"Self Regulation in the Modern Era"

In the first half of 2006, the notional value of swaps and contracts surveyed by the group stood at more than $250 trillion, and that applies only to interest-rate and currency contracts. This measure has grown ten-fold in ten years. Moreover, we have all become aware of the systemic risk that can be created as a result of credit and operational problems that stem from the exploding volume accompanying the growth of credit derivatives.

Second, our markets have become democratized. Individuals have become aware throughout the globe that an effective savings plan for major life events and retirement must include meaningful investments in equities

These changes have increased regulators’ concerns over investor protection and ensuring that securities firms have strong controls in place regarding the sales of securities to individuals.

Third, across the developed world our populations are aging. Of particular importance is the generation born shortly after World War II. The baby boomers, as we like to call them, are moving swiftly to retirement age, provoking a host of pressures on government and corporate pension programs. Those pressures are forcing baby boomers, as well as in some cases their children, to make major investment decisions on a scale not previously seen.

Americans’ retirement assets reached a record $14.5 trillion in 2005, a seven percent increase over 2004. Retirement assets now account for more than one-third of all household financial assets in the U.S. (Source: Investment Company Institute, July 2006.)  The generational transfer of wealth in the coming decades is also expected to be significant. One widely cited estimate finds $41 trillion will be transferred via estates over the next 50 years. (Source: Havens and Schervish, Center on Wealth and Philanthropy, Boston College .)

Fourth, there has been a dramatic increase in the size and activity of institutional participants, in particular less regulated hedge funds. While it is impossible to simply categorize the dizzying array of strategies and trading techniques employed by hedge funds, their increased access to capital and aggressive trading techniques have significantly transformed both the equity and fixed income markets. Moreover, their increasing economic importance to major financial firms has raised new challenges for those firms’ compliance controls.

Finally, the creativity and competitiveness of the securities industry has led securities markets world wide to respond to opportunities, increased capital demands, and competition by shifting from membership organizations to public corporations. Preceding the demutualization of the 214-year-old New York Stock Exchange were the Australian Stock Exchange, Deutsche Bourse, Nasdaq, and the London Stock Exchange. Importantly, the Tokyo Stock Exchange has also embarked on the path of public ownership.

In the next few minutes, I would like to discuss with you how we at New York Stock Exchange Regulation have tried to respond to these seismic events, as well as highlight what I think are the collective challenges and opportunities of securities regulators going forward.

Role of Self-Regulation
The question of the proper role and organizational structure of self-regulatory organizations, or SROs as they are known, in the dynamically changing market environment has been actively debated in the United States . I know that recently has been true in Japan , as well.

I believe there are few that would not acknowledge the important values of self-regulation. In simplest terms, self-regulation offers the benefit of greater expertise, the ability to leverage government resources, and the ability to impose ethical standards that would be inappropriately imposed by a governmental entity. In my mind, self regulation:

• ultimately results in a more precise set of rules for an individual market, which is more effective than a single set of standardized rules for all marketplaces
• provides a great economic incentive to ensure that a market’s reputation is enhanced through strong regulation and enforcing the highest standards of ethical conduct, and
• allows the regulator to operate as close as possible to the regulated activity, thereby gaining specialized knowledge in overseeing market operations specific to that exchange.

Notwithstanding those benefits, self-regulation can only be justified if it operates independently from the market with which it is affiliated. Financial firms and, most importantly, investors must be absolutely assured that all regulatory decisions are made irrespective of the commercial or competitive interests of the market.

Evolution of NYSE Regulation
Three years ago, I accepted an offer to serve as the New York Stock Exchange’s first chief regulatory officer. The creation of my position was part of sweeping corporate governance reforms that were launched after the independence of regulation at the NYSE had been severely questioned.

As part of these new reforms, the NYSE created a structure in which members of its board of directors are independent of the interests of the NYSE member organizations that they regulate. This new structure separated market operations from regulation, assured the independence of regulatory decision-making, and established a governance structure in which the chief regulatory officer reported not to the New York Stock Exchange’s chief executive officer—as previously had been the case—but rather directly to the NYSE’s board of directors. 

While this structure worked extremely well, new developments required further steps. In April 2006, the merger of the New York Stock Exchange and the electronic Archipelago Exchange was completed and the NYSE Group became a public company. As a public company with a fundamental responsibility to maximize shareholder value, it became important to increase the organizational separation that had been created between the market and regulation and provide for full legal separation. 

