Remarks at the Securities & Investment Institute
Chairman and CEO
Good morning to you all. I want to thank Scott Dobbie and the SII for inviting me to join this important discussion and for the opportunity to commune with such distinguished company.
The SII could not have chosen a better topic for this conference; the metamorphosis of markets on both sides of the Atlantic is occurring so rapidly that I fear that much of what I say this morning will overtaken by events before I finish saying it. This aspect of globalization is one that we would all do well to think a lot about and prepare for, because I expect the complexion of the financial markets will soon be markedly and forever changed.
Since I'm the only American regulator speaking this morning, I'd like to talk about how my organization, NASD, has adapted, and continues to adapt, to the evolutionary changes taking place in our markets.
First, let's survey the field and see where things stand. Nasdaq last week increased its stake in the London Stock Exchange from 15 percent to 18.7 percent and no one expects it to stop there. The New York Stock Exchange, Nasdaq's arch-rival, is known to be interested in an ownership stake in the LSE, as well, and is almost certain to make a move soon, now that its secondary offering is completed. Euronext was pursuing a marriage with the LSE, but isn't anymore. Now, Euronext and Deutsche Bourse are talking openly about the possibility of a merger.
I'm sure we all expect that these are only the initial tremors in a seismic series of trans-border market realignments.
In the U.S., efforts by Nasdaq and the New York Stock Exchange to internationalize closely follow a period of domestic upheaval. That period began in 2000, when the dot.com bubble burst and a whole fetid stream of graft, corruption and fraud came pouring out of it. That, along with corporate government meltdowns at Enron, WorldCom and elsewhere, and a spate of wrongdoing in the mutual fund realm, made for the darkest period in the U.S. capital markets since the stock market crash of 1929.
Even so, the dot.com bubble was not an anomaly. Far from it. For as long as there have been markets, there have been market bubbles. Here in London, there was the South Sea Bubble of 1720, a result of overheated stock speculation, particularly in shares of the South Sea Company, whose shares went from £125 in January 1720 to £1,000 in August to £150 in September.
Parliament reacted rather forcefully, sending the King's ministers to jail for taking bribes and pre-IPO stock, and enacting some far-reaching regulatory reforms: the formation of new corporations was banned, and that law remained in force for 100 years. Short sales, futures and options trading were formally outlawed, and remained so for 165 years.
Sir Isaac Newton, after losing £20,000 in the bubble, said, "I can calculate the movement of the stars, but not the madness of men."
What happened four centuries later in the aftermath of the dot.com bubble was not terribly different. We and other regulators fined, jailed and otherwise punished market wrongdoers in record numbers, and we enacted a number of laws and regulations in the hope of preventing any re-occurrence of what had taken place. Of course, the consequences of the bubble weren't limited to the U.S., but the need for this regulatory lock-down was greater on our side of the Atlantic, because there traditionally has been a higher proportion of retail investors in the U.S. markets than in the UK and European markets.
Another inevitable consequence of market bubbles is that the competence and effectiveness of regulators are called into question. As well they should. But I think I can safely say that NASD rose to the challenge, and in so doing, proved the value and efficacy of private-sector regulation.
And I would argue that as markets continue their evolution toward becoming global, rather than national enterprises, that layer of private-sector regulation between government and industry will continue to be necessary, for several reasons.
One is that NASD, as a private-sector regulator, is uniquely able to follow up on the issuance of rules by providing those effected by the rules with services, tools and information to help them understand and comply with them. That is a hugely important part of our mission, and it is not something that other regulators do much of.
We, of course, have had a particular focus of late on mutual funds, and not just on the marquee issues of market-timing and late-trading.
We've been looking at mutual fund sales contests, brokers putting clients in share classes that aren't right for them, brokers failing to award clients discounts on high-volume purchases of fund shares, brokerage firms putting particular funds on priority lists in exchange for investment banking and commission business from the funds, and other problems.
It would have been easy to issue rules saying, "you can't do this anymore," and leave it at that. But all our rule-making processes having to do with mutual funds have been accompanied by sincere and concerted efforts by us to make sure the people and firms we oversee understand what we're asking of them and that they can comply without a great deal of confusion or anxiety.
