Remarks at the Bond Market Association Annual Meeting

Douglas Shulman

Vice Chairman

New York

May 19, 2006

Good morning. Thank you, Randy, for the introduction and, as always, many thanks to the Bond Market Association for inviting me to speak at your Annual Meeting.

As I thought about what to say, and spent some time thinking about the bond markets the past several years, I can't help but be amazed at the pace of change in this market. I don't need to tell you that the regulatory environment has changed, and that NASD and other regulators are spending more time with you. But there are also other huge trends effecting your world. The most positive is the fact that it looks like more and more money will continue to flow into the bond markets. Pension funds and insurance companies are trying to ensure that their liabilities are matched with assets that have predictable cash flows; And as the population ages, and baby-boomers retire, more and more people are putting money into fixed income. Also, it is obvious to even the most casual observer that the derivatives market, particularly Credit Default Swap market, is impacting the cash markets in ways that we are only beginning to understand.

It is clearly an exciting and dynamic time in the fixed income industry, and I'll try to add a perspective from the NASD.

There are three general topics I'd like to touch on today. The first is a set of key NASD initiatives related to the bond markets. I'll touch on TRACE and its effects on the market; our plans to make TRACE information more widely available for research; and NASD's mark-up proposal.

Second, I'd like to talk a little bit about NASD's focus on supporting the industry as it tries to meet market demands and serve investors.

And third, I will briefly comment on the current state of self-regulatory organizations and regulatory harmonization.

Let me start with TRACE. On July 1, 2002, TRACE launched with public dissemination of trades in approximately 550 bonds. We increased transparency over several more phases, carefully evaluating the impact of transparency on liquidity as we moved forward, and reducing the reporting time for trades to 15 minutes. Today transaction reports in more than 30,000 TRACE-eligible bonds are received and made public in real-time.

We speak with the industry and trade associations often and recognize the transition has created challenges for some firms and most certainly opportunity for others.

One consequence of the pricing efficiency that transparency brings to the market is spread compression. For example, a recent academic study found that trade execution costs for corporate bonds had dropped by about 50 percent since TRACE's inception. That's nothing to sneeze at. However, while some players may be having a harder time adopting to the new realities of the market, others are taking full advantage of transparency and are growing and building their businesses under the new rules of the game. For example, an Investment Dealers' Digest (IDD) article highlighted the success that middle market players are having in catering to institutional investors in today's fixed income markets. In addition, several retail brokerage firms have used transparency as the center piece of their campaigns to extend their reach across the fixed income investor base.

From the standpoint of investor protection, which is NASD's polestar, there was simply no compelling argument for continuing to allow this market to be opaque. Not in the 21st Century, and not when virtually all other cash markets are fully transparent.

As for the claim that TRACE has reduced overall liquidity in the market, we haven't seen the evidence of that either. Institutional traders would be most effected by a reduction in liquidity, and they have not told us that they are having problems moving large positions. While certain dealers with certain business models may not be willing to put as much capital at risk, we have not seen a reduction in liquidity in the market overall.

Nonetheless, I commit to you that we will continue to monitor the market and watch for effects on liquidity. We also recognize there is widespread interest in accessing historical TRACE data for research purposes. Recently, we worked with Wharton Data Services and the University of Houston to make historic, public TRACE data freely available to the academic community for research purposes. A number of people have requested that NASD also make non-public components of TRACE historical data, such as uncapped volume, available for research . So, we've decided to solicit input from the industry through a Notice to Members regarding what, if any, non-public historical, TRACE data, NASD should make public.

We want as many eyes as possible studying this previously undisclosed information so that we can discover any effects transparency may have on the market, and how we should move forward with our programs. However, given the intense scrutiny and debate that followed the first round of TRACE data dissemination, we think we should allow for full debate before we release previously undisclosed information. We would welcome your input and look forward to working diligently with industry representatives to determine how to proceed.

