finra

Remarks by Mary L. Schapiro
Chairman and CEO, NASD

STA 73rd Annual Conference & Business Meeting
The Phoenician, Scottsdale, AZ
October 12, 2006 (Final)

 

Thank you, John [Giesea], and good morning. I'm delighted to have been asked to speak at this conference. And since I'm appearing just before lunch, I promise to stay within my allotted time.

It's interesting that the STA and NASD were born at about the same time, in the 1930s, and for similar reasons—to rehabilitate and strengthen the securities industry after the stock market crash of 1929 and the Great Depression, which was still casting a pall over our economy and society. Seven decades later, we're both still here and going strong, and while one of us is a regulator and one is a trade association, we're equally dedicated to upholding the integrity of our industry, which is absolutely vital to the health of our nation's economy.

I last spoke at an STA conference exactly six years ago, October 12, 2000, when I was President of NASD Regulation. I'm sure you were all there and remember vividly what I talked about: NASD's separation from NASDAQ and what I saw as the future of self-regulation. What I want to talk about today is...NASD's separation from NASDAQ and what I see as the future of self-regulation.

In 2000, the plan to spin off NASDAQ as an independent entity was still only that—a plan. And it was not to be realized until August 1 of this year, when NASDAQ began operating as a national securities exchange. NASDAQ is now completely independent of NASD, controlled by its own management and board.

There have been several other, more profound, events in these last six years that have changed the complexion of our industry and the markets in which we earn our living. And some of those events, too, have contributed to NASD's evolution. Owing to globalization, we now see financial markets truly becoming international, rather than local, in nature. Loose allegiances and much talk about "globalization" have given way to concrete plans for markets that truly span borders.

In six years, we have seen the stock market hit bottom—thanks to the Internet bubble—and now rebound. We've been through —and are still going through—the effects of 9/11 on almost every aspect of how we live and work. We have, as you well know, been through a difficult period of heightened regulation and enforcement activity in the aftermath of the bubble and the mutual fund trading debacles of more recent years. And now, we've begun to see what may be our next big challenge, one that we as a society are woefully ill-prepared to handle—the approaching tidal wave of baby-boomers' retirements.

A consequence of all the forgoing is that today, NASD is a substantially-changed organization from what it was the last time we met. With the divestiture of NASDAQ and the American Stock Exchange, which we sold in 2004, we're now a stripped-down, streamlined private-sector regulator unencumbered by the ownership of markets.

But we're actually much more than that. NASD has taken huge strides toward becoming a holistic industry utility, combining our traditional responsibilities for regulation, registration, testing and transparency with a large and growing inventory of industry facilities; as well as compliance-related education and training programs and tools for our members and an ambitious and well-funded investor education effort.

So, today I'd like to talk about what "self-regulation" means in the 21st Century. It means, first and foremost, an unshakable commitment to investor protection and market integrity, fueled by our unique position as a private-sector regulator that neither owns markets nor has any stake in their financial success or failure. It also means regulatory programs powered by a commitment to developing sophisticated technology to support our core regulatory functions and an unwavering commitment to a continuous learning environment for our employees and rigorous development of the skills necessary to regulate ever more complex markets.

It also means using our considerable expertise and financial strength to fund initiatives that enhance the industry's ability to serve its customers. And it means preparing our citizens to meet their responsibilities as investors and full participants in the markets. I'd like to approach this from three angles, the first having to do with streamlining regulation to the greatest extent possible, consistent with our mission of investor protection.

Perhaps the need for streamlining regulation is nowhere more obvious than to the roughly 200 firms that are members of both the NYSE and NASD, and thus are subject to regulation—sometimes conflicting regulation—by each of us. When the NYSE became a publicly-traded, profit-making company, questions arose about whether firms that are members of such an enterprise should be regulated the same way they were when it was a private entity. The SEC, in connection with its approval of the NYSE-Archipelago merger, suggested a first step toward resolving that question: that NASD and the NYSE put our heads together and erase, to the extent possible, the conflicts and discrepancies in our respective rulebooks.

A series of industry committees was convened to assist in the detailed work required to bring our two rulebooks into line. Each committee was responsible for reviewing comparable NYSE and NASD rules and making recommendations, recognizing that different standards may still be appropriate in some cases, given the two SROs' varied membership and certain differences in regulatory approaches.

The committees are looking at a wide range of rules including those covering sales practices, supervision, registration, qualification and continuing education requirements. An example of what might come of this process is that we're considering proposing a uniform definition of the term "institutional investor" for NASD and NYSE rules, perhaps employing the "qualified investor" standard under the Exchange Act. We're also considering whether to eliminate the office of supervisory jurisdiction, or OSJ, terminology from our rules.

The committees have presented their initial recommendations to the NYSE and NASD staffs, and we're in the process of reviewing them. We'll submit any proposed rule changes resulting from this process to our internal rule-making mechanisms with the goal of eliminating discrepancies between NASD rules and NYSE rules covering the same practices.

