finra

Mary L. Schapiro
President, NASD Regulation, Inc.

Owen Distinguished Lecture Series
Vanderbilt University

Nashville, Tennessee
April 3, 1996

 

Good afternoon. It's a great pleasure and honor to participate in the Owen Distinguished Lecture Series. I will, however, try not to make my comments today sound like a lecture. As for the "distinguished" part, I'm not sure either the speaker or her material will rise to that level. I thought I would aim instead for being informative.

 

I will also try to be fairly brief. I remember from my college days that the shorter the lecture, the more I liked it and the more I admired the professor who gave it. I decided to apply the same strategy this afternoon. If brevity doesn't win admirers, at least it will allow time for your questions, which I'm looking forward to answering as best I can.

 

I hope to leave you with a better understanding of the system of securities regulation that exists in the United States, and the initial direction of NASD Regulation, the new self-regulatory organization on the block, which will be an integral part of this system.

 

NASD Regulation is very much a work in progress, having only been incorporated in January of this year. The agenda for NASD Regulation is only now being shaped. So is its governing body those who will make policy for the organization and begin to write its history. As for me, I've been on the job less than two months and this is in fact the first forum outside of staff meetings, Board meetings, and meetings with members of the securities industry that I am addressing.

 

So, while I won't be presenting any formal action plan, I think it's important that NASD Regulation's "thought process" if you will, be public not private. It's important that our actions and activities be open to input and suggestions from a broad range of constituencies, including the academic community. That input is welcomed.

 

In order to put the changes that are taking place at the NASD into perspective, it's helpful to look first at the big picture, at some of the trends that are shaping the financial landscape domestically and internationally.

 

I have been extremely fortunate to have landed on a career that has brought me into constant contact with the most powerful agents of economic change in modern history. Those agents are capital markets free markets that harness capital from public investors, channeling it into everything from infrastructure development to the latest Internet idea.

 

The growth and expansion of these markets is a powerful trend, and a sign of how important capital markets have become:

  • Ten years ago, daily trading in currencies stood at $200 billion. Today, the Bank for International Settlements puts that figure at over a $1.23 trillion per day 100 times the volume of world trade.

  • The first global bond was ginned up by the World Bank in 1987. Today, over $200 billion in global bonds trade simultaneously in financial centers around the world.

Commodities, futures and equity markets have all been the site of enormous growth. A recent article in Global Finance noted that there were barely 50 countries that had stock markets in 1985. Today, that number has nearly tripled. New stock markets were being launched at an average rate of more than one a month during the past decade.

 

Total capitalization of these markets has jumped from $4.7 trillion to $16 trillion. The Nasdaq market alone has seen its capitalization more than double in just four years from $500 billion in 1991, to $1.2 trillion today.

 

As phenomenal as the growth of capital markets has been even more astonishing growth may be on its way. It's been estimated that 70 percent of the world's population has yet to be brought into the global finance system. For instance, China's middle class is growing at a rate of 20 percent a year. Middle class means many things, but from the standpoint of global finance, it means that families that once only had enough money to survive, now have money to invest.

 

Side by side with the growth of capital markets has come another trend the growing participation of institutional investors, who now control the majority of assets traded in capital markets today.

 

The growing dominance of institutional trading is itself evidence of a trend toward managed investing, particularly investments in stock mutual funds.

 

Last year alone, investors poured over 660 billion new dollars into this country's more than 5,700 mutual funds. Over $400 billion of that new money went into risk-bearing stock funds, much of it transferred from bank products where rates of return were guaranteed.

 

Today, the combined assets of stock mutual funds and corporate equity is just under $5 trillion, compared to $4.5 trillion invested in real estate. What this means is that for the first time in 25 years, U.S. households have more wealth invested in stocks than in home equity [Dean Witter study].

 

To the trends I've just mentioned, we have to include the constant advances in electronic communications that are fast creating a global information infrastructure. In time sooner rather than later this infrastructure will give rise to financial markets that are themselves truly global.

 

The regulator's role in the environment I have been describing is more important, and more demanding, than ever. The ultimate fruits of financial markets are growth capital, job creation, and higher living standards. All depend upon the ability of both markets and market intermediaries to win the trust and confidence of investors. Investor confidence goes hand in hand with the supply of investment capital.

 

Effective regulation is essential to winning and keeping this trust. It is essential to the continued expansion of global capital markets. It is essential to making strides in offering people better lives and more secure futures.

