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I also want to commend Jay and all my former colleagues for convening this very timely conference, and thank them for honoring me with an invitation to participate and to be among such distinguished company.
I see that Richard Haass of the Council on Foreign Relations is speaking in the other luncheon session and his topic is "The 21st Century: What to Expect." I have a picture in my mind of people in the audience keying in their brokers' numbers on their cell phones, holding their thumbs over the "send" buttons and hanging on his every word.
I really don't mean to make light of Richard's topic, because I, too, want to talk about some eventualities that I see on the horizon - eventualities that undoubtedly will change the complexion of securities markets around the world and the way in which they are regulated.
No matter where the current wave of market realignment takes us, though, there is one essential truth that cannot and will not change. And that is that the regulation of securities markets must always ensure that they are fair and that the rules are followed, while not inhibiting efficient capital raising and allocation. That will always be the case, no matter how dramatically markets redefine themselves in the coming years.
So, I want to talk today about how securities regulation has dealt with some truly dramatic realities of recent years, and then about some new regulatory realities that I see taking shape in the next half-decade or so.
The event that has, more than any other, defined the regulatory landscape of the nascent 21st Century is the bursting of the dot.com bubble in 2000. This, combined with the mutual fund scandals that closely followed it, made for the darkest period in the U.S. capital markets since the crash of 1929. Investor confidence in the markets and their trust in securities professionals were measurably damaged. All securities regulators - state, federal, non-governmental - were forced not just to respond, but to respond forcefully, aggressively and fast.
For NASD, the challenge was to deal with the wrongdoing by punishing those responsible for it and imposing new rules aimed at preventing any reoccurrence of it, and to do all this without strangling the securities industry. Needless to say, this has been something of a tight-rope walk for all of us at NASD, and none more than me. I have always been an advocate of free markets and limited government. But I think it's safe to say that we've succeeded. Notwithstanding the inevitable complaints from some quarters about heavy-handedness and regulatory overkill, the industry we regulate is thriving. The Securities Industry Association reports revenue growth of 8.1 percent for the industry as a whole in 2005, compared to 5.2 percent in 2004.
I should add that our response to the recent unpleasantness has not just taken the form of writing rules and enforcing them. We have also made, and continue to make, sincere and concerted efforts to provide the people and firms we regulate with the tools and tutorials they need to meet their compliance responsibilities and without a great deal of confusion or expense.
We've also invested heavily in market transparency and investor education, based on the proposition that an educated and informed investor is well-equipped to provide the front-line of his own protection and avoid problems that might otherwise require enforcement or arbitration.
Another recent turn of events that has substantially redefined the markets is the transition of the major stock exchanges from mutually-owned, non-profit institutions to for-profit, publicly-traded ones - NASDAQ in 2000, the New York Stock Exchange in 2006. The American Stock Exchange apparently intends to follow suit. In Europe, Euronext, the London Stock Exchange, Deutsche Borse and others have taken the plunge. This is all to the good, I think. For-profit exchanges will be able to operate more efficiently, to more easily raise the capital they need to acquire the most state-of-the-art transaction and reporting technology, and will have available a publicly traded stock that can be used to effect mergers. Capabilities such as these are crucial in the globally competitive environment in which exchanges now operate.
But this salutary change from non-profit to for-profit status has required regulators to revisit the self-regulatory model that Congress established in the 1930s as the principal means of overseeing the operations of exchanges and brokers. That model, which remains in place today, envisioned that each exchange would regulate its members and their trades, under the supervision of the Securities and Exchange Commission. So, the NYSE was, and still is, the regulator of its 200 or so member firms and of trading on its floor. And from 1970 until just recently, NASD was the owner and principal regulator of NASDAQ, in addition to being the regulator of all American securities firms and brokers.
The conflicts inherent in this system are obvious, but unavoidable. To paraphrase Churchill, self-regulation is the worst form of regulation - except for all the others. Self-regulation provides the advantages of private-sector efficiency, productivity and results-based compensation, has financial resources freed from the political funding cycle, and is well equipped to understand the complexities of the securities industry it regulates. But when the exchanges made their moves toward for-profit status, the conflicts became much larger and harder to defend.
When NASDAQ set off on this path on 2000, we decided that building a wall between our management and regulation of the exchange - as some had recommended - wasn't enough. We took the more dramatic step of totally de-coupling NASD and Nasdaq, which is now fully independent from us, with its own management, own board and own balance sheet. We have effectively reduced our ownership of NASDAQ to zero. NASD believes that a for-profit exchange should not be in the regulation business and we acted on that belief.
The New York Stock Exchange today finds itself facing a similar conflict - how to simultaneously operate as a for-profit exchange and regulate the roughly 200 firms that trade thereon. There is also the fact that those firms are regulated by NASD and the NYSE. Thus, they have to follow two sets of rules, answer to two regulatory and enforcement staffs and pay two sets of fees and assessments. With the securities industry now increasingly faced with global competition - it's not just domestic anymore - this is a costly and burdensome regulatory inefficiency that the industry could well do without.