Rule harmonization has obvious and unassailable merits but we will keep our eyes open to the possibility for greater collaboration and coordination with the NYSE in the regulation of our dual members.

The second aspect of NASD regulation in the 21st Century that I want to discuss is the growing use of our expertise and financial strength to fund initiatives that enhance the industry's ability to serve its customers to their satisfaction and to provide tools to assist members in meeting compliance obligations. I said at the beginning that NASD is evolving from being a traditional SRO to becoming a holistic industry utility. Developing and offering this inventory of compliance-related tools and services is a large part of what makes that so.

I could talk all day about this one aspect of our work, but I'll just give you a few pertinent examples.

We have for many years offered District Office seminars and other compliance-related conferences all across the country, on regular and frequent bases. More recently, we've begun supplementing these events with an assortment of on-line webcasts that sales and compliance people can watch while sitting at their desks. These are on-demand streaming video presentations that take less than 10 minutes to watch. They cover timely industry issues ranging from 529 college savings plans to suitability considerations to customer data protection to fee-based brokerage accounts.

We recently supplemented the webcast series with a series of audio-only podcasts, that front-office and compliance staff can listen to on their iPods or other mp3 players. They cover some of the issues firms find most challenging, such as anti-money laundering, branch office registration, equity indexed annuities, and supervisory controls. In May, we also began releasing monthly update podcasts. These recap regulatory deadlines, Notices to Members and press releases. The logical progression, in our view, is from compliance education to tools that broadly enhance the industry's ability to meet compliance obligations.

 

One tool, of particular industry-wide and investor value is the mutual fund breakpoints search tool. It used to be that determining a customer's eligibility for a volume discount on front-end load fund shares could be an ordeal, because there were so many factors to consider—whether the customer had money in another fund of the same fund complex, whether members of the customer's family had shares in the same fund, whether the customer had committed to buying additional shares in the future, and every fund complex has a different set of rules to apply and offered a different percentage discount. And, indeed as a result of historical shortcomings in firms' performance in this area, more than $100 million has been refunded to investors in the past two years.

With the tremendous support of an industry task force, we set up an on-line, comprehensive database of pricing methods, breakpoint schedules and fund linkage rules that brokers could use to establish eligibility for discounts.

Registered reps can now log onto our Web site and use our Mutual Fund Breakpoint Search Tool to quickly and easily research their clients' eligibility for volume discounts on large purchases of Class A shares.

There is also the on-line Report Center, which provides access to firm-specific data and reports generated by NASD and designed to support firms' compliance activities. This information can help you detect reporting problems early and identify areas for improvement. For example, the TRACE report card, published on a monthly basis, shows the number of late trades that a firm reported to the Trade Reporting and Compliance Engine. The report that your firm receives includes the performance of the industry overall and of peer groups, so that you can see how your firm is doing in comparison with others.

The third aspect of the new look of self-regulation I want to talk about is transparency—transparency of markets and transparency of products. I'll start with market transparency, and specifically, TRACE.

You undoubtedly saw press reports last month that bond investors had saved in the neighborhood of a billion dollars per year since TRACE's inception in 2002. Or, depending on what publication you read, you may have seen press reports last month saying that bond traders had lost about a billion dollars per year in revenues since TRACE's inception.

Contracting spreads is an expected and generally desirable result of transparency, because it's a sign of more efficient markets, it encourages more investor activity and reduces the cost of execution. We believe that in the long term what's good for investors is good for broker-dealers. But, we recognize that transparency may cause broker-dealers some short-term pain, and we remain extremely sensitive to that possibility. That is why we phased TRACE in over a three-year period—to give traders time to adjust. We also believe that, in the long term, more efficient markets provide new and exciting opportunities for increased profitability through enhanced liquidity and broader market participation.

As you know, before we put TRACE on-line, retail bond investors were effectively blindfolded and had to rely on their brokers to take them by the hand and lead them around the market. Many retail brokers only had a view of their own firm's markets and didn't understand other firm's markets.

Consequently, their guidance was limited. Maybe that wasn't so troubling when the corporate debt market was almost the exclusive preserve of institutional investors. But that is no longer the case. Today, roughly two-thirds of corporate bond trades are in amounts of $100,000 or less, and that suggests that individual investors are wading into this market in large numbers. Denying them access to basic trade and price information on these securities was simply no longer defensible.

Today, retail investors can log onto TRACE via our Web site and get a read-out of easy-to-comprehend trade and price data on any one of 30,000 corporate bond issues, updated within 15 minutes of any trade.

Another major transparency utility operated by NASD is the Central Registration Depository, the industry's central licensing and registration facility and provider of broker and firm transparency to investors through BrokerCheck. We have sought over the years to leverage our specialized expertise and resources in developing registration systems in support of other financial services sectors. In 2001 we launched the Investment Adviser Registration Depository. And, we recently signed a contract with the Conference of State Banking Supervisors to develop and deploy a web-based system to register mortgage companies, branches and individuals with state jurisdictions. The deployment of the system is targeted for December 2007.

