Remarks at the SIFMA Compliance and Legal Division's Annual Seminar

Richard G. Ketchum

Chairman and CEO

Phoenix, AZ

March 22, 2011

As prepared for delivery.

Thank you, Howard [Plotkin], for that introduction, and thank you very much to SIFMA for the invitation to join you this morning.

I'm going to devote most of my remarks today to a vision for FINRA's evolving approach to financial regulation, but first, I'd like to look back—very briefly—at what we've dealt with during the past two to three years.

For all of us working in and around the financial system, it's been a beyond extraordinary period. It was three years ago this month that Bear Stearns collapsed, which marked the onset of what we now think of as the financial or credit crisis. Two years ago this month, the S&P 500 plunged to a level not seen since 1996. And last May, on the day before I spoke to you, we had the extreme market volatility that has become known as the flash crash. The culmination of the credit crisis was, of course, the passage of Dodd-Frank. And the reality is now that it impacts all of our lives.

More recently, markets have been rattled by a sovereign debt uncertainty in Europe, municipal debt uncertainty in the United States, political turmoil in North Africa and the Middle East, and the massive earthquake and tsunami that hit Japan 11 days ago.

These developments really do stand as a potent reminder that just about the only constant in today's markets and regulatory environment is change. Change is always a challenge for regulators—and equally for you in the legal and compliance function—as we try to not only adapt to new market environments, new institutions and new financial instruments, but also anticipate future regulatory needs. And given the pace of change, it's more important than ever for both of us—as regulators and you, as compliance and legal professionals—to be nimble and responsive; in other words, prepared to move quickly to keep pace with developments in the financial system. And adding one more big degree of difficulty to our challenge is the economic climate, which calls for us to use our regulatory tools, and develop new ones, with a high degree of economic efficiency.

With all of that as a backdrop, I'd like to talk this morning about FINRA's vision to evolve how we regulate firms and the markets to better detect risk and manipulative behavior in a way that anticipates change as the norm and works to prevent—rather than just react to—problems.

Examination Program

Starting with FINRA's examination program, during the next two to three years we want it to become more grounded in the risk-based approach we have already begun to implement. But before I talk about where I see us going, let me spend a few minutes on where we've been—and the changes we're already making.

As I've visited firms around the country over the last two years, it's clear that many of you continue to be frustrated that regulators did not have enough understanding of your business or enough appreciation of where some of the most serious risks reside.

We get it. We recognize that one-size-fits-all regulation is a thing of the past. And we have already taken steps to make sure our exam teams are more focused on those areas that pose a real risk to investors, starting with the expansion of our coordinator program. Those of you who've worked with ROOR recognize that ROOR has—for years—depended strongly on coordinators and financial surveillance directors to maintain a dialogue that helps them better understand how your firms evolve.

But from the standpoint of our sales practice program, since last year, we've added 20 more coordinators to our district staff—and accompanying surveillance managers—with the goal of being able to have more effective, ongoing conversations about where and how your firm is changing, both from the standpoint of your business model and elsewhere. This expansion—which essentially separates the exam function from the surveillance function—has served to decrease the ratio of firms per coordinator and improve our exam planning process.

The same thinking applies to our examiners. We have added resources and staff with more expertise to ensure that our exams are more risk-focused and risk-defined. We're using risk analysis to better prepare our examiners before we come onsite so they're asking the right questions when they walk in the door. And, at the end of last year, we created FINRA's Office of Risk to help guide the exam program's focus and keep us current on changes to the industry and how they impact our regulatory programs.

Similar to what we've heard about exams, we have also been aware for some time that the member application process does not always work as well as it could. So, we've taken a look at it and recently announced some significant changes.

We have centralized the member application process to manage the review of all new and continuing membership applications. Beyond this structural change, we are evaluating the entire program and working to improve the application process while maintaining the core investor protection principles.

But these steps need to be just the groundwork for what I think needs to be a transformational process on how we run our member oversight program in the future.

So now let me talk about where we collectively want the exam program to be in 2 or 3 years, and how we plan to pursue that vision:

First, we will strengthen FINRA's ability to identify high-risk firms, branch offices, brokers, activities and products through broader data collection and more comprehensive analysis. To achieve this, FINRA will be asking for more information that will help us better understand firms' various business models, including information about business activities, product mix and customer base. This information will be used to better understand the risks firms are dealing with and to tailor a regulatory response that is aligned with those risks. We will also obtain more information about branch office activities so we can better identify those riskier branch offices and target our regulatory resources.

