Remarks from the NACUBO 2014 Endowment and Debt Management Forum

Richard G. Ketchum

Chairman and Chief Executive Officer

New York, NY
February 6, 2014

As prepared for delivery.

Thank you, Bob [Shea], for that introduction. I am honored to be here and I appreciate your interest in how FINRA protects America's financial system and investors.

I want to talk to you today about two roles FINRA plays that are key to our mission of investor protection and market integrity—and that intersect with your role as stewards of your institutions' financial well-being. Since some of you may not be familiar with FINRA, I want to start by telling you who we are. FINRA is the Financial Industry Regulatory Authority—an independent, non-governmental regulator for all securities firms doing business with the public in the United States. FINRA regulates about 4,100 brokerage firms and about 635,000 registered securities representatives. We are out there on the ground and in the field every single day—in offices all across the country—overseeing virtually every aspect of the securities business.

In addition, FINRA monitors 90 percent of all trading in U.S. listed equities markets—or nearly 6 billion shares traded each day. Our technology enables us to look across equity markets to detect potential abuses. In fact, FINRA handles more "big data" on a daily basis than the Library of Congress or Visa—processing approximately 6 terabytes of data and up to 30 billion transactions every day to build a complete, holistic picture of securities trading in the United States.

Given your role to maintain the financial health of your institution—and your experience and understanding of the markets—I'm sure that you've shared our concerns over the number of technology-related problems and market disruptions we've seen in the last few years. So I want to share with you some of the steps FINRA has taken to address these issues and our vision for taking market regulation to the next level.

The second topic I want to address is financial education. Part of FINRA's job as a regulator is to provide investors with essential tools to help them better understand the markets and basic principles of saving and investing. As financial leaders, I'm sure you also support—and are involved in protecting—the financial health and capability of your students. So I want to share with you some of what FINRA is doing to address financial capability among younger Americans.

Maintaining the Integrity of the Market

Keeping up with computerized trading and evolving markets is a never-ending challenge for FINRA and other regulators. While we may not be able to prevent a technology failure from occurring, our job as a regulator is to implement programs to minimize the impact of a failure and prevent widespread market disruption. We have made significant progress, particularly in how we identify problematic trading activity and how we limit widespread problems when there is a trading glitch.

Since the flash crash in May 2010, FINRA, the SEC and the exchanges have implemented a safety net for the markets to minimize the impact of technological malfunctions. For example, single-stock circuit breakers have been put in place to give market participants an opportunity to assess their positions, valuation models and operational capabilities when extreme periods of volatility occur. Last year, the first phase of an SEC-approved limit up-limit down plan went into effect to address the type of sudden price movements that happened during the flash crash. Under the plan, a marketwide limit up and limit down mechanism prevents trades in national market system stocks from occurring when prices are outside of certain ranges. And if the changes in price are more significant and prolonged, the limit up-limit down plan would trigger trading pauses.

In addition, smaller activation levels have been set for marketwide circuit breakers. And all the markets have adopted uniform standards to handle erroneous trade claims. The SEC has also adopted the Market Access Rule, which, among other things, imposes pre-order execution requirements to detect erroneous orders and requires firms to establish reasonable limits on their own—and their customers'—trading activity.

While these initiatives have been extremely helpful in preventing and minimizing extreme market volatility, the firms we oversee have to do a lot more to ensure that their procedures and practices regarding the development, introduction, testing and monitoring of algorithms are effective. When we examine brokers, we assess whether a firm actively monitors and surveils algorithms and trading systems once they are placed into production or after they have been changed. For example, we assess a broker's procedures and controls to detect potential trading abuses. And we expect that the firms can tell us about their approach to firmwide disconnect or "kill" switches, as well as their procedures for responding to catastrophic system malfunctions.

One example of the type of practice that is a regulatory priority for us is the use of so-called "momentum ignition strategies," where a market participant attempts to induce others to trade at artificially high or low prices. This includes layering and spoofing strategies, where a market participant places a non-bona fide order on one side of the market in an attempt to bait other market participants to react to the non-bona fide order and trade with another order on the other side of the market. We've seen variations of these strategies in terms of the number, price and size of these orders, including the use of wash sales as a component of the strategy. The essential purpose behind these strategies remains the same: to bait others to trade at higher or lower prices.

Another example of problematic high-frequency trading or algorithmic activity is momentum ignition and spoofing strategies related to the open or close of regular market hours. To carry out the strategy, participants distort disseminated market imbalance indicators through the entry of non-bona fide orders and/or aggressive trading activity near the open or close.