Transparency of products is as important as transparency of markets. And nowhere is that more true than with mutual funds. More than half of America's households own fund shares, and their assets exceed $8 trillion. So, after the dust had settled from the directed brokerage and revenue sharing enforcement issues of a couple of years ago, we assembled an industry task force to make recommendations on, among other things, how to make mutual fund fees and expenses more transparent to investors.

In accordance with the task force's recommendations and in response to the SEC's Point of Sale Disclosure proposals, we have developed and consumer-tested a brief disclosure document that explains in plain English the material features of the fund an investor is considering—fees and expenses, investment strategies, risks and conflicts of interest—information that is either embedded in a prospectus or SAI, or not provided at all. This Profile Plus, delivered on-line, as well as by more traditional means, will allow investors, by way of hyperlinks to the prospectus, to customize their disclosure to fit their needs and interests, and will allow for quick access and easy comparison of different funds. If the SEC does permit on-line delivery or access, NASD has committed to construct and maintain the database that will house these point-of-sale documents for all broker sold mutual funds.

Perhaps the most relevant transparency initiative to this audience is our responsibility for transparency in the equities markets. To the Over-the-Counter Bulletin Board, and an expansion of ADF to include all exchange-listed securities, we are now adding multiple Trade Reporting Facilities, or TRFs.

Simultaneous with NASDAQ's becoming an independent exchange, we established a TRF for NASDAQ-listed issues. When NASDAQ was an NASD subsidiary, member firms' internalized trades were reported to ACT and were considered a part of the trading volume executed on NASDAQ.

When NASDAQ petitioned for exchange registration, the SEC questioned whether internalized transactions in exchange-listed securities can be executed on an exchange. So, NASD took the initiative to develop the convention of trade reporting facilities for the internalized trading of listed stocks.

Any exchange is free to enter into a joint agreement with NASD to establish a TRF to compete with NASDAQ on fundamentally the same terms as every other TRF. Under such an agreement, the participating exchange provides the reporting facility—for example, ACT in NASDAQ's case—and pays NASD for the cost of regulation. After recovering our costs, NASD in turn passes on all remaining revenue to the exchange. The exchange makes all pricing or revenue sharing decisions and manages the profit and loss, but the exchange has no control over NASD's regulation of transactions reported through a TRF.

I expect the advent of these TRFs will lead to heightened competition among exchanges for the reporting of internalized trades in NMS securities. That would be fine. NASD is agnostic as to where these transactions originate, and to whether market-share for non-exchange trades stays stable or declines. We are, consistent with our mission, merely a facility provider with no bias toward the commercial success of one exchange over another.

Since I promised to get you out of here in time for lunch, I'll close with a few words about a different, but related, subject—one that will surely shape the role of regulators well into this century—investor education as investor protection. I believe very strongly that the people best able to protect investors from mistakes, misunderstandings, deception or outright fraud are the investors themselves—if they are knowledgeable about investing and the markets. I cannot overstate the importance of this, particularly given that we're facing a looming crisis—the impending retirements of millions of baby-boomers, many of whom are financially ill-prepared to stop working.

Making matters worse is that Americans, by and large, are not particularly well-schooled in how to manage their own finances, nor do young adults enter the workforce with even a basic appreciation of the importance of starting to save and invest for retirement early.

Then there is the fact that there is a dizzying array of products being invented and marketed to investors, leaving them confused and perhaps even paralyzed in making decisions. The complexity of many new products—with elements of insurance, options, interest rate, commodity or real estate exposure, to name just a few twists—makes understanding their risks through different economic cycles a challenge, and deciding how they fit into a diversified portfolio even more daunting. Many investors feel they are simply not capable of understanding, so they toss the dice and buy an expensive, complex product they don't understand, or they give up in frustration and don't invest at all.

NASD has a deep and abiding commitment to investor education. Almost three years ago, we established the NASD Investor Education Foundation and endowed it with $31 million, all derived from disciplinary fines. The endowment will receive another $55 million from a court-ordered settlement of the SEC's research analyst cases. I am told it is the largest foundation in the U.S. devoted solely to investor education.

Our foundation issues grants to universities and non-profits for research and programs that help people understand the complexities of investing and the markets. It is particularly concerned with population segments that are underserved, such as minorities, members of the armed forces and senior citizens.

Investor education is not a very exciting topic, but it is crucial to our ability as a nation to ensure that our citizens have invested consistently and well and can avoid living in retirement with much reduced means, or even in poverty.

I've tried this morning to give you a sense of what self-regulation looks like in the 21st Century. I haven't talked much about regulation and enforcement, but I don't want you to think that they have somehow taken a back seat to these other aspects of our work. They have not and never will. Rigorous but fair regulation is what Congress created NASD to provide and it will always be our top priority. But we think that an important pillar of investor protection is enabling firms to meet their regulatory obligations.

It's almost lunch time, and I hear your stomachs growling. So, I'll stop here and express my gratitude to the STA for inviting me and to you for listening.