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U.S. Securities and Exchange Commission

Speech by SEC Staff:
Security Traders Association

by Annette L. Nazareth

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

Washington Congressional Conference

May 3, 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 morning. It is always a pleasure to participate in this conference. 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.

This morning I will focus my remarks on a few topics that are occupying a great deal of the Division's time. They are the implementation of the Commodity Futures Modernization Act and the Gramm-Leach-Bliley Act; our reexamination of the way market data is collected and distributed; and shortening the settlement cycle to T+1. Taken as a whole, these efforts evidence the evolutionary nature of our financial markets and our continuing goal of increasing transactional and market efficiencies.

Let me begin by addressing new regulatory structures under the Commodity Futures Modernization Act and the Gramm-Leach-Bliley Act. It is fair to say that these statutes 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.


As I am certain you will recall, 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. Their proposal was largely incorporated into the final version of the CFMA.

Under the legislation, 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. 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. For instance, the CFMA has created new streamlined registration procedures for markets and intermediaries effecting transactions in these products. A firm may already satisfy these registration requirements if it is currently registered as both a broker-dealer and a futures commission merchant. Non-dual registrants - both markets and intermediaries - may "notice" register with the SEC so long as they are "full" registrants of the CFTC, and so long as their only securities business is in security futures. A similar system will allow SEC registrants to "notice" register with the CFTC.

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.

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 Act 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 once certain thresholds are met, that should encourage listing of the same security future on multiple markets.

Competitive concerns also drove provisions of the statute related to margin. 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. The Federal Reserve Board has delegated its authority to establish margin rules to the SEC and CFTC, and we currently are working with CFTC staff to draft margin rules consistent with the legislation.

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.

As you can see, the SEC and CFTC worked together to ensure that the CFMA applied 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 me turn now to the other major piece of financial services legislation -- the Gramm-Leach-Bliley Act. As you may know 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.

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.

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 a 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 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.

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.

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.

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 need to ensure an equal level of protection for all investors, and the desire of banks to continue to engage in certain securities activities that they had historically engaged in without securities oversight.

I know that many of you are interested in the Commission's progress on this subject because we have heard from you in the last several weeks. As you know, these provisions are scheduled to be effective on May 12, 2001. We understand that both the banking and securities firms need more time to come into compliance with them, and would like more explicit guidance on the functional regulation provisions - in particular, the "trust" exception and the "custody" exception. In response, the Commission released statements indicating that it plans to issue rules very shortly, and provide banks with additional time to come into full compliance. In particular, the Commission expects to provide the following temporary exemptions for banks. First, banks would be exempted from the definitions of broker and dealer until October 1, 2001. Second, the compensation received by banks and paid by banks to their employees would not affect the availability of any exception from the definitions of broker or dealer, until January 1, 2002.

Market Data

The Division is also spending considerable time addressing the issue of market data. As you know, market data today is collected and distributed through various national market system plans jointly implemented by the participating SROs - namely, the CTA/CQ, Nasdaq/UTP and OPRA Plans. Under these plans, a central processor collects quotation and transaction information from the various market centers that trade a security - and then the central processor consolidates and distributes that information to vendors and broker-dealers. As a result, investors today have ready access to an NBBO (national best bid and offer) and a consolidated transaction stream for each of the thousands of equity securities that are actively traded in the U.S. markets.

Our market data system has efficiently provided investors with useful data for many years. But because of the dramatic structural changes our markets are undergoing, the Commission decided to take another look at our current arrangements for distributing market data. Some of the developments that prompted this reexamination include the substantial increase in retail investor involvement in the markets and their growing desire for real-time market data, the potential demutualization of the existing SROs and the possibility of for-profit SROs, and the implementation of decimal pricing.

To further explore these issues, the Commission, in December 1999, issued a Concept Release that sought public comment on modified approaches to the regulation of market data fees and revenues. The Concept Release focused primarily on the fees charged for market information and the role of revenues derived from those fees in funding the operation and regulation of the markets. Ideas raised in the Concept Release included: (1) developing a flexible cost-based approach for evaluating market data fees; (2) possible ways of distributing market data revenues that would fund more directly certain SRO functions; (3) greater public disclosure concerning fees and revenues; and (4) broader industry and public participation in the process of setting and administering fees.

The views in response to the Concept Release ranged from recommending no Commission action to urging significant changes to the present system for collecting and distributing market data. In light of the divergence of opinion and the fundamental importance of market information to our National Market System, the Commission decided to explore market data issues in more depth, and to tap private sector expertise in this process.

Thus, last summer the Commission took the unusual step of forming a federal Advisory Committee on Market Information to assist it in evaluating market data issues in the equities and options markets. The Advisory Committee has a broad mandate to explore both fundamental matters, such as the benefits of consolidated market information, and practical issues such as how prices for market data should be determined. Specifically, the Advisory Committee will make recommendations to the Commission in at least six areas: (1) the value of transparency to the markets; (2) the impact of decimalization and electronic quote generation on market transparency; (3) the merits of consolidated market information; (4) alternative models for collecting and distributing market information; (5) how market data fees should be determined and evaluated; and (6) practical matters relating to the joint market information plans, such as appropriate governance structures and issues relating to plan administration and oversight.

The Advisory Committee has 25 members representing a wide range of perspectives, including exchanges, ECNs, broker-dealers, vendors and other market participants, as well as the public at large. The Advisory Committee is focusing on various ways to improve our current model of collecting and distributing market information. In addition, the Advisory Committee is examining several alternative models for consolidating and distributing market information submitted by Committee members. The alternative models that were discussed inject, to varying degrees, market forces and competition into the process of pricing market data, as well as into the consolidation and distribution functions. The Advisory Committee faces a difficult task: striking the appropriate balance between the benefits of injecting greater competition into the market data arena, and the risks that the existing pervasive and reliable stream of market data might be impaired by those changes. We look forward to reviewing the Advisory Committee's report when it is issued this coming September.


