Remarks at the The Bond Market Association Legal and Compliance Conference
Chairman and CEO
Thank you, Robin. And thanks to all of you for being here this morning.
We come together at a propitious moment. For the first time in four years, the business news wrap-ups this year were full of stories about markets on the rise. For 2003, the Dow and S&P 500 were each up by a bit over 25 percent; the NASDAQ, by 50 percent. And while the fixed income markets did not match their outsized gains of recent years, they turned in another solid performance.
With the markets up and volume growing, Wall Street looks to be returning to profitability. Two weeks ago, the largest firm in the securities industry reported 2003 net income of $17.85 billion—more than any other company in history. And at firm after firm, bonds carried the first half and contributed to a strong bottom line at year’s end.
You know better than anyone what a vital role the fixed income market plays. In global terms, this has grown to be a $17 trillion market. In domestic terms—counting Treasuries—the dollar volume of business done on all the U.S. debt markets in the first hour of trading typically exceeds the dollar volume on the New York Stock Exchange in an entire trading day. And the secondary corporate debt market alone is roughly half the size of NASDAQ.
What’s more, this market is more liquid—and does far more business with ordinary investors—than previously thought. Of the more than 23,000 corporate bond trades reported in an average day on NASD’s Trade Reporting and Compliance Engine, or TRACE, 65 percent involve a par value under $100,000. Roughly a fifth of TRACE-eligible bonds—about 4,700—trade every day, and 46 percent trade at least once a month.
I’d venture those last few figures are significantly larger than most of us in this room would have guessed. They’re certainly higher than I thought until I saw the numbers.
But with the fixed income market’s immense size, success and visibility, there comes a corresponding responsibility. I’d like to talk with you this morning about the nature of that responsibility—and why it’s one your firms should embrace.
In less than three years, the brokerage industry’s reality has been fundamentally transformed. The economic environment is different; the legal and regulatory environment is different; the attitude of investors, the media and Congress is different.
Today, investors are following the adage, “Trust but verify.”
Today, it’s not just those of us in this room with gray hair who remember that securities markets go down as well as up.
Today, neither investors nor the media, Congress, regulators or anyone else is any mood to let a rising market excuse any compliance problems or outright abuses that are discovered.
All these changes point in one direction. Across the financial sector, we have entered a world where the presumption has turned ever more broadly against nondisclosure and in favor of transparency.
In the wake of the bubble, we’ve applied it in a number of areas, as I’ll discuss. We’re seeing it every day in proposals from Congress, federal and national regulators, state officials and other influential voices regarding the mutual fund scandals and how to remedy them.
And in the financial sector more broadly, we’ve seen the demand for greater transparency applied in a range of ways in the Sarbanes-Oxley Act.
Now, at the start of 2004, the fixed income sector of the U.S. securities industry is poised to continue its own transition to greater and greater transparency across more and more securities. I believe this trend is tremendously important and will continue to be extremely well received.
When the SEC first called in 1998 for increased transparency in the secondary corporate bond market, it fortunately was not spurred by dire scandal or the glare of intense political or media scrutiny.
Instead, TRACE grew out of a straightforward recognition that with so much of the securities industry being subject to extensive disclosure requirements, it makes no sense to leave out of the transparency picture something as fundamental as price discovery in corporate bonds. The SEC also sought creation of a surveillance program, to be based on the new database of reported transactions, to better detect fraud and foster investor confidence in the fairness of this market.
Since then, NASD has worked closely and cooperatively with the fixed income community to meet the SEC’s requirements. Together, we have successfully addressed the more obvious issues in the market. Our challenge now is to make the hard decisions that remain about how [much] to take transparency even further.
Today, the universe of TRACE-eligible securities encompasses $20 billion in daily turnover, with some 500 firms trading every day.
Under Phase II, on average, we are disseminating information on almost 70 percent of the investment-grade market by volume, as well as 50 of the more liquid high-yield bonds, representing about a tenth of that market. Looking to full dissemination, Phase III recommendations will be ready in the first half of this year.
One argument we often hear is that while the industry can understand the need for more disclosure as to ordinary investors, institutional investors represent the vast majority of the secondary corporate bond market by volume, and they simply don’t need the protection that disclosure provides.
I can think of at least four telling responses to this argument.
First, to provide retail trade disclosure without full disclosure of institutional trades is to withhold essential context—without which the retail information loses much of its usefulness. If institutional trades represent the vast majority of corporate debt by volume, how can we say we are truly protecting retail investors from potential mispricing if we continue to withhold information on a significant portion of these large trades?
