Remarks at the Financial Accounting Foundation Board of Trustees Dinner

Richard G. Ketchum
Chairman and Chief Executive Officer
Washington, DC
May 17, 2016

Good evening. Thank you, Terri [Polley], for that introduction.

It’s a pleasure to be here with you this evening to talk about our shared interests, one of which is ensuring investors have accurate and reliable financial information to better inform their decisions. I don’t need to tell you how inaccurate information—whether because of weak or inconsistent accounting standards, poor customer disclosure, or lack of market transparency—can negatively impact the U.S. and global economies. Strong financial reporting standards that encourage government agencies, and public and private organizations to provide better financial information and greater transparency, are essential to the efficient functioning of our capital markets. As a regulator, FINRA relies on accurate information from the firms we oversee, and the work the FAF, FASB and GASB do in setting accounting standards is an invaluable piece of the regulatory process.

In the end, ensuring investors have consistent, understandable and fully accurate financial information is fundamental to delivering the investor confidence necessary to ensure vibrant equity and fixed income markets, which in turn allows public corporations to effectively access capital necessary for them to effectively innovate, compete and respond to the needs of their clients and shareholders.  

Like the FAF, transparency and investor protection are central parts of FINRA’s work. We oversee the management and operation of over-the-counter market transparency facilities that provide the public and professionals with timely quote and trade information for publicly traded equity and debt securities. On the equities side, we provide data on the trading activity in each alternative trading system, including all dark pools. More fundamentally, our market surveillance, examination and enforcement programs are the other side of the financial information coin, contributing to the investor confidence necessary to ensure vibrant capital markets.  

The end goal of our respective disclosure, transparency and investor protection programs is the same: promoting investor confidence in the U.S securities markets. But that isn’t always an easy task. Indeed, after the 2007 financial crisis and the significant frauds that were uncovered around the same time, investors lost confidence in our securities markets and the ability of regulators to protect them. As a regulator, we learned some painful truths during and after the 2007 and 2008 financial crises. More recently, significant market volatility and talk about rigged markets have also eroded investor confidence.

With each new blow to investor confidence, we take steps to close gaps in regulation, enhance market transparency and tackle fraud because our securities markets depend on confident investors. One of our core jobs as a regulator is to maintain investor confidence in our markets. So this evening I want to focus my remarks on how we go about doing that through our market and investor transparency initiatives, efforts to shore up our equity market structure and our focus on a culture that puts investors first.


I'll start with market transparency, which is a central part of any market regulator's job and represents a significant portion of what we do at FINRA every day, in both the stock and bond markets. Part of transparency is price reporting—for example, the tickertape of old—that makes markets understandable, and helps allow for a realistic assessment of value, liquidity and fairness.

Before FINRA created TRACE, the Trade Reporting and Compliance Engine, the debt markets were almost entirely opaque. Broker-dealers were not required to report information about their fixed income transaction activity to anyone, including regulators. In stark contrast to the equity markets, investors had no so-called “tape” to compare the prices they paid for fixed income securities to prices of other similar transactions, and regulators had no audit trail to identify and monitor firms that were trading fixed income securities.  

We know from our experience with TRACE that reporting of corporate bond transactions has enabled careful surveillance of trading in these bonds. And when information on these transactions was made public, this transparency in corporate bonds contributed to better pricing, more precise valuations, reduced investor costs and substantial reductions in the bid-ask spreads, resulting in lower investment costs for both individual and large institutional investors.

Since we introduced TRACE, we have steadily expanded it to make trading in bonds less opaque. Investors now have access to information about transactions not just in corporate bonds but also in asset-backed securities, mortgage-backed securities and Small Business Administration-backed securities. Similarly, the Municipal Securities Rulemaking Board, through its EMMA database, has greatly enhanced transparency in the municipal bond market. And, following the unusual October 2014 trading volatility in the U.S. Treasury market, the U.S. Treasury Department and the SEC are now signaling their intention to expand the transparency regime to Treasury securities and foster more informative collection of trading data for Treasuries.

On the equities side, where we have a more mature transparency framework, we are taking steps to increase the transparency of alternative trading systems, including dark pools. One of our concerns is whether information that is available from all trading venues allows investors to assess prices and valuations in a timely and accurate manner, and enables regulators to investigate and analyze market events.

A substantial percentage of trading today takes place in dark venues, which lack transparency in many respects. For example, the orders placed in a dark pool are not displayed; and while a trade, once executed within a dark pool, is reported to the tape, the trading by an individual dark pool is not separately identified. We currently make the volume and trade count information for equity securities executed in an ATS available on the FINRA website, and plan later this year to start providing additional data about the levels of block activity within ATSs.

In April, we began publishing additional information about equity volume executed over the counter by FINRA member firms, including the trading activity of non-ATS electronic trading systems and internalized trades. This information is available free of charge to all users on FINRA's website, and will help investors better understand a firm's trading volume and market shares in the equity market.

