"The Risks and Rewards of Technology" Remarks by Chairman Arthur Levitt United States Securities and Exchange Commission International Federation of Stock Exchanges New York, New York -- October 13, 1997 I'm very pleased to be here today. This is an historic and exciting time for our securities and financial markets, and this organization plays a central role in addressing the challenges we all face. In the 1990's, we've witnessed an unprecedented expansion of global securities markets and an unparalleled revolution in the technology used to serve them. Technology has changed everything: from customer service, to the clearance and settlement of trades, to the very concept of what constitutes an "exchange." Every day we see new products, new trading mechanisms, and new investors. The benefits of technology are enormous. Perhaps the most significant development is the way technology is erasing the boundaries between our markets. As the Internet and high speed telecommunications become essential business tools, investors throughout the world are gaining greater access to markets and instantaneous trading information -- in ways that were unimaginable a decade ago. As we in the securities industry know better than most others, however, reward is almost always accompanied by risk. Rapid technological changes are presenting new challenges to our operational systems that must be addressed. We in the United States have been exploring ways to meet these challenges -- and so have you. We need to continue to work together to address these pressing issues. With that in mind, I thought it might be helpful to review how we're working to accommodate technology in three areas: exchange regulation, clearance and settlement mechanisms, and "Year 2000" computer conversions. * * * In the U.S., we're taking a global view of how our regulatory needs will shift as technology advances. We want not only to bring our regulatory structures up to date, but also to create regulations that are flexible enough to grow as technology advances -- in effect, creating a regulatory version of what software engineers call "open architecture." We recently issued a paper that examines how technology has transformed the concept of an exchange. The paper explores and invites public comment on ways that we can adjust our regulations to keep up with new developments. Our securities laws, like many of yours, were enacted at a time when most trading was done on the floor of an auction market. Indeed, in the 1930s, thinking about a screen-based electronic trading would have been viewed as fanciful and farfetched -- and about as likely to happen -- as having a portable device in your pocket that's no bigger than your wallet that is a telephone, an answering service, a rolodex, a newspaper headline service, and a stock ticker. Today there are numerous electronic trading systems that provide alternatives to traditional markets. Depending on the system, investors and other market participants are able to display, negotiate and execute orders confidentially, often reducing their trading costs in the process. In this remarkably creative and competitive era, and with the rapid expansion of computer power and bandwidth, the development of even more innovative trading systems is inevitable. The alternative trading systems we've seen thus far combine the characteristics of traditional exchanges and broker-dealers. Rather than regulate these entities as exchanges in the traditional sense, which would have imposed onerous restrictions out of proportion to their activities, the Commission initially chose to approach them as broker-dealers. However, this approach has not proven flexible enough to account for the growing volume and significance of these systems. In particular, under the current approach, alternative trading systems are subject to a regulatory scheme that may not be particularly suited to their market activities and may not provide for sufficient transparency, surveillance, and systems oversight. In the paper we published -- which is known in SEC jargon as a "Concept Release" -- we explored a number of ways to shrink these gaps. We could, for example, require these systems to satisfy certain standards for markets to ensure adequate transparency and investor protection. We are also considering ways to reduce unnecessary burdens on traditional registered markets, so that they can remain competitive amid technological advances. * * * As we review our domestic regulatory structures to accommodate developments in technology, we must always be mindful that the rules we make to protect U.S. investors will affect international markets. Likewise, developments in the international markets will almost certainly affect U.S. investors. A significant development addressed in the Concept Release is the growing number of foreign trading systems that provide access to U.S. investors. While most agree that access to cross-border trading opportunities benefits investors and markets alike, it nevertheless raises complex regulatory issues. The host country of a trading system would appear to have an obvious interest in regulating that system. That interest has to be balanced alongside the interest of other countries in maintaining high standards of investor protection in their markets. There is also the interest that we all share in avoiding overlapping and redundant regulatory burdens that can unnecessarily increase costs without any benefit to investors. Like the alternative trading systems that are appearing in the United States, cross-border trading facilities increase competition among existing markets. The goal of a jurisdiction seeking to regulate a foreign trading system should be to provide necessary investor protections without discouraging the extension of these systems to that jurisdiction's investors. The international community has been working to come to grips with these same issues. The FIBV has been at the forefront of these efforts, and I applaud your leadership. In its 1994 Report on the Regulation of Electronic Markets, the