FINRA President and CEO
Remarks: New Special Study Conference
New York, NY
Updated: April 18, 2017
Good afternoon. Thank you, Merritt [Fox], for that kind introduction and for the invitation to speak with you this afternoon. It’s a pleasure to be with you today and to participate in this ambitious initiative to conduct a New Special Study of the securities markets.
As all of you know, the original Special Study was a defining event in the history of U.S. securities regulation. Perhaps less known is that it was also the catalyst for important refinements to the framework for self-regulation in our securities markets. Not surprisingly, that is the topic I would like to address today.
Self-regulation was first codified in the federal securities laws more than 80 years ago as what some might call a special form of public/private partnership. Since that time, as with other aspects of the industry outlined in the papers for this conference, the evolution in the nature and role of self-regulatory organizations (SROs) has been sweeping. FINRA, which is the only SRO that is a national securities association, is no exception.
Although as I mentioned the Special Study did address SROs, the last comprehensive and public review of the SRO model was in 2004, when the SEC issued its Concept Release on self-regulation. Thirteen years is a long time in this industry. The FINRA that I inherited several months ago looks quite different from the SRO models that were considered then. Indeed, FINRA in its current form did not even exist at that time. In addition, the Concept Release focused on for-profit exchanges and the conflict that may arise when an SRO has commercial interests that may be affected by the regulation of its members. While this issue remains with us today, as I will discuss in a moment, it is not particularly relevant for FINRA.
And so today, as you pursue your holistic study of the securities markets, closing gaps in our knowledge and identifying implications for policy, it would seem logical, timely, and even necessary that the subsequent stages of your analysis include the topic of self-regulation. Fully acknowledging that I have neither the academic credentials nor the objectivity and independence that make this group’s contributions so valuable, I would like to offer you some general thoughts on the issues in self-regulation that you might consider as you formulate a definitive plan of action for completing the study.
The Importance of Considering the SRO Model
Now, some may question why the CEO of FINRA would invite scrutiny of the SRO model. I frankly welcome the conversation. For one thing, I am confident that a thoughtful review will ultimately validate the compelling benefits of self-regulation as embodied in FINRA. The SRO model has been periodically questioned and re-examined by policymakers over the years, and these reviews have sometimes resulted in important changes to SROs and their regulatory functions. But these reviews also have consistently recognized the many advantages offered by the SRO model, and ultimately affirmed the critical role of SROs in the success of our markets. A good example is the Special Study itself, which concluded that while the regulatory framework needed “considerable adjusting and strengthening,” its basic design “appears to have stood the test of time and worked effectively in most areas.” Then SEC Chairman William Cary affirmed the agency’s “continuing belief in self-regulation as an ingredient in protection of the investor.”
This is not to say there is no room for improvement today. To the contrary, a second reason that I welcome a discussion about the SRO model is that there are likely opportunities to make it more effective and efficient. I am eager to identify steps FINRA can take to better achieve its mission. Since I became CEO, I have been on a listening tour, meeting with investor advocates, member firms, industry groups, fellow regulators, policymakers, and other stakeholders to hear their perspectives on FINRA. In charting a course for FINRA over the next several years, it is critical that we understand what our stakeholders think we are doing well and where we may be falling short.
This listening tour has generated valuable feedback, most of it focused on how FINRA performs its day-to-day regulatory operations. And we are acting on this feedback. We have launched a comprehensive organizational improvement initiative – FINRA360 – to take a fresh look at our operations to ensure we are optimally organized and managed to achieve our mission.
The listening tour has also revealed broader questions from some about what self-regulation should look like today. As a membership organization, we must be open to a conversation with our members about these questions, and other perspectives must be part of the dialogue as well. FINRA must be willing to consider any changes that will better serve the interests of investors while promoting strong and vibrant capital markets. Your input would help us do that.
Another reason I embrace a discussion about the SRO model is that it provides an opportunity for all interested parties to develop a common, informed understanding about how SROs function. This point is an important one for FINRA. One thing that has emerged – somewhat surprisingly – from my listening tour is that FINRA’s structure and programs often are not fully understood. Indeed, some (but certainly not all) criticisms of FINRA have reflected a misunderstanding about what we do and how we do it, as well as how we differ from other SROs. Essential to an effective discussion of FINRA is a clear understanding of its structure and operations, some of which I will discuss in more detail in a moment.
