Remarks at the SIFMA Compliance and Legal Division's 38th Annual Seminar

Mary L. Schapiro

Chairman and CEO, NASD

JW Marriott Desert Ridge
Phoenix, AZ
March 26, 2007

Good morning. It is once again a great pleasure to be with you at one of the most important gatherings in our industry.

All of you, the dedicated compliance and legal staff of securities firms, are truly the first line of defense when it comes to maintaining the integrity of the U.S marketplace. At NASD, we recognize that the important work you do every day helps safeguard the long-term health of the industry and the financial future of millions of Americans. We look forward to keeping our lines of communication open with you as the firms you support continue to grow and serve investors in America and around the world.

I am both honored and excited to be here today. We are at an historic moment in the evolution of the U.S. markets and it seems like a propitious time to share with you a vision for the future of regulation.

With the unprecedented consolidation of NASD and NYSE Regulation on the horizon, we have the rare chance to write the future of regulation on a clean slate. This is more than just the combination of two great and dedicated regulatory staffs—it's a transformational moment. We can step back, take an honest look at our history and make more than just a mid-course correction. It's our chance to ensure that regulation continues to be a force in the success of our capital markets and our economy—and we'd be remiss if we didn't seize it.

As you may know, this plan will combine the member regulation operations of NASD and NYSE Regulation into a single, new self-regulatory organization (SRO) that will be the sole private-sector regulator for all 5,100 firms doing business with the public in the United States.

The new SRO, with nearly 3,000 staff, will bring together all of NASD and NYSE Regulation's member firm examination and related enforcement functions, as well as arbitration and risk assessment. Not only does this plan produce the largest private-sector regulator in the financial world, it also simplifies a critical component of the U.S. financial regulatory structure. It ensures that under the strong oversight of the SEC, self-regulation will continue to play a vital role in the U.S. capital markets.

The consolidation plan sets forth a more sensible and less complex regulatory regime that will make private-sector regulation more efficient and effective. It will reduce regulatory costs for all firms—some quite dramatically—while providing more effective protection for the tens of millions of people who invest for their future in the U.S. capital markets. This is the first modernization of the self-regulatory regime in decades, and it sets up a unique structure that I believe will serve our industry and investors well for years to come.

When the new organization is in place and fully integrated, there will be a single set of rules adapted to firms of all sizes and business models. There will be one set of examiners and one enforcement staff. Duplicative regulation and overlapping jurisdiction will become a thing of the past. Inconsistent approaches and rule interpretations, and matters falling through the cracks between two separate regulators, will be historical footnotes.

Before I go on, I want to make sure that I reiterate the fact that we have this opportunity in large part because of people here in this audience. By voting in favor of this transaction, firms chose to define the future of regulation themselves, rather than have it defined for them. For that, your firms deserve a great deal of credit. Your support was crucial to the success of our bylaw vote-and SIFMA, in particular showed up in spades. In fact, none of this might have happened if the SIA hadn't planted the seed on regulatory consolidation by publishing your white paper back in 2000.

So thank you. Not just for stepping up to support the concept of regulatory consolidation—but for stepping up to make history.

If you look back over the last twenty years of regulatory operations and developments broadly—and truth be told, I have been a regulator for that many years and a few more—you'll find that the type of people in this business haven't really changed. This industry is blessed with people in regulatory roles who are deeply committed to their missions, serving at the federal, state and SRO level.

What has changed in those 20 years is what regulators are facing—the broadened scope and complexity of our responsibilities and how we are choosing to evolve with those challenges to keep the markets fair.

Twenty years ago, regulatory success was measured pretty much by the numbers. How many exams did we complete? How timely were they? How many qualification tests or continuing education sessions did we administer? How many cases did we bring? And how much did we levy in fines?

From my perspective, that regulatory approach was appropriate for the times. Market structures were less complex—uncomplicated by the choice, technologies and competition we have today. Firms fell into traditional, easy to define models. There was a lot more product clarity and fewer complex instruments, at least in the retail space. Insurance products looked like insurance, equity looked like equity, hedge funds were rare and only for the very rich.