FIBV outlined a number of principles essential to regulating electronic markets in multiple jurisdictions. These principles promote functional regulation, which simply means that entities performing similar functions should face similar regulations. The Report also specifies the goals of any new regulations: they should promote fairness among markets, they should not create uneven competitive advantages, they should be flexible to foster innovation, and they should encourage self-regulation. These principles are a model for all of us. For our part, the SEC would be pleased to hear any of your thoughts on these issues as we go forward. We hope that our Concept Release may be of use to you as you explore similar issues in your home markets. * * * There are many reasons for us to continue to work together to address these issues. One of the most important is our common desire to reduce systemic risk. Simply put, this is the risk that a major market participant's problems will spread to other participants and markets, which in turn will spread to even more markets. Reducing and limiting systemic risk must be one of the most important and urgent objectives of our era. This will not only enhance investor confidence, it will pave the way for domestic and foreign trading systems to provide seamless services to the investing public. The clearance and settlement of trades is a key area for the reduction of risk. Reliable and efficient mechanisms to ensure that payment is made and securities are delivered are essential to liquid, attractive securities markets. The Group of Thirty, in March of 1989, emphasized that, to promote market integrity, there must be -- among other things -- a centralized securities depository, timely comparison of trades, and a delivery versus payment system. I agree wholeheartedly. It's been a priority of mine to improve the efficiency of the U.S. clearance and settlement system. One of the most effective steps we've taken is to shorten the settlement cycle for securities transactions from five business days to three. The shorter cycle gives us increased stability, capacity, and certainty; a reduction in credit risk; greater discipline among financial entities; and faster discovery and resolution of problems. We are pleased to see other countries moving towards shorter settlement cycles. Let me make special mention of the efforts of the United Kingdom, which had the difficult job of moving from a fixed, two-week settlement period to a rolling, five-day settlement cycle. I believe that shorter cycles will benefit all of us. And, because many investors now look to markets around the world for investment opportunities, it may be wise for us to consider establishing uniform, global settlement cycles to increase liquidity and enhance the movement of funds across markets. Another step we took in the U.S. was to convert from a next day funds settlement system to a same day funds settlement system -- which requires financial intermediaries to pay in funds that are immediately available. This system ensures that payments made today are good today. It also forces financial intermediaries to have the resources in place to meet their settlement obligations -- thus eliminating the risk of withdrawn or reversed payments. Disclosure is also important to understanding and controlling risk in the settlement process. Earlier this year, the International Organization of Securities Commissions and the Committee on Payment and Settlement Systems of the Central Banks of the G-10 Countries developed a framework for making important disclosures about securities settlement systems. This framework will help market participants evaluate the risks of participating in securities settlement systems. The Commission has asked major U.S. clearing organizations for their response to the disclosure framework, and I urge you to encourage clearing organizations in your own jurisdictions to complete the disclosure framework as well. In the U.S., there is still widespread use of physical certificates, which are at best an inefficient transfer mechanism. We've been taking steps to reduce dependence on physical certificates. For example, recently adopted U.S. market rules require book-entry settlement of most transactions between financial intermediaries; they also require that all exchange and NASDAQ securities be made eligible for deposit at a clearing agency. In addition, we are working with a group of industry representatives to develop what we call a Direct Registration System that allows retail investors to hold securities in book- entry form at the issuer, and to electronically move positions between the issuer and the investors' broker-dealers. Our hope is that all securities transfers will eventually be made electronically. I note that other countries are also putting into place electronic systems that streamline the settlement process. For example, the new Swiss model allows for the bundling of securities transactions -- combining the purchase or sale, settlement, and transfer functions in one single operation, all within a matter of seconds. Besides the obvious advantages of eliminating steps that could result in errors, this system all but eliminates transaction failures and counterparty risk. Each country must examine its own needs, however, and determine what clearance and settlement systems may work best within the structure of its markets. * * * There is one other technology-related issue I'd like to discuss with you today that is more prosaic than profound: the Year 2000 problem. As most of us have now learned, many of the computer programs in existence until just recently assumed that the first two digits of a year were always "19." These programs, therefore, provided for the entry of dates using only the last two digits of the year. If any entity, whether regulator or regulated, fails to fix its systems before the final tick of the clock on December 31, 1999, the result may be potentially catastrophic. All the date functions performed on the entity's computers would be