Remarks at the ASECA’s 7th Annual William O. Douglas Awards Dinner Honoring Stephen Hammerman

Mary L. Schapiro

President, NASD Regulation, Inc.

The Capital Hilton Hotel
Washington, DC

February 25, 1999

I want to talk this evening about the future of self-regulation. I will try not to talk too long because tonight should be an opportunity for us to talk with and not at each other, to renew acquaintances and friendships and to honor Steve Hammerman, who in many regards embodies all that is great about this industry and self-regulation in particular.

The primary point I want to make tonight is that ensuring the viability of self-regulation is more important than ever before, and that in order to remain viable it must adapt as the markets themselves are adapting—to changes in technology, competition, and market structure. We stand at the threshold of a radical remaking of the financial services landscape. We don’t yet know precisely what the new world will look like; that depends in large part on how people respond to change, and people tend to be unpredictable. We do know enough to perceive that the landscape will be a very different one, and one of the implications is that the industry’s capacity to police itself effectively will be challenged and scrutinized.

The history of self-regulation and the motivations of the draftsmen of the ’34 Act and the Maloney Act are well known to the people in this room. The proponents of self-regulation understood it was required as a practical matter. The then-Assistant Secretary of Commerce testified in 1934 that "Self regulation, with government holding its power in reserve to see that self-regulation is exercised, is, after all, a necessary recourse in view of the mere physical limitations in time and personnel, which operate on the direct exercise of powers of government as the task of regulation becomes more and more extensive over a wider and wider field."

They were right for their time and right for ours.

Self-regulation, particularly as practiced by the NASD, already has changed significantly through the years, as we know. Much of this change paralleled the growth of the over-the-counter market. According to the Special Study, in 1939, NASD membership comprised 1,500 firms, or 22% of all registered firms. By the end of 1962, the total number was over 4,700—83% of registered firms. And today, virtually every firm in the business is an NASD member.

Over time, growth in the industry has been accompanied by functional changes. Some of these grew out of specific recommendations of the Special Study. Others represented responses to the increasingly important role that the industry has come to play in the national economy. The role of the staff at the NASD also has changed, gaining a greater responsibility in helping to propose and shape policy, and in giving concrete form to the vision of the industry leaders who year after year lend their time and talent to the goal of promoting fair and efficient markets.

Many more organic changes came about in the aftermath of the SEC investigation and 21(a) report—the corporate separation of the regulatory function, changes to Board composition, and revamping of the disciplinary process, to name a few of the more important. The NASD through most of its life, of course, was either solely or primarily a regulator, and later a sponsor of market systems, but only incidentally so. The unprecedented growth of Nasdaq changed all that, and it also created tensions and stresses that, in my view, made a crisis of some dimension all but inevitable.

What was not inevitable was whether the self-regulatory system would survive. But it has, in no small part because the voices in the industry that mattered most recognized that change was inevitable and rose to the challenge.

Even in the short time since these structural changes were put in place, new dynamics require us to question whether even more adjustments are needed to maintain the viability of self-regulation.

One major development with the potential to dramatically change the shape of self-regulation is the greatly enhanced technology that is now broadly available to the market place including investors at the retail level.

The best example is the increased use of the Internet by individual investors for research and trading. This is one development that should have taken no one by surprise, although I think most of us assumed that we would have more time to prepare for the revolution.

Like almost everything connected to technological change, the Internet as an investment tool holds great promise for the average investor. There also is a darker side that we ignore at our peril. As regulators, we need to be concerned not just with shielding investors from unscrupulous conduct. At least as important are educational and other efforts to give them the tools they need to advance their own interests.

On the positive side, the Internet has provided a wealth of research, quotation, and other valuable information to investors who never had practical access to it before, and in offering these services, firms compete both in terms of price and quality. The more investors shop around, and the more familiar they become with various sources of information, the more discriminating they become.

There is still entirely too much misinformation printed in chat rooms and on bulletin boards, and we won’t back away from going after those who spread it. But we should also take care not to do anything that discourages firms from making good information as widely available as possible.

The transaction capabilities that the Internet provide also are something of a mixed blessing. Because they allow execution costs to be trimmed to razor thin margins, they can prove especially valuable to investors who trade actively and don’t need or require specific direction or advice. However, all investors —even the dedicated on-line users —need disclosure of the access and capacity limitations provided by on-line firms. They do need to understand the risks of transacting in enormously volatile markets where orders may be delayed in their execution. They do need to understand that whether you are investing on-line or in-person, investing wisely is still hard.

The immediacy of the market access that technology can provide is another advantage with a not-so-hidden downside. The ability to execute a trade quickly does not equate to the speed of making a sound investment decision.

One aspect of the darker side of electronic access, as I see it, lies in the unrestrained promotion of day trading to investors who stand to lose everything —and all too often everything is very little—on a bet as to which way the tide is running. When the tide is running with you, it is insidiously easy to believe that there is no better or faster way to make money. When the tide turns, small investors can be buried before they even see the wave.

One step that both firms and regulators should take is to scrutinize advertisements carefully, and I will say that some of the ads I have seen are close to the edge. Few people really believe that they’re going to acquire an island paradise by trading on-line. But often there is an underlying bandwagon mentality promoted, and a message that investing is easy and risk free. I think those who are in this business for the long haul and care about its future should aim higher.

