Remarks From the SIFMA Compliance & Legal Division's Annual Seminar

Richard G. Ketchum

Chairman and CEO

Washington, DC
May 7, 2010

Good morning. Thank you for that introduction Louise [Guarneri], and thank you for inviting me to speak this morning.

When I spoke at this conference last year, we were reeling from the devastating economic events that produced a global recession and brought investor trust and confidence to historic lows. I spoke of the daunting challenges that faced us—reforming and filling the gaps in financial services regulation and bringing about a cultural shift in firms' thinking about risk, compliance and the interests of investors.

Since last year, we've made real progress. Congress is carefully crafting comprehensive reform legislation. Which, while none of us would judge as a complete answer, does—in my judgment—take important steps to close regulatory gaps and exposures. Regulators, including FINRA, are refocusing their examination and enforcement programs to more aggressively detect and quickly prosecute serious fraud and re-thinking how regulation can do a better job of giving investors the protection and information that they need. And, I think many firms have become more attuned to addressing risk, compliance and the interest of investors.

Of course, both regulators and the industry have much more to do, and given the dynamic pace of change in the financial industry, this work is part of a never-ending journey—one that's focused on ensuring investor protections and market integrity. We can both benefit, and help investors in the process, if we continue to have a meaningful dialogue about market developments and cooperate on addressing the vital issues of the day.

I'd like to touch on some of those vital issues this morning, including market regulation and audit trails, product reviews, modifications to our examination and enforcement programs, the fiduciary standard, and point of sale.

Let's start with market regulation and the issues of the market. Now, I made that decision before the interesting trading patterns that happened yesterday but let me take a brief detour not to comment but to talk a bit more broadly.

Obviously all of us will be looking carefully at the issues involved and whether they did involve any erroneous trading or any other problematic trading or the like. But I do think that the one thing that is worthy of this organization, SIFMA, and all of our organizations with regulatory responsibility across the exchanges and across FINRA is that it's an important time for us to quietly step back reflectively and recognize that with the huge changes in the market we need again to look at market structure. I give the SEC great credit from the standpoint of its concept release but more than that we need to quietly reflect among all of us with regard to how other markets and other countries deal with issues of thinness of books when tremendous trading comes in either as a result of panic or as a result of errors.

We need to do that in at least three ways. First, as we and the New York Stock Exchange have consistently said you, as firms, need to understand with respect to your order routing handling issues the ability through screens and otherwise to ensure that you don't continuously feed in orders once markets have broken with respect to precipitous declines.

Second, this is a clear example without suggesting that it involves any particular firm or inherent transactions that demonstrates again the wisdom of the SEC's proposal from the standpoint of direct access. We have always said and will always say that firms that provide their name and sponsoring transaction have a responsibility to ensure the proper screens are in place. The supervisory responsibility is yours as long as that activity can occur from a co-location standpoint around large numbers of entities and both broker-dealers and non. But the SEC's approach is right. There needs to be some assurance that people are being looked at and examined regularly by some regulatory entity if they have the ability to directly and profoundly impact the market in a matter of instances.

Third we ought to take a look from the standpoint of other markets abroad and learn from their wisdom and recognize the simple fact that when liquidity disappears in markets today, it disappears absolutely. And that there are cliffs with respect to electronic books and there simply is not a level of expectation on how market making operates to ensure any modulation once you reach those cliff moments.

We need to step back and ask what that means. Whether it involves taking a brief break after a 15 to 20 percent drop in an extraordinarily short time or otherwise. There need to be shock absorbers in the market. We can't be in this position of redesigning what happens in trades and making decisions in what trades should be broken with respect to markets that go close to zero. That isn't an acceptable place.

It is truly the exchanges and the industry who are the right ones to work through a sensible conclusion on this. We saw these warnings in September/October of '08 when books were driven through. We've seen it again yesterday. We must collectively step together and come to the answers that both allow competition but avoid what happens today.

As I'm sure you may have heard, we announced on Tuesday an agreement for FINRA to assume responsibility for providing regulatory surveillance and enforcement services for NYSE's U.S. equities and options markets—the New York Stock Exchange, NYSE Arca and NYSE Amex.

This is a significant step toward addressing the realities of today's trading environment, which is characterized by rapid changes and increasingly fragmented markets. As I've said many times before, the fragmented trading environment is not a healthy one for regulators.

While some of this fragmentation is the natural byproduct of technological progress, it has nonetheless eroded the ability of regulators to get a complete picture of market activity.

