Speech by SEC Chairman:
Remarks Before the Bond Market Association

by Chairman Arthur Levitt

U.S. Securities & Exchange Commission

in San Francisco, Calif.

April 23, 1999

San Francisco has long been known as one of the most dynamic cities in America. Over the past 150 years, our capital markets have contributed, in no small way, to that dynamism. Stocks and bonds helped finance the railroads that tied West to East. Bankers provided hundreds of millions of dollars to rebuild San Francisco after the devastating earthquake ninety years ago.

Over the years, our markets have helped many local enterprises blossom. California Packing, underwritten for $16 million in 1916, is today Calpak, the largest U.S. fruit and vegetable canner. Yesterday, cans; today, computers – our capital markets continue to play an important role in the Bay area's prosperity.

With the enormous growth in equity markets, there seems to be a common misconception that the bond market is somehow less important to our country's well-being. But, as we all know, the opposite is true.

Today's bond markets play a major role in America's economy – from raising the funding to build schools and hospitals, to investing in factories and equipment. It impacts the assets of public and private pension funds, and channels capital to mortgage and car loans.

The significance of the bond market is due, in part, to its sheer size. While New York Stock Exchange equity trading amounts to $28 billion per day, trading volume in all bond markets totals roughly $350 billion per day. U.S. corporate bonds outstanding have more than quadrupled since 1980. Municipal bonds have experienced similar growth. The total value of the bond market today is over $10 trillion – up approximately 400 percent since 1980.

There is no doubt that America's debt markets play a crucial role in our economy. Their growth is America's growth; their strength is America's strength. That's why a mutual commitment to be responsive to the markets is so important. I'm here today to renew that commitment, discuss where we are on some of the bond market initiatives I have advanced, and examine forthrightly where I think they need to take us forward.

In my six years as SEC Chairman, I have pursued relentlessly two basic goals: (1) to see that our nation's securities markets – debt, equity, options, all of them – are both fair and efficient; and (2) to ensure, through meaningful safeguards, that our nation's investors – both individual and institutional – have faith in the integrity of our system.

The SEC is proud of the role it plays in helping to maintain the underlying strength of our markets. Some, however, believe that the SEC pays disproportionate attention to the equity markets. Some may, in fact, prefer that we do just that. But our mandate applies equally to the debt markets.

Our fundamental philosophy and goals – those basic ideals of fairness, efficiency, and investor protection – are as salient to the bond market as to every other market. The methods of achieving them – transparency and disclosure, surveillance capability, a strong and properly equipped enforcement program, and rules that balance the interests of all participants – remain the same.

Of course, we recognize that the debt markets have their own unique structure, function and characteristics. The debt market is primarily an over-the-counter principal market. Prices for many debt issues are calculated by reference to certain benchmark securities. And, of course, there are far more different issues of debt than equity. We have successfully worked together in the past precisely because the SEC has acknowledged those differences and has not tried to force these markets into the mold of the equity markets.

Having said that, I don't believe for one minute that these differences mean we shouldn't apply to the debt markets the time-honored and fundamental goals that have served the investor interest – and ultimately, everyone's interest for decades. And, so I believe it is time to put aside our differences and work together to achieve our common goal of strong, resilient and dynamic debt markets.

One way to do this is for you to actively support efforts to increase market transparency. I firmly believe that the ready availability of prices that are visible and understandable to market participants is fundamental to promoting fairness and efficiency in every one of our nation's capital markets.

Transparency is just as important for bonds as it is for stocks. Indeed, because bond values are often closely related, the price of one bond can provide important information about other comparable bonds. Often, there are no recent market prices for the bonds an investor holds, and their value must be inferred from the prices of other bonds. That's why comprehensive price transparency is so crucial.

The undeniable truth is that transparency helps investors make better decisions, and it increases confidence in the fairness of the markets. And, that means more efficient markets, more trading, more market liquidity, and more business for bond dealers. That's why I believe that a sound and sensible approach to bond market transparency is in everybody's interest.

