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U.S. Securities and Exchange Commission

Speech by SEC Commissioner:
Remarks to the Federal Reserve Bank of New York

by Commissioner Laura S. Unger

U.S. Securities and Exchange Commission

New York, New York

October 7, 1999

Thank you for inviting me to speak before the Federal Reserve Bank of New York. As an SEC regulator, it is so rare to be invited to come to speak at the Federal Reserve. I have been following with some interest the debate over whether the central banks should continue to sell off their gold reserves and have been wondering what that means for the gold vault that is housed in this building. I heard that you are considering renting it out to hold Pokemon trading cards -- which are now more valuable than gold.

Today, I want to discuss the changes that electronic trading is bringing to the markets, their impact on Commission regulation, and the challenges ahead for securities regulators. Before I begin, I must make the standard disclaimer that the remarks Iím about to make are my own and do not necessarily reflect the views of the Commission, its staff, or the other Commissioners.

Changes that Electronic Trading is Bringing to the Markets:

Let me touch briefly on three trends fueled by electronic trading: the rising dominance of on-line brokers, changes to market structure, and changes in the capital formation and corporate governance process.

The Rising Dominance of On-line Brokers:

The most significant trend in the securities markets today is the increase in competition due to the rise of new market participants -- on-line brokers. On-line brokers empower investors by giving them more choices and more information. Fueled by the longest bull market in history, new on-line brokers are giving traditional full-service firms a run for their money.

In 1994, there wasnít a single broker on the Internet. Today, there are 160 broker-dealers on-line, accounting for about 16 percent of all equity trades and over one-third of retail customer trades. These entrants have increased access for investors by offering lower prices for services. Commissions for on-line trades have dropped about 70% in the past two years, from around $53 to around $16 today.

Asset gathering, data mining, and cross selling have become the strategies of choice in competition for market share from individual investors. Technology has developed to the point where diversified financial firms can develop highly sophisticated customer profiles based on past observed behavior, combine it with transaction history, and deliver highly personalized information to their customers.

According to Meridien Research, the securities industry will increase its spending by about 14 percent a year on "customer relationship management" software -- more than any other financial services provider. In 1998, the securities industry spent between $120 and $170 million on such software. By 2003, the securities industry will spend between $250 and $300 million. Of course, the securities industry is still trying to catch up to commercial banks, which spent over a billion last year on customer relationship management software. Finally, diversified financial conglomerates may be able to profit from the synergies that have eluded their predecessors. The financial industry seems poised to achieve the holy grail of on-line brokerage -- the industrialization of financial advice.

The on-line stampede is contributing to the blurring of distinctions between competitors in the field of financial services. While banks are buying broker-dealers - Chase just announced a deal to buy Hambrecht & Quist, broker-dealers are buying thrifts -- E-Trade announced a deal to acquire Telebank. Even unusual competitors are getting into financial services. Wal-Mart, AAA, State Farm, have all sought thrift charters. Yahoo! Finance, Microsoft Money Central, and Quicken.com are all competing against banks and broker-dealers for usersí "eyeballs." A Yahoo! representative even suggested that they would consider chartering a bank if their customers wanted it.

Changes to Market Structure:

Technology has also blurred the lines between exchanges and broker-dealers by enabling remote trading, away from the traditional market centers. Before the creation of the SEC, there were 32 organized exchanges in the United States with thousands more issues trading in the over-the-counter market. Today, there are eight exchanges and nine electronic communications networks, or ECNs, that function similarly to exchanges.

However, even exchanges and ECNs are not the whole story. Today, broker-dealersí internal routing systems compete for order flow with these more traditional market mechanisms. In fact, these new electronic trading platforms are putting unprecedented pressure on the traditional floor-based systems. Established markets and exchanges with huge infrastructures to support have been looking for ways to remain competitive in this new environment. As a result, the NASD and NYSE have been considering making public offerings and private placements in order to streamline decisionmaking and infuse cash.

Because of the entry of low-cost competitors, established markets in London, Stockholm, Hong Kong, Australia, Toronto, and now the NYSE , Nasdaq, and the Pacific Exchangeís equities business, have either demutualized or are considering doing so. Eight European exchanges are creating a common trading platform to compete against the U.S. exchanges. Exchanges around the world are doing what eBay has done for on-line auctions -- attracting liquidity to their systems.

Changes in the Capital Formation and Corporate Governance Process:

Technology is also starting to affect the securities offering process by making securities offerings more widely available to individual investors. It was only four years ago that the first issuer, Spring Street Brewing, used the Internet to offer its shares to investors. At that time, it was a very new process to us. We even asked Spring Street to halt the offering -- only to let them proceed with a few modifications. We have come a long way.

