finra

Remarks by Mary L. Schapiro
Chairman and CEO, NASD

The Exchequer Club
Washington, DC
June 20, 2007

 

Thank you, Penny [Rostow], for that kind introduction. The Exchequer Club has such a proud history of exploring the great political and financial issues of our day and I'm honored to be here.

When I was invited to give this speech, it made me think about how much the world has changed since the Exchequer Club was founded in 1960. And I wondered what topics those original members talked about as they gathered that first year.

Surely they talked about the Cold War and the Soviet Union and the clash of two competing economic philosophies. And there's no question those early days were also filled with talk of the presidential campaign between Richard Nixon and John F. Kennedy.

Historians say that campaign marked a transformational moment in American politics. It was the first campaign where a relatively new technology - television - changed the way politicians would campaign over the next four decades.

As we know, television left politics forever altered. But technology didn't stand still. It kept moving forward and today the Internet and YouTube are testing candidates and campaigns like never before.

Well, technology isn't standing still for the financial markets either. And today, the financial world is facing a test of its own - and, in a way, its own transformational moment.

Technology, along with globalization, international mergers and an endless stream of new products, has left the landscape of the markets forever altered.

As business leaders, I am confident that many of you have read the reports warning that America risks losing its position as the world's financial capital. These reports raise important issues about the competitiveness of U.S. markets and have spurred a lot discussion - as well they should.

I personally don't believe we are witnessing the decline of U.S. markets in an absolute sense. What we ARE witnessing is the natural maturation of developing international economies and markets.

As the world grows smaller through globalization and technology, foreign markets are becoming more dynamic, more attractive and more reliable for capital-raising, and there will continue to be healthy competition from the likes of London, Hong Kong and others in the future.

But I, for one, am not betting against U.S capital markets.

First, the people who make up America's financial sector are among the most creative, dynamic and forward-thinking group of business people you'll ever find.

And second, our markets, more than any other in the world, are defined by fairness and integrity. Strong regulation here gives institutions and individuals abroad confidence to invest in American markets. And that trust will be the key to success for U.S. markets in the future as well.

I guess it's no surprise that someone who has been a regulator for 25 years believes that strong regulation plays a significant role in making our markets among the most attractive, the broadest and most liquid in the world.

Just look at the numbers - 45 percent of global mutual fund assets reside in the U.S., 70 percent of hedge funds with assets of at least $1 billion are located here and of the $2.1 trillion in global hedge fund assets, $1.5 trillion is housed in the U.S.

These numbers are impressive by any standard and they underscore why regulators need to constantly ask ourselves, "How do we best ensure investor protection, market integrity and fairness, while allowing the industry to grow and innovate in this new era of constant transformation and increased competition?"

So today I want to talk about how we can bring about more efficient, forward-leaning regulation that will keep U.S. capital markets strong, fair and competitive in this era of enormous change.

The most significant step we have taken is the pending consolidation of NASD and NYSE member regulation operations. This is the most dramatic restructuring of the self-regulatory model since the 1930s.

In 2006, self-regulation provided a layer of informed and effective regulation valued at over three-quarters of a billion dollars - wholly funded by industry, NOT taxpayers.

It is an extraordinary regulatory construction, which, under the oversight of the SEC, invokes industry expertise to create and enforce the first level of investor protection - writing rules, examining for compliance with and enforcing those rules, surveilling markets with state-of-the-art technology and providing major utilities, such as transaction reporting systems and a centralized testing and registration facility for nearly 700,000 brokers.

But, that is not to say there are not inefficiencies and perhaps some unnecessary hurdles.

Many of those inefficiencies flow from the fact that 200 or so of the largest securities firms in the U.S., accounting for 80 percent of industry revenues, are dually-regulated by both the NASD and the regulatory group at the New York Stock Exchange.

We at NASD realized that if we expected to keep up with the changes taking place around us, we needed to bring our work into the 21st Century. That meant eliminating duplication and streamlining regulation - making it more efficient, more effective and more responsive.