But effective transparency goes beyond market price reporting to the equally important goal of ensuring that investors can understand the quality of executions that they receive. One of the key areas where we are working to enhance fixed income price transparency relates to the markup dealers charge retail customers on fixed income transactions. FINRA is concerned that fixed income investors are limited in their ability to understand and compare transaction costs associated with their purchases and sales. When a dealer is acting as principal in a bond trade, the dealer may include a markup to the bond it’s buying for or selling from its inventory as part of the overall price a customer pays. And that markup isn’t a separate line item like the fixed commission someone might pay on a stock trade where most brokers act only as an agent. When we analyzed TRACE data, we found a material difference between the median mark-up/mark-down and the tail of the distribution, indicating that some customers paid considerably more than others in similar trades.

Our current rulemaking proposal would require dealers to disclose the markup and include it on retail customer confirmations. We at FINRA believe this additional pricing information will promote transparency in firms’ pricing practices, and better enable customers to evaluate the cost and quality of the services firms provide.

We are working in concert with the MSRB on this proposal. To strike the right balance, we are also meeting with industry participants who will be making the disclosure, and we are conducting focus groups with retail investors to best ensure the disclosure we ultimately require will be meaningful to those it’s designed to protect.

Separately, we often find that firms fail to make required disclosures pertaining to municipal securities. So we provide firms with data and reports that help firms detect these kinds of potential compliance problems early. For example, the monthly Municipal Continuing Disclosure Report helps firms review municipal security trade activity. It identifies trades involving municipal securities in which key disclosure information—such as official statements and financial information—was not available on the MSRB's EMMA system when the trade was made. It also identifies trades involving securities that have been the subject of a disclosure through EMMA, such as a ratings change or default, during a certain time period. Firms can use the information when reviewing their municipal bond sales to help determine if they are taking available information into consideration when making investment recommendations and making appropriate disclosures of material information at the time of trade.

Industry feedback on this report indicates it has raised awareness of the information available on EMMA as well as firms’ disclosure responsibilities. It has also encouraged firms to enhance their disclosure procedures. A number of vendors have stepped in to develop automated systems, which help firms comply with their disclosure obligations.

Another example is the Municipal Primary Offering Disclosure Report, which we also publish monthly to help firms ensure they provide official statements to customers purchasing new issue municipal securities. This report, in turn, has raised awareness of underwriter responsibilities to file official statements and related documents on EMMA in a timely manner so that they are available to market participants when these disclosures must be made to investors.

Market Structure

Shifting back to the equity market, I want to talk about the work we’re doing in partnership with the SEC and the exchanges to address the concerns raised by extreme volatility. Just as investors depend on accurate and complete financial information to make equity and fixed income investments, they expect the equity markets to operate efficiently without incidents of dramatic, unexplained volatility.

Since the May 2010 flash crash, the SEC, FINRA and U.S. stock exchanges have implemented a variety of initiatives to minimize the impact of extreme volatility, the causes of which can vary from market forces to technological malfunctions. These initiatives have created a multi-faceted safety net for the markets and are designed to promote investor confidence. Among the changes, regulators adjusted the marketwide trading pause, which gives market participants an opportunity to assess their positions, valuation models and operational capabilities when extreme periods of volatility occur.

In addition, we implemented a limit up/limit down initiative, which addresses the type of sudden price movements that the market experienced during the flash crash. Under the plan, a limit up and limit down mechanism prevents trades in national market system stocks from occurring at prices outside of certain ranges. And if the changes in price are more significant and prolonged, the limit up/limit down plan would trigger a trading pause in that security.

We had an excellent opportunity to evaluate the effectiveness of these changes last August 24, when the Dow plummeted more than 1,000 points within the first 10 minutes of trading. The events of last August demonstrated the value of having appropriate controls in place. Were it not for the limit up/limit down procedures, the market fluctuations last August would have been more dramatic. There were more than 1,200 trading pauses that day, with more than 1,000 occurring in exchange-traded products, many of which were repeats in the same ETP. Clearly, the August events showed that refinements to these processes are serving a crucial function, but also showed that additional enhancements are necessary.

For example, the extreme volatility raised questions about how exchange-traded products, and equities, more generally, operate. One of the issues that day was the big gaps between the value of underlying indexes and the exchange-traded funds that track them. ETFs combine aspects of mutual funds and conventional stocks. They operate like a mutual fund by offering an investor an interest in a professionally managed, diversified portfolio of investments. Unlike mutual funds, however, ETF shares trade like stocks on exchanges and can be bought or sold throughout the trading day at fluctuating prices, whereas mutual funds are priced just once at the end of the trading day. On August 24, unusual trading affected many of the major ETFs. While trading volume surged, public display of trading interest—or liquidity—dropped. And we saw pricing volatility in ETFs because of the conflicts between halts on the underlying stocks within the indices and the pricing of the index.

The volatility and the issues we saw with ETFs offers up a great opportunity for the SEC, with input from its recently formed Equity Market Structure Advisory Committee of which I'm a member, to take another look at the effectiveness of the initiatives put in place after the 2010 Flash Crash, as well as our market structure generally.

