Remarks at the STA Annual Conference
Vice Chairman, FINRA
Thank you so much for that kind introduction. It's an honor to speak at this conference.
Conferences like this provide an ideal setting for regulators and market participants to engage in a productive dialogue concerning the exciting issues in this fast-changing market.
This afternoon, I'd like to take a wide-angle view of the industry and discuss some of the extraordinary changes taking place in the capital markets, as well as the challenges ahead.
But first - an interesting fact: on this very day 49 years ago, in 1958, the first transatlantic passenger jetliner service began with flights between London and New York.
It was an historic milestone in aviation. But it wasn't only a new era in aviation. From that day forward, the world began to grow smaller and almost every aspect of life would be changed - from culture and commerce to international relations. But it was only the beginning.
Today, globalization, international mergers, faster technology and consolidations are bringing the world together like never before and transforming the financial services industry. Our challenge will be to anticipate that change and, when possible, get out in front of it.
As I look ahead, there is no doubt in my mind that the challenges we face will test firms of all business models and sizes - as well as regulators.
So today I want to focus on what FINRA is doing to prepare for these challenges and the evolving markets of the future.
The most visible step we have taken to keep pace with the changing marketplace is the NASD/NYSE regulatory consolidation. This plan combines NASD and NYSE member regulation into a single, new self-regulatory organization, the Financial Industry Regulatory Authority.
The consolidation is helping us to establish a more sensible and less complex regulatory regime with a single set of rules adapted to firms of all sizes and business models. There is now one set of examiners and one enforcement staff.
We will also look toward fashioning the new rulebook in a more targeted way taking into account firm size and business model. We believe that this tiered approach to regulation should yield a rulebook better rationalized between intent and impact and, therefore, more efficient regulation.
As far as governance, FINRA's Board has strong industry representation. Ten of the twenty-three governors are industry representatives. Of these industry seats, three are allocated to large firms, one to medium sized firms, and three to small firms.
In addition, there are three industry seats set aside for particular business models - one of which is allocated to an independent dealer/insurance affiliated firm, one to a NYSE floor broker and one to an investment company affiliated broker/dealer.
As you know, there have been several recent reports questioning whether the U.S. capital markets can keep their current competitive edge with the current regulatory regime. Through our merger with NYSE member regulation, we are doing our part to streamline the regulatory structure of the US markets.
Trends and Issues
One of our jobs as a regulator is to understand the trends facing the industry, and to stay ahead of those trends.
Clearly, a major issue confronting us all is the technology revolution. I know that technology has changed the lives of every person in the trading community. Statistics show that as many as half of all trades today are computer-driven. And even the trades that are originated by live human beings are routed through sophisticated technology.
This rapid technological change creates both opportunities and challenges for the industry. As firms adopt faster and more complex trading strategies, they must establish safeguards to ensure that they can monitor the technology used to implement these strategies.
The regulatory community isn't immune from these changes either. We have to invest in technology to keep up with new rules, new strategies, new market participants and an ever more complex and interrelated marketplace. Today, we have over 400 million orders, quotes and trades that move through FINRA's technology systems every day. While it gives us a great view into the market, this kind of footprint creates its own complexity.
We like to say that in the area of markets, we no longer chase bad guys… We chase bad computers.
While of course this is an exaggeration, the key for market participants is to put into place the proper controls to ensure that their computer systems are compliant with rules and regulations and are operating as intended. This will only become more important over time, as the world becomes more and more automated.
Another, major topical issue is the recent events in the credit markets. As you know, FINRA has responsibility for financial and operational oversight of brokerage firms. Rather than talking about specifics of our oversight of the firms, let me make a few broader observations.
Much of what we are seeing is Investing 101. If you go to FINRA's website, which is geared toward individual investors, you will see a basic precept of investing: Don't buy things that you don't understand.
It's clear that as Wall Street sliced and diced credit into more esoteric structures, many buyers either couldn't or didn't fully evaluate the risk inherent in these new instruments. From a common sense point of view, if a product is producing outsized returns with seemingly minimal risk, buyers and regulators should be skeptical.
If firms were treating complex mortgage-backed securities like cash or highly-rated debt, but were getting a much higher interest rate on those instruments, it is not surprising that those instruments carried more risk… regardless of what the rating agency or model said.
So, we go back to the basics. You pay for higher return with higher risk. That's how markets work, and it is hard to escape that fact.
