Remarks at The Bond Market Association's Eighth Annual Legal & Compliance Conference
Vice Chairman, NASD President, Regulatory Policy and Oversight
The Roosevelt Hotel
New York, New York
Good morning and thank you so much for inviting me to speak with you today. We live in a time of exponential change in our industry, so every opportunity that we get to communicate face to face is of critical importance. The effects of economic change, natural rotations in the business cycle, corporate governance lapses and the imbedded conflicts of interests between financial services intermediaries and their clients, have seemingly come to a head and intersected at a single point in time. No doubt, the industry has felt these effects, and, I assure you, the regulators have been impacted as well.
NASD is in the business of private sector regulation, but even we wish that business could be somewhat slower. But it is not to be. The industry and the regulators continue to be faced with challenges that I have no doubt will be met. And, not just because we have no alternative. All of us are passionate about the financial services industry, understand its importance to investors, the capital markets, and, therefore, in a very real sense to the strength and fabric of America itself, and we are determined to meet the obligations that come with that understanding.
All of which brings me to the theme of transparency, because I believe it is the animating concept that should serve as our touchstone in determining the future course of the financial services industry specifically, and corporate conduct and governance more generally.
I suppose the term "transparency," beyond its literal meaning, could be viewed as a term of art when applied to markets. I would like to touch on both meanings this morning in discussing NASD developments in the debt markets and other current and future regulatory considerations.
Let me begin by briefly reviewing with you the progress of transparency in the corporate debt market, with the advent 7 months ago of the Trade Reporting and Compliance Engine, known by its acronym as TRACE.
The TRACE Rules require our members to report secondary market corporate debt transactions to the NASD, if such transactions are over-the-counter. And, most corporate debt transactions ARE OTC transactions. Members have to report a transaction whether they are the executing broker or the introducing broker, and whether they are the buyer or the seller. The reach of TRACE has been substantial. Approximately 1,900 member firms are reporting trades into TRACE. About 400 firms submit at least one trade report on a given day. From these firms, NASD receives a total of approximately 25,000 trade reports each day in 26,000 "TRACE-eligible" securities, which represents nearly all US dollar denominated corporate bonds. A surprising 65% of transaction are retail-sized orders (under $100,000 in par value).
NASD is creating a publicly disseminated stream of information on debt transactions. For the first time, investors, large and small, and professional market participants, can see the prices of these trades. This is a big leap forward in transparency from the days of FIPS reporting when NASD received trade reports only on high yield securities; and, only 50 of these high yield securities, during any calendar quarter, ever had any pricing information disseminated about them.
Although almost 26,000 bonds are reportable to TRACE, dissemination involves a much smaller number of securities. Currently, dissemination occurs for approximately 540 securities—490 of which are the largest, very liquid Investment Grade bonds—those issues of over $1 billion in original issue size. The remaining 50 securities that are disseminated are Non-Investment Grade bonds.
This market will become even more transparent in the very near future. In November, the NASD Board approved a proposal to expand significantly the number and types of securities that will become subject to real-time dissemination. This proposal, approved yesterday by the SEC, will increase the number of bonds that will be disseminated to over 4,000. Rule 6250, requiring that transaction information in certain Investment Grade debt be disseminated, will be modified to require dissemination of transaction information on:
- all Investment Grade debt of $100 million or more of original issue size that are rated at least A3 or A-, and
- 90 pre-selected bonds rated "triple-B"
The Bond Transaction Reporting Committee, which is composed of 10 industry experts, who are dedicated to assisting the NASD in increasing bond market transparency, played a key role in developing the proposal. Several very active members of The Bond Market Association have given significant time to the work of the Committee and we appreciate their efforts.
People may forget that transparency was not the only motivating policy goal articulated by the SEC when it tasked NASD with creating a bond reporting system. Sharing equal billing was the expectation that an enhanced regulatory scheme would be created, using this new audit trail, for the benefit of investors and market participants alike. We have not forgotten about this half of the mandate. NASD has developed systems and processes designed to ensure the quality and completeness of the "tape," and to detect market or investor abuse, either systemic or trade-by-trade. And while, yes, we understand that the markets are different and require different approaches, we won't apologize for exporting some elements of equities regulation (or futures regulation, or muni regulation, whatever it takes to make us the most effective) into our corporate debt regulatory program.
