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U.S. Securities and Exchange Commission

Speech by SEC Staff:
Remarks before The Bond Market Association Legal and Compliance Conference

by Annette L. Nazareth

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

The Bond Market Association Legal and Compliance Conference

January 8, 2002

Good morning. I'm delighted to have been asked to speak to you this year. It is always an honor and a privilege to address the participants at this conference, but it is fair to say that this year has significance like no other because of our shared experience of the past few months. September 11 was a particularly difficult time for many in our industry, and undoubtedly the participants in the fixed income markets were particularly affected. Before I begin my talk today I must remind you that my remarks represent my own views, and not necessarily those of the Commission or my colleagues on the staff.

I. Lessons Learned from September 11 Events

I thought I would start with some of the lessons learned from the September 11 experience. As you may know, the Commission, like a number of other regulators and industry groups, is in the midst of an effort to assess the response of the securities industry to the September 11 events, and consider lessons learned from them. While I think everyone would agree the industry performed remarkably well in the face of this tragedy, we all are eager to determine whether there are ways to strengthen the resiliency of the securities markets, so that we are even better prepared going forward.

We at the Commission were most impressed by all of the hard work and the exceptional level of cooperation shown by the securities industry in its recovery from the World Trade Center disaster. As a result of these herculean efforts, the U.S. markets were able to reopen quickly and without incident, helping to restore an understandably nervous public and restore faith in our financial system.

The September 11th experience also evidenced the extraordinary power of cooperation and partnership between the public and private sectors. As a government agency, our job was to ensure that our markets once again were able to function properly so investors could exercise their freedom to buy or to sell, and so public companies could raise capital in the strongest, deepest, most liquid capital markets in the world. The Commission reached out to all sectors of the marketplace for ideas concerning the best way to ensure that our markets would reopen with the greatest amount of liquidity possible, consistent with the protection of investors and the national interest. With the industry's help we crafted a series of emergency measures, such as a temporary broadening of the issuer repurchase safe harbor, that served to create a more stable market environment. We were pleased with the impact of these temporary measures, and our experience with some of them may serve as a basis for consideration of permanent regulatory changes in the future.

But despite the remarkable achievement of the securities industry in recovering so quickly and smoothly from the terrorist attacks, inevitably there is room for improvement. As a result, the Commission and others now are seeking to identify ways to further protect the financial markets in the event of future crises. Two areas that I expect to be the subject of particular focus are business continuity planning and crisis management.

With respect to business continuity planning, my sense is that most now recognize the need for more rigorous plans that address problems of wider geographic scope and longer duration. For many, the September 11 attacks made clear the possibility of a large-scale regional disaster. Thus, there seems to be consensus that business continuity planning needs to adapt - to plan for events of wider scope and, in general, become more robust and resilient.

For example, prior to September 11, contingency planning generally contemplated problems with a single building. Some firms arranged for their backup facilities to be in nearby buildings on the assumption that - worst case - a fire might incapacitate or destroy a single facility. Very few planned for an emergency impacting a district or region, so that, in the aftermath of the September 11 events, some firms lost access to both their primary and backup facilities. As a result, many firms now are considering modifying their business continuity planning to include backup arrangements with broader geographic diversity.

The September 11 events also demonstrated the importance of an organization's trained human capital. Following the terrorist attacks, several market participants realized that, while they had taken great pains to establish an offsite backup data center, they had not arranged for adequate backup space for their employees to conduct business. Post-September 11, it became clear that an adequate "desktop" recovery strategy - one that contemplates the movement of, at minimum, core employees to fully-functional backup office space - is a critical element of a firm's business continuity planning.

With respect to testing of backup sites, I believe firms now recognize how important it is to conduct tests not just from their backup site to the primary sites of other market participants, but from backup site to backup site as well. After all, with a large- scale disaster, like that of September 11, there is a likelihood that many businesses will be operating out of backup sites.

Market participants also realized the importance of maintaining current copies of records and software at their backup facilities (or other secure location). Some firms had been in the practice of sending records offsite only at weekly or monthly intervals. As a result, when they lost their primary offices, they had to devote substantial resources to reconstruct records that had not yet been transferred to their backup facilities. Many of these firms now intend to ship records offsite more frequently, perhaps daily or even several times per day.

