finra

James P. Donovan
Senior Executive Vice President for Technology and Strategy

XBRL US National Conference

 

November 18, 2009

As prepared for delivery

 

Thank you for the invitation to speak and thank you all for coming today.

 

This is an important time for the U.S. financial markets. While the equity markets have made up some of the losses incurred over the past two years, there is still considerable uncertainty, given how close we came to a global financial meltdown. Congress and the regulatory agencies are now moving to modernize the regulatory structure of our financial markets, which should help to prevent a repeat of the conditions that led to last year's extreme volatility.

 

The task before us isn't easy and the proposed remedies won't be universally popular—nor will they guarantee an end to market volatility or financial wrongdoing. However, what remains constant throughout the debates is the call to boost investor protections, enhance transparency and streamline the way we share information.

 

The market meltdowns and scandals of the last two years highlighted some of the vulnerabilities of our current financial system. There is a clear need to reform our financial system and increase the effectiveness of our regulatory oversight. Part of that process is gaining an understanding of the underlying problems that led to the global market meltdown.

 

I won't rehash the ongoing analysis of what went wrong or the failures of the current system. But an overarching lesson that has been learned from these recent scandals, and the broader market volatility, is the need for greater transparency across financial markets. Investors need to be able see more in the markets, because informed investors are more likely to understand risks and rewards, and calibrate their investment decisions based on this information.

 

Just as investors need more information, so do regulators. One of the fundamental challenges facing any financial regulator is trying to keep pace with the constant change that defines financial markets. We can't afford to forget that the financial industry is in a state of perpetual motion—constantly offering new products to new customers. On the other hand, the financial regulatory system tends to be less dynamic. Part of the long-term objective of financial reform must be to create an architecture in which regulations can evolve to adapt to the inevitability of changed circumstances in the financial sector.

 

At FINRA, we've launched a number of initiatives that will help us gain a better understanding of what's unfolding throughout the markets, and I will talk about those. But there's even more to be done, given the structural changes in the markets that have had the effect of obscuring information and eroding the ability of regulators to identify developments that could be a preview of troubling market trends. I will talk about some of those challenges, and some of what's underway to address them. A standardized language for financial reporting is a valuable step in the right direction. It will benefit public companies, investment companies, regulators and, most importantly, investors.

 

FINRA Initiatives

 

I'd like to begin by exploring some of the work underway at FINRA focused on how we can more effectively carry out our mission of serving as an advocate for investors.

 

Over the past several months, FINRA has enhanced our routine examination programs and procedures to better detect fraud. We have also provided new training programs on fraud detection for our examiners. Last March, we established an Office of the Whistleblower to handle high-risk tips. And just last month, we formed a new Office of Fraud Detection and Market Intelligence. This office will provide a heightened review of incoming allegations of serious frauds, and serve as a centralized point of contact internally and externally on fraud issues.

 

Looking forward to the broader issue of reforming financial regulation, we are focused on specific issues, including the need to harmonize the regulation of broker-dealers and investment advisers to enhance investor protection.

 

We believe there are two main avenues to achieving reforms that enhance investor protection: The first is establishing a consistent fiduciary standard for investment advisers and broker-dealers providing investment advice, and the second is harmonizing the oversight and enforcement of that standard and the other rules relevant to each channel to better ensure compliance.

 

FINRA also believes that Congress should authorize the SEC to designate one or more independent regulatory organizations to augment the SEC's efforts in overseeing investment advisers to better protect investors regardless of how their financial professional is registered.

 

Transparency

 

As I mentioned at the outset, FINRA is also focused on promoting greater market transparency. The financial industry on the whole has to assess whether investors are getting the information they need to make sound financial decisions. And we, as participants in the financial markets—whether regulators or broker-dealers or finance managers of public companies—are obligated to provide investors with a more effective disclosure process.

 

At FINRA we have announced two major initiatives this year to improve the transparency of market information:

 

BrokerCheck

 

In April, we proposed a major expansion of FINRA's BrokerCheck service. BrokerCheck is a free online system through which investors can instantly see the employment, qualifications and disciplinary history of more than 650,000 brokers under FINRA's jurisdiction. 

 

Under the current rules, a broker's record generally becomes unavailable to the public two years after he or she leaves the securities industry and is therefore no longer under FINRA's jurisdiction.

 

We estimate that there are more than 15,000 individuals who have left the securities industry after being the subject of a final regulatory action whose disciplinary history is not currently available on BrokerCheck.

 

Our proposed expansion would make records of final regulatory actions against brokers permanently available to the public, regardless of whether they continue to be employed in the securities industry. This expansion will address one problem we've seen in a number of recent frauds: Individuals previously barred by FINRA and other securities regulators have resurfaced as perpetrators in other scandals responsible for millions of dollars lost by unsuspecting investors. We believe that making brokers' records available on a permanent basis will prevent unscrupulous financial professionals who were barred from the securities business from moving on to other firms within the broader financial industry.

 

TRACE

 

We've also made another one of our transparency services—TRACE, which is the Trade Reporting and Compliance Engine—more robust by including debt issued by federal government agencies, government corporations and government sponsored enterprises (GSEs), as well as primary market transactions in new issues.

 

Currently, TRACE reports real time pricing and trade volume information only on corporate bonds trading in the secondary market. Investors using TRACE can find out recent trading activity, pricing and trading history on bonds they're interested in purchasing.

 

Last month, we proposed further expanding TRACE to include all asset-backed securities, including mortgage-backed securities and collateralized debt obligations. If approved, this expansion would enhance our ability to supervise the market through a better-informed surveillance program designed to detect fraud, manipulation, unfair pricing and other misconduct. It would mean that nearly 70 percent of the U.S. debt market would be subject to FINRA surveillance, compared to 27 percent currently. Our proposal to collect data on asset-backed securities would also emphasize disclosure as an effective means of creating more stable capital markets.

