Remarks at the Bond Market Association Legal and Compliance Conference Keynote Address

Douglas Shulman

Vice Chairman

New York

February 2, 2005

Good morning. Thank you, Micah, for the introduction and thanks to the BMA for inviting me to speak here today.  You've no doubt noticed NASD's and other regulators' increased focus on debt markets, so I'm grateful for the opportunity to bring you up to date on our thinking and initiatives.

I'm going to focus my remarks, not surprisingly, on enhancing the quality and quantity of information available to investors. I'll also say a few words about my take on the future and the challenges we are all likely to face.

As I just mentioned, we have had an increased focus on the debt markets in the past few years.  The reasons are obvious.  It is an enormous market, with $23 trillion in capitalization versus about $15 trillion in the equities markets.  There are more than 4.4 million municipal, corporate and U.S. government fixed income securities, compared to about 7,000 equities listed on the major stock exchanges.  And the daily turnover in the fixed income markets is $814 billion, about ten times the daily turnover in the equity markets.

Yet despite its enormity, this is a market that has been largely mysterious to retail investors.  Making matters even more interesting is that roughly two-thirds of corporate bond transactions reported to NASD are executed at the retail level.  That is, they trade in quantities of fewer than 100 bonds. 

So, as we've been saying for some time, it's clear that the ranks of individual investors with a stake in the bond market is large and growing and that this market can no longer be considered the sole domain of institutional investors.  As we've also said before, institutional investors are often proxies for retail investors.  Monoliths like CalPers and TIAA-CREF, as well as mutual funds such as Fidelity, Vanguard and American Funds, have billions of dollars in capitalization, and almost every dime of it is invested on behalf of ordinary working people. 

Last year NASD sponsored surveys on bond investing.  Some of the results were astonishing.  We found, for example, that 60 percent of people who identify themselves as investors did not understand the most basic principle of bond behavior that as interest rates rise, bond prices fall.  Also surprisingly, about 34 percent of those people either thought their broker didn't charge them anything for bond trades or didn't know whether or not they did.

Bonds are typically marketed as low risk alternatives to equities.  Purchasers of bonds and bond funds often believe their principal is safe and they are guaranteed a particular yield on their investment.  Moreover, most of the processes and procedures for ensuring sales transparency that are simply a way of doing business in the equities markets, such as a national best bid and offer or firm quote rules, simply don't exist in the fixed-income market.

Today there exists a convergence of factors that, I believe, will likely make the next few years tricky in terms of investor sentiment towards the fixed income markets.  The market is shifting from a reliably stable, low interest rate environment to one where interest rates rise and bond prices fall.  We have seen a dramatic loss of investor confidence as a result of the bursting of the equity market bubble and the seemingly unending series of scandals.  If prices fall precipitously in the fixed income market, we should be prepared for a similar fallout.  We also now have evidence of strong retail activity in the corporate bond market at all levels of credit quality.   Even in the riskiest, high yield sectors more than 40 percent of trades are for fewer than 100 bonds.  Add to this a new transparency regime, where there once was little or no reliable information available about trade prices, and there now is an abundance of information that sheds light where it hasn't been shed before.  These three factors-- a potential significant drop in prices, high levels of retail activity, and new levels of information-- make it very important that we let investors know that this is a market that treats them fairly. 

NASD believes, and I'm confident that you do too, that there is no better way to build trust than for the markets to operate in total daylight.  Many investors have told us they think investment professionals are more concerned with their own interests than those of their customers.  And recent trends in our dispute resolution forum suggests that investors are increasingly disinclined to put up with it.  We believe that it is essential that regulators and broker/dealers work together to get investors, and in particular retail investors, the best possible information about the markets and their investments. This is the foundation for rebuilding their trust, which has been badly eroded by recent well-publicized events.

We have two major initiatives underway to help you address this issue of investor trust and confidence. The first is TRACE and the second is a series of activities that are an outgrowth of a corporate debt market panel that we assembled last year.

NASD, at the behest of the SEC, launched TRACE  the Trade Reporting and Compliance Engine  in 2002.  This is the first intraday consolidated tape in the U.S. over-the-counter fixed income markets.  All broker-dealers that NASD regulates are required to report corporate bond transactions to TRACE under SEC-approved rules. TRACE enables investors to receive information on the actual sale price of U.S. corporate bonds.  While we have often trumpeted TRACE's benefits to retail customers, it also gives a whole new level of information to professionals, particularly individual brokers and investment advisors, who also historically had difficulty finding good information.