We recently granted no-action relief to Wit Capital, an on-line broker-dealer created by the same people who brought us Spring Street Brewing, so that it could distribute IPOs electronically without violating the prohibitions in the Securities Act of 1933. Now, on-line brokers such as

E-Trade and Schwab are offering IPOs to their high net worth customers on a first-come first-serve basis. The staff of the Division of Corporation Finance is preparing to recommend that the Commission issue an interpretive release addressing certain issues arising under the Ď33 Act in connection with the electronic offering process.

Corporate Governance and Shareholder Relations:

The Internet is also changing the process of corporate governance and shareholder relations. Individual investors want unprecedented access to issuer information: many companies post in multimedia format corporate information such as periodic reports, names of analysts who follow the company, consensus earnings estimates, and even live analyst conference calls. The Internet also gives shareholders an unprecedented ability to organize: a large money manager can post its proxy voting record on-line so that investors can consider it as they vote their own proxies; a mutual fund, aptly named the Open Fund, posts every trade that it makes on its website; some shareholders even try to solicit proxy votes on-line.

While, in some cases the Internet gives more access to information to individual investors, in other cases it highlights the significant informational disparities between institutional and individual investors. For example, institutional investors may view preoffering roadshows where companies make earnings projections not disclosed in the offering documents.

While more and more companies have begun opening up analystsí calls to investors, issuers may follow up the webcast with private one-on-one calls to the analyst. We also hear about analysts who disclose two sets of projected earnings estimates -- one for their institutional clients and one for the investing community at large. In fact, some earnings whisper numbers posted by amateur websites have proven more accurate than the earnings estimates publicly disclosed by analysts.

As an aside, I will mention that some tell us that selective disclosure will always exist and that some investors will always enjoy an informational advantage over other investors. It has been a particularly vexing issue for the Commission over the years. I understand that the staff disagrees with this view and is planning to recommend disclosure rules to the Commission to address the problem of issuers selectively disclosing material non-public information.

The Internetís Impact on Commission Regulation:

Let me explain how the Internet has impacted our regulation. There are a number of goals underlying our body of regulation. The three most important are: protect investors, promote fair and orderly markets, and promote fair competition. Investor protection, partially through disclosure, is at the cornerstone of securities regulation and of investor confidence in the securities markets.

The disclosure-based underpinnings of the federal securities laws lead us to a regulatory philosophy that is different from banking regulation, which does not contain an investor protection mandate, but rather is premised on ensuring that banks operate in a safe and sound manner.

Many people ask me how technology has affected the way the Commission regulates. We generally follow the same rules on-line as we do off-line. In many situations -- such as dealing with fraud -- we need nothing more than additional resources. Although we do not currently need additional laws to deal with on-line fraud, the wide and almost instantaneous reach of some of the scams mean we have to act more quickly to protect investors.

In the past five years, we have brought enforcement actions for alleged fraudulent on-line investments involving coconut plantations in Costa Rica, eel farms, the developer of an "underwater city" called "New Utopia" (he claimed that we had no jurisdiction over him), a car dealer who claimed that he had found cure for HIV, and a furniture maker who was trying to raise funds in order to build a space station. (It never took off.) Even a number of traditional prime bank fraud schemes have moved on-line. We now have a 250-person part-time cyberforce searching for fraud on the Internet.

Enforcement has also been vigilant in monitoring the Internet bulletin boards. These boards show both the promise and peril of the Internet. While investors may learn a great deal of very good information through these sites, fraudsters also use them to "talk up" or "talk down" a stock. We are now beginning to see a particularly vexing type of stock fraud -- stock manipulators who collude using Internet bulletin boards to talk the price of a stock up or down momentarily so that they can take a quick profit.

Much on the Enforcement front is actually good news. The Internet allows to us to catch some frauds before investors lose a penny. We have filed a number of cases involving similar violations together as part of concerted "sweeps." In some of the offering cases, investors had actually visited the sites allegedly making unregistered offerings over the Internet, but no sales were made.

However, by bringing a number of these actions simultaneously, we are able to get in early and send out a strong deterrent message before investors were actually harmed. The Internet provides a window into developing fraud that was never before available for viewing.

Some also claim that the anonymity of the Internet poses a challenge to us. That is not true, however, in most cases of on-line securities fraud. Fraudsters must show themselves in order to find victims, and when they show themselves so they may be anonymous -- temporarily -- but not invisible. Most of these fraud artists also leave a trail that is fairly easy to track. We follow the footprints left by the money, the marketing, the audit trail, and the trading.

When we do prescribe more specific rules to take into account changes necessary due to the Internet, we try to keep them "technology neutral."

A significant rule in the off-line context where broker-dealers say that different rules should apply on-line is determining whether they have an obligation to recommend only suitable securities to their customers. This is the Commissionís version of the "know your customer" rules.

According to news reports, suitability claims were the number one complaint filed in arbitration last year although we do not know how many claims were against on-line firms. On-line firms tell us that they do not believe that they have any suitability obligations because they do not "recommend" securities to their customers.