Finally, there is unique value in considering self-regulation in the context of your broader review of the securities markets. The role of SROs in today’s markets is sometimes discussed in isolation from the broader, more high-profile issues of market structure and market integrity. While this is understandable given the complexity of these issues, your study offers the opportunity to identify inter-relationships and dependences in the challenges and opportunities for SROs presented by our current markets and regulatory framework. This integrated approach may suggest options that a more piecemeal approach might otherwise miss.
The Benefits of Self-Regulation
Where, then, to start thinking about SROs? One useful point of departure is to review the rationale for self-regulation in the securities industry. Why do we have SROs? Why not just have the government handle their regulatory functions?
Self-regulation in the securities industry has traditionally been understood to provide three distinct advantages compared with direct regulation by the government. The first involves access to expertise. SROs that operate markets are experts regarding how those markets work. And all SROs can involve their member firms more directly in their deliberations and thus benefit from their expertise on relevant matters, such as the different business models of those member firms and how they operate in practice, the complex and rapidly evolving securities markets in which they trade, and the wide range of investors they serve. SROs can use what they learn from their members to enrich their regulatory programs and develop solutions that are perhaps more practical, tailored, and effective than what could be developed without such input. The connection between an SRO and its members can also help SROs more rapidly identify and respond to new risks to investors and markets. And it can enable an oversight of the day-to-day operations of markets and firms that is impractical for the government.
The second advantage that has traditionally been identified is that SROs can raise the standard of conduct in the industry. This benefit is most apparent in the ethical requirements and detailed business conduct rules that an SRO can establish that extend beyond the realm of federal law. These standards can deter dishonest and unfair practices that might not amount to fraud, but nonetheless can undermine investor confidence and compromise capital formation. For example, FINRA and most exchanges require firms “to observe high standards of commercial honor and just and equitable principles of trade,” in addition to prohibiting manipulative, deceptive or other fraudulent practices. Just and equitable principles of trade require standards of behavior above and beyond those required by the antifraud provisions, and they allow SROs to deal with types of misconduct not yet specifically described by a particular rule.
FINRA also has detailed individual testing and continuing education requirements, and extensive provisions addressing key functions like supervision and communications with the public. Another example is the best execution rule, which Ryan Davies and Erik Sirri discuss at some length in their conference paper. And SRO rules, such as FINRA’s Uniform Practice Code and customer account rules, can also address highly complex operational matters. When informed by close consultation with the industry, these rules can result in a regulatory framework that takes into account nuances of market practice and behavior in ways that go beyond what might normally be expected from the government.
Third, SROs are funded by their regulated entities, and do not rely on taxpayer dollars. The industry bears the cost of its own supervision, which alleviates the need for ever larger government expenditures for this purpose. This funding can lead to heightened supervision. In the case of FINRA, for example, the SRO model has resulted in a regulatory regime in which every broker-dealer member of FINRA is examined at least once every four years by the SEC or FINRA, and many are examined more frequently. New entrants to the industry must have their applications approved by FINRA, and they are examined within one year of becoming members. Industry funding also provides greater certainty regarding the timing and availability of funding and thus greater ability to make capital investments in longer-term initiatives. Depending on your perspective, during times of budget challenges and uncertainty, the concept of charging the costs of regulation to those who generate the need for it may be appealing.
In addition to the advantages traditionally recognized, I would add a few more based on my observations from my brief tenure at FINRA. First, considering that the ultimate goal of securities regulation is to change behavior in ways that protect investors and promote strong capital markets, FINRA’s SRO model enables it to pursue that goal in creative, practical ways that go beyond what we might normally expect from the government. For example, FINRA engages in extensive investor education initiatives and has various programs – like our Helpline for Seniors – through which we can provide direct practical assistance to investors.
In addition, FINRA can work with its members to create templates, checklists, compliance report cards, and other practical tools to aid member firms in developing policies, procedures, and programs for compliance. It can also offer a program of conferences, meetings, and education that are responsive to the real world compliance challenges and questions identified by firms. FINRA does all of these things today, and I am very interested in doing more. To be clear, examinations, surveillance and enforcement are and will remain vital, but we also protect investors when we enable firms to comply with regulatory requirements, thereby hopefully preventing customer harm from occurring in the first place.
