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Good morning.
A lot has happened since I spoke to you last year at the Annual Seminar of the Compliance & Legal Division. In terms of compliance, there have been some marked improvements to talk about.
The industry has raised the bar in terms of their compliance functions and is reacting more quickly to regulatory gaps. Also, the experience level of dedicated regulatory staff has increased, while compliance technology is more widely deployed. Firms are also doing a better job policing their sales forces and are quicker to terminate brokers who work outside of the rules.
As a further example of the securities industry’s progress, the SIA became S-I-F-M-A, or to those of us who can’t help ourselves, SIFMA.
Of course, we also have been immersed in historic structural changes and both the industry and the SEC were active participants in this process.
In November, NYSE Regulation announced that it would merge its broker-dealer regulation and other functions with NASD in the first major reform of the self-regulatory structure in more than 70 years. So we are now in a similar position—working to devise a fresh, dynamic name for our new organization.
We are learning from the industry—as we frequently do—and understand how important it is to get the name right. Our new brand will be unveiled in the coming months, and I think I can speak for everyone here—we are glad you did this first, or should I say F-I-R-S-T.
U.S. investors deserve a regulator that has the resources and skills to keep pace with an increasingly complex and changing securities industry. And our member firms deserve the most efficient regulatory structure possible based on a single rulebook and one consolidated examination and enforcement program. By combining the enormously talented staffs of NYSE Regulation and NASD, we will be able to meet the challenges of tomorrow.
Reflecting back, I feel honored to have led a revitalized NYSE Regulation at a time of incredible change. But this new organization is an idea whose time has finally come. This new SRO will have outstanding leadership provided by Mary Schapiro. I am very pleased to have the privilege of serving as chairman of the newly merged entity while continuing as the chief executive officer of New York Stock Exchange Regulation, overseeing NYSE Group’s market surveillance and listing compliance divisions, as well as an enforcement staff focused upon trade-related issues.
As Mary described in detail yesterday, the challenges of the newly merged SRO in its first year will range from integrating two different organizations to ensuring that the industry quickly receives the benefits of a fully coordinated examination program and, perhaps most importantly, the creation of a single rulebook.
During the past year, NYSE Regulation and NASD have spent considerable time and effort on the SRO Rule Harmonization project that will operate as a critical precursor to a single rulebook. In its approval order of the NYSE-Archipelago merger, the Securities and Exchange Commission asked us to compare our rules with those of NASD and, to the extent practicable, harmonize the two regulatory schemes.
The Rule Harmonization initiative involved several committees comprised of NYSE Regulation staff members, NASD, SEC representatives, and securities industry professionals. It was, in my opinion, an outstanding example of how regulators and the industry can work effectively together.
As a result of this work, we filed proposed amendments and other rule changes with the SEC at the end of February.
The rule filings involved over 100 NYSE rules in the areas of
- Sales practice
- Financial/reporting
- Operational/clearing
- Settlement and buy-in rules, and
- ACATS.
It also included the deletion of the term “allied member” and in certain instances the term “member” in our rules to the extent necessary to reflect the current regulatory scheme of the Exchange. Not a bad start in less than one year. But there is much more that can be accomplished through the new SRO.
Both the merger of regulators and the march toward a single rulebook are important steps toward addressing what many believe is the eroding competitiveness of U.S. financial markets. A single rulebook is a natural progression of improvements to our own regulatory programs. At NYSE Regulation, we recognized that as part of our own fundamental self-examination, new approaches and thinking were required. I can’t help but look back three years since we began this process and note my belief that concrete improvements abound. The strides forward for us are significant and range across all of our divisions.
In Member Firm Regulation, we have embraced a pro-active, risk-based approach to examinations, that is made more efficient by extensive planning before fieldwork begins. New areas of risk have been identified, leading to significant examination findings. New examination scopes have been developed, including those to address conflicts of interest in proprietary trading, broker jumping, and investment advisory transactions. New rules have been adopted for specialist capital, portfolio margining, and we continue to make important strides in the automation of our examination program.
In Enforcement, we are getting money back into the hands of harmed customer through the pursuit of fee-based account, sales-practice, and other cases. We have clearly laid out our expectations for members by publishing Information Memos on Cooperation and Factors Considered in Sanction Determination. And firms are addressing operational control problems that directly effect customers in areas such as prospectus delivery and blue sheets.
In Market Surveillance, we are equal partners in the Exchange’s development of the Hybrid Market, ensuring a substantial and expert regulatory perspective in one of the most fundamental operational shifts in the long history if the Exchange. Surveillance methods—under continuous review—have been created and updated. We have been pro-active in reaching out to other regulatory and industry groups and creating tasks forces to address emergent issues.
Perhaps equally important, I think we have taken important strides toward a more consistent and effective working relationship with the industry.
The communications between our senior staff and your senior managements is now regular practice, and I think far more candid.