FINRA is working hard to stop these kinds of abuses. New advances in technology allow us to aggregate data from across multiple trading venues and see trading patterns we weren't able to see before. For example, nearly two years ago, we launched a suite of 23 cross-market surveillance patterns that canvass activity on the markets FINRA oversees, including NASDAQ's and NYSE's family of markets. We look at data from FINRA's Order Audit Trail System along with data from NASDAQ and the NYSE to create a cross-market data model. The model tracks about 15 billion to 20 billion events a day. With these cross-market patterns, we can track orders from their inception, as they move through the market and are either cancelled, replaced or executed. This is particularly important since market participants are increasingly dispersing their activity across trading venues in an effort to mask improper trading schemes.

We designed the patterns to detect a variety of trading abuses, including layering, spoofing, algorithm gaming, wash sales, marking the close and open, and front running. Since we introduced the patterns, we have found that about 44 percent of the manipulation-based alerts involved conduct on two or more markets. And 43 percent of the alerts involved conduct by two or more market participants.

We believe the cross-market surveillance patterns are a material step forward in promoting market integrity. But we also know that we can do much more with technology to improve surveillance.

One example is a consolidated audit trail—or CAT—that would collect and accurately identify and link to customers every order, cancellation, modification and trade execution for all exchange-listed equities, options and fixed income product across all U.S. markets. CAT will allow us to look not just across markets but across products. It will provide more comprehensive and granular data that will reduce false positives and false negatives in our surveillance alerts, and enable us to detect activity that we can't detect today. FINRA is working with the exchanges to create and develop the CAT.

FINRA has also issued a concept proposal for a system that would further advance our analytical capabilities. The proposed Comprehensive Automated Risk Data System—or CARDS—would allow FINRA to collect—on a standardized, automated and regular basis—account information, account activity and securities holdings that a firm maintains as part of its books and records. FINRA would use the information to run analytics that identify potential red flags of sales practice misconduct, such as churning, excessive commissions, pump and dump schemes, markups and mutual fund switching. And the system would also help FINRA identify potential business conduct problems with member firms, branches and registered representatives. We are interested in hearing comments from any interested party on the proposal. So if you have some thoughts, please be sure to let us know.

Promoting Financial Literacy

Now I want to turn to the second area where our roles intersect.

FINRA believes that investor education is a critical component of investor protection, and we have worked hard to develop a strong investor education outreach program. We produce alerts, interactive tools and educational content to help investors make informed financial decisions. And the FINRA Investor Education Foundation engages in a variety of initiatives to reach underserved Americans—including students—and provide them with the knowledge, skills and tools necessary for financial success throughout life.

I want to take a moment to highlight some of the FINRA Investor Education Foundation's work to support financial capability among younger Americans—a group that's very familiar to you. Since 2008, we've partnered with Channel One and the Consumer Federation of America on a project called "Generation Money" to address everyday personal finance topics that are important for teens to understand. The Foundation has also funded research by the Institute for College Access and Success to look at students' use of private loans. The study found that a large number of students use private loans before maximizing their use of federal student loans. And students also don't appear to understand the differences between private and federal loans, or that the capitalization of interest on private loans can have a huge impact on the amount they eventually have to repay.

The Foundation's own study—the National Financial Capability Study, which we conducted in 2009 and 2012 to measure the progress Americans have made in improving their financial futures—also found that student loan debt continues to be a problem for many Americans. Among the younger respondents, 36 percent of 18- to 34-year-olds report having student loan debt, and more than half of respondents with student loan debt are concerned that they will not be able to pay it off.

Another important area that the study tracks is the level of financial literacy. Financial literacy remained flat, or even slightly down by some measures. In 2009, respondents could correctly answer three of five questions on a financial literacy quiz, and in the 2012 study that number held steady. However, another way to look at it is that we classified 42 percent of the respondents in 2009 as having high financial literacy—meaning they could answer four or five of the five questions correctly. In 2012, the percent of respondents classified as having high financial literacy dropped slightly to 38 percent.

But we also found some encouraging signs about financial literacy. Respondents who were offered and participated in financial education could answer more of the financial literacy questions correctly when compared to respondents who were not offered financial education or who were offered it but did not take advantage of it. When asked whether they thought financial education should be taught in schools, 89 percent of respondents said yes. That finding underscores the power of financial education and the important role that higher education institutions play in boosting financial literacy.

As business and investment officers, I suspect most of you spend more time in the board room than the class room. But I encourage you to think creatively about the role your institution can play in helping students protect their financial health. It's very true that part of the reason that young people perform more poorly on financial capability measures may be grounded in experience—or lack of experience. Most of us don't gain financial knowledge until we make a financial decision, like investing in a 401(k) plan or using a credit card. But for many students, especially those who take on debt, financing a college or graduate school education is their first major financial experience. How can you make it a positive one?

Building financial capability is a complex issue that requires all our combined efforts. One of the things we have learned is that we can't address financial capability in a vacuum. It must be woven into the fabric of our lives—at home, in our schools, in the workplace, in our communities, and in the way we design and regulate financial products and services.

Thanks for listening.