With the imminent merger of NYSE Regulation and its nearly 500 staff with NASD's 2500 employees, we will create a new, single self-regulatory organization for the securities industry. No longer will there be competing rulebooks. Duplicative regulation will come to an end. And overlapping jurisdiction will be a thing of the past.

In fact, when the consolidation is complete we won't even be called NASD any longer.

Now, until this moment, we haven't revealed what the new organization will be called. But I think it's time to make the new name public and what better place than the Exchequer Club to make a little news.

But first, I want to admit something. The new name wasn't my first choice. I wanted the name to be Vanguard. What a perfect name for a regulator - "the Vanguard of investor protection, at the vanguard of regulatory innovation." That has a nice ring to it.

However, there is a small mutual fund company by the same name that refused to give it up. Hard as I tried, they wouldn't budge. So we went back to the drawing board.

I believe our new name describes the new organization very well. The new organization will be known as the Securities Industry Regulatory Authority or SIRA.

We're working around the clock to see that the consolidation is finalized soon. Once that happens, SIRA will be the largest self-regulatory organization for securities brokers and dealers in the world.

The new SRO, with nearly 3,000 staff, is committed to reducing regulatory costs for all firms while providing more effective protection for the tens of millions of people who invest for their future in the U.S. capital markets.

This consolidation will lay a strong foundation from which we can create a more effective and streamlined regulatory approach for the entire U.S. securities industry.

But just as when you build a house, the laying of the foundation is only the first step. After that, many decisions follow. And it will be the same for SIRA and the future of self-regulation.

Fundamental questions will need to be examined. Questions that go to the very heart of what it means to be a modern regulator in a complex global economy.

For me, the answers lie in making regulation as flexible and innovative as the markets we regulate, while still protecting investors. And our new organization - SIRA - gives us an historic opportunity to write the future of modern self-regulation on a nearly clean slate.

It's important we get it right. Let me cite a recent case that clearly outlines what's at stake.

Just two weeks ago, NASD sanctioned a large brokerage firm $15 million after it failed to adequately supervise a team of brokers based in Charlotte, NC. Between 1994 and 2002, these brokers were using misleading sales materials as part of a sales pitch targeting hundreds of employees of BellSouth Corporation.

As a result, more than 400 BellSouth employees opened over 1,100 accounts with these brokers. The employees typically cashed out their relatively safe BellSouth pensions and 401(k) accounts to invest in higher-risk products being pushed by the brokerage.

NASD found that the brokers downplayed the risk involved in these investments, as well as the fees, and failed to tell the employees that they could actually lose money.

In the end, over 200 BellSouth employees saw the principal in their accounts decline by a total of approximately $12.2 million.

While such misleading tactics have been around as long as markets have been in existence, the challenge for SIRA will be to protect investors like the BellSouth employees and keep the markets fair while allowing the industry to thrive during a time of heightened competition and globalization.

That challenge will demand a new perspective on regulation. A new perspective committed to modernizing the regulatory structure by using what works, discarding what doesn't and being open to new ideas and approaches.

It means not shying away from exploring what a more principles-based approach would offer or the benefits of prudential regulation.

If SIRA is to be a true modern regulator, we first need to define what that means. To me it means engaging investors and ensuring they have choices; being proactive - not reactive; assisting industry in complying with rules; and understanding the world in which we operate.

These characteristics will be the true underpinnings of SIRA's mission of investor protection and market integrity - so let me talk about each one for a moment.

Today, whether consumers are shopping for cars, cell phones or breakfast cereal, choice is king. The number of colors, models, features and flavors are unlimited for consumers.

It should be the same for investors. The modern regulator must ensure that investors have choices in the types of firms they seek to do business with and the number of products and services they have to choose from.

That will require firms to design products thoughtfully to meet investors' needs - and to properly train sales people to understand, explain and recommend appropriate new products to their customers.