It's also important for us as regulators to have a detailed, microscopic view of the market in order to detect trading abuses that are imperceptible. Today, through our agreements with exchange clients, FINRA monitors trading in 99 percent of the listed equity market and 65 percent of the listed options market. We have the ability to pull together data across exchanges and alternative trading systems to see one big, virtual market instead of a disjointed patchwork of individual markets.

We developed an innovative cross-market surveillance program that allows us to run dozens of surveillance patterns and threat scenarios across the data we gather to look for manipulation and frontrunning, as well as layering, spoofing, algorithmic gaming and other abusive conduct. This sophisticated surveillance allows us to detect activities that we were not able to see before. For example, 47 percent of our cross-market alerts identify potential manipulative activity by two or more market participants acting in concert. And 60 percent of our cross-market alerts identify potential manipulation by a market participant on multiple markets.

As strong as our cross-market surveillance program is, the implementation of the SEC's proposed Consolidated Audit Trail—or CAT—which will collect, identify and link orders, trades and quotes in equities and options from all market participants, would go a long way toward improving the ability of regulators to surveil the market. Currently, regulators don't have a single database with comprehensive and readily accessible order and execution data. Each regulator uses its own separate audit trail system to track information relating to orders in its respective markets. For its surveillance, FINRA must gather and merge large volumes of data from different entities to analyze market activity.

A consolidated audit trail that functions on a near real-time basis would significantly enhance regulators' ability to monitor and analyze trading activity. By having unique identifiers for accounts, better order audit trail information for options, more detailed information about each trade, and linkages between related equities and options trades, among other things, regulators' surveillance systems should be able to zero in on problematic trading—not only cross-market, but also cross-product—with the result being quicker and more exacting investigations that will better serve investors.


The third component that is essential for maintaining investor confidence is a culture that puts investors first, and that requires professionals and firms that operate ethically. The all too numerous industry compliance breakdowns that have harmed investors—whether it involves the packaging of sub-prime mortgages, the marketing to retail investors of complex and illiquid products, the lack of transparency of many direct and indirect fees or the efforts to manipulate a range of market indexes—are equally damaging to healthy capital markets. These failures have lead investors and clients to question the industry’s commitment to put investors’ interests first.

Regulators have responded to these events with a variety of rules, including Dodd-Frank and the DOL’s rulemaking regarding retirement plans. Whatever the effectiveness of these efforts, however, I think it is important to recognize that rules alone cannot address the very real challenges that financial firms have in ensuring that “good people” behave in a manner that looks out for the best interests of their clients and that does not expose their firms to unnecessary risks.

Accordingly, I want to take a minute to talk about the culture at broker-dealer firms. After nearly 40 years as a securities regulator, I can say without a doubt that firm culture has a profound influence on how a securities firm conducts its business. And I’ve seen over the years how a culture that doesn’t value ethical behavior leads to failures for the firm and significant harm to investors. Some industry experts estimate that fines and litigation costs to firms, or their parent companies, related to cultural failures have totaled more than $300 billion since 2010.

It’s important that the securities industry embrace a culture that puts investors first. A culture that consistently places ethical considerations and client interests at the center of business decisions helps protect investors and the integrity of the markets.

FINRA has been focused on firm culture, conflicts of interest and professional ethics for some time now, and we think firms should also be paying keen attention to these related areas. In 2013, we issued a Report on Conflicts of Interest that highlighted effective practices. More recently, we have been focused on conflicts that a firm’s compensation system may create. Specifically, conflicts in the compensation area can impact the quality of advice provided to and products sold to investors, especially to retail investors.  

This year we began reviewing how firms establish, communicate and implement cultural values, and whether cultural values are guiding business conduct. We are looking at a number of factors, including how a firm communicates and reinforces values directly, implicitly and through its reward system. We are also interested in how a firm measures compliance with its cultural values, what metrics, if any, it uses and how it monitors for implementation and consistent application of those values throughout its organization.

In our reviews, FINRA is assessing five indicators of a firm’s culture: whether control functions are valued within the organization; whether policy or control breaches are tolerated; whether the organization proactively seeks to identify risk and compliance events; whether supervisors are effective role models of firm culture; and whether sub-cultures—for example, at a branch office, on a trading desk or in an investment banking department—that may not conform to overall corporate culture are identified and addressed.

We are only at the beginning of our review, so it’s premature to draw any broad judgments. However, we have observed that many firms are paying more attention to their culture and how they manage conflicts of interest. We continue to work with firms to improve their focus on culture. And, without dictating culture, we will continue to work with firms to ensure the industry fully embraces a culture that puts investors first.


These three areas—transparency, market fairness and a culture that puts investors first—show clearly how investor confidence is closely intertwined with investor protection. So it is imperative that regulators and the industry continue to work together to strengthen these related areas to uphold the integrity of our financial markets, and rebuild investors' trust in the securities markets.

Thanks for listening. I’ll take your questions.