Our Compliance Advisory Committee has been fully integrated into our efforts of issue spotting, interpretations, and rulemaking. This is paying hugely positive dividends, for in the end self-regulation depends on equal parts of absolute independence in decision-making and effective understanding of the burdens our rules might impose.
All of this—either by preventing or correcting wrongdoing—cultivates confidence in our markets. And confidence is a critically important element of winning financial-services business in the global arena. This is an important point because never in my 30-plus year career has the relationship between regulation and the competitiveness of the U.S. financial industry been more the focus of conversation.
While I believe the U.S. regulatory system has consistently demonstrated its ability to adjust and become more flexible as financial markets have grown and became more complex, today the debate concerning the regulatory system’s impact upon the competitiveness of the United States in global capital markets continues. In the past few months, several reports have been published that address this issue. In particular, it has been argued that the U.S. is losing its position as the financial capital of the world to London .
Although most of these reports acknowledge that factors ranging from the enormous growth of the world economy, geography, time zones, and increasingly open capital markets explain many of the reasons why the U.S. is in a more competitive position with foreign financial markets, their concerns regarding the impact of excessive private litigation and prescriptive regulation in the U.S. deserve careful attention. In particular, many of the reports endorse the Financial Services Administration of the United Kingdom ’s style of “light touch” regulation that they believe allows a smoother and more nuanced regulation appropriate for today’s complex, fast changing, globalized markets. Indeed, this type of “principles-based” approach has received specific support in the Bloomberg-sponsored report, as well as the study by the Committee on Capital Markets Regulation.
I admit, as a long time regulator, that I have a viscerally negative reaction to what seems to me to be an oversimplification of regulatory issues in these reports. But that doesn’t change the recognition that when these concerns are broadly held, they deserve careful attention. If we are going to evaluate calls for change, however, it is important to step back and think about how our system of oversight has evolved.
Historically we started with a very principle-based regulatory scheme. When I began my career in regulation in the 1970s, market regulation was supported by four cornerstone concepts:
- Just and equitable principles of trade
- Know your customer
- Fair and orderly markets, and
- Rule 10b-5 concepts of disclosure, duty and fraud.
These tenants continue to be the foundation of market regulation today but the rulebooks are much thicker. Why?
There’s no way to say this other than that over time more prescriptive rules were created to address specific instances of industry failure and to encourage competition. The more detailed regulations added reflect regulators frustration over the industry’s previous inattention to controls and our desire to protect investors. Interestingly, it also reflected the industry’s demand for greater specificity—driven largely by disciplinary actions, greater legal exposure, and increasing penalties.
Notwithstanding that history, a good argument can be made that things have changed. As I noted earlier, the industry has made a broad-ranging effort to increase compliance resources and the quality of its controls. Moreover, the increased complexity and competitiveness of financial markets and the financial industry argue that it is time to at least reevaluate the efficacy of our regulatory approach. A careful re-examination also has to be thoughtful regarding how words and concepts are used and misused.
Some of the studies cited today have taken great pains to achieve balance and parity among competing ideas. Others are more partisan in their support of a particular viewpoint and the depths of their convictions are revealed by language.
Like Commissioner Nazareth and Mary Schapiro, I am somewhat leery as to how advocates of principle-based regulation impart meaning to these words. Indeed, in focusing on the meaning of words, I think it is helpful to look overseas to the United Kingdom —not particularly as the home of the FSA and ancestral source the English language—but the native land of…the Beatles. In the song “Revolution” we are reminded of how words are used and misused, especially in the language of protest. While John and Paul were not Registered Personnel, it seems to me the song provides a useful warning in beginning this debate.
A paraphrase of the key lyrics goes something like this:
“You say you want a revolution, well you know, we all want to change the world.
You say you got a real solution, well, you know, we’d all love to see the plan.
But when you talk about destruction, don’t you know you can count me out.”
And:
“When you want money for people with minds that hate—all I can tell you is brother you have to wait.”
So other than fulfilling a life-long dream to talk about the Beatles and Revolution at a SIFMA conference, why do those words have meaning here?
First, while the concept of principle-based regulation is appealing, advocates believe that providing firms with flexibility to decide what business process and controls to use will better align good regulation with good business practice. Understanding how they can be implemented in the U.S. financial markets that boast strong institutional markets and widespread direct and indirect individual investor participation is the challenge.
Just as the Beatles demonstrated through satire how the romantic, well-intentioned meanings of a word can hide cynical intents, we need to be on guard to avoid having the debate on regulatory techniques be employed as a means to avoid regulatory compliance costs or disciplinary accountability.
Said directly, and the FSA statements are in full accord on these points, the first principles of any regulatory reform effort must be that the bedrock and immutable tenants of investor protection and market integrity cannot be eroded and when those goals have been violated, swift and stern accountability through enforcement actions must follow. My purpose in throwing out these concerns is not to thwart a dialogue on these topics—just the opposite. It is to encourage a clearly articulated debate that looks to change without violating those first principles.