Twenty years ago, our examination process was also simpler. We reacted to issues as they arose. We conducted exams with less regard for risk and more regard for the calendar. For the most part, our exams were one size fits all. They were heavily manual—and we performed them onsite, using standard checklists and reams of paper. Very little technology was involved. We were limited in our ability to collect data—both internally and externally—that could help paint the full picture of a firm's operations and risks for our examiners. And because of this, we sometimes missed the forest for the trees. We focused on each firm individually-rather than looking across the population to find trends and patterns of behavior that warranted a broader, cross-industry look.

Simply put, our previous regulatory model was suited for yesterday's market, but not today's. Times have changed and markets have changed. And so must our approach.

Especially considering today's global economy.

In the past, perpetual U.S. dominance in the world for capital formation was an absolute given.

In the past, we rarely even looked across our borders, except perhaps to argue that U.S. GAAP accounting standards were the best in the world. But this is not the past. And these days, past dominance is no guarantee of future success.

What will help ensure that U.S. markets stay competitive? Academic studies show compelling evidence that strong regulation is key to the viability of any trading market. And the transparency that regulation mandates decreases transaction costs—providing further incentives for market participation and liquidity.

I will let you judge for yourselves whether regulation has historically been successful. But let me point out that in a year when the roar of voices calling for deregulation has been deafening, there have been record corporate profits and record broker dealer profits.

But the point I want to make today is not whether regulation is needed. My point is that in order for regulation to continue to be effective, we need to make sure that it evolves at the same pace as today's capital markets.

We are engaged in an extraordinary balancing act—simultaneously trying to preserve integrity and honesty and fairness in financial dealings, yet allow for innovation, competition and choice. And to do it all in the most economic and efficient way possible.

As part of that balancing act, to be a successful regulator today we must be more things to more people. What does this mean? It means engaging investors and giving them choices. It also means being proactive and giving industry the tools and training they need. It means having sensitivity to the burdens we impose and understanding the ramifications of our actions. And it means understanding the broader world in which we operate.

I see five ways that we need to evolve as regulators in order to keep pace.

First, the modern regulator must ensure that investors have choices—in the types of firms they seek to do business with and the array of products and services those firms offer. We must be more sophisticated in understanding and accommodating different business models without compromising investor protection.

Part of that means losing the blinders of "one size fits all" rulemaking. In some areas that argues for a more principles-based approach to regulation; in others it may argue for tiered regulation based on firm size and business model; and in others, a clearer distinction in the rule set between retail and institutional investors.

Let me add here a word about "principles-based" regulation. At NASD, we are no stranger to principles-based regulation. Our just and equitable principles of trade and suitability rules are good examples. But we continue to look to where perhaps we can do better.

The FSA, which has been held up by many as the paradigm of the modern regulator, relies upon 11 principles for financial services regulation. One of the principles is simply called Treating Customers Fairly and it states, "A firm must pay due regard to the interests of its customers and treat them fairly."

In addition to the 11 principles, which can and have been enforced by the FSA through disciplinary actions and fines, there are 8000 pages of rules. In other words, their system is a combination of rules and principles, as is ours. But we place more emphasis on rules and they on principles.

While I believe we can move in their direction, I think a challenge for everyone in this room will be to operate with less certainty and clarity—which of course, is inherent to the principles-based approach.

Business entertainment is one area that comes to mind. While some in the industry welcomed a principles-based approach, others were decidedly uncomfortable. Legal and compliance staff, in particular, at many firms felt that such an approach left too much room for interpretation and ultimately, abuse, and the uncertainty of enforcement action.

So, with the benefits of principles-based regulation also come the challenges.

Which brings me to my second point: the modern regulator is proactive not just reactive.

We must always survey the landscape for risk and look around the corners for nascent problems. Waiting for a product or practice to blow up and then reacting is not effective investor protection. And it is no longer sufficient in this day and age.

At the new SRO, we will be combining the NASD Emerging Issues program with NYSE Regulation's Office of Risk Assessment. We will continue to have a team devoted to examining emerging trends in the industry that may have regulatory or investor protection implications so that we can address them at the earliest possible stage.