I also think that we must seriously consider the need to better define obligations of firms which actively recommend to their customers day trading strategies—whether in the way of disclosure or evaluating whether those targeted understand and are financially positioned to absorb the risks of such an aggressive strategy. Imposing new duties on firms in this arena will strike some as overly paternalistic. But, the fact is that day trading is not purely a "do-it-yourself" activity—it is activity that generally is encouraged, taught and facilitated by firms.

We force members to scrupulously document every recommendation of an individual security, no matter how safe or risky. On the other hand, when firms promote or recommend trading strategies that by their nature carry substantial risk, we impose no duty on the firm vis-à-vis the individual investor, and that strikes me as incongruous.

We also need to remember that volatility associated with exaggerated expectation of profit endangers not just those who have placed their bets —it can affect the integrity of the market as a whole. So far, most firms seem to have done a pretty good job of dealing with the market integrity concern —principally by increasing margin in particular stocks, or limiting on-line trading for some issues, for example. At the same time, we are looking at our own margin regulations to see if any adjustments are needed.

On the question of how regulators should respond to these events, there will be plenty to argue about, but there should be no argument over the broader point: the way that people invest is changing, and that is sure to affect the various roles that market professionals, including NASD members, play —and it will affect them in ways that we can not fully anticipate.

In fact, all of the major trends at work are challenging the existing order and may ultimately redefine the very nature of the broker-customer relationship. In some respects, those trends push in the direction of consolidation, particularly of established markets. In other respects, they tend toward fragmentation, as entrepreneurs experiment with more ways of providing a greater variety of services.

Such profound change always means dislocation, and that’s why I believe the future of self-regulation will be on the line: if it fails to respond effectively, a void will be created, one that surely will be filled, one way or the other.

What does it mean to respond effectively in this context? First, I think the basic precepts behind self-regulation will continue to be highly relevant. Strong self-regulatory organizations can always react faster, and adapt more readily, than government can. Those who have made a lifetime commitment to the business will always have the largest stake in public confidence, and they also know that the public’s perception never strays far from the truth, and not for long.

I believe that self regulation can continue to be strong only if it is perceived to be, and is in fact, a model of fairness and efficiency. In my view, meeting that goal in the long term will require that the self-regulatory function in all its aspects be both centralized and independent.

Centralization is tied to efficiency because it is connected to economies of scale, which become more important as the job of regulation itself becomes more technology intensive.

Centralization is also tied to fairness. If it is true, as the Congress long ago determined, that the securities markets are a matter of fundamental public concern, then it is vitally important that centers of trading that perform the same function should operate roughly under the same set of rules. Those rules should not be applied differently by different people, particularly those with a financial stake in their application.

Independence is also tied very much to fairness —and by that I mean independence from the commercial interests of any particular trading venue. In the case of the NASD, those concerns led to the corporate separation of the market and regulatory functions. The same set of concerns are bound to arise if regulation of new trading operations is conducted in-house. Over the long term, I don’t think it will make sense for each individual regulated market to try to replicate the current NASD structure, or to adopt a new one.

Consolidation of existing exchanges has already led to a consolidation of the arbitration function. We are in the process of creating a separate arbitration subsidiary that can focus entirely on this vital function. Over the long term, a single and separately funded arbitration forum may be the best way to preserve the benefits of arbitration for both investors and firms.

For the same reasons, it is not too soon to talk seriously about the potential value of a single self-regulatory body, with appropriate safeguards to ensure that the public interest is directly represented and that is accountable to the entire industry, not just one sector of it, and to the Commission. The SEC’s new rules governing alternative trading systems and exchange registration is certain to accelerate the trend toward new and more specialized trading centers -- while at the same time increasing the transparency of the trading that takes place in each of them. What is less certain, is how these new markets, and the marketplace as a whole, will be regulated. In this new world, new markets must demonstrate they are able to meet their regulatory obligations, and it will be incumbent on all participants, new and old alike, to expand and adopt the current cooperative arrangements between SROs. Failure on either of these issues would have serious consequences, permitting market competition, which is good, to lead to regulatory fragmentation, which is bad. I can think of no easier roadmap for abuse than allowing a single issue to trade in 4 or 5 different markets with less than complete transparency for regulators; or no greater disservice than if competition allows regulatory scrutiny or regulatory costs to affect where people choose to trade.

In the new environment, a single SRO may be the best way to ensure that self-regulation does not come to be viewed, as the draftsmen in 1934 worried, as "a device to avoid regulation."

The obstacles and challenges are substantial, and I don’t mean to minimize them. The broader the constituency, the harder it is to guarantee balance, and even harder to convince all elements that you have done so. But I also think that the goal of evenhandedness is harder to accomplish —and perhaps impossible —if regulation becomes balkanized as the markets themselves evolve. You could argue that the SEC can ensure fair treatment on its own, but I’d suggest it is much harder to do one step removed from the process, and the Commission clearly has enough direct responsibilities to keep it busy.

In any event, I trust that this is an issue that will be taken seriously, and especially by the alumni of the Commission, because as alumni, we have been proud to serve the public interest directly. And, as we have carried that spirit into other ventures, we have gained an even stronger realization that the public interest is very much our own.