A crucial lesson learned from the events of September 11 - but one not entirely within the control of the securities industry - is the importance of connectivity and the need to ensure that an organization has truly redundant telecom arrangements. Many firms thought they had achieved redundancy in their communications systems, by making arrangements with multiple telecom providers, only to discover that the lines of all those providers went through the same Verizon switching facility - which happened to be located next to the World Trade Center. Others had taken the time to map their telecom lines to assure diverse routing, only to find out that their telecom providers had rerouted some of those lines - and eliminating that diversity - without telling them, or contracted out the service to other providers already in use by the firm. Going forward, the securities industry must assure that diverse routing is acquired and maintained, so that truly redundant communications systems are created.

In addition to improving business continuity planning at the individual firm level, it is also clear that coordinated industry-wide planning is necessary to protect the key elements of the markets. The events of September 11 graphically demonstrated the interdependence of securities market participants - wherever located. While firms located outside the disaster area were impacted to a much lesser degree, most did, for example, lose connectivity to markets, broker-dealers and others in lower Manhattan, and this in many cases severely impeded their ability to conduct business. Thus, thought should be given to ensuring business continuity planning at comparable levels by all critical elements in the financial system. It is clearer than ever that a chain is only as strong as its weakest link.

As you all know, a disruption in one critical element of the government markets - namely the clearing banks - led to some of the most significant systemic problems experienced by the securities industry in the aftermath of September 11. In particular, the widespread communications and other problems experienced by one of the two clearing banks for the government securities market prevented market participants from confirming the status of their accounts at that bank, and whether the delivery of funds or securities to those accounts had been made. The impact of these errors snowballed and led to a dramatic increase in the number of settlement fails in the government securities markets-an issue that took well over a month to be resolved. This issue of clearing bank concentration in the government securities markets is one that undoubtedly the Federal Reserve will take the lead in addressing.

I'd also like to say a few words about crisis management issues, and in particular about how we all might communicate more effectively in the event of future emergencies. But first, let me say that the self-regulatory organizations and industry groups - including The Bond Market Association - should be congratulated for their untiring efforts to coordinate industry efforts, to exchange information on market developments, and obtain regulatory input, in the wake of the terrorist attacks. Especially in a crisis, it is important that information flows widely and deeply, and these efforts were critical to a successful response to the September 11 disaster.

Inevitably, though, there will be a certain amount of confusion and miscommunication in a crisis, and some have said that the level seen in the days following the terrorist attacks was higher than it could have been. Several have complained that they lacked information about the initial decision to close the equity markets, and the timing of the reopening. Many learned of these decisions through the media, and perhaps rightfully believe they should have received this information directly from the regulators or the markets.

Communications problems also were present in the debt markets. Some have pointed out that the initial recommendation by The Bond Market Association that the debt markets close on Wednesday, September 12, was not widely disseminated, and that confusion surrounded the scope and timing of subsequent recommendations to reopen the markets and for pauses in trading. There also seemed to have been confusion concerning the scope of the The Bond Market Association's recommendation to extend the settlement cycle to T+5 - although it applied only to government securities, some thought it applied to corporate and municipal debt as well. And a few have expressed concern with the diffuse regulatory responsibilities for the debt markets, and the fact that no single entity seems to have the power to make a binding decision about their closing and reopening.

As a result of the September 11 experience, I think you can expect there to be renewed efforts to improve crisis management in the securities industry going forward. While, under the circumstances, it is difficult to truly fault the performance of the industry following the terrorist attacks, strengthening the procedures and mechanisms through which regulators and the industry communicate in future emergency situations undoubtedly would be a worthwhile endeavor.

Finally, I'd like to point out how the September 11 experience might provide insights into other current issues, particularly in the clearance and settlement area. Specifically, some are suggesting that these events demonstrate the importance of proceeding diligently to implement a T+1 settlement cycle and further restricting the use of physical certificates.

