finra

Rick Ketchum
Chairman and Chief Executive Officer

FINRA Annual Conference Welcome Remarks

 

Washington, DC

May 19, 2014

 

Note: An audio podcast of this speech is available.

 

Restoring Investor Trust in the Markets

As prepared for delivery.

 

Good morning. It's my pleasure to welcome you to another FINRA Annual Conference. It's good to have you here and to see so many of you again.


For the next few days, all of us are going to have opportunities to talk about the issues facing firms. And I look forward to being part of many of those conversations.


My remarks today are centered on trust—I want to talk about the role FINRA is determined to play in restoring investor confidence and trust in the securities industry. I want to talk about the challenges we are facing, and how we plan to address those issues—how we're planning to move to a new age of regulation.

Seven years ago, we were faced with one of the worst financial crises this country has ever seen. That event—and others that followed—have spawned a seven-year crisis of their own, a crisis of confidence among investors.


Think about it.


Starting with the credit crisis in 2007 and the market plunge of 2008, to the devastating frauds of Madoff and Stanford, to the Flash Crash and other market disruptions—investors have witnessed a string of events over the better part of a decade that have left them with the perception that our capital markets have fundamentally changed. And not for the better.


To many investors, the markets have become complex to the point of seeming inaccessible. So it should come as no surprise that there's been a loss of confidence. It should come as no surprise that investors are feeling de-emphasized and vulnerable. The current debate on high-frequency trading and market structure only adds to the confusion.


I suspect that everyone in this room is affected by this issue. These investors are your customers, and you must be feeling that same vulnerability and lack of trust.


It's frustrating, to say the least, if not distressing. When the vast majority of firms and registered reps are honestly committed to putting the investor first, but that investor is too skeptical to engage, what can you do? What can FINRA do? How can we work together to regain investor trust?


That's what I want to talk about today.


FINRA is determined to be a key engine in restoring trust in the securities markets. Can we solve all of this country's consumer and market issues? No. But we can tackle many of them—and how we do that is what I'm going to focus on this morning.


I want to share our vision for revolutionizing how we regulate firms and the markets. And, I want to invite you to join us in realizing this vision. Because none of us can stand by in good conscience and let investor confidence continue to erode. We are all in this together.


Before I jump into where we are going, I think it's constructive to briefly review where we are today. We have already done a significant amount of work over the last few years to improve our ability to protect investors and maintain market integrity. Our risk-based exam program—which you've heard me talk about frequently—is one of the most meaningful results of that work.


So, let's talk a bit about the current state. One of the changes you may have noticed about our risk-based exam program is that it's now more data-driven. We are collecting more information electronically weeks before a scheduled exam and using available technology to better manage and analyze that data. To do this efficiently, last year, we fully implemented the Request Manager system, which streamlines the exchange of information between firms and FINRA and improves our ability to obtain and analyze data before conducting exams.


The Risk Control Assessment (RCA)—now in its third year—is another example of how we're collecting data electronically and analyzing it with a focus on risk. The data that we get from this survey allows us to better understand the business activities that firms engage in, the products and services they sell, and the kinds of clients and counterparties with whom they deal. Using what we're learning from the RCA, we're also now better able to identify and prioritize the underlying risks associated with a firm's business model, and gain an understanding of the controls intended to manage those attendant risk exposures.


This data-driven approach has already resulted in a sharper focus and narrower scope of many of our exams. We're spending more time reviewing information from you before we show up, which means more efficient exams. 


In addition to the data we're collecting as part of the exam requests, we are now also leveraging transactional data—such as the data we gather via TRACE—to inform our exams. By taking a look at this information, we can identify riskier transactions and narrow the field of customer accounts and information that our examiners review.


Understanding individual transactions is only one facet, though. We also use risk analytics at the account level to identify customer or house accounts with outsized risk positions to narrow the field for our coordinators and examiners. Using this kind of analysis, our coordinators can better plan our exams and our examiners can focus their time and resources on, for example, suitability reviews and other serious business conduct concerns where there is a higher likelihood of harm to investors. 