Let me hasten to add that this is not about taking all risk out of investing—that is not possible, nor desirable—it is about identifying ways that we as regulators can be as proactive as possible in helping both investors and the industry avoid potential pitfalls.

Specific issues that this group is currently focusing on include sales practices aimed at seniors, the emerging life settlement industry, margin practices, investing in foreign securities, and the use of automated supervisory systems.

Through this program, we are also collaborating closely with the industry on several innovative projects. For example, we are in the early stages of developing a model "plain English" account opening agreement that firms could use on a voluntary basis. And we are also developing a voluntary emergency "Hand-Off" Program where, in the event of a pandemic or other major disaster, small firms can temporarily hand-off their customer accounts to pre-established partner firms. We hope that this program never has to be implemented, but it is vital that we do all that we can to be prepared for any possibility.

Proactive regulation means exploring all of our options for addressing emerging issues once we identify them. The automatic response to potential pitfalls once upon a time, was to write a new rule. There should be no automatic response. We must consider a range of options in addition to or in lieu of rule-making, including best practices, guidance, education and task forces to help us understand the problem and propose viable, effective solutions.

One example is our approach to the number of increasingly complex investment products that are being introduced to the markets. Some— such as the vast array of structured products including equity and currency linked instruments—are not well understood by retail investors. They also raise concerns about suitability and potential conflicts of interest.

But, rather than just write a new rule to deal with these potential issues, NASD is offering guidance to firms, urging them to take a proactive approach to reviewing and improving their procedures for developing and vetting new products.

What we're asking is that at a minimum, those procedures should include clear, specific and practical guidelines for determining what constitutes a new product, for what group of consumers it will be suitable, how reps will be trained to sell it and how it will be marketed and advertised. The issues surrounding new product manufacture and distribution will take on heightened currency as the flood of products marketed to retirees and aging baby boomers hits.

But even where rules are the right answer, it will no longer be sufficient to write a rule and walk away. We have an obligation to follow through with appropriate steps to help member firms comply.

Which leads us to the third attribute of the modern regulator: to find ways to assist the industry in meeting its compliance and regulatory obligations.

Education of the industry so that there is clarity and understanding of what we expect is one of our central obligations as a regulator. Ten years ago, our way of dealing with this was to offer a small handful of conferences to the industry.

Today, member education is a much bigger—and absolutely integral—part of our role as a regulator. We've invested significant energy and resources into developing a wide range of programs to offer—from the compliance certificate program at Wharton to a master's degree program at the University of Reading in the UK, to conferences, training courses and more recently, a compliance boot camp and a wide range of online programs such as e-learning, webcasts, podcasts and online workshops.

You will see much more from us in terms of member education—particularly when it comes to offering online programs that are easily accessible for firms of all sizes.

Aside from helping firms comply with our rules by offering educational programs, we also need to make sure that we periodically step back and examine the impact of those rules. What we need to be asking ourselves on a regular basis is: Are the rules doing what we intended them to do? Are they protecting investors? At what cost? And finally, is there a better, more efficient way to achieve the benefit?

We are committed to a rule regime that supports well-functioning and fair markets, which builds investor confidence. Still, we want to respond to concerns that the benefits of some NASD rules do not justify their burdens. So, we have created a pilot program to analyze the impact of recently enacted rules. Our goal is to re-visit certain rules when they have been on the books for a couple of years to ensure that they are working the way they should be, and that the burden they impose is warranted given their beneficial effects.

Traditional cost-benefit analysis is done before the fact. But these before-the-fact analyses suffer from the defect that assumptions must be made about the rule's operation and its costs. The process we have developed will occur after the fact, so it can be performed with harder data that would eliminate much of the guesswork, and produce more reliable conclusions.

We will implement this program going forward with our pending variable annuity proposal. But, we don't want to wait two years to get started. So we also plan to analyze the OATS rules to determine how they have worked and whether changes are appropriate.