invalid, leaving firms, investors, counterparties, and others with enormous exposure to risk. In June 1997, IOSCO urged all "members and market participants in their jurisdictions to take all appropriate and necessary action to address this critical matter." I cannot emphasize enough the need for the international securities industry to work together on this critical problem. The Year 2000 arrives first in Japan and will sweep around the world in 24 hours. Our systems must be ready to track it. To avoid the problems associated with the Year 2000, it is imperative that all trading, clearing, and operational systems be checked and reprogrammed well in advance -- a monumental task. All systems must be converted to avoid failures and disruptions in the international securities markets. The Commission is working with the U.S. securities industry to educate investment professionals and exchanges about these potentially devastating problems. On the international level, we must work together to prepare for Year 2000 conversions. Let me speak as candidly and directly about this subject as I can. The SEC realizes that there are other important technology issues that demand immediate attention. Among these are the anticipated "Big-Bang" in Japan's securities and financial industries, and Europe's move to the European Monetary Unit. These issues likely will consume significant resources. However, if we fail to correct the problems raised by the coming millennium -- a deadline that obviously cannot be bumped or delayed, fudged or finessed, even by a single second -- we risk serious disruptions to the world's securities and financial markets, and I daresay enormous damage to our economies. These disruptions could undermine any progress we make to resolve these other issues. We therefore need to coordinate not only on the EMU and Japan's Big-Bang issues, but also on Year 2000 problems. And while it may not be as exciting or inspiring, the Year 2000 problem must be at the top of the list. The Commission has already taken several steps to address this issue. Our efforts have centered on encouraging swift and aggressive action and actively monitoring progress among the exchanges, the NASD, and the clearing agencies. We are also speaking to public companies, reminding them of their disclosure requirements, and offering informal guidance about how to apply those requirements to the Year 2000 problem. In addition, we're working with industry groups to educate the public on the issue. The U.S. exchanges and the NASD likewise have taken an active approach to the Year 2000 problem by emphasizing to their members the importance of preparing their computer operations -- and by putting their members on notice that they will be held accountable for failing to do so. Starting in early 1999, industry-wide systems testing will begin in the United States, involving exchanges, registered clearing corporations, depositories, and broker-dealers. The Commission regards this industry-wide testing program as critical to the Year 2000 effort, and we expect the entire industry to participate. An essential component of all Year 2000 preparations is contingency planning. This includes creating back-up capabilities to recover from any unexpected operational glitches that may arise after January 1, 2000. It also includes planning for possible failures of brokers, dealers, transfer agents, and clearance and settlement firms. Exchanges themselves must also create and test contingency plans. We are fortunate to have a strong working relationship with our exchanges, the NASD, securities firms, transfer agents, clearing firms, investment companies and advisers, and mutual fund complexes. But as I said earlier, it's not enough to address this as a domestic problem. It's vital that all securities exchanges, regulators, and industry participants in every corner of the world make certain that Year 2000 computer conversions and contingency plans are in place by early 1999 to allow for global testing. We must coordinate our efforts now, in order that global systems testing can begin in early 1999. The FIBV can play an essential and invaluable role in addressing the Year 2000 problem. You can stimulate action by your members to take needed steps, including industry-wide testing well in advance of the year-end. This will afford everyone a few months to work on any unforeseen problems, to ensure that we are all ready for January 1, 2000. * * * The market today is very different from the one that existed when I entered this business as a stockbroker several decades ago. Indeed, it has changed dramatically during the four years that I have chaired the Commission. Technology has made trading information and other valuable services broadly available. It has reduced the cost of entry, and it has allowed greater participation in worldwide markets. Transactions that used to take several days and involve substantial labor can now be accomplished at the touch of a button. New instruments that fulfill important investment strategies can be brought to market with increased speed. And investors can now obtain real-time trading information from a variety of on-line sources. * * * These dramatic changes present major challenges to our regulatory and oversight structures. At times like these, the initial reaction is sometimes to scrap the old system. Yet even the most zealous revolutionary would have to agree that the international capital markets are working quite well. It would be foolish to throw this working system out the window, in the name of modernization. But it would be equally foolish to assert that there is no room for improvement, or to resist change in the name of our current success. Change can be disruptive. But the securities industry has succeeded spectacularly not by resisting change, but by embracing it. Change has always been the hallmark of our markets, and we have succeeded by recognizing that fact and responding to it. I look forward to continuing to work with all of you to maintain that proud record of achievement. # # #