Remarks at the Securities Traders Association
Good morning and thank you for inviting me to come and visit with you today. I thought I would talk to you about some of the things happening in the world in which I live—self-regulatory organizations (SROs), exchanges and other players who work to make markets safe and efficient.
The first of several topics that I want to discuss with you today is the consolidation of NASD and NYSE Regulation's member oversight responsibilities.
There are very few businesses that are as dynamic and fast changing as the securities business. And the regulatory structure must keep pace with those changes. In this country, we've relied heavily on self-regulation in the securities industry since exchanges began operating. Exchanges laid the foundation for self-regulation by setting standards, to which their members were required to adhere, for trading conventions, financial responsibility, listed company registration and financial reporting. With the stock market crash of 1929, Congress examined the system of self-regulation and ultimately passed the Maloney Act in 1938, which established the concept of a National Securities Association.
By enshrining self-regulation in 1938, Congress affirmed that a layer of private-sector regulation that compliments federal governmental regulation is a sensible way to organize our regulatory structure. The SRO system is cost effective, allowing the SEC to focus on oversight and leaving a lot of the day-to-day regulatory work to the SROs. It also allows extensive industry participation in the regulatory process. This is essential, because industry participants are close to the market and have nuanced insights into the conduct (good and bad) of market players. While the SEC has anti-fraud authority, it is the SROs that set the standards for sales practice, just and equitable principals of trade, and other detailed business conduct rules.
But since 1938, some firms were subject to both the rules of NASD and the NYSE. All brokerage firms who did business with the public had to be members of the NASD, and a subset of those firms also had to adhere to business conduct rules promulgated by the NYSE. This redundant regulation, rooted in the historical precepts of being an exchange member, has increasingly made less sense over time. That is why NASD and NYSE Regulation came together to develop the recently announced consolidation plan.
Let me review the reasons why we believe this transaction is good for the industry and good for the markets. The consolidation plan, which, as I said, was approved by the NASD Board of Governors, will make private-sector regulation more efficient and effective.
Having one regulator—rather than two dueling regulators—accomplishes a number of objectives:
- It helps make U.S. markets more competitive by streamlining regulation.
- It makes regulation more sensible, and more effective, through the creation of a single regulator. It reduces complexity and eliminates potential conflicts.
- It ensures industry participation in the SRO process. This comes at a time when the whole self-regulatory system is under review by the SEC.
- We'll be able to eliminate dueling rulebooks, which have been a major cause of ratcheting up regulation.
- It creates cost savings for every firm in the industry, and
- It ensures that the structure we have in place is good for investors.
Congress and the SEC have the authority to shape this process for us. By implementing this plan, we are stepping forward to shape the process ourselves. We are leading the way to streamline regulation while ensuring that we preserve industry participation.
The consolidation was recently approved by a substantial majority of NASD member firms, who agreed with us that this is a major step forward for self-regulation. This is clearly a major step forward for self-regulation.
We are very excited about this plan. As I said, on its face, there are tremendous advantages for both investors and the industry. We have also discussed some of the other possibilities that we hope will emerge, as we move forward as a single SRO for the industry. First, with one entity responsible for member firm oversight, we think there are real opportunities to tailor our rulebook in a more targeted way towards firm size and business model. Those of you who may have been following our proposed approach to debt mark-up regulation will know that we have believed that there should be a carve-out from this rule for certain defined institutional customers who trade in non-investment-grade debt securities. Similarly, we are committed, going forward, to making distinctions in regulation, where feasible, between firm size, business focus and business model. We believe that this tiered approach in our thinking about regulation should yield a rulebook better rationalized between intent and impact and, therefore, more efficient regulation. We plan to seriously explore this going forward.
We also think that a single SRO will help the U.S. capital markets keep their competitive edge. People from Europe and Asia look at our regulatory scheme in the U.S., which includes the SEC, CFTC, states and multiple SROs, and scratch their heads. While this does not cure all of the jurisdictional confusion of multiple regulatory regimes, it is a major step in the right direction.
And finally, we think this is the right long-term allocation of duties among SROs. As exchanges became for-profit entities, it only makes sense to have general member oversight done by a regulator that has no commercial interest in any market center. There has been a lot of debate regarding where competition should take precedent over centralized utility facilities. Clearly, stock markets are no longer industry utilities, but, rather, aggressive for-profit competitors. In Europe, the same is true of clearing corporations—while in the U.S., the DTCC has remained (and I think wisely) an industry utility. Whatever the arguments for competition, they make little sense in the space of regulation; with our combination with NYSE member regulation, the regulatory oversight of members will be centralized into a non-profit entity. This evolution makes sense.