Second, the growing number of institutional investors subscribing to NASD’s real-time dissemination service—now in excess of 4,100—is strong empirical evidence that they find this price information useful. By industry standards, $720 per year is not a lot of money. But industry professionals would not be paying for this information if they did not find it valuable.
Third, even institutional participants are, in many cases, downstream investors of retail assets. From the likes of CalPers and TIAA-CREF to the smallest municipal pension fund, all these institutions invest on behalf of ordinary working people. If such people would be entitled to convenient price discovery on their own behalf, why should this be unavailable when their funds are pooled together and invested by others?
Finally, and most fundamentally, in an era when retail and institutional investors alike have access to a wealth of price and other information about equities and other alternatives to bonds, it is simply an anachronism to withhold the basic building blocks for convenient, confident price discovery in the secondary corporate debt market.
Which leads to one conclusion. In this era of broad disclosure in the financial markets—and aggressive price-shopping by consumers for products of all kinds—providing price information for every corporate bond possible is not only a matter of regulatory compliance, but investor confidence. And that makes it not only the right thing to do, but the smart thing.
Across the board, I have a fundamental view that more information is better than less. One of the bedrock principles of our free market system is that all participants have access to information about prices and costs that will influence their decisions. When this information is hidden or distorted, investors are not able to make the best-informed decisions about where to invest their money. When they do have this information, investors are in a better position to evaluate the recommendations of those who create and sell these investment products—and to act accordingly.
Simply put, knowledge is power; and more market knowledge brings more market discipline. And that benefits all of us who have a stake in markets that are truly free and fair.
To put this in context, NASD along with the SEC, other regulatory agencies and Congress are focused on the importance of transparency in all areas of the securities industry.
NASD’s new analyst rules and our proposed IPO rules all focus for example on expanded disclosure so that the relationships potentially influencing analyst independence and causing conflicts in the initial public offering process will be more transparent for all investors at all levels.
Transparency is also a major focus today in the area of mutual funds. Looking at both the funds and the practices used to sell them, the picture that has emerged is worse than unacceptable—it’s appalling. And on a number of the troubling issues with regard to funds, the answer is increased transparency.
NASD of course doesn’t regulate funds but we do regulate brokers that sell funds and the sales practices they use. Our focus therefore has been on the suitability of the mutual fund share classes that brokers recommend; the sales practices brokers use; the disclosures they make to investors; and the compensation they receive from mutual funds, including so-called shelf space. We also have played a pivotal role in policing whether brokers give customers the proper volume discounts—called breakpoints—off of the front-end “loads” or commissions that many funds charge. The bottom line for us is this: When a brokerage firm or its registered representative has a financial incentive to sell or recommend particular funds, investors should know about it. NASD has therefore issued new proposals that would bring increased transparency to a range of these practices.
I will add that I believe the mutual fund industry’s own self-interest will be served by better disclosure of costs and fees and payments for distribution, as well as enhanced governance of the funds themselves. These changes will help the industry with its own customers. In fact I read last week that one mutual fund is proposing these kinds of changes of its own initiative as part of an effort to send a positive message to current and prospective customers. It is also, frankly, a good message to send policymakers, including legislators, regulators, and others who may otherwise feel the need to put in place specific additional requirements.
It’s also an important example of a member of the financial services industry taking its own initiative to help restore investor confidence. This kind of attitude needs to become the norm not the exception.
For those of you here today and your industry as a whole, to the extent that you are seen as fully supporting—if not leading—the effort to increase transparency on and customer protection for bond pricing, it would send a powerful and positive message to investors. To the extent that investors hear that any part of this industry wants to keep pricing in the back office and out of the daylight, it can cause investor suspicion.
The greatest challenge now facing this industry is not technical or technological, but cultural. Only by strengthening the ethical culture of compliance throughout our industry will investors have the confidence on which the success of our capital markets depends.
In an interview with Money magazine this fall, the chairman of Vanguard described the message given to new employees in stark terms: “The difference between right and wrong is black and white. If you think there’s any gray area, you won’t last long here.” When it comes to matters of compliance, he declared, “The most important defense is cultural.”
Other influential voices have also noted that the abuses we see today do not turn on rocket science or fine shades of gray. For example, commenting on the current mutual fund scandals, former SEC Chairman Richard Breeden told the New York Times this month that “If someone comes to you and asks for the right to engage in trading that is blatantly illegal, it should not take longer than a nanosecond to say No.”