As a result, NYSE Regulation was organized as a separate not-for-profit corporation, wholly owned by the NYSE Group but with its own independent board of directors.

In this new structure, the independence of regulation at the New York Stock Exchange has been strengthened.

Every director of NYSE Regulation, except for myself, is independent of the management of the NYSE Group, of the Exchange’s member organization community, and of its listed companies. A majority of the directors of NYSE Regulation must also be independent of NYSE Group.

The NYSE Regulation board of directors oversees all compensation decisions for Regulation employees, as well having sole responsibility for the nomination of new directors.

As for disciplinary actions, the decisions of NYSE Regulation and its board of directors are final and are not subject to review or approval by the NYSE Group board.

This architecture insulates NYSE Regulation from the for-profit interests of NYSE Group and from the interests of the other entities and persons whom NYSE Regulation regulates. 

Our new structure adheres to the principles that made our initial reforms, some three years ago, effective— proximity to the markets, investment banks, and listed companies that we regulate on behalf of the Exchange, while regulatorily independent of them.

All this enables NYSE Regulation to play the critical role of monitoring and regulating the activities of its member firms and listed companies by enforcing compliance with NYSE Rules and the Federal securities laws of the United States .

I recognize that in Japan you are presently wrestling with the very same issues in light of the Tokyo Stock Exchange’s decision to become a public company. I note with pleasure that the path the TSE is pursuing in separating its regulatory arm is quite consistent with the steps we have taken at the NYSE.

Rule Harmonization
In a number of countries, including both the U.S. and Japan , there is more than one significant securities self-regulatory organization. Our experience has demonstrated that if self-regulation is to maintain its central role in the increasingly complex financial industry, we must seek to eliminate needless duplication from our rules, our examination programs, as well as in our enforcement investigations.

In the United States , alongside NYSE Regulation, the other major front-line regulator of equities exchanges is NASD—formerly known as the National Association of Securities Dealers.

Working with NASD, we have already achieved some significant results in reducing regulatory duplication of brokerage firms that are members of both of our respective organizations. We have a Memorandum of Understanding with NASD that assures firms that if they request a joint oversight exam, rather than separate visitations, they will get it.

On the examination side, within the past year, we have informally cooperated in certain examination areas when both the NYSE and NASD are conducting an exam in the same year. Moreover, we are doing a better job of coordinating with the SEC and NASD in communicating across our respective organizational lines with regard to sweeps or targeted examinations.

Finally, we are in the midst of an ambitious rule harmonization program with NASD and representatives of the securities industry. We have jointly committed to identify unjustifiable differences between NYSE and NASD rules and interpretations and to propose a program of revisions to harmonize by the first quarter of next year.

I am pleased to report that we have made substantial progress in this initiative and we and NASD expect to be providing recommendations for harmonized rules in the next few months. Self-regulation has many strengths but it should never become an excuse for subjecting the financial industry to inconsistent rules that impose unacceptable financial costs.

Regulatory Challenges
While ensuring the organizational and operational independence of a self-regulatory organization is an important step to building investor confidence in our securities markets, it is only the beginning. Critical to this task is overseeing the sales practices of financial firms in dealing with individual investors.

The continued global growth in equity investing is absolutely dependent on the quality of those firms’ controls so that investors are placed in suitable investments and they fully understand the risks of their investment strategies.

In the U.S. and in many other jurisdictions recent events have raised concerns about the quality of those controls. There have been conflicts over the operation of investment and research, improper facilitation of mutual fund market timing, and trading after the close. There have also been cases of major firms making investment recommendations based on undisclosed revenue sharing from mutual fund and annuity complexes. All have raised serious concerns over financial firms’ conflicts and their ability to build effective compliance controls.

Since the occurrence of these troubling events, there has been a dramatic new commitment by leading financial firms to build a more effective compliance culture. These firms have instituted more thorough, regular reviews of potential conflicts and approvals of new financial products that might impact their recommendations to individual investors.

While these strides have been welcome, our challenge as regulators is to ask where the next problems are likely to arise or where the controls are still not strong enough.

As the demographic trends I discussed earlier underline, the varying decisions surrounding retirement deserve further focus.  There has been a profound shift in the United States from corporate supported defined benefit plans to corporate contributions to more limited pension plans and 401(k) assets.

