Remarks from the FINRA Annual Conference

Richard G. Ketchum

Chairman and Chief Executive Officer

Washington, DC
May 21, 2013

As prepared for delivery.

Thank you Cathy [Mattax] for that introduction. It's good to be back with you again today.

The financial services industry has weathered many challenges in the last few years—a recession, significant frauds, a flash crash. And while we have worked hard to prevent those kinds of events from being repeated, they have had a lasting effect on investors' trust and created a true crisis of confidence in the markets. Added to the mix are the recent technological hiccups we've seen in the market, which have only done more to discourage investors.

Today's markets are complex and moving faster than ever, and investors face a wide array of new and complicated products with features and risks they don't always understand. We realize investors are hesitant to return to this rapidly changing market. And we realize that getting investors back in the market is dependent on their feeling less vulnerable.

So how do we rebuild investor confidence in a market that is so complex and volatile? The answer, I believe, lies in doing a better job of anticipating problems before they occur—both on the regulatory side and on the firm compliance side. Today I want to talk to you about how FINRA is enhancing our regulatory programs to make sure we are better prepared to respond to changes in the market.

But firms also have a significant role to play as well, especially since you are on the frontlines interacting with customers every day. It's important that you look at how you communicate with your customers about strategy in a changing world. I want to address how we can help investors learn how to make thoughtful, knowledgeable decisions about their investments and better understand and manage the risk they take on.

Enhancing FINRA's Regulatory Programs

Throughout this conference, you have heard us talk about the changes we're making to our regulatory programs to focus on areas that pose a real risk to investors. We have made significant progress in this area. Earlier this month we released the 2013 Risk Control Assessment survey, which is a central part of our risk-based examination program. As you may know, the RCA helps FINRA better understand your firm's business activities, products and services, and the kinds of clients and counterparties with which your firm deals. It also helps us to identify and assess the integrity of the controls firms have to manage their underlying risks. Based on our 2012 experience, I can tell you that completing the RCA benefits both your firm and FINRA. Firms that completed the 2012 RCA told us that their subsequent sales practice cycle examinations were more streamlined and that examiners arrived on site with a better understanding of the firm's business. So far, the feedback on this year's survey has been positive and I encourage you to complete it if you haven't already done so.

By the end of the year, you will begin to see the next phase of the risk-based exam program. Since October, a few firms have been involved in a pilot program that streamlines the process of examining firms. Instead of using a standard set of exam questions and prescriptive review steps, staff involved in the pilot arrives at an exam armed with more firm-specific data, which has been uploaded from the firm and analyzed before the exam. And the examiners have greater flexibility to quickly make decisions when they come across red flags and other areas of heightened focus. Firms involved in the pilot have told us the process is vastly improved and is a move toward a true risk-based exam program.

Another area where you'll soon begin to see more change is in our membership application program. We know this has been an area of continued frustration for firms and we're working hard to shorten the review times. As you know, we centralized the MAP group in 2011. This has helped us realize some efficiencies and identify opportunities for further improvement. Since February, we've been using a triage approach on a pilot basis with a small group of firms. The triage team assesses all new and continuing membership application filings to determine the level of risk and the complexity of the proposed changes. Firms involved have seen a dramatic decrease in processing time. For example, we completed seven reviews of low-risk changes in an average of 15 days. That's significantly down from the average processing time of 121 days for CMAs in 2012. Our goal is to reduce the processing time for all applications, with a target of 30 to 60 days for applications that are low-risk and not complex. Starting in July, all membership application filings will be part of this triage process.

Turning to market oversight, we have also made significant changes to ensure we keep the markets fair. Last year, we implemented comprehensive cross-market surveillance patterns that address more than 50 threat scenarios and canvas about 80 percent of the listed equities market. In addition, we introduced a suite of surveillance patterns to further enhance oversight of trading in non-exchange-listed OTC equities. This will allow us to better review for potential manipulative trading activity, such as front-running, marking the close and layering.

Investors count on us to detect and stop fraud early and we continue to be very aggressive in that area. We act quickly when we suspect fraud, and our Office of Fraud Detection and Market Intelligence is aggressive about referring suspected cases of fraudulent conduct to other entities that have jurisdiction over the firms or brokers. So far in 2013, the office referred more than 250 matters involving conduct indicative of fraud to the SEC and other federal or state law enforcement agencies. About half were insider trading referrals and the rest were fraud referrals.

This year, we are undertaking an effort to review the impact of our rulemaking in a more structured fashion, and we are going to call on you to help us in that process as well. We will be reviewing certain rules retrospectively to determine if the rules have achieved their intended purpose. And we will be analyzing the costs and benefits of existing and potential rulemaking. Jonathan Sokobin, FINRA's new Chief Economist who just started this week, will oversee this effort and will be responsible for gathering and analyzing data on securities firms and markets. You should expect to hear more from us on the retrospective rule review later this year.