It will also require regulators to be sophisticated both in understanding the risks those new products may present for investors - especially that burgeoning demographic of retirees - and in understanding and accommodating different industry business models without compromising investor protection.

Part of that means losing the blinders of "one size fits all" rulemaking. It also means more tiered regulation based on firm size and business model - something we aim to accomplish through the consolidation of the NASD and NYSE Regulation rulebooks.

There are circumstances where it will also argue for a more principles-based approach to regulation. But I hasten to add that we're not going to throw out the rulebook and simply rely on principles to guide firms.

That's not even a realistic possibility. After all, let's not forget, even in the U.K., where principle-based regulation is the standard, the Holy Grail, in fact, the FSA's 11 core principles are backed up by more than 8,000 pages of rules.

So if anyone is hoping the rulebook will just fade away, they will be sorely disappointed. But SIRA does need to, and will, look at ways to make the rulebook more principles-based where appropriate.

That may take some time. Because unlike the U.K., the U.S. has a much more complex regulatory structure, which makes it more challenging to make dramatic changes to how the financial services industry is regulated. We have a products-based approach here with different regulatory authorities for insurance, securities, futures and banking. The UK has a single financial services regulator in the FSA.

There is also a difference in culture. In the U.S. we're operating in a very different political and legal culture from the U.K. It's a culture that questions an FSA-like approach to regulation, with its de-emphasis on enforcement and its reliance on general proscriptions against bad conduct.

Our culture is, rightly or wrongly, one where U.S. regulators are many times judged by the number of enforcement cases they bring against firms. I agree that is an important aspect by which to judge the work of regulators, but it should not be the only way.

Yet, while London may get all the attention for their emphasis on principles, NASD is no stranger to principles-based regulation.

Our requirement that firms conduct business in accordance with high standards of commercial honor and just and equitable principles of trade, and our rules requiring that brokers' recommendations to customers must be suitable, are good examples where we have taken a principles-based approach.

Another example is our recent guidelines on business entertaining where we have said, "We will not tell you how much you can spend to entertain clients so long as the entertaining is not illegal and does not amount to commercial bribery. Just make sure your firm has policies, that you follow them and you keep records."

But while CEOs loved the approach, compliance officers at many firms felt it left too much room for interpretation and ultimately abuse, and have repeatedly sought more prescriptive guidance.

So, you see, when we don't give industry bright lines to follow, they ask for stricter guidelines and when we do give them strict guidelines, they say we should leave it up to them to determine the scope. I guess that's just human nature.

At the end of the day, the debate between principles and rules in not an either/or situation. There are times when principles work better than rules and vice versa. I think former Senator Everett Dirksen had it just about right when he said, "I am a man of fixed and unbending principles, the first of which is to be flexible at all times."

That's pretty sound advice. Finding the right blend and balance between principles and rules will require openness and flexibility - on the part of regulators and industry.

Being open to a more principles-based approach is an important component of the second attribute SIRA must embody as a modern regulator - the need to be more proactive not just reactive. In the UK, they would call it "prudential."

Proactive regulation means exploring all of our options for addressing emerging issues once we identify them. At one time the automatic response to potential problems was to write a new rule. But there should be no automatic response.

We must consider a range of options in addition to or in lieu of rule-making, including best practices, guidance, education and task forces to help us understand the problem, propose viable solutions and educate the industry.

But even where rules are the right answer, it is no longer sufficient to write a rule and walk away. Finding ways to assist firms in meeting their compliance and regulatory obligations is the third way SIRA must evolve as a modern regulator.

Providing clarity to the industry is one of our central obligations as a regulator. Ten years ago, our way of dealing with this was to offer a small handful of conferences to the industry. Today, member education is a much larger part of our job.

We've invested significant resources into developing a wide range of educational programs. We offer a compliance certificate program at Wharton, a master's degree program at the University of Reading in the UK, as well as conferences, training courses, and internet-based tools.