Baby boomers facing retirement today are often choosing to roll over substantial assets into brokerage accounts that often far exceed the amount of money that person and his account manager have previously been managing. The risks of misleading communications, account churning, and unsuitable investments are considerable. Indeed it is perhaps not surprising that a very substantial number of the disciplinary actions that NYSE Regulation brings relate to mishandling of these retirement assets.

Yet the compliance systems of many firms do not focus in particular upon these “wealth effect” moments where significant assets are transferred into an account. NYSE Regulation has made this an area of high priority. We are participating with the SEC, NASD, and the states in a Senior Initiative to identify firms that improperly use retirement seminars to prey upon senior investors.

Moreover, we are emphasizing in our examination program the importance of compliance systems at firms to give particular attention to the decisions made when substantial assets are transferred—even if normal activity alerts are not triggered.

Finally, we are working with various organizations through information sessions to try to increase the level of knowledge and investing awareness of present and prospective retirees. This is an area where we will all be measured in the coming years. I hope we can exchange valuable ideas in the next two days.

Market Surveillance
Equally important to maintaining investor confidence are our mutual efforts to ensure fair markets. The explosion of volume and the complexity of trading today also pose unparalleled surveillance challenges. Insider trading, as well as manipulative trading to—among other things—mark the close, can impact the pricing of secondary offerings or provide “window dressing” to improve monthly or quarterly performance figures and raise serious concerns. These schemes demand sophisticated surveillance responses.

NYSE Regulation is very focused on these threat scenarios and has a suite of manipulation surveillances designed to detect potential market manipulation during the entire day and over a period of days at the close, with the ability to cull trades to detect recurring patterns.

We are also redesigning our suite of insider trader surveillances to allow our analysts, investigators, and attorneys to delve deeper into pattern recognition of insider trading trends.

Today, however, insider trading and manipulative activity is not limited by product or geographic boundaries. Accordingly, the days in which each of us can search for these fraudulent activities solely in our own markets are over.

Our ability to cooperate with each other has never been more critical. Collectively, we need to take advantage of the opportunities created by the cooperative networks we have implemented such as the Intermarket Surveillance Group.

Intermarket Surveillance Group
The Intermarket Surveillance Group, also known as ISG, provides a framework for sharing information and coordinating regulatory efforts among its multinational membership. Members of the ISG agree to share information with each other on surveillances, investigations, enforcement matters, and on related practices and techniques.

The ISG was created in 1983 by the major U.S. securities exchanges in response to the growing need to share regulatory information related to the conduct of effective market surveillance. The proliferation of related products and derivative instruments underlined the need for a system of formalized, consistent procedures for the exchange of information across different jurisdictions.

Today, the ISG has grown to include North American, Asian, Australian, and European exchanges, all of which have a common interest in ensuring that the securities and futures marketplaces are regulated effectively and efficiently. The ISG provides a valuable framework for mandatory sharing of confidential surveillance information and regulatory coordination among its member markets on trading that may involve potential intermarket insider trading, manipulation, and other trading abuses. The ISG also provides a forum for discussing common regulatory concerns, thus enhancing members’ ability to fulfill efficiently their regulatory responsibilities.

As this year’s chair of the Intermarket Surveillance Group, New York Stock Exchange Regulation is hard at work in strengthening our collective vision of protecting investors and enhancing the integrity of our markets. Together with our sister exchanges, we are expanding our communication capabilities, an example being the recent development of the ISG Portal or Web site.

The Portal offers each ISG participant the ability to securely and privately exchange information and facilitate the ability to engage in coordinated, cross-border investigations. The ISG Portal also serves as the formal repository of ISG documents used by certain members in their surveillance functions. We are currently discussing further enhancements to the Portal.

In addition, ISG is currently considering expanding the consolidated equity audit trail that is used in the U.S. to provide a sequential reconstruction of trading in every stock. This expansion would include, for example, order information and details of the handling of orders, as well as options data, that would facilitate the development of future surveillances and be significant for timely analysis of anomalous trading.

Also being discussed is the feasibility of a single surveillance operator facility in the United States . This facility would develop the surveillances required by each U.S.-based self-regulatory organization and provide the surveillance output as required.

Over time, as trading becomes even more globally integrated, we need to ask ourselves whether even these steps are enough. The time may not be far off when we should begin a dialogue regarding the creation of consolidated information from across geographic and political borders. 