Moving Beyond a Culture of Compliance

While we have seen tremendous improvements in how most firms handle their compliance responsibilities over the past 10 years, we still have more work to do. Let me take a moment to acknowledge some of the improvements in compliance that we're finding during examinations.

We're seeing better conflict-management processes and improved coordination among firms' compliance, risk-management and legal functions. In firms with multiple affiliates—including federally regulated banks—we have seen improved controls within the broker-dealer and better communication among the affiliates. And compliance is more frequently being invited to participate in a more meaningful way in the risk-management functions of the broker-dealer. Firms have also told us that they have enhanced their processes for conducting due diligence on new products, and have enhanced the technology they're using in automated surveillance of customer activity. In addition, more firms are taking proactive steps to improve data security—something they will need to continue to focus on as these risks evolve and grow over time.

All of these are meaningful improvements in supervision and compliance. However, we continue to see many instances of breakdowns—whether it's the serious financial failures and sales practice abuses accompanying the credit crisis or, in the last two years, the sale of complex products and speculative products with low liquidity, to unsuitable customers by financial advisers who often don't fully understand the risks of the products. So it's a good time for us to think about how we can do a better job of anticipating problems and making sure investors better understand their investments.

A good place to start is to acknowledge that the strategies that were appropriate for many investors a few years ago may no longer be appropriate today.

Take the fixed income market for example. In this zero-yield environment, where investors are understandably frustrated with the return on many of their investments, many are taking on more risk by moving to longer-duration or high-yield fixed income products. We're worried about investors taking on risks that they either don't understand or cannot afford.

I don't come today with Cassandra-like warnings about the fixed income market. Given the activism of central banks and the complex challenges facing the global economy, I don't claim any ability to predict whether inflation will rise or interest rates increase from their historically low levels in the near term.

But it is clear that interest rates have far more room to go up than down and that history would tell us that, in this environment, the quality of non-investment-grade bonds able to be floated is likely to go down. Accordingly, it is a great time to have conversations with your clients about the risks and possible negative scenarios of concentrated holdings in longer duration or more speculative fixed income securities. Similarly, it is a great time to remind clients that bond funds are not the same as directly owning fixed securities—if the market moves, losses will occur instantaneously and there will be no ability to hold a bond to maturity.

I raise fixed income as one example of an area that calls for increased communication with your clients, but it really raises the larger question of, how do firms talk to investors about strategy in a changing world? How do they convey the risk? It's clear that we need to move beyond a culture of compliance to ensure that investors have a better understanding of risk and what's being sold. Let me give you another example. Funds that invest in leveraged loans attracted a lot of investors in 2012 because of their higher yield and variable interest rates. Unlike traditional fixed income bonds, floating-rate loans do not trade on an organized exchange, making them relatively illiquid and difficult to value. Funds that invest in floating-rate loans may be marketed as products that are less vulnerable to interest rate fluctuations and offer inflation protection. But the underlying loans held in the fund are subject to significant credit, valuation and liquidity risks that may not be transparent to investors. If you are going to make these investments available to retail investors, you should think carefully of how to explain the possible negative scenarios that can impact this investment to your clients and your financial advisers. Similar points could be made for a range of illiquid investments, including private REITs, closed-end funds and private placements.

Thinking through how firms can do a better job of talking to customers about risks like these is part of the overall conversation about conflicts of interest. It's especially important as investors move into more illiquid, complex and speculative products—or overly concentrated positions where they may not understand their exposure. At this conference last year, I asked you to assess how you identify and disclose conflicts of interest. Since then, we have talked to firms to understand industry practices, and we plan to issue a report in early summer that outlines some strong conflict management practices. The right "tone from the top" is a critical element in implementing a framework within which conflicts can be considered and addressed in an ethical manner.

While firms use different approaches to managing conflicts of interest, what's important is that firms establish a conflicts governance framework that's effective and appropriate to their business. In order to make sure that their conflicts framework stays current, at a minimum, firms should conduct periodic inventories of conflicts of interest in their business, sometimes as part of a broader analysis of risks a firm may face.

Most of the firms we interviewed told us that staff training was a critical component in implementing an effective conflicts management framework. And their policies, procedures and controls for reviewing new products are an important check point for identifying potentially problematic products, including from a conflicts of interest standpoint.

It is premature for me to discuss more fully the findings resulting from our conflicts review, although we will provide a full analysis of the best practices in the industry and the concerns that we have identified in our report. For the moment, let me just say our review is particularly focused on the controls firms have built around the sale of structured products both to their own private wealth divisions and to other firms. In addition, we are looking carefully at firms' controls around compensation, both their own efforts to design more product agnostic commission grids and with respect to third-party incentives.