In the end, I’m not going to be able to provide a neat conclusion that will satisfy most of you or myself regarding this topic. But it does seem to me that where this much concern about the competitive impact of the regulatory structure has been expressed, it is the right time for all of us to demonstrate the maturation that has occurred in the relationship between the industry and the regulators.
Indeed I think it is the right time for a wide-ranging, problem-solving discussion of these topics involving the regulators and the stakeholders—both industry and investor representatives. Let’s leave at the door scare tactics, defensiveness, and manipulation of the English language and make an attempt to agree on a way forward. Of course, it hardly needs mentioning that the pursuit of a single SRO rulebook is one good point of departure for these discussions.
In that spirit, let me leave you with what I think are five fundamental underpinnings of effective regulation that I would hope could guide the discussions.
First, we should build on the process to date and place a steadily higher emphasis on prudential regulation. SEC Chairman Christopher Cox’s recent speech at the Investment Company Institute and Commissioner Annette Nazareth’s speech yesterday made this point extremely well. There is no question that regulators gain from regular and candid, substantive conversations regarding changes in a firm’s business, strategic priorities, and compliance issues. Similarly, a firm gains when regulators both understand the business better as well as have an appreciation of efforts to create a more effective compliance culture.
In addition, these discussions allow both senior business and compliance officials to gain a better appreciation of where regulators’ concerns lie. This has begun to become a way of life with those firms subject to the SEC’s consolidated supervision, but we need to continue to take it further and apply it more broadly across the industry. Effective compliance occurs when senior management is actively involved and this will help make that happen.
While prudential supervision is not a substitute for strong discipline when a breakdown by a firm harms or jeopardizes investors, the increased confidence it provides a regulator in the overall strength of a firm’s compliance system should properly influence our decision as to whether or not to exercise our prosecutorial discretion. As more effective prudential supervision takes hold, it may be appropriate to rethink in many cases if it is necessary to bring enforcement actions with respect to isolated control and technology failures that have not directly harmed investors.
Second, rulemaking should always involve a conscious consideration as to whether a more general requirement that gives room for more industry-empowered, risk-based discretion is possible. We are finalizing a joint memorandum with NASD on the Review and Supervision of Electronic Communication that I hope will provide a good example of where the right thing is to depend on your experience and discretion to make risk-based determinations in this very difficult area. Portfolio margining and the recent gifts and entertainment rules also depend upon the industry developing the controls appropriate for firms’ sizes and its particular business models. The single rulebook exercise is a great opportunity to look back and ask this question with respect to some number of our existing rules, in particular those relating to wholesale trading and institutional businesses, as opposed to retail selling practices.
Third, given the importance of strong compliance controls, regulators must recommit to provide greater levels of interpretive guidance. At NYSE Regulation we have tried to respond with new interpretive notices when our examination or risk program has identified areas of widespread weak compliance or where the industry calls to our attention ambiguity in our rules. If we do find more areas to embrace more flexible risk-based rulemaking, this becomes even more important. As I discussed earlier, firms may love the theory of being provided greater compliance discretion, but without guidance regarding best practices and warnings of actions that are unacceptable, that freedom could get pretty scary, real quick.
Fourth, regulators need to rededicate themselves to effective interaction with stakeholders in formulating and applying our rules. The notice and comment processes are fine, but they tend to be adversarial and encourage the drawing of black and white lines. The interaction we have had with our Compliance Advisory Committee in the last three years has been eye opening to me. A relationship that started with cynicism and fear has evolved to mutual self-respect and has significantly helped us in crafting rules that effectively address compliance gaps without imposing unnecessary burdens.
I am no romantic here. As a regulator I will always be suspicious, maybe even cynical of your motives and you will always think I am somewhat out of control, but interaction makes the rulemaking process better. In my mind, the major lesson coming out of the last decade is that while self-regulatory decision-making must be absolutely independent of the industry, our strength is to gain perspective through more informative interactions with the industry. Moreover, dare I say, as an SEC alumnus and loyalist, this is an area where the Commission should look closely at the example set forth by the FSA.
Finally, we must clearly accept that one of the core regulatory responsibilities is investor education. Candidly, none of us has fully figured this one out. I am pleased that NYSE Regulation has shed its traditional isolationism and begun regularly putting out investor alerts and interacting with educational groups. The NASD under Mary Schapiro’s leadership has taken this effort even further, in particular through the work of its Foundation. But a conscious focus for us of allocating both funding, time, and evaluation of what really works in communicating with investors should be a core part of our mission.
In closing, I believe the coming year provides exciting and truly unique opportunities to continue efforts to improve our regulatory system. Working together, we can achieve change that supports the continued flourishing of U.S. financial markets, while retaining a bedrock commitment to effective investor protection.
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