Risk Assessment
Finally, given the increasing complexity of both the firms and markets we regulate, each of us must search for more effective means to identify regulatory risks so that we can focus our limited resources in the right direction.

I spoke earlier about the various technological approaches we take to identify troubling patterns of trading activity. Similarly, we at NYSE Regulation are leveraging technology to assist us in performing risk-based examinations of our member firms in both sales practice and financial and operational areas.

The technology being used in sales practice examinations is helping us to identify individual registered representatives who may pose a threat to individual investors. We are combining information that we receive from firms and registered persons through various filings with specific data we are requesting before the commencement of each examination. 

We have identified a series of data elements that relate to customer accounts and branch offices and have built a technology platform to receive that information electronically. At the customer-account level, this includes the number of trades in a three-month period, profit or loss in the account for the same period, turnover of securities, and commissions charged to the account for the year. 

For each retail branch office, we are requesting records such as the total number of cancel and rebills for a three month period, the number of account designation changes, the number of order errors, the number of margin extensions, the dollar amount of commissions generated by the office, the number of registered reps in the office, the dollar amount and number of bounced checks, the number of discretionary accounts, and the number of independent contractors. 

This information, combined with the data we receive routinely from the member firms—such as customer complaints, employee terminations for cause, arbitration awards, and settlements with customers—allows us to zero in on customer accounts and branch offices that may warrant further review. 

Once specific customer accounts are identified, we ask for information such as investment objectives, annual income, and net worth for those particular accounts.  Using this data, we are able to select branch offices and customer accounts that do not necessarily pop up on our member firm exception reports. 

Receiving this data electronically allows our staff to place a weight or multiplier on particular criteria and prepare a risk matrix that identifies those registered representatives and branch offices we want to focus upon during our examination. With the use of technology, we have been able to spend more time analyzing the activity in customer accounts for suitability, rather than randomly selecting accounts for review.

On the financial side, we completed a pilot program of an automation initiative by receiving the stock record and customer protection calculations from several of our member firms. The pilot phase helped us to lay the groundwork and develop appropriate infrastructure and processes necessary to proceed on a larger scale. 

The receipt of this data enables us to take a more risk-based approach in planning and conducting the examination. For example, we are able to identify concentrations of securities in a single customer account, in proprietary accounts, as well as across customer and proprietary accounts.  Many of the regulatory computations that examiners spent days in the past verifying manually can now be done automatically with exception reports produced to identify problems. Through the use of exception reports, we may make a decision to eliminate altogether a review of a particular area of an examination.

We have a lot more work to do on the technology front, but I am very excited about the opportunities to work smarter in the future.

Over and beyond these specific efforts, we recognized that a more proactive approach to assessing emerging trends and regulatory risks in the securities industry was warranted. 

So, attempting to see over the horizon, NYSE Regulation created a Risk Assessment Unit in October 2004. The Unit’s efforts enhance the protection of the investing public and increase NYSE Regulation’s effectiveness in identifying and responding to emerging trends or practices that may compromise investor protection. 

Our Risk Assessment Unit employs staff with a wide variety of expertise, including highly skilled examiners; analysts and attorneys knowledgeable about a variety of different rules, products, and practices; as well as technologists with know-how in systems for trading and trade monitoring. The staff’s mandate is to be proactive, creative, and curious about new or lesser-known industry practices, possible internal control weaknesses, and new products offered to the investing public in order to anticipate areas of emerging risk that could pose regulatory concerns. 

Armed with this mission, the Risk Assessment Unit mines information collected from a variety of sources within NYSE Regulation—including arbitration filings and customer complaints—while gathering intelligence from the news media and industry experts such as broker dealers, trading professionals, and compliance and legal professionals. 

Because the staff in this Unit was selected from divisions with responsibility for the exam, surveillance, and enforcement programs, they are in an excellent position to step back and review products, practices or issues indicating internal control weaknesses that may not readily be recognized as areas of concern.

Conclusion
In summary, the challenges that all of us face have never been greater.  I have tried to set out some of the results of New York Stock Exchange Regulation’s efforts to define and respond to some of those challenges. Yet by the very nature of the markets and firms we regulate, those challenges are global and common to us all. 

Therefore, the real value of this conference is the chance to exchange ideas and learn from each other’s experiences. I look forward to that opportunity. We must collectively ensure that the dialogue begun this week continues.