With respect to T+1 settlement, as you know, the goal of that initiative is to reduce systemic risk - particularly exposure to credit risk (and market risk that could generate credit risk) - and help prepare the U.S. securities markets to handle greater trading volumes. Many believe the impact of the events of September 11 was unusual in that the settlement fails that occurred resulted almost exclusively from operational problems. Most financial crises involve both operational and credit issues. In a sense, then, we were fortunate in the aftermath of September 11 because, had credit problems arisen, the systemic consequences would have been much more severe, particularly given the fact that the settlement cycle for government securities was lengthened to T+5. Thus, many are of the view that, in light of the September 11 experience, we need to proceed all the more diligently on the T+1 initiative in order to reduce the exposure of the clearance and settlement system to credit and market risks, and thereby reduce the chance that a future crisis will have a major impact on our financial system.

As for physical certificates, many are of the view that the September 11 experience demonstrates how physical certificates add cost and operational risk to the financial system. Several broker-dealers stored physical stock certificates for their customers in vaults beneath the World Trade Center, and those vaults were destroyed in the terrorist attacks. While efforts are being made by the Securities Transfer Association and others to streamline the replacement process, some point out that this problem would not exist if the U.S., like many foreign jurisdictions, had converted to either a dematerialized or book-entry only system. As a result, they argue that the use of physical certificates should be further discouraged, in order to avoid the operational and other problems they caused in the wake of the September 11 events.

II. Anti-Money Laundering Initiatives

The September 11th terrorist attacks also have brought renewed focus to our anti-money laundering efforts. On October 26th, the President signed the USA PATRIOT Act. The Act provides clear direction for the securities industry, the Commission and other financial regulators on steps we need to take together to detect and deter possible money laundering and terrorist financing through our markets.

We have been working closely with the Department of the Treasury as it moves to adopt rules to clarify the role of financial institutions in the anti-money laundering effort within the time frames Congress has called for under the USA PATRIOT Act. For example, attention is being directed to assure that all financial institutions have effective anti-money laundering programs in place, that they can effectively identify customers, and that they scrutinize business with foreign banks. In addition, in December, Treasury, with input from the Commission, proposed a rule to require broker-dealers to report suspicious transactions. We, along with Treasury, look forward to considering industry comments that further our shared goals of strengthening the effectiveness of our anti-money laundering efforts.

III. TRACE Transaction Reporting System

I thought I would also say a word or two today about corporate debt transparency and, in particular, the TRACE transaction reporting system. As you know, the TRACE system was developed by the NASD to improve transparency in the corporate bond markets by requiring NASD members to report transaction information on specified depository-eligible corporate bonds within one hour of trade execution. Bond transaction information will be consolidated and made publicly available under a phase-in schedule, with data on large-sized bonds distributed first, and data on smaller bonds distributed later.

The Commission approved the NASD's proposal for the TRACE system last January. We are hopeful the increased transparency provided by the TRACE system will enable investors and dealers to make better investment decisions, make the debt markets more efficient and more effective, and increase investor confidence. The TRACE system also should allow the NASD to develop a more proactive market surveillance program, and thereby foster public confidence in the corporate debt markets.

As you're aware, the NASD recently decided to delay implementation of the TRACE system until July 1 of this year. It did so in order to permit members to re-establish, to the extent possible, normal business operations in the wake of the events of September 11. Testing of the TRACE system will begin next month. While, under the circumstances, we certainly were sympathetic to the need for a delay in the implementation date, we look forward to TRACE ultimately commencing operations on July 1, and to the resulting benefits that will inure to the corporate bond markets.

IV. Alternative Trading Systems for Debt Securities

Let me now turn to alternative trading systems for debt securities. Debt alternative trading systems - other than those that trade only government securities - generally are subject to Reg ATS, and its various recordkeeping, reporting, fair access, computer system reliability, and other requirements. However, the national market system provisions of Reg ATS - relating to order display and execution access - do not apply to alternative trading systems for debt securities.

In addition, the Commission had been deferring the applicability of the fair access and computer system reliability requirements of Reg ATS to alternative trading systems for corporate debt securities, which apply to those systems that have 20% or more of the trading volume in either investment grade or non-investment grade corporate bonds. The Commission had been extending the compliance date for these requirements because, in light of the fact that the TRACE system had not yet been implemented, alternative trading systems for corporate debt securities would have difficulty determining whether they met the 20% threshold. This past November, however, the Commission declined to further extend the December 1, 2001 effective date of these requirements. In so doing, the Commission noted that, based on available data, no alternative trading system for corporate debt securities currently meets the 20% threshold, and it invited those who believe they may exceed that threshold to consult with the Division of Market Regulation.