Let me now move on and briefly comment on the effects that technology and product convergence are having on the markets, and the attendant need of regulators to evolve as markets evolve. Technology is transforming the business in many ways, including serving as a bridge that facilitates the linking of products and markets.
Customers are now looking for solutions to financial problems and goals from brokerage firms, not just single product or security offerings. I think of financial products as packets of risk/return profiles, which are constructed for customers to match their investment goals. In the retail context, a customer may want a mix of mutual funds, individual stocks and bonds, and variable annuities. In the institutional context, they may have specific cash flow and rate of return targets that require a portfolio of cash bonds, hedged with credit default swaps. Equities are hedged with options and futures. And structured products are being designed that slice risk and performance features into thinner and thinner, and more tailored packages.
This cross-product influence in the markets appears in many places. You may have seen a New York Times article a few months back that inferred that the credit default swap market is the newest place where insider trading is taking place. You also may have seen that NASDAQ has announced plans to launch an options exchange, and the International Securities Exchange and Chicago Board Options Exchange plan to launch equity markets. All of this news points to the trend that traders have known for some time—that the line between markets is becoming more and more blurred. Options, equities, plain vanilla debt, convertible debt—the list goes on. As regulators, we will be watching this trend and asking where we need to move to keep the markets fair. One obvious place is transparency. As sophisticated investors trade across products, we will endeavor to ensure that the information available is similar among products, in order to help market players understand the markets and allocate risk accordingly.
As we emerge as a consolidated, single member regulator, one place we will continue to focus on is transparency—using our central position in the markets to get good information into the hands of investors and professionals. You will see our investor education efforts continue to accelerate, as well as transparency facilities like TRACE or our mutual fund breakpoints utility.
The third subject I want to talk about today is Reg NMS. This regulation, a product of the SEC, will increase transparency in a number of ways and will provide better protection to the best displayed quotes in electronic markets. The regulation's access provisions are designed to ensure that everyone can reach all electronic markets and the best displayed quotes, and its trade-through rule will mean that, with a few exceptions, one cannot trade through the best quotes. In its pursuit of a more perfect national market system, Reg NMS has leveled the playing field and will probably increase competition among markets.
While not yet fully implemented, many of the effects of Reg NMS are already apparent in the marketplace. We have seen a continued decrease in trade-throughs over the past year. NYSE has launched its hybrid market. There has been a remarkable revitalization and investment in the regional exchanges—at last count, 22 broker-dealers have invested in the likes of the National Stock Exchange, Philadelphia Stock Exchange and Boston Stock Exchange. All of these events are largely driven by Reg NMS.
Another result of NMS and other factors seems to be that competition among stock exchanges is fiercer than ever before. As a result, some traditional exchange functions like regulation of members is less of a focus than chasing order flow and customers. As many of you know, NASD is now the only SRO that is solely in the business of providing pure regulation and market services, with no profit motive. It took a lot of time and a lot of work for us to get to this focus of mission. We have now sold 100 percent of our economic interest in NASDAQ. And now, with developments such as the merger of the New York Stock Exchange with Euronext and NASDAQ with Instinet (and maybe the London Stock Exchange) and the advent of Reg NMS, we are the SRO best positioned to pick up the regulatory reins.
Today, NASD either has, or is trying to reach, agreement with virtually every securities exchange to examine and enforce member conduct rules across SROs—a practice permissible under the Exchange Act (known as a 17D-2 agreement). This is good for both investors and the industry as redundancy and overlap of competing exchanges enforcing their rules are eliminated and streamlined through NASD's regulatory operations. And while our combination with NYSE member regulatory operations is the most publicized, we also have 17D-2 agreements with the American Stock Exchange, CBOE, Philadelphia Stock Exchange, NASDAQ and the ISE.
With respect to market regulation, we have regulatory service agreements with NASDAQ, the International Stock Exchange and the Amex. And we remain open to discussions that would lead to other market regulatory activities in addition to expanding our responsibility for enforcing broker-dealer conduct rules.