Recently, we also announced that we planned to add indicators to the TRACE data feed that would show whether the transaction was a customer buy or sell or a dealer-to-dealer transaction. NASD planned to introduce this information because industry participants said firms needed it to comply with NASD corporate bond mark-up guidelines (I'll discuss mark-ups in a minute). Also, many professionals told us they felt the additional information would be valuable for determining market conditions and pricing. In fact, this additional trade information is already available in the municipal bond market via MSRB's real-time transparency initiative. Once we announced the planned introduction date, however, we received feedback from a group of market participants who were concerned about negative impacts this new information might have on the market. We listened carefully to the concerns and have subsequently issued a Notice to Members to allow interested parties to formally comment on the proposal before deciding how to move ahead.

I would be remiss to stand up here and not say a few words about our debt mark-up rule.

As you know, this rule has been pending at the SEC for several years, has gone through multiple iterations, and has engendered some controversy, to say the least. Some industry participants feel it is unnecessary and some feel strongly that further guidance and clarification is essential. In the meantime, we have brought several mark-up cases, but only where the conduct was inarguably over the line.

Discretion being the better part of valor, I do not want to say too much about the rule as it sits at the Commission. We have had extensive conversations with the BMA and its constituency on this matter and, as you have heard others from NASD say, we view the proposal as being, for the most part, a restatement of the current law on debt mark-ups. We do not address the issue of market maker head-on except to acknowledge that nothing in the proposal prevents a broker-dealer's being deemed a market maker when and where it comports with the statutory definition.

We recognize that there is a perceived need for more clarity in the definition of market maker and past iterations of our filings in this area have tried to deal with that issue. Those attempts have come to naught. Consequently, we have decided not to hold rulemaking on debt mark-ups hostage to this one issue because we believe it is vitally important to move forward and have a more definitive debt mark-up rule in place. We know first-hand that many broker-dealers agree with that view. That said, this does not mean that any final rule in this area needs to be artificially static. We can and should continue our dialogue on these matters. With the knowledge acquired from experience with our new rule in this area, if and when it is approved, we can consider whether further regulatory revisions are warranted.

We have also heard dealer concerns regarding the application of the proposed rule with respect to institutional customers in certain segments of the debt market, distressed and bespoke structured debt being prime examples. While I cannot commit to an outcome on these issues, and while questions remain about which segments of the debt market to consider and how we should define "institutional customer," these points merit serious consideration in the context of this filing and they are getting it.

I think it is critical that, as stewards of transparency and investor protection, we also recognize the importance of working with the industry to ensure that we weigh and understand the potential impact of our initiatives. We recognize that the debt market has its own characteristics, and that rational regulation must take account of those characteristics. We are especially attuned to the unique characteristics of distressed debt and structured products, particularly as they related to sophisticated, institutional clients, and we will always listen carefully to market participants as we craft our regulatory programs.

We also try very hard to keep our eye on the overall dynamics of the marketplace, so that we can understand what factors are driving change and how we need to adjust to do our job. As business people you know that the pace of change in our industry is staggering, and I won't pretend that we can always anticipate where the market is heading. However, advances in technology clearly are changing all securities markets, and fixed income is no exception. For the most nimble firms, technology is fast at work helping create efficiencies and reducing the cost of distribution, securities processing, and the rest of the expense side of the equation-- even as transparency may have put pressure on the top line. And the growth of electronic trading platforms such as MarketAxess and TradeWeb responds almost exclusively to the desire of institutional bond investors for easier and faster access to trade and price information to facilitate trades. Clearly, this advent of electronic trading is a key factor that will continue to shape this market. [STOP]

Let me now spend a few minutes discussing what we at NASD are doing to support the industry as it tries to meet the demands of regulators and changing market dynamics.

After three or four years of scandals and the heavy regulatory activity that followed, everyone in the industry is looking to ensure that regulation is as efficient as possible. Clearly, the firms need to be the front-line of defense for investors. One thing we can do is support firms who try to abide by the rules and treat their customers well. We at NASD are putting more and more emphasis on supporting the industry in their own, firm-specific compliance efforts. Over the past several years we have increased our informal dialogue with the industry in areas like standard setting, and have worked to bring tools to industry professionals to help them meet their regulatory obligation.