While we will begin asking firms for a broader set of data, we will be focused in our approach. We will request data that is aligned with your firm's business model. We will seek industry feedback on data delivery specifications and ensure a reasonable amount of time for participants to write to those specifications. And, where appropriate, we will be flexible so that data can be provided by clearing organizations, clearing firms, carriers and/or service bureaus. For FINRA, more standardized data provided by the industry will enhance our automated risk and compliance efforts. It will also help ensure that our regulatory resources are aligned and directed to those areas of perceived risk. For regulated firms, more standardized data means you won't need to constantly react to ad hoc information requests. Examiners will reference standard reports and ask firms to submit the data on one or more of those reports.

We will also be requiring—and analyzing—standard, detailed data to help us better understand the risks and features of products being manufactured and distributed to investors. We have begun testing an approach to capture information about new products from manufacturers before our examination field work.

Finally, we will be employing new techniques to help us better analyze the data we get. We are already testing link analysis—a network analysis technique that explores associations between objects—with our existing data set to identify otherwise hard to detect relationships between brokers, activities and entities. In the future, we will use this link analysis and other data mining techniques with the aim of more effectively measuring risk characteristics of firms and brokers, including activities and products.

Second, we will leverage the data we collect to make our exams more effective and enable more work to be done off-site. Two to three years from now, far more will be done to better prepare our field examination staff prior to their arrival at your firms. Specifically, we will build robust profiles of your business models and underlying risks to help target examination protocols. This will help our examiners focus their reviews on higher-risk branch offices, brokers or products. For example, firms will be asked to provide detailed securities and financial transactional data, including purchase and sales data, customer data and data about the broker. FINRA will acquire product reference data and bind this information with the transactional and customer data to develop profiles which we can then run through risk and compliance scenarios. This will enable our examiners to better detect the needle in the haystack that deserves their attention.

Third, when we are on-site at the firm, we will spend more time better understanding the risks at the firm and how well firms manage or mitigate their risks. This will be accomplished through risk and control self assessments we ask firms to complete, and more interviews of key business personnel to better understand the business and the level of underlying risks. There will also be a more careful assessment of controls in discrete areas, and those related to bigger risks, as well as a qualitative assessment of the firm's risk and control environment in priority business areas. Having this qualitative view of your firm provides an important and necessary complement to our more quantitative approaches. Every facet of our regulatory program will attempt to uncover more information about a firm so that we can better size up its risks and how effectively the firm manages them.

Fourth, we will provide guidance to the industry through information learned from thematic reviews so that better practices are identified and described. These reviews will involve a targeted number of firms and will be built around a specific theme—like new product development—where the examiners develop a deeper understanding of the business, risks and controls in a certain area. What we learn from these reviews will influence changes to our broader exam program, such as enhancements to examination procedures, and may also result in additional guidance to the industry and investors. The results of thematic reviews also provide a valuable reference point with which to assess other firms' practices in a given area. In the end, our job one is to protect investors, but that's your job one, as well. We can do this better if we do it collectively, if we do it together, and with better communication.

Finally, we will build a flexible exam framework to help us better identify and size up material risks to investors, the markets and FINRA. Our recently expanded coordinator program is a key component of this transformed examination framework. Coordinators are tasked with understanding the business and changing dynamics of a firm that together are analyzed to identify the attendant business risks. Going forward, the combination of the qualitative information we collect through coordinators and our on-the-ground exam staff—and the quantitative information we gather through data collection and analysis through FINRA's new Risk Office—will better enable us to identify risk and decide where, how and with what intensity to apply our resources.

The net effect of these objectives, once realized, is to better enable the development of examinations that are tailored to those areas that pose the greatest risk to investors and the markets.

Equally important is the need to eliminate artificial and jurisdictional restrictions across one customer-facing financial advisory business. Accordingly, let me take just a minute or two to talk about what I believe is a significant risk to investors—the fact that for joint broker-dealer/IA firms, we at FINRA are limited in our ability to look fully at what is an equally integrated business and the fact that currently, investment adviser firms are being examined, on average, only once every decade, if at all.

As you know, broker-dealers and investment advisers currently face very different levels of oversight and regulation, even though the services they provide are virtually indistinguishable to the average consumer. In the wake of the SEC's recent study on investment adviser oversight mandated by Dodd-Frank, Congress is now considering how best to provide additional oversight of a universe of advisers that are only examined, on average, once every decade. One of the options being considered is authorizing one or more SROs to assist the SEC—the kind of structure that works very effectively in the broker-dealer space.