As you know, we worked closely with the BMA and the bond industry in our roll-out of TRACE.  As of next Monday, we will have moved from disclosing price information on only large, investment grade bonds to full price dissemination.  Each step in that process has been a response to recommendations by the Bond Transaction Reporting Committee, a group of fixed income professionals appointed by the BMA and NASD.  I want to personally thank all of the members of the BTRC for their hard work and sage guidance as we moved from zero transparency to full transparency, without any apparent damage to liquidity. 

Eleven years have passed between the introduction of FIPS, which brought transparency to a small number of high yield bonds, and the present, with this week's full dissemination of post-trade information.  You and we have not always been of like minds during that time, but during the last two-and-a-half years we have worked together to steadily and cautiously increase transparency.  I'm sure that some of you still believe that full transparency is not the way to go.  But on Monday, investors will have access to trade prices in approximately 29,000 corporate bonds at all levels of credit quality.  And we have yet to see any evidence of damage to liquidity.

We'll reduce reporting time from 30 minutes down to 15 minutes in July of this year.  In fact, at the end of 2004, about 88 percent of all corporate bond transactions were already reported in 15 minutes or less.  At the same time, we welcome the advent of complete transparency through immediate price dissemination in the municipal bond market, launched this week.

We are working hard to get that data into the hands of professionals and investors.  There is a big difference between transparency and truly accessible information.  While we spent the last two years making this market transparent, we are now putting a lot of effort into making it truly accessible.  Professional users can access TRACE data instantly through Bloomberg, Market Axess, Trade Web or other data vendors.  Retail investors typically access it through web sites such as our or, a part of the Bond Market Association's web site. At least one broker dealer delivers TRACE data to its retail investors through its web site, and we encourage each of you to do the same.  We are also working with a number of web sites to provide data to retail investors.  And let me commend Micah and his team at the BMA for having such a great site and continuing to make it more and more useful for investors. 

As some of you know, effective next Monday, we will start disseminating real-time information to retail investors free of charge.  This only happened through close collaboration with the BMA.  In addition, you may have noticed that the New York Times now carries aggregate corporate bond market data as well as most active issues. In combination with the Wall Street Journal's information on most active issues, this sets the stage for wide print media distribution of this information during 2005.

Another area of particular interest to us is market performance benchmarks to help investors measure their investment performance.  Although many of your firms provide indices for institutional investors, there is no widely recognized retail index in the corporate bond world, no equivalent to the S&P 500 or Dow Jones Industrial Average.  We are looking closely at this disparity and encourage others to do the same.  We think individual investors would be extremely well-served if there were better ways for them to track the overall bond market, so they could monitor their investments and compare them to others, as they can do in the equities markets. 

Finally, we are actively looking for ways to improve the quality of bond pricing for customer statements and net asset value computations.  I've never heard an investor or, for that matter, an industry professional, express much confidence in the bond prices they see.  In addition, if interest rates rise and the NAVs of bond mutual funds fall, there will be an increased focus on pricing of bond mutual funds.  There seems to be a consensus view that TRACE and the new MSRB data help but don't get us all the way there. We are soliciting ideas and suggestions from as many parties as possible and would love to engage the industry in a dialogue on this issue.

In addition to helping brokers and investors, TRACE data has been enormously helpful to us.  For example, we've learned from it that the bond marketplace is much more active, and much more liquid, that anyone realized before TRACE went on-line.  On a typical day about $18 billion in par value of corporate bonds turns over in roughly 22,000 transactions.  Of the 5,200 broker-dealers that NASD regulates, about 1,900 report transactions to TRACE.  And of that number, approximately 500 report trades every day.

Also, TRACE data  along with MSRB information on municipal bond sales  helps us monitor sales practices in the 50,000-plus trades that occur daily in these two markets. 

Our commitment to transparency was also behind our decision last year to put together an expert panel to study the corporate bond market with an eye to making it more accessible, and more comprehensible, to mainstream investors.  Consisting of 12 experts representing various sectors of the market, the Corporate Debt Market Panel, as we called it, released its recommendations last September.  The panel looked at both retail and institutional investor issues, but decided to focus on the retail side because of institutional investors' higher levels of sophistication and resources.