I should note that as part of NASDAQ's becoming an exchange, we remained responsible for the operations and regulation of the over-the-counter markets. We now run the OTC Bulletin Board and are in the process of providing trade reporting facilities in partnership with several exchanges. When NASDAQ was a subsidiary of NASD, the members' internalized trades were reported to ACT and were seen as parts of the trading volume being executed on NASDAQ. When NASDAQ petitioned for exchange registration, the SEC raised the question of whether internalized transactions can be deemed to have been executed on an exchange.
I do not propose today to rehash the largely existential questions of internalized trading vis-à-vis exchange activity; these questions have been settled through the SEC notice and comment process and NASD has no dog in that fight. What NASD developed with the SEC was the convention of trade reporting facilities for the internalized trading of listed securities. In essence, the way it works is that each exchange is free to enter into a joint agreement with NASD to establish a TRF. Under such an agreement, the participating exchange provides the reporting technology—for example in the case of NASDAQ the facility is ACT—and is responsible for the business aspects of the TRF (connectivity, operations, pricing and customer service). In turn, the TRF operates subject to NASD's self-regulatory oversight and NASD is responsible for governance of the facility and regulation. NASD is paid its cost of overseeing and regulating the TRF, and the business partner retains the excess profit for suffers any losses.
NASDAQ and the National Stock Exchange are the first participating exchange in a TRF, and we have reached or are working toward agreements with other exchanges, including the Boston Stock Exchange and New York Stock Exchange.
The advent of TRFs may have exchanges competing for the reporting of over-the-counter internalized trades in listed securities to their branded TRFs. NASD is agnostic on the question of where OTC transactions in listed securities are reported, provided, of course, that they are reported. We are indifferent as to whether trade reports go to one of the competing TRF venues or to our facility. We are, consistent with our mission, merely a facility provider without any interests in the commercial success of one exchange over another. But I do want to point out one continued benefit from the advent of TRFs and that is that many buy-side institutions prefer to have their block orders worked off-exchange for reasons of confidentiality, efficiency of execution and reduction of market impact. If the name of the game is choice, our serving as the neutral TRF partner with multiple exchanges will clearly give the buy-side more choice, while ensuring market integrity with a single regulatory playing field.
Let me close with some observations about the internationalization of markets. We see the New York Stock Exchange is merging with Euronext, and NASDAQ has purchased a significant interest in the London Stock Exchange. If we look beyond certain nationalistic reactions in some countries about the proper ownership of national stock exchanges and concerns about which country's regulatory regime would apply after mergers and joint ventures take effect, one thing seems certain: the pull for international convergence of markets is unlikely to abate, and one day you will be able to buy shares in foreign listed companies as seamlessly as you can buy the shares of domestically listed and traded companies. Greater globalization simply appears to be inevitable.
One issue of great concern to the business community is the effect that regulation has on investment decisions—particularly, whether regulation is driving business to competitors oversees. As you know, the exchanges are worried about the effect of Sarbanes-Oxley on their listing business. And there have been much publicized studies, including the recent Interim Report of the Committee on Capital Markets Regulation, that have pondered the question of how U.S. regulations can protect investors without hurting U.S. competitiveness.
At NASD, we are not just watching these developments; we have begun to think more broadly about regulation in such an environment. Many of our members are really part of a globally diverse financial services industry made up of many affiliated companies in addition to the U.S.-registered broker-dealers.
We realize that we have to look at our rules, some of which are decades old, to see how they fit in this new environment and ask whether some need to be revisited. Undoubtedly, the answer in some cases will be yes. For example, we are starting to examine the definition of the term "associated person" in an international context. As you may know, any person controlled by a U.S. broker-dealer is an associated person, subject to that broker-dealer's supervision and our rules. Questions inexorably flow from that simple statement of our rules. When a firm's proprietary trading book is transferred around to global affiliates or research is written by analysts of affiliated companies, are those traders and analysts associated persons and do our rules apply in addition to local regulatory standards? The answers are not easily found. This is an example of the type of anticipatory thinking we know we must engage in during this period of rapid change in the markets and their structure.
Let me conclude by saying that as NASD consolidates with NYSE member regulation functions, changes its name and enters the new era as a single, consolidated SRO, we will continue to evolve with the markets. The new SRO will focus on our mission of investor protection and market integrity, but will do so in deep consultation with the industry that we regulate. We will continue to explore what technology advances and cross-product investment and trading strategies mean to our mission and approach. And perhaps most importantly, we will continue to be utterly committed to our regulatory mission, but will be committed to doing no unnecessary harm or restricting innovation in the industry and markets.
Thank you for inviting me today. I'm happy to answer any questions you may have.