Some investment advisers—especially those entities that are not affiliated with a broker-dealer—have consistently opposed an SRO, especially FINRA. They have mounted a campaign that is focused on the premise that the SEC should receive the necessary funding from Congress to comprehensively regulate investment advisers. I don't think it takes a political pundit to recognize that the reality of that happening is unlikely. In fact, Congress is talking about cutting, not increasing, SEC funding. The cynic in me might say that IAs taking this position are really trying to preserve the status quo of going 10 or 11 years without being examined. But I recognize, that for many advisers, it reflects a genuine fear that an SRO—particularly FINRA—would not be sufficiently sensitive to the different regulatory risks of advisers.
Specifically, whenever the discussion moves to whether FINRA should be the SRO for investment advisers, the talking points for IAs in opposition are simple: FINRA is not qualified because it only regulates broker-dealers and therefore doesn't understand the differences between the two models—meaning the end result would be that IAs would be forced to live under a broker-dealer regime. Frankly, that's simply wrong.

First, let me agree that there are important differences between broker-dealers and investment advisers. Any entity that would be empowered to oversee IAs would need to recognize that and regulate accordingly—and FINRA most certainly would.

If FINRA became the SRO for some or all investment advisers, we would have no intention to force the full suite of specific broker-dealer requirements on investment advisers. That would not be appropriate or in the public interest. The regulatory concerns regarding investment advisers primarily relate to the lack of examination resources, which places advisory clients at unacceptable risk, which is why we have said, and will continue to say, that SROs—especially for stand-alone IAs—should be viewed as a positive development for investors. No matter how rigorous the regulatory requirements, an adviser's obligations may provide only hollow protection to investors absent rigorous examination and enforcement. That's a service FINRA is well-positioned to provide.

FINRA would implement regulatory oversight that is tailored to the particular characteristics of the investment adviser business. We would have authority to examine for, and enforce compliance with, the Investment Advisers Act and the SEC rules under that Act. We don't see the necessity for extensive SRO rulemaking and believe that the extent of that authority should be fully a matter for the SEC to determine. Of course, as it does with SROs now, the Commission would approve all rules. FINRA and its predecessor entities have operated under a similar regime for more than 70 years and would have no problem operating the same way in the IA space.

The other red herring related to FINRA serving as an IA SRO is that our governance structure would only reflect broker-dealer interests and not have IA representation. As we stated in our comment letter to the SEC—and as I have said many times—if FINRA becomes the SRO for investment advisers, our governance structure would appropriately reflect investment advisers. This would be carried out most effectively by setting up a separate affiliate that would have a board comprised of majority public representatives, but members of the investment adviser industry would be allocated the remaining seats.

The debate on how best to increase the oversight of investment advisers is one worth having, but the problem is too significant to let it wallow. As a proud "alumni" of the SEC, I would never suggest the Commission couldn't do the job if it had the resources. But the idle hope of that funding should not justify more delay. As Commissioner Walter said in her statement when the IA report was released, we must act now—investors deserve no less.

Market Surveillance Program

In addition to a strong examination program, another cornerstone of effective financial regulation is to have a comprehensive view of what's happening in the markets. We've seen important advancements recently, stemming from FINRA's assumption in June of the NYSE market regulation functions. But I'd like to focus on the need to continue to evolve our market surveillance capabilities—especially in light of new trading vehicles and strategies, and the speed and volume at which trading occurs. This is another area where acting now is critical to keep pace with the constant changes in the markets that will unfold over the next two to three years.

One significant enhancement is already slated to take effect. In July, OATS will be expanded to include all NMS stocks, which will mean that more than 1 billion order events could be reported to us per day. This change will mean the end of NYSE OTS, so firms will have one uniform order audit trail requirement across NMS stocks.

Taken together, this expanded order information—coupled with the market-specific data available to FINRA from its regulatory contracts with various exchanges—will have a significant impact. FINRA's consolidation of all the market data for integration into new cross-market surveillance patterns will drive new efficiencies and effectiveness and help us identify problematic trading activity more quickly. Having access to uniform, consolidated data means we will be better equipped to detect improper conduct and stop it before it spreads. And our automation and data mining will allow more efficient identification of atypical quoting or trading, while also helping us pinpoint firms that need additional scrutiny.

Yet, even with these changes on the way, critical gaps will still remain—underscoring the need for a mandated consolidated audit trail. The SEC has issued a rule proposal on a consolidated audit trail, and if implemented, it would ensure that a single SRO can review data across all markets and participants, applying consistent standards to the audit trail data. It would also provide for direct and more timely access by the SEC and SROs to comprehensive, uniform audit trail data.

One lesson we continue to learn is that more granularity is needed to make us more efficient and effective in identifying market integrity issues. As participants continue to change the way they access and trade in the market, our audit trail must keep pace. To that end, we need more data on sponsored access and large trader relationships, while balancing the incremental benefits of collecting that data with the burden on firms.