Another way we are using data to help us quickly home in on risk is through our oversight of individual, high-risk brokers. Early last year, we launched an initiative to identify for targeted, expedited review those individual reps who pose a significant risk to investors or the industry—and where they have harmed investors and violated our rules, to bar them from the industry as quickly as possible. This "High Risk Broker Program" uses incoming regulatory intelligence such as broker terminations, complaints, tips, arbitrations and field reports from ongoing exams to pinpoint brokers we want to quickly investigate. Since we introduced the program last year, we have expanded it, and this year created a dedicated enforcement team to pursue high-risk broker disciplinary cases.


All the work I've just mentioned is important to advancing our risk-based exam program. And we are seeing a difference in the speed and efficiency of our exams. But these are still discrete, point-in-time programs that are characterized by the collection of information on an ad hoc basis.


If that's all that we needed to do to boost investor confidence, I'd step off the stage right now. But clearly, there's still more work to do. We need to take our vigilance to the next level and leverage the advanced technology now at our disposal. We need investors to understand that there is ongoing, aggressive monitoring of how firms and reps are investing their money. We need investors to understand that we are watching the markets like hawks—and monitoring to see that orders are handled fairly. We need investors to understand that when we see potential or existing harm, we can respond quickly. We need investors to trust in the markets again.


In short, FINRA's role in responding to these needs—and our role in promoting investor confidence—should be focused on a single, strong set of organizing principles. Those are:

  • to be data informed,
  • to be technology empowered,
  • to be responsive to change, and
  • to be capable of more quickly and effectively identifying and disciplining bad actors.


These overarching principles will guide us in our rulemaking, our firm examination programs and enhancements to our market surveillance going forward.


An important cornerstone of fulfilling these principles is CARDS—or the Comprehensive Automated Risk Data System. CARDS is the next step—and big leap forward—in the evolution of our risk-based regulatory programs. CARDS will allow us to collect and manage data from firms in such a way that we can quickly identify trends and product concentrations that are harmful to investors and take swift, responsive action.


With the technologies that are now available to us, we can do things to transform our exam program in ways that haven't been available to us before. And frankly, it would be unconscionable not to embrace these technological advancements to better fulfill our investor protection and market integrity mission.


Using those technologies, CARDS will allow us to collect information—the same information we're already collecting on an ad hoc basis as part of our examination program—in a standard format across all firms on a regular basis. 


CARDS will provide us with on-going "birds-eye view surveillance"—similar to our current market regulation program—that complements our boots-on-the-ground exams. Let's face it: Regulators will need both to be effective in the future.


We are convinced that CARDS will revolutionize securities regulation and help us drive out activities that harm investors.
And we are equally convinced that without initiatives like CARDS, the markets will continue to face a crisis of confidence.


CARDS will also allow us to be more transparent with firms when we see problem areas. For example, with CARDS, your coordinator will have more timely conversations with you about issues we're spotting. And CARDS will also provide you with data and tools that enhance your ability to identify and address problem producers and actions. While CARDS won't replace the work done by your compliance department, it will help strengthen and improve the effectiveness of that work. After addressing the start-up costs, we can envision an environment down the road where CARDS would reduce costs for firms across the board.


Just as one example, consider when we have a product concern, because of credit quality such as Puerto Rican bonds or because of complexity with respect to an exotic ETF. Today, we have to triage a range of sources to identify firms that are most likely active in the product. Then, we need to send out wide-ranging sweep letters to begin narrowing down whether any firms' activities are of concern.


In a CARDS world, we would already have the data to make that evaluation. We could begin instantly focusing on the few firms actively selling the product to retail investors and who have encouraged large, concentrated positions. Gone would be the burdensome reviews of many firms whose activity does not concern us. In short, CARDS enables a more focused, less arduous exam process and vastly improves the speed with which we can quickly intervene to protect investors.


Obviously, this was not a controversial proposal, since we only received approximately 800 comment letters about it!


Look, we value your engagement. We need your feedback and are listening to your concerns. That's why we did this as a concept release. That's why we are separately reaching out to many firms and forming working groups to give us input. We need to get this right.
 
How we've dealt with the issue of personally identifiable information, or PII, is a good example. We clarified that PII is not part of the proposal, so CARDS data will not include account names, addresses, tax IDs or Social Security numbers. Thus, customer accounts will not be linked across firms. We know that CARDS will be effective without collecting this information.


We've also heard your concerns about the security of such a large database. We believe the security risk is very low—and dispute that CARDS could create systemic risk. Given that we will not be collecting personally identifiable information, the chance that anyone could exploit what is, in effect, anonymous data for nefarious purposes is very small.


