Speech by SEC Commissioner:
Regulating on Internet Time

Remarks by

Commissioner Laura S. Unger

U.S. Securities & Exchange Commission

Conference on Integrating Technological Advances for Online Brokerages,
New York, New York

September 22, 1999

I'm happy to be here today to share some thoughts with you on the appropriate role of regulation in the online brokerage world. Before I begin, I have to dispense with the obligatory SEC disclaimer: the remarks I'm about to make are my own, and do not necessarily reflect the views of the Commission, its staff, or the other Commissioners. If this was on the Internet, I bet you'd click through that disclaimer. Believe me, I would.

Assessing the Need For a Changed Regulatory Approach

I've been asked more than a few times whether the regulatory challenge brought about by the Internet and online brokerage requires the Commission to adopt a new regulatory approach. The Commission's regulatory mandate is to protect investors and to promote fair and efficient markets. So the question is really whether the Commission's current means of achieving these regulatory goals continue to be appropriate.

While the Commission has a great deal of direct regulatory authority, it is mainly a disclosure-based agency. Because of its power as a means of broadly disseminating vast amounts of information on an almost instantaneous basis, the Internet is potentially one of the best tools available to the Commission in enhancing disclosure. As a result, the Commission has encouraged the entities it regulates to take the maximum advantage of the Internet in disseminating information to investors. The Commission itself has made great use of the Internet to provide information to investors. In fact, we've recently opened a new investor education website at www.sec.gov/oiea1.htm.

So I will say that at this point, that I don't believe that online brokerage creates the need for the Commission to adopt an entirely new regulatory approach. However, it has changed investor behavior in a way that compels the Commission to adjust its regulatory approach somewhat. Online brokerage allows investors to participate more directly in the markets and creates a faster velocity of investor activity. In response, the Commission has moved to be involved earlier in the process.

One example of this is our enforcement efforts on the Internet. We have filed a number of cases involving similar violations together as part of concerted "sweeps." The most recent was an Internet offering sweep. In some of the offering cases, while investors had visited the sites allegedly making unregistered offerings over the Internet, no sales were made. However, by bringing a number of these actions simultaneously, we are able to get in early and send out a strong deterrent message before investors were actually harmed.

Even beyond the Internet and online brokerage, the pace of technological change itself has impacted the Commission's regulatory approach. With the industry operating on Internet time, the Commission has to move at a faster pace as well. Not keeping up with industry initiatives – whether novel or mundane – puts market participants at both competitive and financial risk. It also denies investors access to potentially beneficial products and services.

One thing I've heard over and over during the last year is that regulators shouldn't attempt to keep pace with the industry, but can't afford to fall too far behind. How does the Commission keep both from losing sight of, and unnecessarily holding back, online brokerage?

First, we can maintain an ongoing dialogue with online brokerages. The better the agency understands the online brokerage industry, the more effective it can regulate. In a 1998 Deloitte & Touche report on online trading, many of the firms interviewed expressed a belief that their regulators didn't understand the electronic trading environment.

We are trying though. In the first half of the year, our Office of Compliance Inspections and Examinations conducted examinations of almost 40 broker-dealers' online operations. The examinations were intended to provide the Commission and staff insight on the online brokerage industry. Of course, some may argue, that an examination is less than the ideal forum for a free-flowing dialogue.

As you probably know, since I mention it at almost every public appearance, I personally have made an effort to understand how online brokerage changes regulation by hosting a series of roundtables regarding online brokerage in the first half of the year. I am in the process of finalizing a draft of a report to the Commission detailing my findings and recommendations. The report should be publicly available within the next several weeks.

One approach to regulation we could adopt in this rapidly-changing environment is to be more goal-oriented. This would give firms flexibility in complying with regulations and accommodate their ability to keep pace with evolving technologies. This approach has proven very successful over the past several years. Examples of goal-oriented regulatory approach include the October 1995 interpretive release on electronic delivery of disclosure documents, the May 1996 interpretive release on broker-dealers' and investment advisors' use of electronic media, and the March 1998 interpretive release on U.S. firms' use of the Internet for offshore offers and sales. In all of these releases, the Commission avoided mandating the use of any particular technology to achieve a regulatory goal. This type of rulemaking makes a lot of sense in today's technologically driven marketplace.

Weighing the Effects of Current Regulatory Policy on
Market Growth and Liquidity

How successful has the Commission's current regulatory approach been? To answer that, you would need to examine its effect on market growth and liquidity. As we all know, online brokerage has made low commission trading available to millions of Americans. Trading volumes and the rate of individual investor participation in the equities markets are at all-time highs. Spreads have shrunk dramatically over the past several years, particularly in Nasdaq stocks.