A good example of this occurred in 1995 when – with our encouragement – the MSRB began collecting the details of dealer-to-dealer transactions in the municipal bond market and distributing daily summary reports. In August of last year – with SEC approval – these daily reports were expanded to include customer trades as well as interdealer trades. The MSRB has committed to implementing trade reporting on a real time basis, and we expect to see more progress in that direction very soon. That's the kind of leadership that benefits us all.

I also want to congratulate the Association for offering daily summaries of municipal bond prices on your website. Now, for the first time, prices from the previous day are available to the general public. And, I think it's safe to say that a lot of people have responded. In just the first three weeks of its operation, the Web page received 17,000 hits.

This is good progress, but it's not nearly enough. You may recall that, in 1994, we considered amending our rules to require the disclosure of mark-ups in municipal and other debt securities. We held off on the proposed measures because the industry told us that transparency was a better alternative to mark-up disclosure. We also deferred action because participants in the municipal debt market had committed to take important steps to improve transparency. The government bond industry had displayed a similar commitment to increased transparency a few years earlier when it created GovPX – an electronic reporting system that distributes real time quotes and transaction prices for U.S. Treasury and other government securities.

Despite my expectation that participants in the corporate debt market would follow the lead of their peers and likewise embrace greater transparency, the results up to now have been disappointing.

I know that many of you believe that the corporate debt market is sufficiently transparent and that improvements are unnecessary. Others of you may believe that the Corporate Trades I system sponsored by the Association to report high grade corporate debt transactions is sufficient progress. I simply disagree. The technology exists to gather transaction prices, distribute them, and interpret them in a timely, accurate, and efficient manner. The time has come to illuminate this needlessly dark corner of our capital markets.

I challenge each of you to support enhanced transparency. In the short-term, it may impact your business, but that's why I seek your input on how we can work together to craft a sensible but effective remedy. Our markets are second to none because of the ability to innovate and develop creative solutions. I ask you to respond to this challenge with the same commitment you demonstrated in the municipal and government debt markets.

A second area where we need to work with each other more effectively is market surveillance and enforcement. We must have zero tolerance for wrongdoing, fraud and deceit in our securities markets. From the Commission's standpoint, we need regulatory access to comprehensive trading information in order to produce audit trails and other sophisticated market surveillance and enforcement tools. One specific tool I have asked for is the creation of a database of transactions and a surveillance program for the corporate debt market to better detect and prevent fraud. As many of you know, this is an area where until today there has been no organized system to proactively watch for abuse.

I recognize that institutional investors comprise the bulk of debt market trading. But this so-called "wholesale market" is not limited to sophisticated institutional counterparties. I challenge you to recognize that not all institutional investors are alike. While some are highly sophisticated, others have as little investment experience as a dentist managing his own retirement account or a treasury department of a small corporation.

The enormous diversity in experience and sophistication among institutional investors preclude the general application of a single "institutional" standard. As we have seen, the consequences of treating all institutional investors as though they were Fidelity can be devastating. Some institutional investors simply do not have the expertise in certain types of investment products or markets. So, they are compelled to rely on a dealer's analysis and recommendation in evaluating whether to purchase a security.

In these cases, the Commission believes that suitability rules have an important role in raising the ethical and professional standards of the securities industry beyond the minimum floor provided by the antifraud provisions. We worked closely with the NASD and the dealers to fashion a carefully drawn suitability interpretation for institutions, based on their capabilities and level of reliance.

We made allowances in the suitability rules for transactions with sophisticated counterparties. In applying these standards, you can take into account whether the institution has the ability and the independent judgment to evaluate the product it is buying. We think similarly tailored rules are the way to address questions of institutional markets – not a wholesale removal of protection for purportedly sophisticated institutional buyers.

We need to continue to work with each other to ensure that current regulations are continually adapted to meet the demands of 21st Century markets. I know that you have an interest in modernizing the capital requirements for broker-dealers, and I want you to know that I share your interest. In fact, we already have taken steps to incorporate modern risk management techniques into our net capital rule.

