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U.S. Securities and Exchange Commission

Speech by SEC Staff:
New Regulatory Structures

Remarks by

Annette L. Nazareth

Director, Division of Market Regulation
U.S. Securities & Exchange Commission

to the Securities Industry Association Legal Compliance Committee

February 20, 2001

The Securities and Exchange Commission, as a matter of policy, disclaims responsibility for any private publications or statements by any of its employees. The views expressed herein are those of the author and do not necessarily reflect the views of the Commission or the author's colleagues on the staff of the Commission.

Good afternoon. It is a pleasure to be here today. As usual, before I start, I am required to point out that these comments represent my views – they may not represent the views of the Commission or my colleagues on the staff.

The standard disclaimer is especially appropriate for my topic today – new regulatory structures under the Commodity Futures Modernization Act and the Gramm-Leach-Bliley Act. As we speak, the staff continues to study the statutes and to form opinions on their nuances as we implement the new laws. Both statutes are tremendously complex, and together will revolutionize modern financial regulation.

A careful reading of the statutes and an understanding of their legislative history reveal common themes. First, the statutes reflect one of the greatest challenges facing modern regulators – how to coordinate regulatory interests in the same or similar financial products or intermediaries. Second, the new laws reflect a basic policy goal: facilitating the growth of quality markets without mandating a particular market structure. The bills permit a variety of types of markets and intermediaries to offer similar financial products in an innovative fashion, while encouraging basic market goals such as competition, market integrity, and investor protection. Both statutes preserve the traditional investor protection and market integrity frameworks that the Commission has so effectively implemented over the last 70 years.

Today, I would like to discuss these themes in the context of the security futures provisions of the CFMA and the securities law provisions of the Gramm-Leach-Bliley Act.


In December 1999, various Congressional committees asked Chairman Levitt and CFTC Chairman Rainer to jointly propose a legislative plan under which the almost 20- year ban on single stock futures could be lifted. In September 2000, they submitted a proposal, which was largely incorporated into the final version of the CFMA.

You may be familiar with the basic provisions of the bill. The SEC and the CFTC will jointly regulate the market for single stock futures and narrow-based stock index futures. Products will be free to trade on commodities and securities exchanges, derivatives transaction execution facilities, and alternative trading systems. Moreover, both broker-dealers and futures commission merchants will be able to trade these products.


From a regulatory perspective, the CFMA starts with a simple premise: single stock futures and narrow-based stock index futures – collectively known as security futures – will be regulated as both futures and securities. The CEA was modified to make clear that the CFTC has jurisdiction, but not exclusive jurisdiction, over security futures. The CFMA also defines these products as securities. Because both the SEC and CFTC will be deeply involved in the regulation of these products, effective coordination between the agencies will be critical. I must say that our experience to date working with the CFTC to implement the CFMA has been most encouraging with very constructive cooperation from both agencies.

To avoid duplicative regulation, the CFMA directs each agency to apply only core provisions of its regulatory scheme to entities they do not otherwise regulate. However, recognizing each agency's role in the regulation of security futures, the CFMA requires markets and intermediaries effecting transactions in these products to register with both the SEC and the CFTC.

Your firm may already satisfy the registration requirement if it is currently registered as both a broker-dealer and a futures commission merchant. If not, there is a special registration procedure that illustrates the coordinated roles of the SEC and CFTC. More specifically, expedited "notice" registration with the CFTC would be available to securities markets and intermediaries who are not dual registrants and whose only futures business consists of security futures. Such "notice" registrations will be effective on filing. In addition, such individuals and entities will be exempted from certain futures law requirements that are duplicative of securities law requirements applicable to such registrants. Of course, a similar expedited "notice" registration procedure will be available for futures markets and fcm's whose only securities business is in security futures.