Our agreement with NYSE Euronext will help change this. It will allow FINRA to better capture and analyze data that can help us detect problematic trading activity across multiple markets and financial products. This more holistic, unified approach to regulating trading goes a long way toward strengthening our ability to protect investors—and has multiple benefits for the markets.

In addition this will allow us to move to a single order audit trail platform. Today, as many of you know OATS operates as the order audit trail for securities listed on NASDAQ or traded on the over-the -counter market while the NYSE's OTS system imposes reporting requirements for NYSE and Amex issues. Two duplicative reporting systems make no sense. They impose needless cost on the industry and cause both FINRA and NYSE Regulation to see only part of the story. The combination of our surveillance programs will allow us to get one step closer to our goal of a consolidated audit trail with a single set of eyes looking at all equity market activity.

The evolution of the US equity markets, however, simply does not allow us to rest after this important step. The SEC's recent concept release on market structure highlighted a number of automated trading strategies in use and raised questions as to whether they pose potential market integrity issues.

Now let me be clear, I do not support the notion that high frequency trading is in any way inappropriate. It has been a natural evolution in response to technology advances and the reduction to barriers to entry that naturally result from Reg NMS, ATS and the move to decimal pricing. In a world where there are relatively few incentives to market making, it also fills an important void by providing the market with short-term liquidity.

Nevertheless, the tools available to high frequency traders that allow them to instantaneously enter and cancel large numbers of orders create risks of inter-market manipulations and other trading abuses to which we must be able to respond. In today's markets, manipulative scenarios are not constrained to one market. For example, a market participant could enter orders on a non-primary market for the purpose of influencing, for that participant's benefit, the national best bid and offer and subsequent pricing decisions in the primary market's closing session.

Similarly, a market participant could spread wash trading activity across numerous markets to achieve that participant's goal of creating the appearance of legitimate trading activity in a security.

We catch many of these activities today through the cooperative information sharing efforts of each of our market surveillance staffs, but the risks of missing instances of manipulation, wash sales, abusive short selling and other improper "gaming strategies" is unacceptably large.

That is why the SEC was absolutely correct when it stated in a footnote in the concept release that we need to move to a consolidated order and transaction audit trail. The consolidation of FINRA's OATs and NYSE's OTS as well as the integration of each market's transaction audit trails is a great first step, but far more needs to be done.

  • There is no consistent convention in place to identify a market participant across different markets and no easy way to determine which desk within a firm is effecting the trading.
  • Moreover, audit trails are limited to identifying the executing and clearing of broker-dealers and do not, in many cases, identify the true party behind a trade—whether it be a customer, hedge fund, an investment advisor or even a separate broker-dealer accessing the market through a direct access relationship with the clearing broker-dealer.

Clearly, there needs to be more granularity in the audit trail so that the trading activity by market participants can be readily identified. To do this, we believe there should be unique MPIDs for walled-off areas within broker-dealers, for ATS's and for each entity with direct access and these unique MPIDs need to be used uniformly by these participants regardless of where they trade—a major task for both regulators and the industry undoubtedly. But, if we are to regain investor's trust in the integrity of our equities markets—an absolutely essential one.

Let's move beyond equity trading to the questions regarding information barriers confronting firms across product groups. I raise this issue not looking backwards at a specific fact situation but, rather, to challenge us all to take a fresh perspective. Information barriers remain a very effective way to separate proprietary and agency trading desks as well as, of course, a wide range of investment banking and capital markets activity. However, beyond the efficacy of information barriers, when a firm develops a corporate trading strategy, whether as a result of risk management reviews or otherwise, there needs to be a careful rethinking of compliance controls. Leave to the side for the moment any carefully crafted arguments on legal responsibility—the business intersection of proprietary trading, market making, agency and banking is an accident waiting to happen. It poses the risk of faulty disclosure, unsuitable recommendations or a host of other, at least reputational, exposures. While each fact situation may be different, some things are clear: these decisions should not be made without the participation of legal and compliance officers so that there is someone there to ask the simple question "What is the impact on our customers?" It is for that reason that I have underlined again and again the importance of compliance and legal participation in risk management committee deliberations, as well as senior staff meetings.

A separate but related area we are focused on is the interaction of debt market research with fixed income trading desks. We are acutely aware of the significant differences in how fixed income and equity analysts operate. I also recognize that the guiding principles issued by the Bond Market Association in 2004, prior to the creation of SIFMA, were designed to provide best practices on how to address potential fixed income research conflicts with a focus on supervision, internal controls and effective disclosure to the marketplace.

