ideas raised by the panelists, and we extended the public comment period on the proposal. Some seven hundred commenters wrote to express their views and to offer their suggestions. We have benefited enormously from this input, and this input has been instrumental in helping us to refine our thinking on the best way to proceed with the needed reforms.
The package of reforms that we proposed last February was complex and its pieces were, to some degree, inter-dependent. As our thinking has evolved, we have been mindful of the possibility that a change to one piece of the puzzle, if you will, could affect how one would view the picture as a whole. Indeed, this possibility motivated us to issue the supplemental request for comment last May. Now that we have reached some preliminary conclusions, we have decided to share them with the public for one final discussion before we act.
I hasten to add that this is a departure from our normal administrative process. Recognizing the importance of this rulemaking and its potential impact on a broad range of market participants, we have decided to go beyond our statutory obligations and give all interested parties as much exposure as possible to the direction of our thinking.
I’d like to say a few words about a component of Regulation NMS that has received a great deal of attention in recent weeks: the so-called trade-through rule. I am often asked what the purpose of a trade-through rule is. Certainly, for those not involved on a day-to-day basis with the plumbing of our equity markets, the rule may seem arcane and perhaps even counter-intuitive.
Why would we tell someone to trade with an order offering a better price, if he was willing to accept a worse price? Why do we need a rule that requires the trader to do something that, at first glance, looks like it’s in his economic interest in the first place?
The answer is that there may be times when it is not in the individual interest of a trader to trade with an order showing a better price. It may be faster to trade with another order at a worse price. Or the trader may be selling a large number of shares at a price below the best quote, and not want to bother trading with a relatively small displayed quote.
So why should the government interfere with the private choices of these traders? Because the cumulative impact of their private choices – beneficial though they may be to the individuals themselves – can discourage the most precious resource of our national market system, which is liquidity.
The investor who is willing to post a limit order supplies liquidity to the marketplace. The limit order shows the market where trading interest lies and helps to establish the best prices for stock trading. This investor provides a public service, and the market as a whole benefits.
But this investor acts at a cost to himself, for he reveals his trading interest, and he offers an option that any other investor can exercise simply by placing a market order. He risks having that option exercised only when the market is moving against him, and losing the trade when the market is moving away from him. His only compensation is the ability to trade when his quote is the best quote available. If he doesn’t get an execution, then he’s not compensated, and he will soon question why he posted the limit order. Worse, if he only gets an execution when the market is moving against him, we can begin to understand why he might choose not to offer the option to the market in the first place.
On the other hand, the trader that chooses to ignore a better limit order so he can trade faster, or execute a large block of stock, simply free-rides on the price discovery provided by the limit order.
So the trade-through rule is not designed to protect the fully informed trader from the consequences of his own actions; instead, it’s designed to reward traders who place limit orders. This should encourage more limit orders, and more limit orders means more liquidity.
That said, the existing trade-through rule is not working as intended, and only a small minority of commenters suggested that we leave the rule the way it is. The fundamental problem with the existing rule is that it treats all quotes as deserving the same level of protection, whether those quotes are real and accessible or not. The existing rule, adopted by floor-based markets decades ago, does not distinguish between fast, automated quotes, and slow, manual quotes. It has been blamed for forcing fast markets to route orders away to slow markets, where an order can sometimes languish unfilled while the market moves away. As a result, the existing rule has rightly come in for criticism from many quarters, and I believe there is little doubt that it needs to be replaced.
We recognize that the benefits of a trade-through rule may come at a cost to traders and market centers that would prefer to trade with one another in isolation and at nanospeeds. In this vein, we sometimes hear the argument that we should step out of the way and leave the markets to themselves – that it would be unwise, at least in the absence of fraud, for us to interfere with the millions of private choices that traders make each day; that we should, in the end, place our trust completely in the markets to arrive at the greatest possible good. Of course, we tend to hear this argument most emphatically from the market participants whom this approach would benefit, and from those with the resources to protect themselves from its most troubling consequences. In this regard, those on both sides of the great debate often illustrate quite nicely the old maxim that “where you stand depends on where you sit.”
The argument is sometimes made, on the other side of the debate, that the best way to foster liquidity and efficiency is to bring all orders together in a unified venue, protect the first order that offers the best price, and in so doing prohibit traders from free-riding on the price discovery provided by others. We can rest assured that this approach would also produce its own winners and losers among the current crop of market participants.