Nevertheless, we are absolutely committed to the highest level of security when it comes to CARDS. FINRA has comprehensive controls in place that are based on industry best practices, guided by federal and international standards and compliant with data privacy regulations and laws.


Let me emphasize: this is nothing new for us. FINRA has been maintaining the highest security standards and safely hosting highly confidential broker data for decades now. And the good that will come from CARDS, and its dramatically increased ability to reduce fraud and market manipulation, will way overwhelm that extraordinarily remote risk.


We are also looking closely at the cost and operational concerns you've raised. While I understand where many commenters' concerns are coming from, they seem to me to be a tad one-sided. CARDS has the potential to be one of the most important investor protection tools to emerge in recent years. And if our goal is to protect investors and boost their confidence, if our goal is to restore investor trust in the markets, then I would strongly urge you to view this initiative through the broader lens of investor protection, rather than through the more narrow lens of how it affects your firm.


Having said that, we recognize that costs tied to CARDS are a real issue for firms. This is why we created a pilot and are talking to many of you about the real, bottom-line impact it may have on you from an implementation standpoint.


We are aggressively engaged in meeting with firms to understand the costs and benefits of CARDS. These meetings have already led to changes from our original concept that will help balance the impact on market participants while maintaining the benefits of CARDS. 


Specifically, and these are just some examples of the progress made to date, we plan to launch CARDS in stages. In particular, we heard in many of your comment letters the concern over the need to send CARDS data through a clearing firm. The reasons varied—many of you voiced concerns about the cost implications of working with a clearing firm, especially since nearly 2,000 firms don't currently have clearing firm relationships. So I'm pleased to announce that we are changing the CARDS proposal so you can choose how to send us the data. You can send it to us through a clearing firm, you can send it to us through a service bureau or you can send it to us directly. It's up to you. It's not exactly Burger King's® "Have It Your Way," but you will definitely have choices. 


Perhaps more significantly, I want you to know that while we will provide firms with a standardized file specification for transmitting data, we also plan to permit variability in the format of data related to suitability. This stems from comments that introducing firms, in particular, use different terminology with respect to information about their customers.  


We've also heard your concerns focused on direct business data and questions about how the clearing firms would handle that data. In its initial phases, CARDS will not require firms to submit information about products not held at the firm, such as variable annuities, DPPs and direct mutual funds.


In a later phase, we may collect this kind of product information through CARDS, but that collection would be pursuant to additional rulemaking—which would provide us with ample opportunity to continue our dialogue and arrive at workable solutions.


I've said this many times throughout this process, and I'm sure I'll say it again. Your input is critical to us getting CARDS right. By giving us your feedback, you have an opportunity to contribute to the best solution possible. Please help us shape this.


Before I move on, I want to quickly address a question that comes up frequently when we talk about CARDS: "Why not implement the consolidated audit trail—or CAT—first?"


I'll talk about CAT in just a moment, but the short answer is: Unlike CARDS, CAT will not contain the kind of critical information about customer risk appetites, investment objectives, cash movements, margin requirements and position data that we need for our sales practice reviews. Moreover, CAT needs to function on a near real-time basis. CARDS does not. To have it do so would be light years more costly than our current proposal.


A properly designed CARDS is the future. It will be transformational. As I said at the start, I invite you to join us in making this leap forward to enhance regulatory effectiveness—and restore investor confidence.


Fair and orderly markets are equally important to investor confidence and the same guiding principles that I mentioned earlier are critical for our response to maintaining market integrity.


The ongoing debate on both high frequency trading and equity market structure has reached a crescendo but has tended to generate more heat than light. None of this is easy for investors to understand and evaluate, particularly when we have popular authors saying the markets are "rigged."


Let me start there. I would 100 percent echo Chair White when I say that the markets are not rigged. In particular, retail investors should not be deterred from participating in the markets. Retail investors trading directly enjoy the benefit of historically low bid-ask quotation spreads and high quality executions. Moreover, the equity and options surveillance operated by FINRA and the exchanges has never been more focused or effective at identifying manipulative or disruptive electronic trading activity.


Having said that, there is definitely more work to be done by every regulator with responsibility for market integrity.