Our coordination however will extend far beyond the registration requirements. For instance, while both agencies have enforcement and examination authority, it is clear that the CFTC is the lead regulator for futures markets and futures commission merchants and that the SEC is the lead regulator for securities markets and securities broker-dealers. The new law generally requires the SEC to consult with the CFTC when we undertake examinations or enforcement actions. Moreover, we will use the CFTC's examination reports to avoid duplicative information gathering, when possible.

We also are exploring how to coordinate regulatory requirements for those of you who currently are dual registrants. For example, we are reviewing the financial responsibility rules to determine how to accommodate registrants currently subject to both the Securities Investor Protection Act of 1970 and segregation requirements.

Quality Markets

In addition to coordinating SEC and CFTC regulatory efforts, the CFMA has several provisions aimed at promoting competition in and among security futures markets, maintaining market integrity, and protecting customers. The bill attempts to foster quality markets for security futures without giving a competitive advantage to one type of market or intermediary. Avoidance of regulatory arbitrage is an important goal underlying the legislation.

The securities laws long have emphasized competition as a way to achieve quality markets. Consistent with this philosophy, the statute requires linked and coordinated clearing that should encourage listing of the same security future on multiple markets. Mandatory implementation of this requirement is delayed until the later of: (i) two years; or (ii) the point in time (as measured by an objective test) when a substantial market exists for such products.

Competitive concerns also drove provisions of the bill related to margin. Under the legislation, margin rules will be established by the Federal Reserve Board or delegated to the SEC and CFTC. Margin levels for security futures products cannot be lower than comparable options margin levels, although the levels may be higher than comparable options levels where the futures markets margin systems require it. If an exchange chose to raise margin levels, the related rule change could be filed pursuant to an expedited rule filing process. Other changes related to margin will be published for comment and reviewed by the SEC.

Quality markets must have market integrity and adequate investor protections. The CFMA also provides mechanisms to ensure these goals. Dual registrants will be subject to the customer protection principles of both the futures and the securities worlds. A notice registrant's primary regulator and self-regulatory organization will provide initial supervision of its customer protection activities. For example, the National Futures Association and the futures exchanges will be responsible for ensuring compliance with the securities laws applicable to an FCM that is a "notice" registrant with the SEC. The SEC will have jurisdiction over the NFA as a special purpose national securities association under section 15A of the Exchange Act. The NFA will be required to file with the Commission suitability rules pursuant to its new role.

As you can see, the SEC and CFTC sought to carefully craft the CFMA to apply the best aspects of both regulatory systems – such as provisions that protect investors – to security futures. In addition, we sought to establish a regulatory scheme that was not overly burdensome, that did not contain duplicative provisions, and that did not unfairly favor futures or securities markets or intermediaries. We believe the new law strikes a proper balance. We also believe that our success in jointly crafting this coordinated regulatory approach with the CFTC, as well as the very productive efforts of the staffs of both agencies in jointly preparing the implementing rulemaking, bodes very well for coordinated regulatory oversight in this area.

Gramm-Leach-Bliley Act

Let met turn now to the other major piece of financial services legislation -- the Gramm-Leach-Bliley Act. This Act permits the combination of various financial services and sets limits on the responsibilities of the various financial regulators over financial conglomerates. This may be relevant to only some of you sitting in this room today, but if the anticipated consolidation among securities, banking, and insurance firms comes to pass, it will certainly affect many more of you in the near future. The Gramm-Leach-Bliley Act requires an almost unprecedented level of coordination among financial regulators. Primary regulatory oversight of entities such as securities firms or insurance companies were retained by functional regulators such as state insurance regulators or the SEC, with umbrella supervision of the holding company resting with the Federal Reserve Board. This structure poses many challenges to both the regulators and the regulated – how to ensure appropriate regulatory supervision without experiencing either gaps or burdensome duplicative regulation. If you work for a securities firm that is affiliated with a bank, the obvious question to ask is, in what way does this affect how I discharge my compliance responsibilities? I'd like to talk about some of the ways.