More generally, there seem to be greater challenges establishing alternative trading systems in the corporate debt markets than in the equity markets. This may very well be due to structural differences in the corporate debt markets, such as the lesser degree of liquidity, large number of securities, lack of transparency, or other reasons. As you know, during the past year, there has been significant consolidation of corporate debt trading platforms as a result of mergers, or firms ceasing operations altogether - BondBook being a prominent recent example. In any event, it will be interesting to monitor the evolution of alternative trading systems in the corporate debt markets to see whether the promise of greater price transparency and anonymity through systems such as these will be realized.

V. Section 28(e) / Soft Dollars

Finally, I'll mention the recent Commission action in the soft dollars area. As you may know, Section 28(e) of the Exchange Act provides a safe harbor to money managers who use the commission dollars of their advised accounts to obtain research and brokerage services. Among other things, the safe harbor requires that a money manager determine in good faith that the amount of the "commission" paid by it was reasonable in relation to the value of research and brokerage services received. Previously, the Commission had interpreted the Section 28(e) safe harbor as only applying to transactions effected in an agency capacity, since the term "commission" generally connotes an agency transaction. Furthermore, when the Commission issued its original interpretation, an agency transaction had more cost transparency than a principal transaction, because frequently imbedded within the cost of a principal transaction was undisclosed compensation to the dealer. In other words, fees on principal transactions were not quantifiable and fully disclosed in a way that would permit a money manager to determine that the fees were reasonable in relation to the value of research and brokerage services received.

Last month, however, in response to a request from Nasdaq, the Commission modified its interpretation of the Section 28(e) safe harbor to include riskless principal transactions in Nasdaq-traded securities. In doing so, the Commission recognized that, since the time of its original interpretation, the NASD had modified its trade reporting rules for certain riskless principal transactions - specifically, to require a riskless principal transaction in which both legs are executed at the same price to be reported once, in the same manner as an agency transaction, exclusive of any markup, markdown, commission equivalent, or other fee. In other words, a money manager opting for such a riskless principal transaction would now be informed of the entire amount of a market maker's charge for effecting the trade.

Thus, the Commission interpreted the term "commission" in Section 28(e) to include a fee paid by a managed account to a dealer for executing a transaction where (1) the fee and transaction price are fully and separately disclosed on the confirmation and (2) the transaction is reported under conditions that provide independent and objective verification of the transaction price, subject to self-regulatory organization oversight.

Together with confirmation requirements, the NASD trade reporting rules mean that a money manager agreeing to a riskless principal transaction receives the same price as the counterparty to the trade, and this price is disclosed on a confirmation, which also discloses the amount charged for effecting this transaction. Thus, the Commission believes that a money manager buying or selling a Nasdaq-traded stock would now have the information necessary to determine whether the transaction fee paid was reasonable in relation to the value of the research and brokerage received.

The Commission also made it clear that transactions in other markets that meet the requirements set forth in the interpretation would be considered to fall within it. But the Commission explicitly noted that the interpretation does not currently apply to riskless principal transactions in the debt markets, because the confirmation and reporting requirements associated with these transactions do not meet the conditions of the interpretation. In other words, the confirmation and reporting requirements associated with riskless principal transactions in the debt market, and for that matter, principal transactions, do not afford money managers the level of transparency necessary to determine if the remuneration paid was reasonable in relation to the value received. Specifically, (1) fees for effecting principal transactions in the debt markets are not required to be disclosed under confirmation rules, and (2) debt securities are not subject to reporting rules that provide independent and objective verification of the transaction price subject to SRO oversight. I should also note that implementation of the TRACE system likely would not satisfy the second prong of this test, because TRACE requires trade reporting on a net basis, which would not permit independent and objective verification of the transaction price. So, it's fair to say that substantial changes to debt transparency and reporting would be necessary before the Section 28(e) safe harbor could ever be available for debt market transactions.

And with that, I end my prepared remarks. Thank you very much.


Modified: 01/10/2002