Congress, interestingly enough, did not mandate theoretical purity in either extreme. It did not decree that we should step aside and let the markets run themselves in the bravest laisser-faire fashion, just as it did not order us to micromanage competition among markets and orders. Congress rightly understood that however appealing these theories might look on paper, a measure of caution is needed before putting them into practice. Instead, in 1975 Congress directed us to take “due regard for the public interest, the protection of investors, and the maintenance of fair and orderly markets” and to use our authority “to facilitate the establishment of a national market system for securities.” Congress asked the Commission to use its judgment to reconcile the twin goals of the national market system: to increase the display of orders and the number of buyers and sellers and thereby maximize liquidity, and at the same time to allow the forces of competition to drive the markets towards ever-increasing innovation and efficiency. It told us to accomplish these goals in the context of a system, where all parts should work together for the benefit of the whole.
Stepping back a bit from these overarching goals, we ought not lose sight of the fact that the U.S. equity markets today work pretty well both for investors and for issuers. Spreads are thin. Volatility is manageable. There is no need for radical surgery in pursuit of a Platonic ideal, however much that might delight the theoreticians. While we need to look for ways to improve the system that we have – and there are certainly problems that need to be fixed – there is little reason to think that we should start from scratch. Instead, I believe that we need to identify real problems, consider the practical consequences of the possible solutions, and then move pragmatically and incrementally towards the goals Congress staked out.
As Annette will explain in a few moments, we are seeking comment on two different versions of a trade-through rule. One version would extend trade-through protection only to the very best quotes of a market center. The alternative version would extend protection to quotes further down the book, if the market center voluntarily sought protection for those quotes. I am keenly interested in the views of commenters on the relative merits and drawbacks of the two different approaches. I am also interested in whether commenters think that the two approaches would, in the end, produce different outcomes.
So to sum up, there are times when private interests and the public interest do not coincide. I believe that it is our duty to try to identify when this happens and then ask whether there is a role for us in furthering the public interest. That is what we hope to achieve with a trade-through rule.
I’d like to touch briefly on the topic of market data. We are not proposing radical changes to the current market data funding system in this rulemaking. We are, rather, proposing to fix problems with the formula that allocates market data revenues among the various SROs. The existing formula has created opportunities for profit through unhealthy and often illegal practices, such as wash trading and trade shredding. We are hopeful that today’s proposal would minimize these opportunities, though we know from long experience not to underestimate the ingenuity of those in the marketplace who would try to seek profits through manipulative trading.
We received a fair amount of comment urging us to re-examine more fundamentally the underpinnings of our current market data system. Commenters focused in particular on the aggregate size of market data fees and whether this size is justified by the cost of production. Some believe that the structure of the current system has produced a number of ill effects in the national market system – not only the manipulative trading just mentioned, but also unfair cross-subsidies, artificial monopolies, unhealthy rebate practices and other distorting behavior.
We take these comments very seriously and for that reason we sought detailed advice from the public on this issue in the prior market data releases, and we are currently examining the issue in the SRO concept release that we published last month. As we indicate in the concept release, it is difficult to analyze the question of market data fees in isolation. Although most would agree that the price of market data should bear a relationship to its costs, there remains work to be done to reach consensus on what those costs are. There is a plain link between the quality and integrity of an SRO’s market data and the effectiveness of the SRO’s regulatory program, and, needless to say, a regulatory program must be adequately funded. This suggests that the price of market data – and thus the aggregate size of market data fees – must be considered in light of the SRO’s regulatory responsibilities, and it invites analysis of the overall question of SRO funding and indeed the SRO business model.
We are committed to working through the complex issues discussed in the SRO concept release, though I would caution that any reforms we implement must be done in a manner that does not threaten the integrity, availability or affordability of the consolidated data stream.
Finally, I’d like to return to the question of process. There is a time for study, a time for consultation, and a time for action. We have studied these issues intensely and we are fast approaching the end of the time for consultation. My expectation is that after a final comment period, and due consideration of the comments we receive, the Commission will be in a position to act on Regulation NMS early in the new year.
I would like to thank the Division of Market Regulation, specifically Annette Nazareth, Bob Colby, David Shillman, Dan Gray, Heather Seidel and Steve Williams, for their continuing efforts on these proposals. I would also like to thank the Office of Economic Analysis, the Office of the General Counsel, the Division of Enforcement and the Office of Compliance Inspections and Examinations for their contributions.