We have, for example, produced a series of short webcasts on share class distinctions, volume discounts, and other topics, and we now provide an on-line search tool that brokers can use to figure out more easily if mutual fund purchasers are eligible for volume discounts.
We have also put on-line a calculator that brokers and investors can use to easily sort out the once-confusing question of when volume discounts on mutual fund sales loads are available.
The inventory of tools and services we provide, free of charge and with no ulterior motives, is voluminous and getting more so. And that is a service that government regulators simply can't provide.
They don't have the money, the manpower or the freedom from bureaucracy to do this kind of work.
However, this flexibility occasionally leads to some ironic outcomes. NASD has a rule that addresses the offering of entertainment to clients of our registered brokers - entertainment such as dinner and drinks, tickets to concerts or sporting events, golf at the broker's club, that sort of thing.
Last month, we filed a proposal with the SEC to amend this rule with some guidance about the types and levels of entertainment that firms may deem acceptable, but we didn't quantify what is permitted.
Rather, we proposed to require that firms have written policies and procedures that set out the details in a way that ensure that their employees act according to commonly accepted ethical standards, and that the firms' principals adequately monitor and supervise employees' adherence to those standards.
In other words, we opted for a principle-based rule that gives firms some discretion to decide what's acceptable and what isn't, rather than a hard-and-fast, endlessly detailed prescriptive rule that says, you can do this but you can't do that.
Nonetheless, the proposed rule has elicited outrage and indignation from the CEOs and compliance officers of some of our regulated firms.
They have accused us of "legislating morality," and of threatening to leave them adrift in a sea of uncertainty about what they can get by with and what they can't. One said the proposal was "galactically stupid" and seemingly "written by someone that has not done any entertaining."
After we proposed the change, some American TV news programs focused on a particularly compelling aspect of the issue - one which, frankly, we hadn't thought much about: is a strip club an appropriate venue for entertaining clients? They accompanied their reports with colorful videotape that really illuminated the issue for those who were weren't sure how they felt about it. I'm sure we're all deeply indebted to them for shedding light on this important question. But I digress.
The point I'm trying to make is that the American securities industry has lobbied for years for less overbearing regulation, such as through more principle-based rules, which I know are standard fare here in the UK. Now that we've proposed one, an argument is made that it's not prescriptive enough. Sometimes it's hard to win as a regulator.
This leads me to think that the securities industry needs to be aware of and open to the fact that the markets in which it operates are evolving at a particularly rapid clip, and that evolution will inevitably lead to new and different ways of doing business.
I would apply that maxim to the regulatory community, as well.
At NASD, we've been watching with interest as Nasdaq and the New York Stock Exchange have been knocking on the LSE's door, bouquets in hand, hoping to engender a meaningful relationship. At the same time, we've been trying to affect some changes in our relationship with the NYSE.
NASD and the New York Stock Exchange are commonly referred to as self-regulatory organizations, although in our case that term no longer applies so neatly, because we no longer have any ownership stake in any of the exchanges we regulate.
Self-regulation has a long and effective history in the American markets.
The U.S. Congress designed self-regulation in the 1930s, envisioning that most of the day-to-day responsibilities for market and broker-dealer oversight would be performed by SROs under the Security and Exchange Commission's direct oversight. Of course, in those days all exchanges were private, mutual organizations owned by their seat-holders.
Now we see exchanges, including NASDAQ and the New York Stock Exchange, becoming for-profit, publicly traded companies. This has caused an important debate in our industry about what this means for self-regulation, specifically if regulation is done by a for-profit, shareholder-owned exchange. In our view, the conflict that arrangement creates is simply unmanageable. In essence, such an exchange is regulating its customers.
We look forward to a continuation of this debate and, I hope, finding a solution to this conflict. I believe the best resolution would be to merge the firm regulation operations of the NYSE with NASD to create a wholly new private-sector regulator to handle the oversight of securities firms, while the exchange would retain responsibility for regulating its trading operations. This arrangement would erase the potential for conflicts and would get the regulated firms out from under the weight of dual regulation. We estimate this would save them, collectively, more than $100 million a year in regulatory fees and assessments.