I do not want to get too sidetracked, but our terrific Chief Economist Jonathan Sokobin and his team have shared with me some interesting economic research that suggests we should consider how regulations are “delivered” to firms in order to more effectively achieve compliance. While this idea has a number of implications, one is that rather than focusing solely on rule-writing, examination, and enforcement, we should also seek to improve our “regulatory delivery” – providing better information, guidance, and resources to help firms comply with rules from the time they are adopted. This approach may be especially useful in supporting smaller firms that do not enjoy the economies of scale that empirical studies have shown are inherent in regulatory compliance.
Another advantage of the SRO model that I have observed first-hand at FINRA is that we can provide industry utilities that benefit members and investors alike. For example, as a non-profit entity, FINRA operates services like BrokerCheck – the online database that investors can use to learn about their financial adviser’s regulatory history. FINRA also operates the CRD, the central licensing and registration system for the U.S. securities industry and its regulators. FINRA’s TRACE platform has brought unprecedented transparency to transactions in corporate bonds and other fixed income instruments, and soon will provide an audit trail of broker-dealer transactions in U.S. Treasury securities. FINRA also operates a dispute resolution forum for securities-related arbitrations and mediations.
Potential Conflicts in Self-Regulation
Now, it is relatively easy for me, as part of FINRA, to describe the many benefits of the SRO model. It is much harder to objectively assess the extent to which SROs actually deliver on these potential benefits, what downsides the model may bring with it, what alternatives should be considered, and what policy prescriptions all this analysis might suggest. Assessing our own performance is part of the work underway at FINRA today, but a full review of these issues is well beyond what I can cover today. Instead, that can be part of your work going forward.
I would like to spend a few minutes, though, on what has been viewed as a key challenge presented by SROs since their inception – the potential for self-interest inherent in the model. Since federal law first recognized SROs, much attention has been focused on how to ensure that self-regulation ultimately serves the public interest. In considering the current debates about self-interest in self-regulation, however, it is important to distinguish between different types of SROs and the different types of functions they perform.
For FINRA, the core question around self-interest in self-regulation is somewhat different than for exchanges. Often it is framed as whether the industry has too much control over FINRA. If this were to happen, FINRA might fail to adequately proscribe, sanction, and deter behavior that could harm investors and markets, and public confidence in securities regulation and in the integrity of our markets might be undermined.
There are several instances in the history of FINRA’s predecessor, the NASD, when the SEC determined that industry influence was problematic. For example, the Special Study found that SROs as they existed at that time tended to subordinate the investing public’s interests to the interests of its members. Among other things, the Special Study called for strengthening SRO governance, clearer standards, and enhanced regulation of sales practices.1 Another important example occurred in 1996, when the NASD settled with the SEC allegations of impropriety involving oversight of NASDAQ market makers by agreeing to a number of structural and other reforms2.
More recently, several commentators have expressed concern about the opposite problem – that FINRA’s members do not have sufficient involvement in its affairs today. Although articulated in different ways, this criticism has centered on whether FINRA’s agenda and operations fail to adequately take into account the member perspectives that should inform and enrich its regulatory model. If true, the lack of sufficient industry engagement in FINRA’s deliberations could mean that one of the benefits of self-regulation that I just described – ready access to and use of member expertise in order to craft creative regulatory solutions – is not being fully realized.
Optimizing Outcomes in FINRA’s SRO Model
So does FINRA’s structure today strike the optimal balance between the benefits of active industry participation in regulatory decisions and our obligation to protect the investing public as a vigilant regulator?
To consider this question, it is important to understand FINRA’s current structure, which has been re-engineered over time based on studied consideration involving not only FINRA’s Board of Governors, but also Congress, the SEC, and our own members. The various elements of this structure create a system of checks and balances intended to enable member participation in regulation while limiting the extent of industry control over FINRA’s operations.
Central to this structure are several channels for engagement with the industry, starting at the top. FINRA’s Board has substantial industry representation that cuts across all firm sizes. Excluding the CEO, industry governors constitute 45% of the Board.3 This structure was voted on and approved by FINRA’s members in 2007, when FINRA was created from the consolidation of the member regulatory functions of the NASD and the NYSE. Some have incorrectly suggested that this merger marked the end of the era of “true SROs” – by which they apparently mean SROs that were predominantly governed by their members. In fact, however, the merger did not represent a fundamental change in governance. For at least 10 years before the consolidation, the NASD had a majority of non-industry governors. And all of the directors of the Board of NYSE Regulation, with the exception of its CEO, were independent.