But if we're serious about assisting the industry in the area of compliance, prudential regulation can and should play an active role in helping to protect investors.

By prudential regulation I mean assisting firms in their efforts to stay in compliance rather than simply relying on enforcement to bring them into compliance.

In fact, NASD already supports efforts at prudential regulation.

In the area of money laundering and business continuity planning, NASD developed templates to assist firms in complying with these rules. We also developed a mutual fund fee and expense analyzer and a breakpoint search tool and database, to help firms make better informed decisions in their mutual fund sales.

It's my hope SIRA can build on these efforts. That said, prudential regulation can't be code for not enforcing securities regulations. But it really isn't an either/or proposition. Again, just like the principles versus rules debate, it will require balance.

We should certainly work with firms without being draconian to head off potential problems before they impact investors. Because if we do it right, effective prudential regulation will, in the end, help firms understand what we expect from them and that will ultimately translate into stronger protections for investors.

Aside from helping firms comply with our rules, we also need to make sure that we periodically step back and examine the impact of those rules.

We will be constantly asking ourselves, "Are the rules doing what we intended them to do? Are they protecting investors? At what cost? And finally, is there a better, more efficient way to achieve the benefit?"

In this new global marketplace, rules that worked yesterday, may not work today. And because of this, one of SIRA's most daunting challenges as a modern regulator will be to understand the world in which we operate.

It's a world where international borders are disappearing, exchanges are merging and the desire for foreign stocks grows by the hour. It's a world no longer defined by geographic borders or time zones.

A smaller world means more challenges for each country's financial regulator. The only way we are going to be able to fulfill our obligations to investors and market integrity is to work much more closely with regulators across the globe. That process is already beginning.

But international boundaries are not the only ones we need to be concerned about. Our jurisdictional boundaries are not serving investors well.

There are so many different kinds of investment products in today's market that I would be surprised if even the most sophisticated investor could distinguish which products are regulated by whom. Frankly, they shouldn't have to.

Our spaghetti bowl of regulators - SEC, CFTC, NASD, NFA, myriad banking regulators and 50 state insurance and securities regulators - means that if we are not going to have rationalization of the regulatory structure for political or other reasons, then at a minimum, we regulators must lock arms and work for a harmonized system of investor protection under a set of unifying principles.

Investors should get the same basic regulatory safeguards and protections no matter which investment product they choose. It is my hope that SIRA will contribute to this goal and we are committed to working with all regulators to establish as level a playing field as possible for investment products, so that, at the end of the day, investors can have confidence that they have been sold products that meet their needs.

Finally, rather than simply respond to investor complaints—or problems that have already come to light— a modern regulator must engage investors through greater access to educational tools and information.

The most effective way to protect investors is to educate them and ease their interaction with the marketplace. This will help head-off problems like the ones BellSouth employees experienced.

It's imperative that we reach large audiences, especially those who are not focused on saving and investing, planning for retirement or protecting themselves from financial fraud.

Each year since I've been at NASD, we have increased our focus on investor education. We now offer multiple tools on our web site that can help investors manage their money with confidence.

Online tools such as BrokerCheck allow investors to search a database to find out if their broker has been disciplined in the past. Other tools, including learning centers, teach investors all of the basics about retirement accounts, 529 College Savings Plans, or bond investing, to name just a few.

Because we view investor education as such an important part of our mission, in 2003 we established the NASD Investor Education Foundation. Soon to be renamed the SIRA Investor Education Foundation, it is currently funded with $82 million, making it the largest foundation in the U.S. dedicated to investor education.

In closing, I'd just like to thank you all for inviting me to speak to you today - it's been a pleasure.

Though NASD's name is changing, our mission isn't. As SIRA, we will maintain a fierce commitment to investor protection and market integrity.

Whether it's through investor education, ensuring investor choice or helping the industry comply with regulations, I'm confident SIRA - remember that name - will meet the challenges ahead and make the most of this historic moment.

Thanks again - I'd be happy to take a few questions.