A recent example of this sort of collaboration is our April 2005 Notice to Members about reviewing new products. We were seeing a lot of them, with all sorts complicated features. So, we spent several months meeting with firms and gathering best-practices about the new product development lifecycle. We cautioned brokers and firms that it would be in their interest to review and improve their procedures for determining what constitutes a new product and for whom it is suitable, and ensuring that prospective customers are properly informed of its material features. It is certainly our hope that in issuing that Notice to Members, we helped firms avoid mistakes that might have required a disciplinary response. And we thought that guidance and best practices made for a better approach than a rule.

In this same vein, we started meeting with firms a few months ago to discuss industry planning for an avian flu pandemic. We wanted to gather and share best practices, as well as consider what potential regulatory relief or "rules of engagement" need to be in place during a major market disruption of this nature.

As a by-product of this, we have been in discussions with the BMA and SIA regarding NASD's support of a project to create an active directory that would ensure that firms know where to reach the appropriate counterparty in the event of a pandemic. We have offered to contribute our operational infrastructure and personnel and partner with the trade associations on this project.

Although these are only two examples of our evolving role, we strongly believe that our role should not be static - that we need to be able to listen to the industry and support participants as they strive to enhance the integrity of the market. Whether it be offering educational content and broker-dealer training, central solutions to industry-wide problems, or a sounding board where the industry might benefit from defining standards of practice, we are happy to help the industry and play a key role. Working with the industry in these ways is what the SRO model is all about.

There is one more topic I want to address briefly.

With all the market realignment and competition going on - exchanges going public, merging with or acquiring other exchanges and so on - I know there is a lot of interest in what it all means for the future of securities regulation. So, let me give you my take on that.

First, let's survey the field and see where things stand. Nasdaq is now a for-profit, publicly-traded company and has acquired Instinet and about 24 percent of the London Stock Exchange. The New York Stock Exchange is now a for-profit, publicly-traded company, has acquired Archipelago and has indicated that it does not plan to stop there. In view of all this, the SEC issued a concept release about a year ago, soliciting comment on some possible changes to the SRO system. They ranged from making a few adjustments on the margins to scrapping the system altogether and replacing it with direct SEC oversight of the industry.

The view that NASD has expressed is that the industry, investors and society at large would be much better-served by something closer to the former than to the latter. The SRO system isn't perfect, but it works quite well. Perhaps its greatest attribute is that SROs are closer to the industry than the government is and thus can have more dialogue with regulated people and entities.

As you know, NASD has divested itself of most of Nasdaq and will no longer have any ownership position by the end of the year. That will make us the only major SRO with no for-profit operations. We are, and will be, a conflict free, non-profit organization focused on regulation and supporting the industry through utility functions like testing, registration and transparency facilities, like TRACE.

In light of all of these structural changes occurring in the industry, we have been looking at streamlining SRO regulatory regimes. As you know, the NYSE undertook a harmonization of its rules with ours in the context of a broader approval order by the SEC to merge with Archipelago. We are engaged in discussions with them about this process. In addition, we have been public in our support of the SIA proposal to create a hybrid member firm regulator. The inefficiencies of two sets of rules, exams and enforcement programs makes no sense, and we believe we should eliminate the duplication.

We've been talking to the NYSE about this and look forward to a continuation of these discussions.

I've covered a lot of ground here, so let me conclude. I'll just say that in this fast moving marketplace, we will do whatever we can to support the firms who are trying to run a clean business. And as we continue to evolve our regulatory approach to the bond markets, we look forward to continued and open dialogue with the BMA and industry members. It is that dialogue that makes the SRO system work, and in turn has helped make the American markets, and in particular the bond market, such a vital part of the economy. So, I'll stop here. Thank you for listening.