However, I am sure that you have all heard about the Amazon.com model of profiling where a bookstore recommends books to a web user based on past purchases. If, like Amazon.com, broker-dealers develop user profiles based on observed behavior or transaction history and bring information about specific securities to that userís attention, that information looks much more like a recommendation which must be "suitable" for the investor. Let me give you some examples:

  • An on-line broker-dealer sees that an investor tends to purchase shares of blue chip companies after its stock price has fallen will be able to send an e-mail to the investor when the stock price of a similar blue-chip company has fallen.
  • An investor has what he believes to be a well-diversified portfolio of stocks. The investorís on-line broker-dealer e-mails a report to him at the end of the year demonstrating that he is actually not as well diversified as he believed to be, and suggesting how to recalibrate his asset allocation.
  • A broker-dealer preparing an IPO for a PC manufacturer could use its data warehouse to find a 60-year old Iowa investor who likes PC manufacturers and has never sold any of her holdings in such companies.

Resolving the issue whether suitability applies in these situations will become more pressing as the firms develop their data mining capabilities and personalize the information that they deliver to investors.

Commissionís Challenges for Regulation:

I would identify the Commissionís future regulatory challenges based on three trends: the consolidation of financial service providers, the globalization of the markets, and the demutualization of the exchanges.

Consolidation of Financial Service Providers:

Probably the most familiar challenge to this group involves the supervision of vast geographically dispersed financial conglomerates.

Since 1997, when the Federal Reserve relaxed the restrictions on affiliations between banks and securities firms, we have witnessed some very notable mergers of banks and securities firms: Alex Brown and Bankers Trust (now DeutscheBank), NationsBank and Montgomery Securities (now Bank of America), Fleet and Quick and Reilly (now Fleet Boston), and Citicorp, Salomon Smith Barney & Travelers Group. These financial services behemoths offer a broad range of services to a large customer base.

Much of the debate over financial modernization has centered on whether certain activities may be conducted in a bank affiliate versus a bank subsidiary. Irrespective of where the activity is conducted, I believe the regulators need to coordinate more. Myopic regulation of full service financial providers benefits no one. As we have seen, it sometimes takes only one trader sitting in Singapore to bring down the bank.

So how will the Commission and the Federal Reserve regulate the industry in the new millennium? As I mentioned earlier, the Commissionís mandate is investor protection while the Federal Reserveís mandate is safety and soundness of the institution.

Absent legislation clarifying our respective seats at the table, I would urge that we work to make room for each other. As lines blur and financial services providers grow, it will be particularly important for the bank and securities regulators to protect the integrity of the financial industry as a whole.

Globalization of the Markets:

A second challenge for the Commission is delivering on the promise of on-line cross-border trading. While competition is global, regulation remains local.

As you know, the Federal Reserve directly regulates a foreign bank only when it has a physical presence in the United States. The Commission has taken a different approach to regulating foreign broker-dealers. About 18 months ago, the Commission issued an interpretive release setting out when a website should be considered an "offer" or "solicitation," and thus, subject to U.S. regulation. Essentially, the release states that an Internet presence in the U.S. is okay so long as the foreign broker-dealer or foreign exchange takes reasonable steps to ensure that no securities transactions result with U.S. investors.

In 1997, the Commission published a Concept Release that considered three approaches to cross-border trading. The first alternative would allow cross-border trading from countries that had "comparable" regulation. This is fairly similar to the Federal Reserveís approach in allowing foreign banks to establish a presence in the United States if they are subject to comprehensive consolidated supervision in their home country. The second approach would require all foreign markets to register as exchanges but then would grant exemptions from registration. The third approach would let foreign markets trade with U.S. investors under a more narrowly tailored regulatory scheme than exists today.

We have not yet decided which approach would best accomplish our regulatory goals. Before we address the issues raised in the Concept Release, the Commission must reconcile what has been to date the irreconcilable differences in disclosure standards around the world. One of the biggest sticking points in this discussion has been developing an acceptable international accounting standard. The Commission plans to issue a Concept Release on international accounting standards soon.

Demutualization of the Exchanges:

The third and most immediate challenge will be to re-examine the self-regulatory system in light of the impending demutualization of U.S. securities markets.

One of my principal concerns is how to address the conflicts that arise between a demutualized exchange being an independent and well-funded regulator and a public company accountable to shareholders for maximizing profits. It is possible that the inherent conflict that exists even today between being a regulator and a market competitor will be heightened once an exchange goes public. Those questions and others are questions of first impression for the Commission that will have to be answered as technology pushes market restructuring.


I have touched upon a lot of issues. However, the one message that I want to deliver is that we need to continue to encourage competition without losing sight of our mission to promote confidence in the financial markets. As the financial services landscape changes and consolidates, both agencies need to work together to maintain the trust that U.S. markets enjoy today.