 

The real question, though, isn't whether regulation is vital, but what FORM of regulation is best suited to creating and maintaining sound markets and safeguarding investors?

 

I cast my vote for the framework of self regulation that has worked well in this country for over sixty years.

 

This probably doesn't surprise any of you, coming from someone working for the securities industry's largest self regulator, which is what the NASD is. It's a bit like one of the established professors here saying they think the tenure system is a pretty good one.

 

But I'm not making this endorsement out of self interest, or from lack of familiarity with other systems of regulation. I've had the opportunity to study and observe first hand the gamut of international regulatory systems through my work with international regulators from Argentina and Mexico to Britain, France, and Switzerland, among many others.

 

The success this country has achieved in raising capital and attracting investors, in contrast to some of the problems other countries have had, gives me the confidence to endorse the U.S. system. A system of self-regulation by securities firms and SROs coupled with vigilant government oversight has proven to successfully balance two extremes.

 

On the one hand there are countries where there is too much government regulation, where the securities industry and other market constituencies have little or no say in the regulation and enforcement of securities laws. In an environment of rapidly growing and increasingly complex markets, governments will rarely, if ever, have the resources for effective, hands-on regulation. As a result, they often erect high barriers to entry, and very strict, inflexible rules because they lack the resources to police a truly free market.

 

On the other, there are countries that, in my opinion, have ceded too much control to the securities industry, without the proper government oversight necessary to keep self regulation from becoming "selfish" regulation.

 

The U.S. has from the early Thirties, when our present regulatory framework was developed, recognized the value of a working partnership between government and the securities industry between the SEC and the industry and its SROs.

It hasn't ways been a warm fuzzy relationship, but it has been a highly productive and effective one.

 

As the SEC's Chairman Arthur Levitt stated at a recent annual meeting of the Securities Industry Association: "We" meaning the SEC and the securities industry "don't always have the same view of what makes a perfect world but somehow the relationship has worked. Together, we've created a regulatory framework that has helped make U.S. markets the deepest, most liquid in the world."

 

The SEC, especially under Chairman Levitt, has demanded a great deal of the securities industry and its SROs and I think that overall the SRO community and the firms themselves have responded well to the challenge.

 

The launch in July of 1995 of an industry-wide continuing education program is a case in point. The program is designed both to raise professional standards and reduce compliance problems. It requires a great deal of the member firms. As part of what we call the "firm element" of the program, firms must implement internal training and re-training programs aimed at building and maintaining product knowledge and high ethical standards, and document participation by all licensed professionals in those programs.

 

This is in addition to mandatory completion of a regulatory component of the program, which includes computer-based training administered by NASD Regulation during the second, fifth and tenth anniversaries of initial registration.

 

Administering this program is expensive, which brings up a very practical reason why self regulation makes sense in today's world. In this era of shrinking government and tight budgets for government agencies, including the SEC the fiscal reality is that more responsibility is being placed upon SROs and firms.

 

Given the economic advantages of self regulation, and its track record of success, both the U.S. Congress and SEC remain convinced that self regulation subject to SEC oversight is the best system for securities regulation for U.S. markets.

A big part of the success of the U.S. system has been its ability to adapt to constantly changing markets and activities of market participants. The self-regulatory prototype is a very responsive prototype. To a great extent this is because the securities industry is an active participant in the process and is itself a highly responsive industry. Out of competitive necessity, it is very good at spotting trends and opportunities and implementing actions to take advantage of them.

This responsiveness, this ability and willingness to evolve to stay effective, is a trait that NASD has exhibited throughout its history.

 

Right now, change is permeating virtually every aspect of the NASD, guided by a major organizational re-structuring. Let me take a few minutes to talk about not only how the NASD is re-structuring itself but why.

 

An integral part of that re-structuring has been the creation of the corporate entity NASD Regulation. A strong, well-funded, well-staffed and independent regulatory organization affords a number of advantages for investors over the old system. I see at least four, which I'll address.

 

Let's first look at why the NASD is changing. There's one major reason: to better fulfill its self-regulatory responsibilities. These responsibilities include not only investor protection through effective oversight of its members including 5,400 brokerage firms and more than half a million salesmen but the efficient operation of securities markets, the largest of which is The Nasdaq Stock Market.

 

In addition to Nasdaq surveillance and enforcement and member firm regulation, the NASD administers qualifications examinations for the industry and maintains an extensive personnel database, including employment and disciplinary histories of the more than 500,000 registered representatives. The NASD is also the major provider of dispute resolution services to the securities industry and investors. We run an investor arbitration program that handles 6,000 cases a year.