Another significant channel for industry engagement is FINRA’s extensive committee structure. We have advisory committees, district committees, and ad hoc committees that play an important substantive role in the development of rules and other initiatives by, among other things, providing feedback to proposals and identifying emerging regulatory concerns. We recently issued a Special Notice4 that describes our committees in detail and solicits comment on their effectiveness, so I will not summarize the committees today. But I will note that at least four standing advisory committees (and often other committees as well) review all significant rule proposals that require Board approval, and their comments are shared with the Board to inform its deliberations. FINRA’s committees also play an important role in other activities. For example, our Economic Advisory Committee includes expert economists and supports our commitment to evaluating and minimizing the economic impacts of regulatory initiatives, and our Market Surveillance Advisory Group includes other academics who help FINRA evaluate and enhance its surveillance programs.
The Special Notice outlines a series of other significant channels for industry input on FINRA’s regulatory decisions, including a rulemaking process that generally provides more opportunities for public input than occurs with government agency rulemakings and an adjudicatory process that includes experienced industry panelists.5 The Notice also outlines FINRA’s extensive member relations program.
Each of these channels for industry input is accompanied by checks and balances to ensure that FINRA’s operations ultimately protect investors and promote the public interest. Here, too, it starts at the top – a majority of Board membership consists of public governors who have no material business relationship with a broker-dealer or registered SRO.
Similarly, as the Special Notice highlights, members of the public serve on key advisory committees, and our work is informed by an Investor Issues Committee composed of notable academics, consumer advocates, former securities regulators, institutional investors, and asset managers. This committee is one of the four that reviews all proposals going to the Board. As I mentioned before, FINRA also maintains very significant investor outreach programs, through which it can identify and draw on additional investor perspectives.
But it is also important to recognize that FINRA’s self-regulatory model does not rely exclusively on non-industry input to counter-balance and address the risk of inappropriate industry influence. All of FINRA’s governance and regulatory operations are extensively overseen by the SEC, which has broad authority to audit FINRA’s programs and direct remedial actions. For example, with limited exceptions, FINRA must obtain SEC approval for all of its rules, and FINRA’s adjudicatory decisions ultimately may be appealed to the SEC and federal courts. FINRA must comply with SEC regulations and is subject to frequent SEC oversight examinations.6
In addition, the SEC has broad authority to add, delete or amend FINRA rules, suspend or revoke FINRA’s registration, censure or impose limitations on FINRA, and remove from office or censure any FINRA officer or director. FINRA’s jurisdiction and authority is also limited by the Exchange Act itself, which reserves important authorities for the SEC and other law enforcement agencies.
FINRA augments this external oversight with internal mechanisms to ensure regulatory vigilance and accountability. FINRA staff must abide by an ethics Code of Conduct. An independent internal audit staff that reports to the Board’s Audit Committee reviews all aspects of FINRA’s regulatory operations. FINRA also maintains an ombudsman who functions independently from other departments and FINRA management, and who also reports to the Audit Committee.
Opportunities for Further Analysis
Collectively, these checks and balances in FINRA’s structure are designed to capture the benefits of FINRA’s unique position as a not-for-profit self-regulatory organization that is actively engaged with and informed by its members, yet also guard against improper industry influence or control and ensure the public interest remains central to our activities.
But I would not have invited this discussion unless I thought there might be opportunities for FINRA to improve. The FINRA360 initiative was launched for exactly that reason: to identify ways to make FINRA better – more thoughtful, more efficient, and more effective. This effort depends on ongoing, meaningful engagement with our members, with investors, and with the full range of our stakeholders, and I invite all of you to read our Special Notice and share your thoughts on how we can potentially enhance that engagement. We expect that additional Special Notices requesting comment on other aspects of our operations will follow.
More broadly, as you continue your work on the New Special Study, I also welcome your thoughts on the current SRO regulatory framework and how to improve it. The papers that have already been presented offer interesting insights on regulatory policy for FINRA and other SROs to consider. But you can also address the extent to which the structure and functions of SROs today are themselves good regulatory policy. While I have offered you some general observations on the benefits of the SRO model and on the conflicts of interest inherent in that model, these themes can be developed more fully. For example, are there places where we could safely inject more industry participation or, conversely, where the extent of industry influence has called into question our vigilance?