The final area of Division focus that I would like to discuss today is the industry's efforts to shorten the settlement cycle to T+1. As we consider all of the technological and structural changes our markets have experienced over the recent years, we are convinced more than ever that these markets cannot function without strong clearance and settlement systems. I believe that as trading volumes rise and market competition increases, especially as our markets compete globally, the effectiveness and efficiency of our clearance and settlement systems may be the determining factor in the success of our markets.

Last year, the International Securities Market Association published a paper discussing clearance and settlement issues. The publication included this quote, which I think sums it up best:

"These days, anybody can replicate the contracts an exchange can offer; anybody can set up the hardware to become an electronic exchange. Maybe the only way left to differentiate yourself is by really good clearing and settlement."

Our clearance and settlement systems are the backbone of the success of the U.S. securities market. They are, and must continue to be, strong, resilient, flexible, and cost efficient. Their success, which is world renowned, relies on a dedicated core of exchanges, clearing agencies, and hundreds of banks, brokerage firms, and companies working together, while still remaining competitive. The degree of interdependence is staggering. And while their success to date deserves applause, our national system of clearance and settlement is only as strong as its weakest link. So we must make sure that all the links are as strong as they need to be.

In the wake of the 1987 market crash, the Group of Thirty initiated its project to reduce risk, increase efficiency, and lower cost in the clearance and settlement systems. The G-30 made nine recommendations, including reducing settlement times. That effort prompted the Commission to request that U.S. industry participants form the Bachmann Task Force in 1992, to address the issues of safety and soundness in the clearance and settlement system and to determine what changes were necessary to achieve a safer and more efficient system.

Probably the most important conclusion from the Bachmann Report was the premise that "time equals risk." The Commission supported the report's premise that "nothing good can happen between trade date and settlement date," and that reducing risk and increasing efficiency in the settlement process through shortened settlement timeframes was desirable. As a result, in 1993 the Commission adopted Rule 15c6-1, establishing T+3 settlement as of June 1995. Our adopting proposal cited three reasons for moving to T+3. First, fewer unsettled trades would be subject to credit and market risk, and there would be less time between trade execution and settlement for the value of those trades to deteriorate. Second, T+3 would reduce the liquidity risk among derivative and cash markets and reduce financing costs by allowing investors that participate in both markets to obtain the proceeds of securities transactions sooner. And third, shortening the settlement cycle would encourage greater efficiency in clearing agency and broker-dealer operations.

While these reasons provide sufficient justification for shortening the settlement cycle further, there are other equally compelling reasons to move to T+1. The first is clearing volumes. While we have no indications that a large number of trades are failing to settle on time, the percentage of trades affirmed by institutional customers on the day before scheduled settlement date (and therefore ready for settlement processing on the next day) has declined over the past couple of years. And trading volumes appear likely to continue to grow.

Improving the affirmation is important for two reasons: First, trading by institutional investors is a significant part of our market's activity. For example, over the past five years, institutional assets under management have almost tripled from $2 billion to $7 billion. During the same period, both block and mega block share volumes have more than doubled.

Second, our current affirmation process does not work as well as it used to. As described in the SIA's T+1 white paper, in 1995, the settlement cycle was reduced from T+5 or five days to T+3. Since moving to T+3, the affirmation rate has slipped. Currently, one day before settlement or T+2, the affirmation rate is 89%. When the settlement cycle was T+5, at one day before settlement or T+4, the affirmation rate was 95%.

The affirmation process for institutional trades is critical to settlement because it is in this process that errors and discrepancies are found. The sooner these problems are found, there is a better chance that can be corrected and the trade will settle on the appropriate day.

As you know, the Commission recently granted the Global Joint Venture Matching Service (GJV), the subsidiary of Omgeo, which is a DTCC-Thomson joint venture, an exemption from clearing agency registration. Omgeo will provide a matching service that is designed to improve the affirmation process. I should also point out that our approval order contains a number of conditions that we believe will enable other entities to compete with Omgeo. We believe competition will help foster innovation and help the industry achieve straight-through processing and T+1.

Another reason for shortening the settlement cycle is that T+1 is inevitable. T+1 is a re-engineering of the post-trade processes. These changes need to be made anyway to keep costs down and meet the challenges of expanding markets. T+1 is a catalyst for these process changes.

A third reason for T+1 now is the globalization of the securities market. Today markets such as Hong Kong already settle in a T+2 environment and are evaluating whether to compress the settlement cycle even further. As more countries move toward implementing innovations that allow them to reduce settlement risk, the U.S. must remain on the leading edge of safety and efficiency in its settlement of trades. The return versus risk analysis for the international trader must take clearance and settlement into account. The safety and efficiency of the U.S. clearance and settlement system contribute substantially to the strength and vitality of our markets and their attraction for traders worldwide.


The Division has many important initiatives to deal with in the coming months. I have highlighted four: implementation of the CMA and G-L-B, addressing market data issues, and reducing the settlement date to T+1. The threads that run through all of these initiatives are reducing unnecessary regulatory burdens, streamlining the regulation of the financial markets, and reducing risk to the markets. Without these initiatives, our markets would remain stagnant and in today's global market place, any market that remains stagnant will ultimately lose out to competitors.

Thank you for your kind attention.


Modified: 05/04/2001