Put differently, we regulators can issue a thousand rules and they still won’t cover explicitly ever loophole. By contrast, if NASD can help firms build a strong culture of compliance and integrity throughout the industry, that culture will take care of a thousand specific situations that no regulator can ever fully foresee.
You’ve heard me say that regulators will continue to do our part. But it is your firms that must do the truly heavy lifting to win back and hold on to the trust of their customers.
That is because enforcement—forced compliance, if you will—comes after the damage is done; after investors have lost money they should not have lost; and after investor confidence has been harmed.
By contrast, improved self-compliance by the firms can prevent investors from being harmed in the first place.
So self-policing is not only helpful, but indispensable, for the health of the capital markets. Because brokerage firms really are the front lines of compliance. It is they who can provide the earliest detection, and the swiftest, most cost-effective response.
All this and more led NASD to propose a signed annual certification by each firm’s CEO and chief compliance officer. Our proposal, as filed with the SEC, will require a signed, annual certification that the firm has in place a process that is reasonably designed to ensure compliance with NASD rules and the federal securities laws. Once approved by the SEC, it will also require each firm to designate a Chief Compliance Officer if one does not already exist.
NASD’s proposal is not designed to be yet another rule, but a mechanism to increase compliance with existing rules. It will promote greater interaction between CEOs and their top compliance people. We are seeking nothing less than to foster a heightened culture of compliance by restoring some balance between the voice and influence of compliance personnel, and the disproportionate clout gained in the 90s by top sales producers and business personnel.
Do any of you remember the classic line from the ad, “You can pay me now or you can pay me later”? You might think of improved self-compliance by firms as paying now. And of enforcement by regulators as paying later.
At the largest firms, the costs of solid compliance and supervisory systems are counted in the millions of dollars. The scandals of the past two years, by contrast, have showed that the costs of lax compliance—in terms of both lost market value and lost business at some of our nation’s largest investment houses—are counted in the billions. You can do the math to see which approach makes better business sense.
Which makes improved self-compliance not only the right thing for the industry to do, but also the smart thing.
Which leads me to another piece of the compliance puzzle. Enforcement. NASD has shown and will continue to show that where warranted, we will bring enforcement actions. Not surprisingly perhaps, last year we brought more enforcement actions than ever, and threw more than 800 brokers out of the business.
We take these decisions seriously and while we don’t just want to be about or known for enforcement, it’s clearly an important message for the industry as well as investors to understand that if you violate our rules, you will be punished. And make no mistake, our enforcement cases have included some very senior people who we held responsible for activities under their control. This trend will continue because we will hold accountable those with authority and responsibility.
We are also looking to these senior people to establish the culture of compliance that will make some of these enforcement actions unnecessary. And we are looking to everyone in this audience of compliance officials for that same purpose.
I’d like to mention one additional area that is part of a program of transparency and rebuilding investor confidence, and that is investor education.
In December, NASD released an investor survey which showed that investors both want and would benefit from being better educated about investing. Almost half of those surveyed said that a better investing background could have helped them avoid a negative experience in the market. And little more than a third could manage a passing grade on the questions we designed to test basic financial literacy.
NASD is doing more than ever to be a leading source of objective information for investors. We provide everything from written materials, investor forums and online content; to specialized offerings on saving for college or retirement. And we announced in December the establishment of a $10 million investor education foundation. This foundation will complement our existing investor education efforts, and it will receive additional funding in the future from fines we levy on the industry.
I know the Bond Market Association has also focused on investor education and I commend you for those efforts. It’s a valuable and important service for your association to undertake.
In closing, I’d like to say that there is much of which to be proud and much for which to take credit in advances of bond market transparency. We have opened up a critical new front to individual investors and to larger, institutional investors who have benefited from TRACE. NASD is committed to continuing on this course of increased transparency and I firmly believe it’s the right path to take. Certainly there will be specific issues to discuss along the way but if we begin with the premise that transparency can and has added great value to the fixed income market, at the end of the day, we will wind up serving investors and, especially through increased investor trust, the market as a whole.
America’s markets have for years now been the most liquid and developed anywhere. Before our careers are over—including those of us with gray hair, or even no hair—I hope investors everywhere will resume without reservation the habit, founded in fact, of viewing the U.S. markets as not only the most prosperous, but also the most admired, transparent and trusted in the world.
And truly, I believe they will.
Thank you very much. And now I would be happy to answer your questions.