And there are plenty of other issues related to the SRO model worthy of consideration as well. For example, are there activities in which FINRA or other SROs should, or should not, engage in order to more effectively achieve its mission? Is the relationship between the SEC, FINRA, and the other SROs optimally designed to avoid regulatory duplication? What should be the allocation of responsibilities between the SEC and the SROs in terms of cross-market surveillance, especially when we have a consolidated audit trail, or in terms of member regulation? As you review the overall balance of regulation between broker-dealers and investment advisers, which Allen Ferrell and John Morley highlight in their paper, what implications are there for both SRO regulation of broker-dealers and for examination and oversight of investment advisers?
I do not have the answers to these questions, but I welcome your perspectives on all of them. This conference has identified many important issues in securities regulation, quite a few of which implicate self-regulation. So I think it would be natural for self-regulation to be an integral part of the definitive plan you will now be developing in the next stage of your process.
In the meantime, I will leave you with a final thought. The U.S. capital markets are among our nation’s greatest assets. While their strength depends on many complex factors, it is perhaps not coincidental that we are one of the few countries in the world in which SROs have been an integral part of the regulatory framework for many years. We must not shy away from changes that can improve the SRO model. But we also should be sure that any interventions are based on careful study of the different structures and features of each of today’s SROs and are well-designed to better protect investors and promote safe and vibrant markets. Your work in the New Special Study can help us identify ways to recalibrate the roles of FINRA, and other SROs, while preserving the benefits this model has offered.
Open-mindedness and self-reflection are indispensable to effective self-regulation. So it is in the spirit of self-regulation that I look forward to your continued contributions.
1. The conclusions of the Special Study prompted both the NASD and NYSE to adopt more rigorous examination and licensing procedures for their members. Notably, the Special Study also called for the creation of a computerized over-the-counter market that could disseminate real-time quotations, which resulted directly in the NASD’s development of NASDAQ, whose growth would eventually lead the NASD to grapple with the same fundamental conflict of an SRO operating a market that had longed faced the exchanges.
2. The NASD reorganized by creating a parent company and separate subsidiaries for its regulatory arm and the NASDAQ market. The NASD eventually completely separated from both NASDAQ and Amex, which it had merged with in 1998, spinning off the two for-profit exchanges in 2004 and 2006, respectively. Several other undertakings from the settlement have become integral features of FINRA’s structure and regulatory operations: a majority public board; professional hearing officers to preside over disciplinary hearings along with industry representatives; staff autonomy and independence with respect to disciplinary and regulatory matters; uniform guidelines for membership; the creation of an audit trail to enhance market surveillance; and an independent internal audit function.
3. The Board consists of 23 persons, one of whom is the CEO, 12 of whom are public governors, and 10 of whom are industry governors. The 10 industry governors consist of three small firm governors (representing firms with 150 or fewer registered persons), one mid-size firm governor (representing firms with 151-500 registered persons) and three seats for large firms (those with more than 500 registered persons). There also are seats designated for a floor member governor, an independent dealer/insurance affiliate governor, and an investment company affiliate governor.
4. The Special Notice on FINRA’s engagement programs is available at: http://www.finra.org/industry/special-notice-032117
5. Hearing panels – effectively FINRA’s trial courts – include a professional hearing officer and two industry panelists, many of whom have served on FINRA District Committees or particular subject matter committees, such as the Market Regulation Committee when the case involves allegations of market or trading rule violations.
The National Adjudicatory Council (NAC) – the appellate court – also includes seven diverse industry personnel among its 15 members. As with the Board composition, FINRA achieves diversity on the NAC by providing for the election of five industry members, two from large firms, one from a mid-sized firm, and two from small firms. In addition to reviewing hearing panel decisions, the NAC also reviews membership proceeding appeals and statutory disqualification proceedings. Unless the FINRA Board decides to review the NAC's appellate decision in any particular case, the NAC's decision represents FINRA's final action that is appealable to the SEC. The NAC also makes recommendations to the FINRA Board on policy and rule changes with respect to fines and other sanctions.
6. In the fall of 2016, the SEC launched a new dedicated inspection team to oversee FINRA, the FINRA and Securities Industry Oversight (FSIO) group.