So, what's the solution? What we have proposed, and others in the industry support, is the creation of a new regulatory entity that would oversee the firms now dually regulated by NASD and the NYSE - an entity in which both organizations would participate.
This would solve the two problems I mentioned - the conflicts inherent in a for-profit exchange's regulating its customers, and the untenable requirement that 200-odd brokerage firms have to answer to two regulators.
As you certainly know, the evolution of markets involves more than exchanges becoming for-profit enterprises. After years of unfulfilled expectations, globalization is finally coming to the equity markets. International trading of government debt and even corporate debt has been a reality for years, but equity trading has lagged behind. That has begun to change, as NASDAQ has bought a 25 percent stake in the London Stock Exchange, perhaps as a prelude to a full takeover attempt in September, when UK rules will allow it. And the New York Stock Exchange has announced a merger with Euronext, although that has not met with unbridled enthusiasm among European political leaders and exchanges. Quel surprise!
However these things end up, it's clear that global integration of exchanges is the wave of the future. I expect we're going to see a lot of it. Corporations will benefit immensely, by being able to list simultaneously on multiple exchanges around the world and gaining access to geographically disparate pools of liquidity. Also, their access to investors will increase, because investors are generally more comfortable buying locally-listed, and locally-analyzed, securities.
Investors, too, have a lot to gain from market globalization. For example, they'll enjoy the benefit of fully integrated, high-tech, trading platforms; investors the world over will be able to buy stocks with the push of a button on a single platform. Trading costs will go down and spreads will narrow, and investors' ability to diversify their portfolios will increase. This last point is important, because the typical investor holds an under-diversified portfolio, heavily weighted with securities from his or her own country.
Hedge funds and other high-volume investors will be able to buy on margin more safely. Trades on the same exchange will permit more easily effected cross-margining of one trade against another, thereby reducing the amount of collateral investors need to post.
With market globalization promising such an abundance of benefits, what could stand in its way? In a word: regulation. The concern has been raised in the UK and in Europe that if the NYSE and NASDAQ set up shop on that side of the Atlantic, they will bring American-style securities regulation with them. And by American-style regulation I mean Sarbanes-Oxley, which is a more demanding law than any governing corporate behavior in Europe - so demanding, in fact, that most newly-listed, non-U.S. public companies in the last 18 months are listed on exchanges outside the United States. In 2000, pre-Sarbanes-Oxley, about 47 percent of global IPO equity was raised on U.S. exchanges. In 2005, post-Sarbanes-Oxley, that number was 5.7 percent. In 2000, nine of the 10 top worldwide IPOs registered on U.S. markets. In 2005, only one of the top 24 did so.1
Regulators on both sides of the Atlantic have been very clear in assuring that Sarbanes-Oxley will not apply to any non-U.S. companies that list only on exchanges in Europe or the UK. But that's only part of the puzzle. What about cooperation between regulators from different countries? How will, say, the AMF in France and the SEC in the states manage to work together? This matters a lot, because investors will reap the full benefits of global markets only when trading platforms and perhaps even more importantly, clearance and settlement systems, are fully integrated. To date, progress in regulatory coordination in Europe has not been encouraging. Euronext, which is a confederation of exchanges in Paris, Brussels, Amsterdam and Lisbon, is overseen by a confederation of national regulators, hardly promising integration.
John Thain, CEO of the NYSE and of the proposed NYSE-Euronext tie-up has assured investors that regulation won't be a problem. Trades done on one of the four European exchanges will be regulated by the home-country European regulator, trades done in New York will be regulated by the U.S. regulators.
This is certainly a sensible solution for now, but will it work in the longer run? The ultimate purpose of the merger is to produce a fully integrated trading platform. Over time, the merged NYSE-Euronext will inevitably migrate toward a more completely computerized trading platform, as have both NASDAQ and the LSE. When this happens, trades won't take place in New York or London or Paris, they'll take place on a satellite over the Atlantic Ocean. What home-country regulator will responsible for those trades?
Regulating these trades will be challenging. Efficient execution of trades will eventually dictate integration of trading platforms and harmonization of trading rules, coordinated to assure consistency with the standards of the involved national regulators. So far, coordination of national regulators - beyond information sharing - has not been a process marked by stunning breakthroughs. This is hardly surprising when you consider that national regulators are, after all, national and subject to national political oversight and pressures. This is an issue that's going to have to be dealt with, and it may be that the American self-regulatory structure can play a useful role in the needed regulatory integration.
Another regulatory "new reality" that needs to be dealt with is the profusion of new investment products that are designed to compete with one another, but fall under different regulatory regimes. In professional boxing, there are sometimes three world heavyweight champions at the same time, because there are three organizations that purport to decide who the champion is. American financial regulation isn't quite that balkanized, but it is complex and fragmented. There are different regulators for banks, insurance companies, securities firms, even municipal securities. And in most cases, industries and their products are regulated by a federal agency and by its state-level counterpart.