Traditional self-regulation in Canada, the UK and Europe has almost completely receded from the landscape.
Nearly all European exchanges fall under the regulatory oversight of their governments or of some quasi-governmental authority like the FSA.
These changing regulatory structures, here in the UK and in Europe, have brokerage firms bracing for an onslaught of new laws and regulations. One thing we can infer from this with a high degree of certainty is that expertise in legal and regulatory compliance will be sorely needed.
Brokerage industry leaders here in London have been heard to complain about a chronic shortage of qualified compliance professionals, while at the same time, the FSA is devolving more and more compliance responsibilities onto the City.
Industry leaders say they expect the problem to get worse before it gets better.
With all this in mind, in January NASD and the University of Reading launched a series of regulation and compliance education programs at the university, designed to help meet this increasing demand for expertise. Participants can earn a Masters of Science degree in capital markets, regulation and compliance, or a lesser honorific, depending on their needs and ambitions.
A secondary benefit the Reading program offers is that its graduates will fan out around the world with a common understanding of regulation and compliance theory.
With geographic borders becoming less distinct and with a wave of cross-border market mergers on the horizon, the need for this sort of symbiosis is obvious. So, we're very pleased to be able to join the University of Reading in filling that need.
In Europe, pending changes to the regulatory climate will also include an effort by the EC to determine when and how to extend certain market transparency provisions beyond equities and into other products, primarily bonds. That being the case, I thought it would be helpful to talk about our experience with fixed-income transparency in the U.S. You may know that NASD has made a Herculean effort to drag the U.S. bond market into the light of day. That effort is called TRACE.
Now, almost four years after TRACE's inception, I can say confidently that it has been a huge success for nearly all concerned.
TRACE, which stands for Trade Reporting and Compliance Engine, is a mechanism for disclosing trade, price and other essential information about U.S. corporate bonds, which number around 30,000. It's free, easy to use and publicly available on NASD's website. Any and all corporate bond trades must be reported to TRACE within 15 minutes of execution. Those trade reports are immediately posted on our website.
Before TRACE went on-line in 2002, commerce in corporate debt was conducted out of the public view. Buying a bond was a little like trading in the dark - one was never sure whether the quoted price was fair.
Bond dealers and buyers defended the lack of transparency on the basis that the market was almost entirely institutional and transparency was only needed in retail markets.
We found, however, that retail investors were wading into the U.S. corporate bond market in large numbers and that roughly two-thirds of the transactions conducted in that market were retail-level transactions. That is, they had par values of $100,000 or less.
Ours being an aging population, it was a forgone conclusion that these numbers would get even larger since people approaching retirement tend to migrate away from stocks and into the calmer waters of fixed-income.
And a huge cohort of the American population, the Baby Boom generation, is now approaching retirement. So, the argument that transparency wasn't needed in the bond market just didn't hold up.
When we committed to develop and deploy TRACE, bond dealers said they feared the openness that it would bring to the market would reduce liquidity in that market. I know that as European regulators have started talking about transparency in their fixed-income markets, the same concern has been expressed here. Well, after four years of observation, I can confidently say that TRACE has had no appreciable effect on liquidity in the U.S. corporate bond market, including high-yield, less traded issues. At least none that we've been able to identify.
One of the reasons we phased TRACE in over a period of years, rather than go full-speed right out of the gate, was that we wanted to gauge what effect, if any, it would have on liquidity. It just isn't there. On the other hand, there has been a reduction of spreads, which is a benefit to investors.
In closing, I'll again state the obvious: the capital markets are in a period of measurable - perhaps even profound - transformation. When the dust settles, we may see one or more truly international stock exchanges. That being the case, this conference and others like it are essential forums for figuring out where each of us will fit into this new world.
The American journalist and author Tom Friedman has expressed the view that, however one feels about globalization, one can no more stop it than one can stop a speeding train. So, we have two choices: stand aside and watch the train go by. Or jump on and enjoy the ride. I think that is an apt metaphor for the market evolution that we're seeing and talking about today.
Here's hoping that each of us succeeds in figuring out what his or her role is in this new world, and prospers.
Thank you very much.