In 1997, the Commission allowed broker-dealers to use theoretical option pricing models to calculate haircuts on listed options and related positions. More recently, the Commission adopted a new regulatory structure for over-the-counter derivatives dealers – known as "BD Lite." These new rules permit OTC derivative dealers to use value-at-risk models to calculate their net capital requirements.

By allowing the controlled use of VAR models by OTC derivative dealers, the Commission will have an opportunity to gain experience with the use of these models – putting us in a better position to integrate statistical models and other risk management techniques into the net capital rule.

This is our long-term goal. However, I recognize the need for more immediate changes in our net capital rule to provide relief to broker-dealers. We have started a project to address ripe – maybe over-ripe – modifications to our existing rules. For example, we hope to develop a new methodology that recognizes more offsetting positions than under the current rule. We have asked the Association to come up with a wish list of short-term changes to the net capital rule, and we intend to move quickly to make any reasonable changes.

Another issue of interest is the new framework for exchanges and alternative trading systems adopted last December. This framework updates the Commission's interpretation of what it means to be an exchange, and gives alternative trading systems – which play an increasingly important role in the markets – a choice to register as an exchange, or to register as a broker-dealer.

Reaction to these new rules has been generally positive. But I know that some participants in the debt markets feel that the Commission may have gone too far, and that it should rethink its approach to regulating these systems – systems that become increasingly important week by week.

Frankly, I don't understand why some are so up in arms over this. The rules don't significantly impact the debt markets. As new proprietary trading systems develop for debt securities, some may choose to register as exchanges – a choice that did not exist before. Others will choose to register as alternative trading systems. These may be subject to some additional market requirements, but only if they grow large enough to impact the markets. I believe this is a considered approach that allows market participants to choose the role they want to play in the market.

The final issue I want to discuss involves the notion of balance. Now, that's not specific to any one issue or area; it's all-encompassing. One of the most difficult tasks all of us face is to look at an issue from the perspective of every actor in it, and arrive at a solution that neither sacrifices the dynamism of our markets nor the welfare of those who place their confidence in them. But, balance is not just the aim of regulators. It should concern anyone committed to the idea of free and open markets. If we have learned anything through our collective experience since our securities laws were enacted, it is this: the interests of investors and the interests of issuers, of corporate financiers, underwriters, broker-dealers, traders, and the many other participants in our markets – even when competing with each other – are not exclusive of each other. In fact, they merge, into one larger public interest for the benefit of all.

A good example of this was in the area of pay-to-play. Six years ago, the municipal securities business was rife with pay-to-play practices, and its reputation suffered accordingly. Because of the importance of these markets, I placed banishing these practices at the forefront of the SEC's agenda, and in 1994, we approved the Municipal Securities Rulemaking Board's Rule G-37.

The Association then called upon the American Bar Association and America's lawyers to join you in adopting rules to end this practice. We will see this summer if the lawyers will finally join you on that high ground – five years later – when the ABA has the chance to adopt an ethics rule prohibiting the practice that its House of Delegates called for last year. I hope they answer the call. Corruption has no place in a truly effective market, whether in our municipal bond market or the global market to which I know your attention increasingly turns.

* * *

I view the SEC's relationship with the Association as a strong example of the importance of the public–private sector partnership. Our partnership has not been without its disagreements. But, the fact is what we agree on is so much stronger than what we do not. And, when we recognize that and act in that spirit, we produce strong, sensible and realistic outcomes that represent balance and progress. And, that's what helps cement healthy capital markets.

The fundamental values of our markets – transparency, disclosure and trust – must remain signal priorities. Your individual and collective commitment to a system that honors and practices these values is absolutely necessary for long-term health and prosperity – not only for the debt markets – but for our country.

America's financial partnership between the public and private sector has been and will be a crucial element to our success. Working together, we have instilled a truism that goes to the very heart of our success: markets exist through the grace of investors.

I ask that we fortify this partnership; that we make it the most effective and productive in the world; and that we continue to serve investors' interests, the markets' interests and by extension – all of our interests.

Thank you very much.

http://www.sec.gov/news/speech/speecharchive/1999/spch268.htm