While the BMA principles have served the industry well, we have seen through our examination process that they have not been universally adopted and, of course, they didn't address the interaction of analysts and the trading desks. This is a perfect area for the industry to work with us to identify the best practices that have been implemented to address the obvious conflicts that exist in this area. We will work closely to fully understand the implications of any action we propose in this area, but you can expect us to move forward with a proposal this year.

As you know, reform of market oversight is only one example of the dramatic regulatory changes that we should expect. Both houses of Congress have taken up legislation to dramatically reform our system of financial regulation. Because of the catastrophic nature of the recent financial crisis, almost every assumption, conviction and article of faith about financial regulation, no matter how firmly entrenched, is now up for grabs. Congress is debating almost every part of federal law, from the treatment of large financial entities and their permissible activities, to consumer product oversight and the possible application of a fiduciary duty to broker-dealers.

At this moment it remains unclear whether Congress will adopt a fiduciary standard for broker-dealers, or whether it will require that the SEC study the issue. FINRA supports a fiduciary standard for broker-dealers that provide personalized advice. But even if Congress does not immediately impose such a standard, I do not believe that FINRA and the industry can stand back as if we have learned nothing from recent history. Regardless of where one stands on the fiduciary question, we all can agree that we must consider other ways to improve broker-dealer regulation. It is time for us to improve the quality of disclosure about products that broker-dealers offer to their customers. Even more important, we must begin to develop disclosure about brokerage services, and the conflicts of interest that a broker-dealer faces when it offers these services.

In thinking about broker-dealer disclosure, we have tended toward disclosure concerning a specific product. Thus, for example, the SEC has adopted the mutual fund Summary Prospectus and has proposed point-of-sale disclosure about mutual funds. Simple, plain English disclosure about specific products can inform customers about the investments that a broker offers and the broker's conflicts of interest that are associated with those products. In 2005, FINRA developed a model document, called the "Profile Plus," which would require disclosure of the features of a particular mutual fund and the conflicts of interest in the way that the broker is paid. We designed the Profile Plus in a manner that permits each customer, through the use of hyperlinks to other documents, to obtain the level of information that the customer prefers. We would not impose one-size-fits-all disclosure on every investor. The Profile Plus should be a useful prototype for the SEC's point of sale initiative. While product-by-product disclosure is important, it will not adequately address the needs of your customers. It is time to develop plain English disclosure about brokerage services, about the conflicts of interest that a broker faces when she offers any service to her customer, to allow the customer to make an informed investment decision. The customer should receive this document at account opening. Like the Profile Plus, it should allow customers to tailor the amount of information they receive by linking to additional material.

Developing such a document won't be easy. The Form ADV for investment advisers is a long and complicated document that I suspect many investors do not read. It is difficult to summarize the various conflicts of interest that any financial professional may face when offering a multitude of products and services. However, I am heartened by the fact that many of you already provide a disclosure document to your customers about these types of matters. I am confident that we can get this done. I hope that the industry will join in this effort to bring simplified, plain English, disclosure about the services that you provide and the conflicts of interest that you may face.

Finally, I'd like to turn to some of the issues we see being raised by today's market climate. The good news is that countless investors have realized significant gains since the market bottomed out in March 2009—the Dow is up about 60 percent. Yet even with these gains, the Dow is still nearly 25 percent below its 2007 peak, and the NASDAQ is more than 50 percent below its 2000 peak, with unemployment continuing to hover around the double digits.

Another important development is that we are in a low interest rate environment that effectively punishes savers. Last September, the Wall Street Journal pointed out that nearly 78 percent of taxable money-market funds were offering annualized yields of 0.1 percent, or less. The article noted that at this yield, the monthly interest on a $10,000 account would be just 83 cents. The effect, not surprisingly, has been to push many investors to chase higher yields.

FINRA has, in fact, been concerned that investors may be steered toward investments that promise higher yields or principal protection, but which may not always deliver on their promise. For example, principal-protected notes are often marketed as instruments that combine the relative safety of bonds with growth potential. Closer inspection, however, places that marketing profile as incomplete or perhaps misleading as different principal-protected notes offer varying degrees of principal protection and include a range of direct and imputed costs while the guarantee is subject to the creditworthiness of the guarantor. Of course, you must make sure that all of the products you offer are appropriate for a customer in light of her needs, goals and current financial situation.

This responsibility begins with a firm's development of a new product and even its decision to sell a novel or innovative product created by third parties. As we have said many times, one of your top priorities is to ensure that your procedures for vetting new products are robust and effective.

In addition to business and reputational risk, deficient vetting procedures can lead to a range of regulatory problems, including unsuitable product recommendations, false or misleading product descriptions, inadequate supervision and training, operational risk, and books and records violations.