So, when you have two investment products that look very much alike, but fall under different regulatory regimes, a serious problem for investor protection arises. Investors have a right to expect uniformity in regulation, so that they enjoy the same protections whichever product they buy. For this to happen, the various regulators have to cooperate to equalize their disparate rules. For example, the SEC and NASD make the rules for sales of mutual funds, because they're securities. College savings plans known as 529 Plans, are also mutual funds, but with an added layer of state and federal tax incentives. However, rules governing their sales are written by the Municipal Securities Rulemaking Board, because they are municipal securities sold by state governments.
Over the years, and particularly since the mutual fund scandals of a couple of years ago, an extensive structure of investor protection rules has been built to police the sale of mutual funds. But the MSRB's rules for 529 sales did not, in the view of many observers, offer the same level of protection as those covering mutual fund sales.
Fortunately, in the last year NASD and the MSRB have been able to cooperate on equalizing their rules by agreeing that the MSRB will, except in unusual circumstances, adopt NASD's mutual fund rules and apply them to 529s.
Would that it were always that easy. Another example of regulatory disconnect is in the regulation of annuity sales. Annuities come in three types - variable, fixed and a hybrid called an equity-indexed annuity. Variable annuities are securities, so the SEC and NASD regulate them. Fixed annuities are insurance products, so state insurance regulators oversee them. Equity-indexed annuities are, essentially, a jump ball, because no one seems to know whether they are a security or insurance product. Trying to decipher them is like trying to understand the flow chart of the U.S. Agriculture Department.
Thus, the degree of protection that investors get when buying annuities is far from equal. For example, sales of variable annuities are covered by extensive suitability rules, but the sales of fixed annuities are not. These disparities are indefensible, and the only way to erase them is for the various regulators to work together on harmonizing the rules covering the three annuity types. NASD recently took the first step in this direction by convening a summit meeting of securities and insurance regulators to start discussing how to achieve this goal. The meeting was encouraging and I hope we can all make meaningful progress in the near future. Investors deserve nothing less.
There is one last point I'd like to make and then I'll stop and invite your questions.
Needless to say, the arrival of the Internet and related telecommunications technologies has profoundly changed the way we live and work, and almost entirely for the better. I wonder how many of you have looked recently at the daily stock tables in the New York Times. Actually, I know the answer: none of you has. The Times stopped publishing those pages a couple of months ago. Several other major newspapers have also stopped and I suspect eventually they all will. The Internet has made them obsolete, by opening up new and more descriptive, more illuminating ways of tracking investments. And there is more we can and should do in this regard.
Today, when you buy mutual fund shares, you get a long, turgid and mind-numbing prospectus in the mail - and not until after you've bought the shares. That is your disclosure document and you can find most anything you need to know about the fund in it - if you have the time and patience to trudge through it.
There is a better way. NASD has proposed that mutual fund investors receive - at the point of purchase - a two-page disclosure document explaining in plain English the fees and less obvious costs that investors in the fund have to pay, any conflicts of interest that the selling broker may have, and the fund's investment style, objectives and performance. These are, we believe, the basic facts that investors ought to have in hand before deciding to buy shares. And now, with Internet access being so widespread, it would be easy to give investors instant access to those facts.
According to a study by the Investment Company Institute, the trade association for the mutual fund industry, 90 percent of mutual fund shareholders have Internet access and about two-thirds of those who have it go on-line every day. The study, released in February, also found that fund shareholders were more likely than other Internet users to access bank and brokerage accounts and search for investment information on-line.
It's clear to me that the time for this has come. SEC Chairman Chris Cox has made encouraging comments about the importance of the Internet in providing investors with easy access to the information they need. So we're working to convince his colleagues on the Commission and the staff of the value of on-line disclosure, and not just for mutual funds. I think the disclosure document I described could easily be adapted to annuities and other products to the clear benefit of investors.
I think I've given you a pretty good picture of some of the new realities that characterize the securities world, and of what I think NASD and other regulators need to do to adapt to them. This is an exciting period in our industry. Markets are changing and evolving rapidly. We can't know how it's all going to end up, although it's safe to assume that some well-established ways of doing business will become obsolete and new ones will take their place. What will never become obsolete, though, is the need to protect investors and uphold the integrity of the capital markets. So, our challenge now is to make sure those needs are fulfilled regardless of what new shapes the markets may take, but to do so without unnecessary regulatory burden that gets in the way of efficient, competitive markets.
Jay Light, thank you again for inviting me. And thanks to all of you for being here. Now if you have any questions, I'll be happy to try to answer them.
1NYSE Chairman Marshall Carter testimony to House Capital Markets Subcommittee, Apr. 26, 2006
("Copyright 2006 National Association of Securities Dealers, Inc.")