First, you may have to start interacting with a larger set of regulators. When Congress enacted the Gramm-Leach-Bliley Act, it established a regulatory framework to govern the interaction between securities, banking, and insurance regulators. Congress was particularly mindful of the potential regulatory burdens that would inevitably be created if multiple regulators asserted primary authority over the same businesses.

Thus, Congress created a two-part system for regulatory oversight of financial conglomerates. While it is recognized that the Federal Reserve Board would have its traditional role as the bank holding company regulator to assess risks posed to the bank by affiliates, it explicitly required the Federal Reserve to defer to the Commission in its role of functional regulator over securities firms. Thus, Congress recognized the regulatory expertise of the Commission by preserving the role of the Commission as the front line regulator over securities firms. Generally speaking, that division of regulatory responsibility should translate into business as usual for your compliance program.

However, there are exceptions to every rule. While Congress intended for the banking regulators to observe the natural limits of their expertise by relying on securities and insurance regulators to the fullest extent possible, it preserved for the Federal Reserve Board a certain amount of residual authority even with respect to securities firms and insurance companies. In particular, the Board is allowed to inspect the holding company and its subsidiaries to assess its operational and financial condition, to assess any risks that may pose a threat to the bank and systems for mitigating those risks, and to monitor compliance with the provisions of the Act. As you know, the securities business is inherently a risk-based business. We do not believe that Congress intended bank regulators to use their residual authority to inspect securities firms anytime they posed a risk to the bank. To suggest otherwise would mean that all bank-affiliated securities firms would be on bank regulators' inspection cycle all the time. In short, the exception would swallow the rule. Nevertheless, you can appreciate the coordination among regulators that will be required for each of us to satisfy our statutory mandates.

As a result of this regulatory structure, we recognize that securities firms may, from time to time, face additional regulatory burdens. Inevitably, there will be some growing pains as we become comfortable in the routine interactions with our fellow financial regulators. In order to minimize the potential additional regulatory burden that securities firms may face, we are developing a system of information sharing with the Federal Reserve Board.

In assigning multiple regulators to financial conglomerates, Congress raised a threshold issue. At what point do the predominant supervisory interests shift to the functional regulator? I believe that the reliance on the expert regulator envisioned by Gramm-Leach-Bliley, buttressed by information sharing and coordination, will be particularly important where a financial holding company – whether it or its parent holding company is a U.S. or foreign chartered entity – is subject principally to market risk, rather than credit risk. This frequently occurs where the holding company derives most of its revenue from the securities activities of its subsidiaries. In these situations, we believe that the GLB Act envisions that the greatest possible reliance should be placed on the expertise of the functional regulator.

It is important to note that the functional regulation provisions of Gramm-Leach-Bliley do not alter the Commission's interest in ensuring the integrity of risk management systems, wherever located in an enterprise, that impact the registered broker-dealer. As securities firms become more complex, we at the Commission have been more focused on inspecting the internal controls that help form the risk management process. Since the securities business is inherently a risk-based business, our increased emphasis on internal controls is an appropriate outgrowth of our oversight function. Our goal is to preserve investor protections and market integrity by tailoring requirements more closely to the risks posed by an institution.

A good model for what the Commission views as appropriate internal control programs is contained in our rule establishing a voluntary registration category for over-the-counter derivatives dealers – "b-d lite." The focus of that registration category was to provide a regulatory vehicle that would allow U.S. broker-dealers to establish a separately capitalized entity through which to book an OTC derivatives business. The rule requires an OTC derivatives dealer to establish a system of internal controls for monitoring and managing risks associated with its business activities. In return for adopting this system of internal controls, OTC derivatives dealers may use value-at-risk capital models for their derivatives business.

On a going forward basis, we will continue to be interested in the risks that holding companies may pose to their affiliated broker-dealers. While we have limited authority over holding companies of U.S. broker-dealers, we have a strong interest in the risk management activities of a broker-dealer's holding company when risk management for the broker-dealer is consolidated at a holding company level. In these situations, we need information from the holding company, beyond that collected under our current risk assessment program, in order to evaluate fully the market, credit, liquidity, operational, and legal risks to which our regulated entities may be subject. As you no doubt can appreciate, this focus on internal controls would be of interest both to the functional regulator and to the umbrella regulator, and justifiably so. The challenge will be to satisfy our collective need for this information in a manner that is minimally burdensome to the financial enterprises.

