Remarks at the FINRA Annual Conference

Richard G. Ketchum

Chairman and Chief Executive Officer

Washington, DC
May 21, 2012

As prepared for delivery.

Thank you, Cathy [Mattax], for that introduction. It's great to see all of you here again.

The conference is a great opportunity for us to continue building a dialogue between FINRA and firms. This morning, we hosted a special program to hear from and talk to small firms about issues that are important to them, and over the next three days you'll find a number of opportunities—including special networking events—to talk directly to members of various FINRA committees.

You can also expect to hear more from us throughout the year. We're hosting more meetings with firms around the country so you can talk with me and other senior staff about your challenges and concerns. We've also added a series of free video webinars to provide you with information on various regulatory issues. We encourage you to take advantage of the opportunities at this conference—and throughout the year—and let us know what's on your mind.

In this spirit, I would like to take a few minutes today to highlight the changes we are trying to make in our key regulatory programs and the compliance issues I believe your firms should be particularly focused on.

Exam Program

Let me start with the exam program. When I spoke to you last year, I talked about changes we were making to modernize our exam program and focus our resources on those areas where we believe the risk to investors is greatest. Today, I want to update you on the progress we've made toward achieving this and other top goals. We are modernizing the technology and processes we use to conduct exams—and in doing so have gained greater flexibility in our approach to assessing risk.

Among other things, we are now collecting more information from firms electronically before an exam. This means our examiners can better understand the activities and risks at firms before they arrive onsite, and we can tailor our exams accordingly.

Let me give you an example. In our sales practice program, we have developed a process to accept more data from firms relating to customer information, such as new account type and transactional activity that is typically derived from the firm's P & S blotter. We ask firms for the information about 60 days before we begin field work.

Through this process, we can take a large amount of data for an extended period of time and quickly digest it to produce information we can use prior to an exam. The examiner and coordinator can analyze the data to identify particular securities, registered reps, branch office locations or potentially problematic activity on which they want to focus. This means that before starting fieldwork, an examiner can ask for specific records related to a firm's transactions, reps or branch office locations. And, as a result, our examiners will spend less time on site.  

Since we started this process, we have found it to be very effective in helping us quickly find problem areas that before we may not have identified or would only have uncovered after manual and time-consuming analysis.

Another way that we are collecting more and better data from firms is through the new risk control assessment survey we sent in February. Let me thank those of you who completed the survey and gave us feedback.

We will use the data we collect through this survey—in combination with data we are collecting through other means—to help us tailor our exams to your firm's unique risks. This is another important step toward our goal of better understanding what's happening at your firm and focusing on the areas that pose the greatest risk to investors.  

The information contained in the Risk Control Assessment—along with the expanded surveillance program we have deployed in the district offices based on a model used by the ROOR team—helps us to ensure that we better understand your firm's business before going on site. And it allows us to conduct better targeted reviews and hopefully makes for a more effective and efficient examination program.  

Beginning with the September 30 quarterly FOCUS filing, we will be obtaining a supplemental statement of income which will enable FINRA staff to capture more granular detail about a firm's revenue and expenses, including a breakdown of principal trading gains and losses by security type as well as detailed components of fee and interest revenues. This information will allow us to better align our examinations with your revenue stream. In addition, firms that derive more than 10 percent of their total revenues, during a reporting period, from participation in unregistered offerings will be required to complete an operational page that requires information about each unregistered offering.

In addition, we have begun shifting the way we address concerns at certain firms. On a case-by-case basis, we are sitting down with senior management at firms when conduct comes to our attention that we think needs to be addressed quickly. This conduct could be related to the culture of compliance at a firm, a breakdown in procedures, concerns about a business model or the activities of one or more employees.

In some cases, we will meet with the firm so that we can address the problems immediately. We will likely ask for a written action plan to be delivered within a specified time frame.

Our goal is to address problems early and prevent harm to investors. This doesn't mean we won't proceed with enforcement action. But we will consider the firm's response and the severity of the issues.