Whatever you may believe, it is clear that the proliferation of structured products and other derivatives, the lack of transparency as to their volume and their financial impact in leveraging directional investment bets creates a new complexity in the markets that will bring about increased dialogue between market participants and regulators in the years to come.
Let me now shift to a discussion of a few important issues related to market structure.
Market Structure Discussion
One area of focus for FINRA - and one that I know is of interest to this audience - is the recent regulatory restructuring of the U.S. equity markets. In somewhat stark contrast to the turmoil we have seen in the sub-prime market, the phased roll out of Regulation NMS has been a relatively smooth one.
Due in large part to the significant amount of advance preparation that took place - both on the part of regulators and member firms - we haven't seen any major market-wide problems.
FINRA has been busy implementing Reg NMS over the last two years. Among other preparations, we have been actively engaged in updating our surveillance systems to detect Reg NMS violations, adjusting our exam modules to cover Reg NMS compliance, and preparing our examiners for their new Reg NMS-related responsibilities out in the field.
We're just now gearing up for the initial Reg NMS sweeps and exams that will cover member firm activity that took place after the July 2007 Reg NMS "Pilot Stocks" launch date.
My advice is simple - the best defense is a good offense. Don't wait for us to find problems in your Reg NMS procedures, systems, or compliance. Get out in front of this one.
As with all significant regulatory initiatives, the final outcome of Reg NMS won't be fully-known until market participants and regulators have had more time operating under the new rules. We need to understand that markets and trading practices are constantly evolving.
And as they do, it's imperative that both the industry and regulators evolve with them to ensure that our markets remain the most efficient and best regulated in the world.
The history of market structure regulation itself is a prime example of the need for regulators to be nimble in the face of changing market conditions. As you know, the SEC, at Congress' direction, began regulating U.S. equity market structure in earnest in the mid-1970s.
At that time, an unprecedented wave of trading technology innovation was underway. The Commission recognized this advancing technology and perceived the need for market structure regulation to keep pace. They built the original National Market System regulatory structure on two basic tenets.
One was price competition - the belief that an investor or market participant willing to display the best bid or offer in the market should be "filled" at that best price before any other inferior bids or offers are filled.
The second was market competition - the belief that vibrant markets can only remain vibrant if they are constantly driven by competition to create new and innovative products and services.
To ease the inherent tension between these two forms of competition, the SEC established a consolidated stream of market data for all quotes and trades in NMS securities, along with rules to govern the trading of securities across markets.
Somewhat ironically, the driver behind the Commission's initial effort to regulate equity market structure - advancing trading technology - required the Commission to revisit market structure through Reg NMS.
While price and market competition are still guiding principles, the equity market landscape has changed dramatically. The creation of a consolidated market data stream 30 years ago enabled market participants to access quote and trade data from all markets in real-time.
By comparison, today's market participants have actual inter-market access to all markets in real time. What do I mean by that?
Using advanced direct market access and order management technology, market participants now spread significant quoting and trading volume across markets at the push of a button.
Rather than just seeing at what price market participants in "away" markets are willing to buy and sell a security, traders can now reach out to one or more "away" markets instantaneously and complete their trades.
As I already noted, it's premature to draw any definitive conclusions about the impact that Reg NMS has had or will have on our equity markets. However, I think I can safely say that Reg NMS is driving more and more automation of markets and algorithmic trading.
Where will this algorithmic trend take us and what will be its ultimate impact on market quality, efficiency, and investor protection?
As a regulator, I won't attempt to dispense trading advice. I will say, however, that - similar to the complex asset-backed securities I already touched upon - firms need to understand the products they are using and whether they are compliant with trading rules, including Reg NMS.
This is particularly important for those firms that are relying on computer-driven algorithms to make sub-second order routing decisions in compliance with Reg NMS.
OTC Market Developments
In addition to implementing Reg NMS, FINRA also has the challenging task of regulating the dynamic Over-the-Counter market.
Not only does order flow now shift rapidly across markets, but as exchanges have innovated in recent years, the number of OTC venues for reporting OTC internalized trades has grown dramatically.
Of course, I'm referring to the development of Trade Reporting Facilities or TRFs, which are venues through which OTC internalized trades may be reported to the consolidated tape.
Since these are relatively new creatures, let me be clear about the structure of a TRF.
Under a TRF agreement, the participating exchange provides the reporting technology and is responsible for the business aspects of the TRF (connectivity, operations, pricing and customer service).