Your efforts at self-compliance are as important here as anything that we will do and I believe that we are already seeing evidence of your efforts. Barely a week passes when my staff is not asked about best execution obligations in the Bond market. I have heard from institutional traders inquiring about unusual pricing on retail trades and expressing concern about whether they really indicate the market. Clearly, these questions show that you are focusing on issues that simply were not on the radar screen before—issues about market integrity that were little discussed. This "early benefit" of Phase I deployment is exactly as it should be and I applaud your focus on compliance.
I also must tell you that transparency, and the regulatory scrutiny that follows, is an inexorable force. We are aware that many in the fixed income community are urging us to move cautiously and slowly. And this is where transparency as a term of art bumps up against its literal meaning to make something easily understood, frank and open. It is the term's literal meaning that makes transparency such a powerful and magnetic concept because it puts upon the industry the responsibility to answer this question: why shouldn't the public know the execution price for all transactions. Believe me, we have heard all manner of justification and you know the names of all these tunes: "YOU DON'T UNDERSTAND THE MARKET," "CERTAIN PRICES ARE MISLEADING," "YOU'LL KILL LIQUIDITY," and on they go.
While there may be some truth in these arguments, the fact is that the lack of transparency, whether in the board room, on a balance sheet, in our markets, or in our dealings with customers is a malady whose root cause is grounded in the notion that a group of people cannot put to good use the complete disclosure of important information. We will see what the economic analyses show us about the impact on liquidity, but it is my hope that dealers will step up to the challenge of operating in a market upon which the light now shines.
Equally, important to the transparency we employ in our markets and in our dealings with the public, is the transparency we apply in determining our own conduct and decision making. It is a fair question to ask what I mean by the interplay of transparency and a firm's conduct and decision making and this is best done by reviewing recent events, albeit events largely removed from the debt markets but instructive nonetheless.
These past two years have shown us public companies engaged in unprecedented earnings management that enriched insiders and duped shareholders. Management treated public companies as a private fiefdom, forgot that they were the custodians of their shareholders interests and believed that the purchasing power of the corporations under their stewardship were assets that they could trade for their personal benefit and profit. The boardroom became a place where loans and cash were stealthily dispensed while the public trust of shareholders cast no shadow. The accounting industry, charged with auditing and certifying the financial results of public companies, compromised their standards and parsed the language of generally accepted principles, regulation and law to the point where they were rendered meaningless. The research product of firms found its purpose in nurturing investment banking relationships as opposed to informing the public about the investment prospects of the companies it was meant to cover. And IPO allocations were done in a manner that at least invites allegations of impropriety and at worst implicates serious violations of the federal securities laws and the rules of the self-regulatory organizations. Did this happen universally? No. Does that matter? Not really. Its effects have crippled particular companies, caused the vaporization of thousands of jobs, dashed the financial security of the retired and the nearly-retired, delivered an ill-timed shock to financial markets trying to climb out of a recession, received massive federal and state attention and subjected financial services firms to a prospective measure of liability that one cannot be sanguine about their ability to absorb. And I have to ask: if the conduct and decision making that lead to these problems was compelled to meet the definition of transparency, that is, if it was required to be easily understood, frank and open would it have occurred? The fact is that these problems were largely the result of rationalization, and rationalization enters where clarity and integrity of thought exits.
Transparency is the foundation of ethical thought and action and it must be the cornerstone of self-regulation. It follows that the notion of "just and equitable principles of trade and high standards of commercial honor" can not be an empty slogan, it is an imperative that arises because the capital markets constitute a public trust which places upon those who serve as financial intermediaries in those markets significant burdens and obligations. NASD will regulate on that basis and understanding and will expect its members to comport themselves accordingly.
At NASD we have tried to look back in clarity upon recent events and draw certain lessons. We have distilled four major lessons to be learned:
- Contemplate whether what you do today will be acceptable three, seven and ten years from now. If we have learned anything from recent events it is this: Crying that hindsight is 20/20 will gain you neither sympathy nor understanding. Avoidance or control of the problem through foresight is the better strategy.
- The penalties from a court of law pale in comparison to those meted out by the court of public opinion. There is really no appeal from the judgment of the press and elected officials as our industry is reaching a painful understanding of this fact.
- The road to damaging the trust and interests of investors is paved with rationalized intentions. Every time a firm decides to bury a disclosure in small print or bundled mailings, argues why it really is in the best interest of their customer not be told about certain charges, commissions or fees, or talks itself into believing that it can simultaneously serve different clients with competing interests without meaningful disclosure - without transparency if you will-a step is taken down this road.