Turning to market surveillance, I have talked to you about our work to develop a comprehensive surveillance platform that gives us the ability to view trading across multiple markets and financial products. Last November we expanded OATS to include all NMS securities. By doing so, we created a uniform order audit trail that we see as the foundation for our cross-market surveillance program. We also made substantial progress in developing cross-market surveillance patterns that will canvas 80 percent of the equity markets and plan to launch these patterns this year.

In addition to facilitating broader, more effective cross-market surveillance, we also continue to believe OATS can be leveraged to become the foundation for a consolidated audit trail that the SEC has proposed. If the SEC adopts its proposed rule, we're ready to begin working closely with the exchanges to develop a cost-effective proposal to implement a consolidated equity audit trail that uses enhanced OATS information. Of course, we can't do this without your help and we will be looking for your input as well.

Like the changes we've made in our exam program to identify problems early, we've taken a similar approach to ensuring that firms can promptly identify and correct reporting issues as they arise. We recognize that OATS reporting can be challenging at times. Let me say that firms have done an outstanding job overall of complying with the OATS reporting requirements. We consistently see very high levels of OATS compliance with respect to timeliness and linking orders routed to other firms or exchanges. For example, the matching rate for orders routed between firms is consistently above 99 percent.

We have historically used a sweep approach in reviewing for OATS compliance. This approach involves categorizing firms by peer groups and assessing their performance over a period of time—typically a three- or four-month period. Then we select for further review those firms whose compliance rates are well below peer group averages.

We have further refined our sweep process to focus only on those firms with consistently low compliance rates throughout the review period. We understand that because of the highly technical nature of OATS reporting, there will necessarily be instances where firms have technical issues that impact their OATS reporting. The recent changes to our review process are primarily designed so firms that promptly identify and correct reporting issues are not subject to formal review.

As a result, we have seen a material reduction in the number of firms selected for review in recent periods. This has allowed us to complete our evaluations on a timelier basis and focus our resources on helping firms with their preventive compliance efforts.

Algorithmic trading also remains a big focus for us. We have expanded our cross-market surveillance to better detect manipulative trading activity arising from algorithmic and other types of trading. We continue to focus on firms' testing and controls regarding algorithmic trading. Specifically, we are looking closely at the procedures firms have in place to develop and test algorithms before they are launched. We're also looking at the procedures to monitor the impact of the algorithms and rule compliance after they are launched. Similarly, through our TMMS examination and Member Regulation examination programs, we are looking at how firms are implementing both financial risk and regulatory risk controls required by the SEC's Market Access Rule. Specifically, our examiners are looking at how firms are assuring that order flow that they sponsor or directly submit to the market meets pre-established credit requirements and is actively monitored for errors and compliance with SEC and marketplace rules.

Finally, we are focused on initiatives that provide greater transparency, both through trade reporting in the fixed income markets and improving the accessibility of BrokerCheck information for investors. We've seen the benefits of increased market transparency. For example, TRACE has helped regulators identify manipulative activity, and it has provided investors with access to information that helps them assess the quality and fairness of pricing and valuation of fixed income products.

As you know, we expanded TRACE in March 2010 to include agency debentures and new issue transactions. In May 2011, we further expanded it to include reporting, for regulatory purposes, in asset and mortgage-based securities. We are now taking careful steps to make securitized products more transparent. Last October, we began disseminating pricing and market activity tables and, subsequently, we filed proposals with the SEC to publicly disseminate TBA transactions as well as MBS or Agency Pass Through Securities traded in specified pool transactions. We will continue to listen and be careful but additional transparency is important in markets that have significant retail participation.

Beyond products, we're also interested in giving investors more information that helps them make good decisions about the investment professionals with whom they work. As you know, two years ago we increased the information we provide through BrokerCheck. We now include criminal convictions, civil injunctions, customer complaints and records on former brokers whose registrations have terminated within the last 10 years.

Last year, the SEC issued a report—as mandated by the Dodd-Frank Act—on improving investor access to information about broker-dealers and investment advisers.