Of course, not all rules lend themselves to this type of review; for example, the principles-based rules that I talked about earlier. These rules are foundations of our regulatory scheme, yet their benefits cannot be readily quantified, so they don't easily lend themselves to this analysis.

Yet we see this initiative as consonant with the need for efficient regulation. It ensures that the law of unintended consequences, which often bedevils regulators, will not have a chance to take hold. And, just as importantly, it will allow us to discover if recently enacted rules are actually protecting investors the way they were designed to do.

The fourth attribute of the modern regulator is to understand the world in which we operate.

International borders are disappearing. You cannot pick up a newspaper today without reading about exchange mergers and joint ventures—NYSE/Euronext/Tokyo come to mind—or firms investing in foreign markets such as India and US investors' hunger for direct access to foreign stocks. The necessity for regulators to operate in a world no longer defined by geographic borders or time zones is now an imperative.

This global transformation is not waiting for regulators to figure it out—the business is moving forward—and if we are to fulfill our obligations to investors and market integrity, then we had better re-double our efforts to accommodate regulation of business that crosses borders in cooperation with fellow regulators across the globe.

International boundaries are not the only ones we need to be concerned about. Our jurisdictional boundaries are not serving investors well. Today's markets offer so many different kinds of investment products and vehicles that I would be surprised if even the most sophisticated investor could distinguish which products are regulated by whom. Frankly, they shouldn't have to.

My view is that retail investors should get the same basic regulatory safeguards and protections no matter which investment product they choose.

I believe that financial product regulation must have a harmonized approach irrespective of whether the product is insurance, securities, banking, or investment advisory. I am not talking about more regulation—or additional jurisdiction for NASD. The point is that regulators need to work together to regulate products that look and act in similar ways.

There should not be a kind of regulatory arbitrage that provides an incentive for the sale of one product over another. A customer should be sold an insurance product rather than a security because the salesperson makes the reasoned judgment that the insurance product meets the best interests of the client as opposed to the fact that such a sale may not be regulated by NASD, and subject to our sales practice rules.

Regulatory arbitrage incentives among competing financial service products do not meet anyone's interests. It will take a long process of partnering with other regulators to harmonize the investor protections available for related products, but if we don't undertake it then who will?

Last year, to start down this road, we held an Annuities Roundtable in which state securities and insurance regulators and industry professionals participated. We are now working with our fellow regulators to extend the protections of suitability to insurance products, such as equity linked and fixed annuities.

The fifth and final (at least for the purposes of this speech) attribute of the modern regulator is that rather than simply respond to investor complaints—or problems that have already come to light—we need to engage investors. Investor education is a component of this of course, but so is delivery of information directly to the public through systems like TRACE and BrokerCheck, that inform and ease an investor's interaction with the marketplace.

Each year since I've been at NASD, we have increased our focus on investor education. We now offer multiple tools on our Web site that can help investors manage their money with confidence. We encourage all funds and firms to make our resources available to their customers and clients, and we do our best to get the word out through investor forums across the nation.

Because we view investor education as such an important part of our mission, we established the NASD Investor Education Foundation in 2003, currently funded with $82 million, making it the largest foundation in the U.S. dedicated to investor education. We fund grants to universities and non-profits for research and programs that help mainstream investors understand the complexities of investing and the markets.

Those complexities, as well as the transformation taking place in capital markets both here at home and across the globe, are here to stay. The only question is how regulators and our industry will evolve to meet the challenge.

I can assure you that all of us at NASD and soon at the new SRO are committed to anticipating change, and whenever possible, getting out in front of it. The millions of Americans who invest in our capital markets demand and deserve no less.

We will continue to take the necessary steps to preserve the pre-eminence of U.S. capital markets while safeguarding the interests of investors and the integrity of the marketplace. That is our ultimate challenge as a modern regulator.

But it is also your challenge. All of you who serve as compliance and legal officers will continue to play a critical role and we will work with you to address your needs and your concerns. The work you do is vitally important. When you return home, I urge you to continue your commitment to a vigorous compliance regime. Nothing is more important to the future of our nation's markets and to the cause of protecting investors.

Thank you for all your hard work.