In turn, the TRF operates subject to FINRA's self-regulatory oversight and FINRA is responsible for governance of the facility and regulation. FINRA is paid its cost of overseeing and regulating the TRF, and the business partner retains the excess profit or suffers any losses.
Together with ADF, in a few short years, the number of venues available for reporting OTC internalized trades has grown from one to four. To the extent that additional TRFs cease operations or new TRFs are launched, FINRA ultimately is neutral as to which TRFs succeed or fail. We're a facility provider with no bias toward the commercial success of one exchange over another. Our goal is to be a strong partner in regulation with each of these facilities.
Looking forward, there is a variety of exciting post Reg-NMS trends already taking shape in the OTC market.
Ironically, as the traditional exchanges undergo historic structural changes to remain competitive, new OTC trading venue models are thriving.
For instance, OTC crossing networks, or "Dark Books", continue to see their volumes surge. Some industry observers estimate crossing network volume at over 10% of total NMS security share volume.
These liquidity pools pose a number of issues that we will have to wrestle with over the next several years.
We'll need to ask ourselves — If they continue to grow, will the benefits outweigh any possible negative side effects? And what is the potential long-term impact of such a significant amount of order flow not being reflected in the consolidated quote stream and not "filling" displayed investor orders?
These are just some of the current issues in the over-the-counter markets that we will look forward to discussing with the industry.
Market Fragmentation and Inter-Market Regulation
Let me end with some broad observations about regulatory fragmentation and coordination. As I mentioned, the creation of FINRA was an attempt by the regulatory community to gain efficiencies and eliminate certain redundancies in the US regulatory structure.
It's clear that regulatory jurisdictional boundaries are blurring, both abroad and at home. As markets merge across continents, and US investors have increasing appetite for international securities, regulators must learn to operate in a world less and less defined by geographic borders.
This global transformation won't wait for regulators to figure it out, so we need to re-double our efforts to work with fellow regulators across the globe.
But global boundaries should not be our only concern. As market competition flourishes, we are seeing ever greater market fragmentation.
Even though competition is often good for investors and traders, it can lead to regulatory inefficiencies and possibly gaps at the regulator level.
If you consider it from a historic perspective, our largest listing venues (Nasdaq and New York Stock Exchange) had always dominated the trading volume in their own securities.
But in just the last decade, we have seen remarkable market fragmentation in which these listing markets are competing directly with each other, regional stock exchanges as well as broker/dealer ATSs and ECNs. This trend of market fragmentation has presented regulators with new challenges in tracking and regulating large order flows and trading activity across markets. I think now more than ever we need to redouble our efforts to coordinate regulation across markets.
There are some prime examples of advances in regulatory coordination.
For instance, SROs are now pushing National Market System plans further than in the past. These plans have traditionally covered inter-market data collection and trading rules, but have not focused on surveillance or regulation per se.
In the options regulatory arena, the Options Regulatory Surveillance Authority, or ORSA, represents a significant step forward in regulatory efficiency. ORSA establishes a structure whereby the member options exchanges engage in joint surveillance of options trading based on agreed upon delegations of authority.
In addition, there has been the advent of the next generation of regulatory sharing agreements. These agreements have historically focused on SROs assuming specific regulatory obligations with respect to examinations of joint members. More and more SRO's have entered into 17d-2 agreements to replace redundant, overlapping exams.
Discussions are also underway to leverage technology and staff in the area of equity insider trading surveillance.
It's imperative — and starting to happen more and more — that regulators coordinate and view trading activity across markets. This should ensure that regulators have sufficient tools available to keep our markets running efficiently and fairly for both market participants and investors.
Today, we take for granted the fact that we can jump on a plane and be in Europe in six or seven hours. But it wasn't always that way. And we also take for granted the technology that's been developed in the last few decades that has enhanced and shaped the global capital markets.
But what we can't take for granted is the integrity of our markets. As the capital markets confront a new era of challenges fueled by globalization and technology, FINRA aims to create a regulatory approach more appropriate for our times.
Indeed, the world has changed a lot since the 1930s - which was the last time there was a significant restructuring of securities regulation in this country. Right now, we're all witnessing the very structure of the capital markets transform and change, and all of us, traders, firms and regulators alike, will need to work together to adapt and anticipate these changes.
That's what we're doing at FINRA, and we hope you do the same.
Thanks so much for listening - I'd be happy to take a few questions.