Finally, our conflicts review is very much focused on the quality of disclosure provided to your customers. It is important to note that structured products raise particular challenges regarding effective training of your financial advisers and effective disclosure to your customers. How do we change the dynamic so investors truly understand what they're buying and, likewise, that financial advisers understand what they are selling?

There are no simple answers to those questions, but it seems to me that effective answers are critical to increasing investor confidence. In fact, your websites are filled with examples of plain English and compelling images that facilitate investor decision-making. They just all reside in the marketing side of the sites, not the legal and risk-disclosure side. I know that litigation concerns have a role in shaping the legislative manner in which risks are disclosed today but, frankly, disclosure that investors and your financial advisers can't absorb, in the end create more risks for firms.

It is time for us collectively to have a dialogue as to how to employ the developing science of behavioral psychology to making risk disclosure as understandable and compelling as sales marketing material. A challenging task, but one worth making a high priority.

Addressing Confidence in the Markets

As I mentioned at the start, we've had a number of technological failures—due to program glitches and human error—that raise concerns regarding the vulnerability of our complex financial services architecture to disruption. It should come as no surprise that investors are wary about the reliability of our increasingly electronic marketplace.

Keeping up with computerized trading and market structure changes is a never-ending challenge for FINRA and other regulators. And while we may not be able to prevent a technology failure from occurring, our job as a regulator is to implement programs to minimize the impact of a failure and head off widespread market disruption.

Since the flash crash that occurred three years ago this month, FINRA, the SEC and the exchanges have implemented a variety of initiatives to minimize the impact of technological malfunctions. These initiatives have created a multi-faceted safety net for the markets and promote investor confidence.

Let me give you a few examples. Single-stock circuit breakers have been put in place to give market participants an opportunity to assess their positions, valuation models and operational capabilities when extreme periods of volatility occur. Last month, the first phase of an SEC-approved limit up-limit down plan went into effect to address the type of sudden price movements that the market experienced during the flash crash. Under the plan, a market-wide limit up and limit down mechanism prevents trades in national market system stocks from occurring when prices are outside of certain ranges. And if the changes in price are more significant and prolonged, the limit up-limit down plan would trigger trading pauses. The plan is being implemented as a one-year pilot in two phases and we have amended our rules to help facilitate compliance with the plan.

In addition, smaller activation levels have been set for market-wide circuit breakers. And all the markets have adopted uniform standards to handle erroneous trade claims. The SEC has also adopted the Market Access Rule, which, among other things, imposes pre-order execution requirements to detect erroneous orders and requires firms to establish reasonable limits on their own—and their customers'—trading activity.

While these initiatives have been extremely helpful in preventing and minimizing extreme market volatility, there is much more that needs to be done to restore investor confidence. One key area is more effective compliance with the SEC's Market Access Rule, which requires broker-dealers to ensure that they have adequate control of the customer and proprietary order-flow they send to the markets.

In that connection, firms must do a better job of supervising their procedures and practices around the development, introduction, testing and monitoring of algorithms. Ensuring robust and thorough testing of new algorithms and other software or hardware changes before implementation is a best practice which aligns with the Market Access Rule. And FINRA, the exchanges and major trading firms must continue to consider how best to implement kill switches so that the problems can be contained much sooner to avoid another scenario like we experienced with Knight Trading.

We also are currently working with the national securities exchanges to respond to the Commission's requirement that we build a consolidated audit trail. Thirty-one companies, including FINRA, have indicated they intend to submit a bid. As we've said over the years, a consolidated audit trail will enhance regulators' ability to conduct surveillance of trading activity across multiple markets and perform market reconstruction and analysis. Once the consolidated audit trail is in place, we'll be able to close the regulatory gaps that currently exist and conduct broader, more effective cross-market surveillance. In doing so, we'll be better positioned to detect improper conduct at an earlier stage.

Finally, the SEC has proposed a plan to better insulate the markets from vulnerabilities posed by systems technology issues. Regulation Systems Compliance and Integrity, or Reg SCI—which the SEC proposed in March—would require SROs, certain alternative trading systems, plan processors and certain exempt clearing agencies to design, develop, test, maintain and surveil systems that are integral to their operations. The proposed rules would also require them to ensure their core technology meets certain standards, conduct business continuity testing and provide certain notifications if a system disruption and other event occurs. The SEC has also asked for comment on applying the proposed rule to broker-dealers. FINRA supports the SEC's proposal and its broad outlines. We have been operating for years under these general requirements. We will be commenting on parts of the proposal that we think are overbroad.


So, while we have made significant progress, more work lies ahead. We're at an inflection point in the markets, which provides us with an opportunity to collectively look at making changes that will help investors regain confidence in the markets. I look forward to continuing that conversation with you, here at the conference, and in the days ahead.