We hope to further refine our risk management approach by developing an alternative voluntary regulatory approach pursuant to the "investment bank holding company" provisions in Title II of the Gramm-Leach-Bliley Act. These provisions of the Act essentially create a parallel holding company structure for broker-dealers that wish to remain solely subject to Commission supervision. We are considering rulemaking to permit these new "investment bank holding companies" so that U.S. broker-dealers that opt for this supervisory structure can compete overseas on an equal footing with other foreign entities that are subject to consolidated supervision. Our initial thoughts are that we would provide for investment bank holding companies to be registered, regulated, supervised, and examined. Some of the elements of this regulatory framework include a risk-based examination and reporting system, oversight of the entity on a consolidated basis, and alternative capital provisions incorporating certain value-at-risk principles for the entity's subsidiary broker-dealer. The Act does not provide the Commission with the authority to set capital standards at the holding company level. Thought, however, is being given to requiring an investment bank holding company to file reports "certifying" that if it were required to calculate its capital on a consolidated basis in accordance with the Basel Capital Accord – as modified to apply to the business of securities firms – that it would be in compliance with those standards. We believe that our proposal would meet the Basel requirements for consolidated supervision and expect that foreign regulators would recognize this fact. We have begun discussions through the SIA Capital Committee with the firms that may be interested in establishing investment bank holding companies and expect to work cooperatively with the industry to craft a regulatory framework.

Another consequence of the Gramm-Leach-Bliley Act that I'd like to discuss briefly are the provisions that allow banks to engage in some securities transactions directly without any oversight from securities regulators. You may have heard these provisions referred to as the "pushout provisions" because they presumably force banks to push out certain securities activities to broker-dealers. That's a bit of a misnomer actually, because banks will be able to "push in" certain other securities activities that are now being conducted by their affiliated broker-dealers, such as the government securities business.

I prefer to think of the "pushout provisions" as the "functional regulation" provisions. These provisions recognize that securities laws apply to any intermediary that is in the business of effecting transactions in securities, no matter where it conducts those activities. It makes sense as a policy matter to treat market participants similarly when they conduct the same business. It is a question of providing the same level of investor protection, while ensuring a level playing field for market participants.

Of course, nothing is ever that simple. From that notion of "functional regulation" evolved thirteen exceptions from broker-dealer regulation in the Gramm-Leach-Bliley Act that are tailored to specific products or securities activities. These functional regulation provisions were the result of a carefully crafted balance between the interests of securities regulators to ensure an equal level of protection for all investors, and the interests of banks to continue to engage in certain securities activities that they had historically engaged in without securities oversight.

As a practical matter, it means that some banks will use dual employees to effect transactions both for securities activities that fall outside of broker-dealer registration and for securities activities that are required to be conducted in a broker-dealer. If your securities employees are also employed by a bank, you should exercise the same level of supervision of those employees that you do with any other securities firm employees. That means that you should have access to the books and records that pertain to that employee's securities business, wherever it may have occurred, so that you may effectively supervise that employee's securities activities. It would be insufficient to surveil only the securities trades that your employee conducted while wearing his or her registered rep hat in the broker-dealer.


To conclude, the Commodity Futures Modernization Act and the Gramm-Leach-Bliley Act bills revolutionize the regulation of financial products, but only serve as a starting point. In the near term, we all must continue to work together to implement these important new laws. Over time, however, modern financial regulation will continue to be characterized by a fundamental challenge – coordinating the interests of numerous regulators in the same financial products. The SEC and other financial regulators must continue to coordinate their regulatory efforts to insure quality markets in the future. With a cooperative spirit and through vehicles such as the President's Working Group on Financial Markets, I am confident that we can rise to this challenge.