The panel had three main recommendations: 

First, the panel articulated its views of what an investor needs to know in order to make good investment decisions.  This is basic information that the panel thought was necessary for an investor to be comfortable that a bond purchase or sale meets his investment objectives, understand the quality of execution and understand the bond's risk/reward profile.  The panel broke the information an investor needs to know into time frames.  At the time that an investor starts thinking about bonds, he needs some basic information such as types of bonds, pricing, payment terms and risks, and how brokers executing the transaction are compensated.  When the investor makes the transaction, he needs a different set of information.  I like to say that investors only truly start to internalize information when they are reaching for their wallets.  This is the time when they need information on price, maturity, coupon, yield, credit rating, and call features. 

The second recommendation had to do with clarity in post trade confirmations.  The panel said that existing post-trade reporting requirements for corporate bond transactions should be augmented and improved.  It recommended confirmation language that ensures that an investor understands that the brokerage firm may have taken a payment for its services from the price he or she paid for the bond.  It also recommended creating a system of symbols for corporate bonds so that investors can more easily find and identify them. 

Finally, the panel recommended that NASD and others redouble their efforts to promote broad dissemination of TRACE and other bond information and encouraged us to work to get retail benchmarks into the marketplace.

Now let me say a word about the panel and information disclosure in general.  The panel was commissioned by the NASD Board of Governors to recommend areas in the corporate bond market where NASD should focus.  Its report came to the NASD staff, and the rule-writing side of our shop has vetted recommendations through NASD committees.  In addition, we have widely circulated the recommendations and met with a broad variety of industry committees and the BMA to discuss their implications and listen carefully to concerns.  Any draft rules will be sent out to the NASD membership for comments by way of a Notice to Members before NASD files anything with the SEC. 

I have spent the majority of my career in the private sector and am very sensitive to claims of too much regulation.  While transparency and better information is the regulators' mantra these days, we need to be careful not to inundate investors with information they don't need.  Our corporate debt market panel did its best to parse exactly what information is useful to investors.  Our regulatory staff is working with the industry now to do the same.  While we may disagree on the details of these rules, the basic premise stands:  Transparency and full disclosure of the costs and risks of a particular investment not just the benefits  is the new standard in our industry.  Regardless of the final outcome of rulemaking, I encourage firms to ask:  "are we giving our customers all of the information necessary to make a wise investment decisions?"  If your firm seriously asks that question, and takes steps to ensure that the answer is "yes," then you will stay ahead of the game.

Your adhering to that standard is in your interest not just because it will keep the regulators off your backs, but because it makes good business sense, too.  Getting good information into the hands of investors and maintaining a solid compliance program will cost you and your firm a lot less than you'll pay in fines and lost business if you don't emphasize compliance and run afoul of the rules.  Consider this the foundation for rebuilding investor trust.  Investors who feel that they understand their investments and that they will get a fair shake in the market historically have been active investors.  And as we know, active investors bring business to your firms.

Abuses in the market hurt us all and diminish investor confidence and trust.  That's why we disciplined 17 firms last year for failing to try to get fair prices for customers who wanted to sell municipal bonds.  It's also why we fined Morgan Stanley  $100,000 for neglecting to tell municipal bond-buyers that their bonds were callable.  It is also why, last year, we found that four major firms had, on many occasions, executed two bond trades almost simultaneously and therefore without risk and charged mark-ups ranging from 10 to 32 percent.  This cost them $5 million each in fines and restitution.

We recognize that the vast majority of professionals in this business try to do right by their customers and treat them fairly, but the actions of a few can have a dramatic effect on investor confidence. 

Let me now say a few words about bonds in relation to other products and how I see the regulatory landscape changing.  First, as I mentioned earlier, while fixed income and equity are different products for investors and different parts of the capital structure for companies, it is hard to argue that an investor should know less when he makes a loan to a company by buying a bond than when he buys an equity stake in the company by buying a stock.  A bond investor obviously needs different information from what a stock-buyer needs, but not less.  So as transparency has grown in the world of equities, to real time last trade data and extensive disclosure of trading information, so too will it grow in fixed income. 

This is also true if you look at bonds in relation to mutual funds.  Due to scandals and concealed information in the mutual fund arena, whether it be hidden fees or hidden payments to brokers from fund companies, a new regime of transparency is emerging in mutual funds.  As investors buy stocks, bonds and mutual funds - not to mention ETFs, options and other instruments -  they are now expecting, and I would wager will get, better, clearer information. 