We believe that OATS is an important foundation for a consolidated audit trail and could be modified to achieve many, if not all, of the SEC's stated goals more easily, economically and quickly than developing an entirely new system. This approach recognizes and benefits from the significant investment by the industry in developing systems to be OATS-compliant.

Ultimately, a consolidated audit trail would be the first step to expansion of uniform audit trail requirements across all products and with that, cross-market and cross-product surveillance. In the meantime, FINRA is engaged in the process of refining and retooling its automated surveillance patterns to detect trading manipulation in a market where high frequency and algorithmic trading predominate.

In particular, we are focused on the detection of so-called "momentum ignition" strategies, where an entity will seek to create the appearance of legitimate market movement by entering non-bona fide orders or even effecting wash sales to bait other market participants to enter the market. We are building our surveillance patterns to be flexible to recognize many variations on this theme, as we realize that these strategies continually evolve as legitimate market participants adapt their own trading behavior to avoid repeatedly being disadvantaged by the same scheme, and potential manipulators respond in kind.

Finally, a step that I think is absolutely critical for the integrity of our markets going forward is the SEC's action to ensure that broker-dealers have adequate financial, risk management and operational controls in place when providing others with access to the market. This move provides greater clarity, building on FINRA's efforts to emphasize the supervisory obligations that are necessary in this environment. From the standpoint of our TMMS exam program, we will look very closely and continue to enforce the SEC requirements and the positions we've already taken about firms' supervisory obligations.

It is not okay for firms to simply allow algorithms to continue to operate without evaluating their results and their impact, without completely understanding how they work in periods of excessive volatility. Reasonable supervision is not impossible; it doesn't require the reengineering of every application that's been designed. But discussion, understanding and testing is something that we expect. I think the new SEC rule is absolutely critical to ensuring market integrity both with regard to market volatility and disruptions, and also with regard to concerns about manipulation.

Industry Evolution

As most of you know, the SEC has issued a thoughtful and forward-looking study with respect to the standard of care for broker-dealers and investment advisers. The commission with that single document took an important step toward a single standard of care.

I'd like to focus on a couple of areas where we can work together to bring the standard forward in a fast and effective way even before final action is taken by the SEC.

Let's start with disclosure. Disclosure alone is insufficient to address fiduciary issues but it is a critical cornerstone to make it work. We need to get away from the environment we have today in which account statements contain too much legalistic information, leaving them downright turgid, causing investors to simply ignore them. That is a fundamentally flawed approach to disclosure.

I would suggest that we need to thoughtfully look at this issue well before Commission or FINRA rulemaking. There are a few questions to ask of your firms and yourselves. How do we interact in an effective way with investors? How do we create a level of knowledge and understanding from the standpoint of investors? And how do we deliver that message both with respect to existing technology tools and with respect to a full understanding of your financial advisers as to how they go through the message?

It was for exactly that reason we published a concept proposal requesting comment in October. The proposed rule would require firms, at or prior to commencing a business relationship with a retail customer, to provide a written statement that describes the types of accounts and services it provides. Firms would also be required to disclose the conflicts associated with such services.

It's how to do that that I think is really the challenge. It's not an easy thing to do—and not something that should be done from simply a regulator's standpoint of the right way to do it. But we need to figure out the right combination of how to capture investors' attention up front; how to provide detail from a web-based standpoint; how to use minimalist but effective point of sale disclosure to remind customers of the questions they should be asking again and again.

The result would be to move to an environment dramatically different than what we have had for the last 20 years. It would be to shift the presumption to that you have conflicts, you have incentives, all firms do. Knowing that, how do you provide disclosure and effective communication with customers so they're able to make those decisions in a rational way. It's an exciting opportunity and I think it's something that shouldn't just be addressed by regulators. It is something that I invite everyone in this room to participate in as part of the dialogue.

Along these lines, FINRA is proposing a document similar in purpose to Form ADV, which investment advisers must provide to each advisory customer. We received many comments on the proposal, and we will keep firms updated on any proposed rulemaking.


Realizing the vision I've just laid out will depend on the ability of FINRA and the industry to be prepared for change. That means both responding to developments in the markets, but also anticipating these developments. This proactive approach will enable us to more effectively pinpoint vulnerabilities and abuses—and combat them—before they destabilize pockets of the financial system.

The ultimate success or failure of these reforms will also depend on all of you making a commitment to complying with not only the letter of the laws, but also the spirit underpinning them. The foundation of a healthy financial system will always be a workforce that possesses a strong sense of what's right and what's wrong, and acts accordingly.

I am confident FINRA and the industry can realize this vision, and do so in a way that fosters more effective regulation, greater investor protections and a more stable financial system.

Thank you.