We're delighted to see Chair White's statement that the SEC is moving ahead to address market structure issues. They're taking a hard look at this matter.


Speaking personally, I am proud to have been part of an advisory group that recommended that the SEC focus on issues like maker-taker pricing, execution quality away from exchanges and possible registration and greater regulatory oversight of active high-frequency trading firms.


I'm glad to see that the SEC is both poised to take needed action, but also basing these actions on data. We will support the SEC's work and partner with the Commission as needed, particularly in enhancing the transparency of trading away from exchanges.


Later this month, we will be issuing our first reports of Alternative Trading Systems volume on a stock-by-stock basis, substantially increasing transparency for ATS trading. Moreover, we intend to carefully consider whether to expand that rule to provide additional transparency for the large amount of non-dark pool trading that occurs away from exchanges.


FINRA also continues to be at the forefront of maintaining market integrity through our unique equity and options cross-market surveillance program. This state-of-the-art program collects and integrates trading data from the multiple trading venues we regulate—and then applies cutting edge technology to detect problematic trading.


In February, we added Direct Edge data to the data we already surveil from the NASDAQ and NYSE family of markets. As a result, we now conduct comprehensive surveillance of 90 percent of the listed U.S. equity market. With the addition of BATS Exchange volume coming in early 2015, that figure will soon increase to 99 percent. 


Even though the markets are widely fragmented, FINRA's ability to pull together data across exchanges and alternative trading systems allows us to see one big, virtual market instead of a disjointed patchwork of individual markets. 


This is powerful stuff—because there are market participants out there who are actively dispersing their trading activity across markets in an attempt to avoid detection. With our cross-market surveillance program, we can run dozens of surveillance patterns and threat scenarios across our mountain of data to look for, among other things, layering, spoofing, algo gaming, wash sales and other manipulative and distortive conduct. 


Because of the sophistication of these patterns, we are detecting things that we had not been able to see before: 

  • over 80 percent of our cross market alerts involve conduct occurring on more than one market;
  • over 50 percent of our cross market alerts involve two or more market participants. 


In addition:

  • we have more than 170 investigations open concerning abusive algorithms, inadequate supervision of algorithms and deficient order controls; and,
  • we have brought cases against firms for inadequate market access controls and manipulative conduct. In fact, just last week we brought a case jointly with CBOE (on behalf of our options exchange clients) involving a cross product manipulation scheme where waves of equity trades were used to artificially impact options pricing. 

   
While we believe our cross-market surveillance program is a major step forward, there is so much more that we can do. Other market integrity initiatives we have underway include:

  • We recently received SEC approval for our "self-trade" rule that is designed to limit self-trades that could have an adverse impact on the markets and price discovery.  
  • In November, a rule will go into effect that will require all ATSs to use a unique market identifier (an MPID) to report volume executed on an ATS. This will bring certainty and consistency to how ATSs are flagged in our audit trail and surveillance systems.
  • And we are thinking of other rules that might be useful to help detect and take action against abusive trading.


And while these changes and initiatives stand to be beneficial, the biggest game changer will be the implementation of the Consolidated Audit Trail or CAT.


CAT will collect, identify and link orders, trades and quotes in equities and options from all market participants—and the activity of each participant will be flagged with a unique identifier. CAT will provide a level of granularity and precision that will dramatically reduce false positive alerts. And, by capturing equity and options data together, CAT will enable cross-market surveillance for options and cross-product surveillance across equities and options. Over time, fixed income, unlisted equities and derivatives will be included as well.


With CAT, regulators will have a detailed, microscopic view of the market in order to detect trading abuses that are imperceptible today. And this is the view we need to restore investor confidence in the fairness and transparency of the markets, regardless of whether that confidence has been shaken by real or perceived harms.


So, back to the issue of trust. What you've heard from me today is that FINRA is firmly committed to restoring investor trust in the markets. We are backing up that commitment with the most advanced technology solutions available to us. We are investing our resources, our staff and our time.


I'll repeat what I said at the beginning: FINRA is determined to be a key engine in restoring trust in the securities industry.


But we can't do it without you. We need you to be committed as well. Embracing strong regulation is good for your business. And a well-regulated broker is something we should all be proud of. Our interests are aligned, and putting the investor first is a goal we should have in common.


The investing public deserves nothing less.