- Defending commercial behavior on the basis that it was standard operating procedure that occurred industry-wide and was well known is a fool's defense. Bad acts repeated and publicized are still bad acts. This may seem to be an obvious statement, but you can't imagine how often we hear the excuse that a course of conduct is acceptable because that's the way everyone does it and everyone knows that that's the way everyone does it. It is not an effective argument
Because of recent events, we still have much to do-regulators and the industry-to repair and regain that most precious of commodities-trust and confidence. "Putting investors first" can't be just a tag line, it must be the prism through which all actions and potential actions are viewed.
We at NASD think the most important ways to meet these challenges are through (1) understanding and anticipating the problems, (2) responsive rule making and interpretation, (3) active enforcement, and (4) accessible education. We have distilled all this down to an initiative we call "Ahead of the Curve" in which we attempt to catch problems at the earliest point in their manifestation. Let me tell you where the industry comes in with respect to this process.
First, there truly needs to be sea change in the acceptance of regulatory risk in your business models. When a decision is made to offer particular products and services there simply has to be greater attention paid to the acceptance of reputational risks and the resolution of conflicting interests in a manner that suggests the investing public may be disadvantaged. We have no illusion that misjudgments won't be made in the future, but there is a difference between misjudgment and rationalization. The observation that you take a risk every time you open your door for business or that there are inherent conflicts in your role as a broker and dealer cannot become the basis for the failure to adhere to the highest ethical expectations of our industry on the part of the investing public.
The second part of your role in getting ahead of the curve involves tweaking the relationship between the membership and the regulator. NASD derives great benefit and insight from its board, standing committees, district committees, and interaction with industry groups such as The Bond Market Association. Industry and public participation in our mission simply makes us better regulators. Especially in the case of industry participation, your critical eye glanced on our rulemaking proposals and Notices to Members keeps us more focused and accurate than could otherwise possibly be the case. But it is not enough to be our critic. You need to provide us with the information necessary for us to do our part in staying ahead of the curve. And you have to understand that we will receive information from you with an ever-more-critical eye. When you tell us in the context of debt mark-ups that your risk is compounded by the fact that investors have superior knowledge compared to the dealer and then tell us at the same time that greater price transparency in debt mark-ups hurts liquidity that we will ask the question: how can providing transactional information to parties you already contend have better and greater information possibly have any ill effects? We need for you to deal with us openly, consistently and honestly. The BTRC is an important step in this direction.
I don't argue that the consequences to member firms in transforming the relationship with their regulator from one of cat-and-mouse to one of partnering is cost free; I simply observe that it is much less costly in the long run to get our views and involvement. We have to recognize that we share the same boat when it comes to investor protection and market integrity. No industry can thrive if customer trust and confidence is absent. We will be reaching out to the industry through various forums to help us reach the goal of cutting off the prospect of these problems at the pass and I ask that you not wait to be called.
It may come as no surprise if I inform you that we will not totally depend upon the industry in getting us ahead of the curve. We plan to marshal our various data banks throughout NASD and employ technological solutions to ascertain information that will allow us to (1) catch on to problematic trends and practices at their earliest points in time and (2) determine whether the data, as currently captured or further enhanced and more finely dissected, has certain predictive qualities about problems outside the viewfinder.
Getting ahead of the regulatory curve may not be an intuitive matter for firms to turn their attention to in the current business environment. After all, the growth in legal and compliance headcount tends not to blossom in economies such as these. But we should not kid ourselves—the problems demanding those resources are omnipresent in our business. We serve in an incredibly diverse industry populated by people who are richly talented, keen thinkers, imaginative and for the very great part, forthright and honest. We must employ those attributes to redefining the relationship between member firm and regulator and tackling together regulatory concerns that engender the prospect of widespread reverberation. NASD and I look forward to undertaking and mastering that task with you.
I know you understand that "ahead of the curve" isn't just our initiatives concerning IPOs and hedge funds, and mutual fund breakpoints, all of which you may have read about recently. It includes once again engaging ourselves in the debt mark-up debate, looking at the data that we collect from TRACE to determine whether new obligations arise with regard to efficient executions in a market where price discovery becomes more ascertainable, and considering the regulatory needs of the market more generally. And it means resolving these debates before questions like these can grow into issues that can damage the credibility of the market.
Some of these will be difficult conversations. Nonetheless, we will undoubtedly need to engage in them. NASD looks forward to meeting the challenges of the future with the industry in a manner that demonstrates that the essence of self-regulation is the realization that industry conduct is most profitable in the long term when aligned with the best interests of investors and market integrity.