As I said before, there is a difference between more information and better information.  It will take a while for market forces to work out the right mix, but we are clearly on a one-way street toward more transparency and disclosure of all kinds.

With that said, let me add that we are keenly aware of the differences between the largely over-the-counter bond markets and the equity markets.  We recognize the vast differences in the complexity of the instruments and the tendency for investors to buy and hold in the bond market.  We recognize that there is significantly greater capital exposure of bond dealers and the average bond transaction is much larger than an equity transaction.  Because of these and other differences, you probably won't see the exact same disclosure requirements as you see in the equity markets.  But I don't want to mislead you either:  fixed income transparency is here to stay and there is going to be more of it.   And as we move forward, I commit to you that NASD will have a good, open dialogue with the industry so that we can all land in the right place.

Now, let me talk a little about some of the changes we see in the industry and the  challenges they pose for the regulatory community.  We recognize that the market environment is changing and that the pace of change is accelerating.  I know from talking with many of you, that at times you are overwhelmed with the level of regulatory activity.  This is compounded by the presence of more aggressive and demanding institutional investors and by greater demands from individual investors. I don't foresee any diminution of these trends. In fact, I see them accelerating. 

I also see a more evolutionary process unfolding with the merging of products.  I've visited some of your firms and I've seen and heard how you are looking more at sectors these days and less at products, and that your trading operations are migrating to support that view.  Ten years ago on an equity trading floor, the over-the-counter and the listed desks were quite separate, yet today they usually sit together and operate as one business.  Today it's becoming more and more common to see equities and high yield debt together and cash debt and derivatives traded by the same people.  In addition, with the growth of hedge funds and their propensity to drive more trading activity, active hedging techniques using credit default swaps and straight credit are becoming increasingly common.  I know this has placed enormous strains on your technology and information delivery infrastructures and forced you to make large investments just to keep up.  It may comfort you to know that it's having the same effect on the regulatory community. We regulators would not be doing our job if we weren't thinking about cross-product selling and trading as we study risks to investors.  I think you will see more and more parallels between expectations and regulations across products as a result of this phenomenon.

Let me finish by taking a few minutes to talk about NASD's unique approach to being a self-regulatory organization.  As you know, several years ago NASD enunciated a strategy to divest itself of its market subsidiaries and focus on regulatory activities.  We think it is the right posture for us and good for the markets.  Consistent with this view,  we will regulate, but not operate, Nasdaq.  You also recently saw that we finalized a sale of the American Stock Exchange to its members.  We now focus on our core functions of rule writing, examination, surveillance and enforcement, and continue to protect investors by providing data to the market and running transparency facilities such as TRACE and our BrokerCheck program, which provides information on brokers to the investing public.

As a private-sector regulator, we have the ability to work closely with firms to help promote a culture of compliance and ethics throughout the industry.  We have a major effort underway to ensure that we support firms that are doing their best to follow rules and regulations and treat their customers fairly.  We view this as a part of our job:  It is better for all concerned for a firm to promote fair dealing and ferret out its own compliance problems before investors are harmed, than for us to come in after the damage is done.

One way we support you is by getting data into your hands to help stay in compliance.  Last year, we invested in the NASD Report Center, an online, secure site that provides firms with information specific to their operations.  Building on our tradition of providing quality of markets regulatory report cards to help Nasdaq participants monitor their compliance, we launched three new report cards last year.  Our first reports were TRACE compliance rates and statistics for your firms and TRACE operational reports.  It was no accident that we launched TRACE and fixed income report cards first.  It is our explicit strategy to use all the tools at our disposal to ensure investors are protected in an area like bonds. 

We continue to roll out new reports, with recent CRD late filing statistics going hand-in-hand with our recent enforcement actions that focus on self-reporting responsibilities.  And shortly we will roll out MSRB G-36 report cards to monitor filing compliance in the municipal bond arena.

Also, in order to help deepen the dialogue about regulatory issues, we have expanded our educational offerings to industry professionals.  Last October we held our first Fixed Income Conference, here in New York. Maybe some of you were there.  We've scheduled a second one for March 30, just around the corner from here at the Waldorf.  There will be sessions on customer protection, transparency, trading practices and other important compliance-related topics.  We've also added fixed income components to our NASD Institute for Professional Development, including a session in April focusing exclusively on debt mark-ups.  These are intended to complement conferences like this one and ensure that our staff working on fixed income initiatives is accessible to the industry.  We are also working with firms to launch an e-learning exchange, where we pool resources and expertise to build on-line courses in key compliance areas.