That report outlined the SEC's recommendations for enhancing BrokerCheck and the Investment Adviser Public Disclosure system, or IAPD. The short-term recommendations included unifying BrokerCheck and IAPD search results, adding a ZIP code search function and adding plain-English educational content to both systems. We completed these enhancements last week.

For the next phase, we're interested in ideas for expanding the range of information we disclose in BrokerCheck, updating the way in which that information is presented, and increasing investor awareness of BrokerCheck. In February, we issued a Notice requesting comment on our proposed changes and received numerous comments. We've heard your concerns about whether your test scores will be revealed. I want to stress that that's not the type of information we're interested in disclosing. Right now, about 90 percent of investors make decisions about investment professionals without first using BrokerCheck. We want to change that by raising awareness of the tool and providing the kind of information that helps investors make good decisions.

So, let's collectively focus on how we can use BrokerCheck to create value for investors.

Challenge/Next Steps

The changes to our surveillance program and the expansion of our risk-based exam program that I talked about are important to allow us to do our job in a more effective and less intrusive manner. These changes help us detect problems early and stop them before investors are harmed. As I said in my opening, however, our work is far from finished. Adapting our regulatory focus to home in on the areas where the risk to investors is greatest is only one part of the equation. Making sure you identify conflicts and place your customers' interests before your firm's is the other. I want to leave you with three thoughts on how firms and regulators can work to do just that.   

First, I call on you to do a better job of assessing—and disclosing—your conflicts. We've heard a lot in the last couple months about the culture at large firms through various media reports and the conflicts that are part of the day-to-day operations. However, I don't think the conversation should just be about the culture at one firm or another. We understand that conflicts exist in the financial services industry. We need to take a step back, acknowledge that there are risks and look at how we handle those conflicts.

Nine years ago Stephen Cutler, who was then director of the SEC's Division of Enforcement, asked firms to undertake a top-to-bottom review of their business operations with the goal of addressing conflicts of interest of every kind. I would like to see such a concept review become a standard part of operating procedure. You should be assessing whether your business practices place your firm's—or your employees'—interests ahead of your customers. What I can promise you is that, particularly with respect to the large integrated firms, we will look to have a focused conversation with you about the conflicts you have identified and the steps you have taken to eliminate, mitigate or disclose each of them.

 Second, I call on you to ensure that the products you sell are appropriate for each investor. We have often reminded firms of their obligation to assess the potential risks associated with products that raise specific investor protection concerns. One of our concerns is the sale of complex products, and in January we published guidance in the form of a Regulatory Notice.

We've brought a number of enforcement actions involving complex products where we found firms didn't adequately supervise the sale of the products, the recommended products were unsuitable for the investors, or the sales material were misleading. We recognize the challenge you face when managing compliance oversight at a time when more customers are searching for yield and financial advisors are looking for products to meet these requests. Nevertheless, the suitability rule remains in effect, and it is the obligation of every firm to take steps reasonably designed to ensure that the suitability issues related to complex and other products are adequately addressed.

Before recommending a complex product to a retail customer, your financial advisers should be discussing the features of the product, how it is expected to perform under different market conditions, and the product's risks, potential benefits and costs. This means describing the circumstances under which the customer could lose money, not just those under which the customer would earn money. It also means explaining carefully the direct and imputed costs your client will incur and, where applicable, the fact that your firm or an affiliate is on the other side of the transaction. For this disclosure to work effectively, it will be equally important that you increase the training provided to your financial advisers to ensure that they fully understand the assumptions underlying the product and what can go wrong as well as right.  

Finally, before any complex product is offered to a retail client, your financial adviser should be able to write down on a single page why this investment is in the best interests of your client. This does not have to wait until you find out the details of any fiduciary rulemaking the SEC may make. Being able to articulate why an investment is in the best interests of your client is fundamental to what the securities industry must be about if it is to deserve the trust of investors. The time to do it is now.  

Thank you for listening. Now I have the pleasure of introducing CFTC Chairman Gary Gensler.