 

Since FINRA introduced TRACE in 2002, we've seen the benefits of increased transparency in the corporate bond market. Not only has TRACE helped regulators identify manipulative activity, but it has contributed to better pricing, more precise valuations, narrowed bid-ask spreads and reduced investor costs in this market. Some independent studies indicate that TRACE has reduced annual trading costs by nearly $1 billion for the full corporate bond market. For regulators, this points to a demonstrated need for continuing to improve market transparency—particularly as we move forward from the financial crisis. Enhanced disclosure in these markets will allow FINRA proactive oversight and a deeper understanding of market dynamics.

 

Market Structure Shift

 

Let me turn now to the structural changes in the markets, and FINRA's efforts to consolidate market data and reduce fragmentation. 

 

The structure of U.S. markets is such that the impediments to regulatory effectiveness are not well understood. This is potentially damaging to the market's integrity.

 

Specifically, we are concerned about the increasing number of genuine liquidity centers that have emerged—and how these cloud the ability of regulators to oversee what's happening in the markets.

 

As our CEO Rick Ketchum said at the SIFMA annual meeting a few weeks ago,

"The decline of the primary market concept, where there was a single price discovery market whose on-site regulator saw 90-plus percent of the trading activity, has obviously become a reality. In its place are now two or three or maybe four regulators, all looking at an incomplete picture of the market and knowing full well that this fractured approach does not work. This is especially true given how easy it is for market participants to move volume on a second-by-second basis between venues."

What we know already is that the audit trail is clouded by changes in the equity market structure. In other instances, order information remains inconsistent and incomplete. We've heard a lot recently about dark pools. And though FINRA serves as the trade repository and regulator of dark pool activity, it's not always clear what activity stems from the pool and what emerges from unrelated desks throughout the firms involved.

 

Further muddying the issue is the variation in data quality across the exchanges. There is no definite set of reporting requirements. And though the market is demanding increased transparency, it's becoming easier to hide the identity of the actual participant in a trade report. It can be days before we understand the participants and particulars of a trade.

 

We believe that, at a minimum, all market data needs to be consolidated. Then, that consolidated data pool should be surveilled by a unified single regulator—a single regulator that can bring together the best technology, the best people and a unified set of rules.

 

Today, there are multiple regulators attempting to respond in a timely way to market changes. A stronger, single regulator would be equipped to meet market surveillance objectives more effectively, and with less expense.

 

Data Sharing & Financial Reporting

 

FINRA's commitment to reforms that help to reduce market fragmentation and increase market transparency extends to financial reporting, as well.

 

We support the concept of standardizing language for communications between private organizations and government. This concept aligns with our focus on better data sharing and our commitment as regulators to share more and better data with each other. Just last month, FINRA signed a memorandum of understanding on information-sharing with the French regulatory body, l'Autorité des marchés financiers (AMF). The agreement establishes a formal basis for cooperating, sharing information on market surveillance and investigations of market abuse and it facilitates the sharing of information on trading by firms that fall within our respective jurisdictions.

 

This agreement with France's AMF follows another agreement we made this summer with Canada's IIROC, the Investment Industry Regulatory Organization of Canada. Like the agreement with AMF, the IIROC agreement enhances the way we share information and cooperate on firm oversight and examinations.

 

Given the evolution in global markets, regulatory agencies must cooperate more effectively. Although regulators are increasingly working together to regulate globally active firms, we need to enhance how we share information we gather among agencies and independent regulatory bodies, both nationally and internationally. We believe that a standard reporting language would facilitate the sharing of information among regulators and agencies.

 

Equally important, a shared language and platform for financial reporting can help to ensure that investors are protected and can get the information they need to make sound investment decisions. The SEC has taken the lead and we applaud the Commission's initiative to transform and improve financial reporting and mutual fund disclosure. Requiring mutual funds to provide risk/return summary information, and requiring public companies to provide financial statements in a manner that is more useful to investors and in a format that can be easily downloaded, are encouraging developments that will help to foster a more informed marketplace.

 

When we look at financial companies—which have been at the center of the recent global financial crisis—we clearly see how closely investors associate the value of assets to the value of the financial entities themselves. Going forward, we need to work toward increased transparency in balance sheets of all companies.

 

As a regulator dedicated to protecting investors, we believe an informed investor is a safer and more confident investor. And we believe a streamlined reporting process, standardization of financial reporting and risk/return disclosures will help investors make more informed investment decisions and help reduce risk. From a regulatory standpoint, we believe it will also allow regulators to better analyze underlying risk factors.

 

Conclusion

 

This is a challenging time for all involved in the financial markets, and especially for regulators who are charged with protecting investors. And a fundamental challenge is to earn back the trust of investors—a trust that many feel has been betrayed twice over the past decade—first with the technology boom and bust, and then with the real estate boom and bust.

 

In 1938, just a few years after the Securities and Exchange Commission was founded, the Commission's chairman, William Douglas, spoke to the importance of trust in the markets. He said,

"To satisfy the demands of investors there must be in this great marketplace not only efficient service but also fair play and simple honesty. For none of us can afford to forget that this great market can survive and flourish only by the grace of investors."

That statement is as true today as it was 71 years ago. At FINRA, we're committed to not only reforming the regulatory system, but to innovation that will improve market efficiency and boost investor confidence. We applaud the technological innovations, and especially a standard reporting platform for financial data. As regulators, we know a shared standard is inevitable, and the transparency it promises to bring will help to ensure investor protection and market integrity.

 

Thank you for listening. I'd be happy to take your questions.