I don't mean to suggest that the burden rests entirely on the industry's shoulders.   Investors have responsibilities, too, and foremost among them is the responsibility to educate themselves about the complexities of bond investing before trying their hand at it.  NASD is strongly committed to helping them with that.  In December 2003, our Investor Education Foundation was born.  We focused our first round of grants on research that might benefit investors who are female, young or elderly. We are very interested in funding research on the subject I discussed earlier:  how to make disclosure more meaningful and user-friendly to investors.

We also offer investors a host of printed and on-line educational resources to help them understand the bond market.  And we'll soon augment those resources with an online learning center focused on bonds.  It will pull together the most critical information about investing in corporate, municipal and government bonds, and will link to and direct people to other useful web sites, such as the Bond Market Association's.  I know the Bond Market Association devotes a lot of resources to investor education, and you are certainly to be commended for that.

So NASD views its role as one of protecting investors using a broad array of techniques:  from rule writing, to enforcement, to disclosure of information, to supporting members compliance to educating investors.  Using just one technique would be like playing 18 holes of golf with only a five iron.

In conclusion, I'll venture a guess that you're wondering where things are headed in terms of regulation and enforcement.  In the long term, that is largely up to the industry.  In the short term, I can tell you that we and other regulators are not likely to become less active anytime soon.  And I can tell you that we will maintain and sharpen our focus on the bond market.

In 2004, my colleagues on the enforcement side of NASD levied $102 million in disciplinary fines.  We suspended 380 brokers and dealers and we kicked another 450 out of the industry for life.  Not all of these were brokers and traders whom we caught trying to get away with something.  Some of them were senior executives who had failed to prevent wrongdoing by their salespeople.  The message here is that we're not just interested in improper sales practices; we're also interested in whether a firm has the processes in place to prevent those practices.

It was not just wrongdoing, but the failure to prevent it, that led us last year to use two enforcement tools we had never used before.  One was a temporary cease-and-desist order, imposed against a firm in Boca Raton, Florida, which had been raising money for its own benefit using fraudulent methods.  The other was an order to a Seattle firm to temporarily shut down a particular line of business.  Specifically, the order was to stop opening new mutual fund accounts for 30 days as punishment for having aided and abetted market-timing.

So, if there's a take-home message here, it's that simply complying with the rules is only half the battle.  The other half is establishing a culture of compliance a culture that permeates every aspect of your firm's operations from the executive office to the back office.  I hear repeatedly that the fixed income traders and salespeople barely knew their compliance officer a few years ago;  that most fixed income traders thought they weren't regulated or at best were 'lightly regulated.'  That has clearly started to change, and I am now told that the compliance officer today often sits in the office next to the CEO or branch manager or on the trading floor itself.  But I don't believe that compliance is the sole responsibility of the compliance officers.  Their responsibility is to be sure that salespeople, traders and managers know their responsibilities and live up to them.

We at NASD place a heavy emphasis on anticipating problems with the hope of preventing them, on being ahead of the curve.  I encourage you to do the same.  Think about what compliance and disclosure practices should be put in place today, before a problem appears.  I know you have done some of this already.  Your work with the BMA on establishing fixed income research guidelines was a terrific example of how the industry can try to get ahead of the curve and learn from the mistakes in other markets.

In that regard, I'll give you something to consider: we have a proposed rule pending at the SEC concerning variable annuity sales. It would create new requirements for sales recommendations, including a suitability analysis, principal review and approval, and training and supervision specifically tailored to deferred variable annuity sales. We have no such requirements for bond sales, nor are we contemplating any. But with relatively unsophisticated retail investors now having a ubiquitous presence in the market, I encourage you to pay attention to regulations in other financial products and ask if they are applicable to your business.

So, the ball is in your court.  Insinuating a culture of compliance into everything you do, and giving investors broad new levels of information, is the way of the future. This evolution will require management, traders and salespeople all to leave the principle of caveat emptor behind and take it upon themselves to give investors more and better information.  And, as I hope I've made clear, NASD is genuinely and strongly committed to helping you in these efforts.  I invite you to let us know how we're doing in that regard.  So, with that, I'll say thank you for being here and thanks to the Bond Market Association for giving me the opportunity to be with you.  Now, I'll be happy to answer any questions.