Many firms have made progress in this area in recent years by formalizing their procedures for vetting new products and involving compliance personnel earlier in the process. These are positive steps, but nobody can afford to be complacent. It is not enough to have procedures on the books—those procedures must be strictly enforced, periodically re-assessed, and updated as needed to keep up with product and market developments. This last factor bears emphasis. Market developments can render obsolete even a well-established product. A sudden rise in interest rates, dramatic currency fluctuations, or other events can interfere with the operation of some investments. Your new product-vetting procedures must take into account not only the features of new products, but the consequences of market developments on old products, too.

This new product-vetting process will continue to be an important regulatory focus for FINRA. However, no problem is more disturbing than the fraud and other serious violations that some members of the industry have perpetrated through their sale of unregistered securities. Earlier this year, FINRA undertook a national initiative to root out and prosecute these violations, an initiative which has already yielded significant results. We recently fined five firms for the illicit sale of more than 8 billion shares of penny stock on behalf of their customers, in unregistered offerings. The firms failed to take appropriate steps to determine whether the shares could be sold without violating federal registration requirements.

We recently filed a complaint against another firm and its president, charging them with securities fraud in the sale of tens of millions of unregistered securities. In March, we expelled a firm for marketing a series of fraudulent private placements on behalf of its affiliate, as part of a massive Ponzi scheme.

This national initiative brings together our improved fraud detection, enforcement, examination and regulatory policy departments to address these private placement issues in a forceful and concerted manner. In April we issued Regulatory Notice 10-22, which describes the responsibilities of a broker-dealer who conducts private placements under Regulation D. This notice includes detailed descriptions of broker-dealers' duties under the antifraud provisions and suitability rule to engage in reasonable investigation of the issuer and its securities in Regulation D offerings that it promotes. As one court stated, this duty emanates from the "special relationship" between the broker and his customer. The scope of a broker's responsibility to conduct a reasonable investigation will depend upon the facts and circumstances, as discussed in our Notice. Whenever your firm is going to participate in a private placement, you should review your procedures relating to Reg D offerings to ensure that they are adequate to meet your regulatory obligations.

As far as FINRA's response to the changes in market climate, we've done a number of things over the past year to rethink our regulatory program. Today, you'll see that in many ways, our examination and enforcement programs have profoundly changed with a substantial focus on fraud detection.

To ensure that serious problems with respect to an industry participant get escalated quickly, we are focused on bringing enforcement actions more quickly and efficiently. Quicker action means more investors escape harm. Of course, no one can ensure that there won't be another Madoff or Stanford, but we are doing everything we can from the standpoint of our program to ensure that we have a more laser-like focus on fraud detection.

In the next year or two, I think you'll see that we'll be making even more changes to our exam program to be far more risk-based and far more informed with respect to the different types of firm business models. If there's one thing I've found traveling around the country in my first year at FINRA, it's that many things about the way FINRA operates and the way our districts operate are working well. But I also recognize that there is a continuing frustration among firms that there's not enough understanding of your business or enough appreciation of where some of the most serious risks reside.

Through our expanded coordinator program, we want to have more continuing, ongoing conversations with you about what's happening with your firm and where and how your firm is changing, both from the standpoint of your business model and elsewhere. The same thinking applies to our examiners—we want them to understand what's happening to your firm and focus on areas of heightened risk. We also want to spend more time in assessing firms with a risk profile and history that merits the attention based on the risk they pose to investors and the markets and less time on those firms that, based on their record, expend the time and resources necessary to achieve performance in line with the highest standards of business conduct.

All of these things, of course, require continued communication with the SEC. But we're seeing a new leadership at the SEC that is truly open to rethinking how to develop an effective exam program. Hopefully, what you'll see in the next few years is a FINRA exam program that continues to be more knowledgeable about what makes your firm tick and wiser about where we choose to spend most of our time. You'll hear more about some of FINRA's examination priorities and changes to our exam program from Grace Vogel and Mike Rufino on a panel late this morning.

In conclusion, we should keep in mind that new regulations can only achieve so much. For reforms to trigger lasting market improvements, it is just as important for industry leaders to communicate to their colleagues that change is underway, and that there is a duty to comply with both the letter of the reforms, as well as the spirit underpinning them. That calls for market participants to exercise a degree of discipline, restraint, and good judgment that has too often been in short supply.

So there is critically important work ahead. I am confident SIFMA can be counted on to continue to be a positive force in the markets, and my colleagues and I hope to have an opportunity to work with you in support of the reforms that will promote both the vitality and integrity of America's markets. Thank you.