 

Our membership size and broad responsibilities have placed a considerable enforcement and regulatory services workload on the NASD. Over the years, the workload has just kept growing.

 

Along with increased regulatory responsibilities has come the astounding growth of the Nasdaq market. It's important to realize that Nasdaq didn't exist when the NASD was created. It evolved from an automated quotation system to a formal stock market with over 5,000 listed companies. It is now the most active stock market in the country, with over 500 million shares trading every day.

 

So the scenario looked like this: the NASD's regulatory responsibilities were expanding. Nasdaq was growing. And there was growing concern inside the NASD and out about potential conflicts of interest that could arise if the NASD continued as both the primary regulator of the U.S. broker-dealer profession and the regulator, operator and owner of The Nasdaq Stock Market.

The result was that the NASD, after consultation with the SEC, sought an independent review of its governance structure and disciplinary process. It sought independent counsel about how it could meet the present and future demands on the organization.

 

The review was undertaken by a Select Committee headed by former Senator Warren Rudman. The Committee made many substantial recommendations. Let me touch on a few of the major ones:

 

First, although a formal "divorce" was not recommended between the NASD and Nasdaq, a substantial re-structuring was to create a degree of separation between the membership association and the market.

 

The NASD Board and its members have since approved changes that in effect say, "Let there be daylight." A new corporate structure is now in place. It consists of a parent organization NASD, Inc. which oversees two separate and independent subsidiaries: NASD Regulation, Inc., which is responsible for regulating the broker-dealer profession and the markets operated by its sister subsidiary, which is responsible for operating the Nasdaq market.

 

Furthermore, the Committee recognized the need to look outside the securities industry for a balance in the policy-making process. It recommended that membership of all Boards would be re-structured to include at least 50 percent non-industry participants.

 

This latter recommendation saw full implementation achieved earlier this week with the announcement of new boards of directors for each subsidiary and the parent. In what will be a first for any SRO, the Board of NASD, Inc. will have a majority of non-industry governors, and the other two boards will have a 50-50 balance of industry and non-industry governors.

As I said, I see at least four distinct advantages to investors of the new structure over the old.

 

First, the creation of NASD Regulation means first and foremost that there is now one organization whose first and only responsibility is investor protection. We have an unclouded mission: strong enforcement and strict compliance. We don't worry about market share, we don't worry about competition for listings, we don't worry about marketing. We worry about ensuring investors an environment that is fair and honest.

 

The second advantage is that with this uncluttered focus, the oversight of our members will improve plain and simple.

One of my top priorities is a substantial strengthening of this oversight in the area of sales practice compliance. With so many new investors in securities markets and with so many products out there it's absolutely essential that firms go the extra mile to make sure recommendations are suitable. They need to be certain both salespeople and the investor understand the products. They need to ensure that the risks of each product are adequately explained. We will also be focusing on issues related to dealing with the problem of rogue brokers and inadequate supervision of brokers by firms.

 

Third, the new structure should improve how investors interact with the organization. We're working to make each corporate entity more user-friendly. 

  • NASD Regulation has taken a significant step forward in Arbitration Reform with the invaluable help of a Task Force led by David Ruder. We are committed to making fundamental improvements to the arbitration process to bring it back to its original purpose, which is to serve as an more efficient, expedient alternative to the court system a process that is fair to all parties.

  • More information about our industry, including disciplinary histories of its members, is being made available to investors. Around the corner, I'd like to see investors able to get this information on-line, perhaps via NASD Regulation's web site, which is currently being developed. I also like to make it easier for investors to log their complaints with us. Here again, the web site might be an option.

  • Organization wide, considerable effort is being made to be more responsive to the individual investor in particular. In the coming months, you can expect those efforts be take the form of formal programs, services and initiatives. Finally, the new structure will offer those outside the securities industry greater opportunity to shape organizational policy. With fifty percent or more of the policy makers coming from outside the securities industry, you can't help but take policy in a new direction.

These are exciting times for markets, for investors and, yes, even for self regulators which you perhaps don't always think of as leading exciting lives. The changes that are taking place at the NASD should allow the organization to build on its successes both as a regulator and market operator.

 

As far as NASD Regulation is concerned, my first order of business is implementing the governance structure that the Rudman Committee has recommended. This new structure will serve as the springboard for further change.

As I said, we're a work in process....and we pledge to keep all of you and the general public informed about the progress we're making.

 

Thank you.