Although it is difficult to quantify market growth and liquidity in the midst of the longest-running peacetime expansion and bull market on record, I am actually going to take credit for some of this market growth by attributing it to the synergy between online brokerage and the Commission's regulatory policy. My backup for this proposition is the tremendous impact that the customer Limit Order Display Rule has had on liquidity.

I know you will want to ponder this for a moment, but where would online brokerage be without the Display Rule? In the old days (1994), even if a customer was willing to enter an order that improved upon the NBBO, nobody knew about it because it was rarely displayed. The order would just be executed if and when the market moved to match it. The Display Rule changed all that. Now, most of the orders have to be displayed – increasing the likelihood they will be executed.

The combination of the Display Rule and online brokerage makes possible what I have heard is the ultimate investor empowerment experience. An online investor can enter a limit order that improves the NBBO in a particular stock. The investor can access a real-time quote and almost immediately see his or her limit order actually moving the market. If the investor's order is sent to one of the ATSs that makes its limit order book available over the Internet, the customer can actually watch the progress of their order through the book to execution. Now, I don't have an online brokerage account myself, but apparently it is the 'nirvana' of online trading.

The regulatory imperative for the adoption of the Display Rule was an instance of market failure – specifically, the collusive behavior found among Nasdaq market makers in the early 1990s. The Display Rule mandated a level of order handling and transparency that reinforced investors' trust of the online brokerage medium and the most popular market for online investors who favor Internet stocks, Nasdaq.

The Display Rule was not the only outgrowth of the Nasdaq market maker behavior. The Commission's simultaneous changes to the Quote Rule also represented significant intervention in market structure. Although the market was extremely wary – and generally not enthusiastic – about the rulemaking, the Commission correctly predicted its impact. I am pleased with the outcome - reducing spreads - but I am convinced that we need to tread very lightly and cautiously in dictating sweeping changes to market structure.

Recent Legislative and Regulatory Policy Initiatives

SEC Rulemaking

Now I'd like to discuss some of the more recent regulatory and legislative developments. On the heels of a couple of eventful rulemaking years, the Commission has been relatively quiet in that regard during 1999. As you may know, we imposed a Y2K-driven moratorium from June 1, 1999 until March 31, 2000 on implementing any Commission rulemaking that requires major computer reprogramming.

One rulemaking proposal that would directly impact online brokerages is the proposed broker-dealer operational capability rule. This proposal would require broker-dealers to have sufficient operational capability to conduct a securities business. The proposal seeks to avoid a modern version of the late 1960s paperwork crisis. Then, a rise in trading volumes to the staggering amount of around 15 million shares a day nearly caused a breakdown in the clearance and settlement process. As part of the Securities Acts Amendments of 1975, Congress gave the Commission rulemaking authority to adopt operational capability standards. The Commission, however, had never sought to exercise this authority until now.

I understand that online brokerages think that this proposal was targeted directly at them because of the proposal's proximity to some fairly well-publicized systems outages earlier this year.

First, I will tell you that the motivating factor behind the operational capability proposal wasn't online brokerage per se, but the increasing reliance of all broker-dealers – on-line and off – on technology. The proposal was an outgrowth of the Y2K operational capability rule proposed at the same time and subsequently adopted this summer. Both proposals actually reflect the industry's dependence on technology.

Second, the rapid growth in online brokerage and inevitable technology strain focused the media's attention on systems outages at online brokers. Some of this attention also came from customers' unrealistic expectations of the dependability of computer systems.

Maybe a little of the attention was self-inflicted by online brokerages' consciously or unconsciously raising customers' expectations about dependability. I will note that since this time, online brokers have done a decent job of trying to deflate customers' somewhat overblown expectations.

Turning back to the operational capability proposal, you may not be surprised and maybe you authored some of them, but the comments we received were almost uniformly negative. The commenters' biggest concern was that because the rule did not define "operational capability," it would not provide sufficient standards for broker-dealers to follow. The staff knew this could be a problem and correctly so. Several Commissioners, including myself, expressed the same concern when the rule was proposed. To be fair, though, we wanted to exercise caution by not dictating too specifically a systems standard for the industry.

The staff has gone back to the drawing board and is currently evaluating several alternative approaches. An operational capability rule would enable the Commission to take preventative measures before a broker-dealer's problems adversely affect its customers or the markets. Currently, the Commission can only address such problems by bringing antifraud and books and records violations after the fact.

The operational capability rule is yet another example where technology is forcing the Commission to modify its regulatory approach and get involved earlier in the process. Hopefully, the Commission will see a reproposal sometime in the near future.

Legislative Proposals

Market data is one issue close to the hearts, or at least the wallets, of online brokerages. It is also the subject of much attention on Capital Hill these days. Congress currently has three bills before it dealing with market data. They are:

• S.95 - The Trading Information Act;
• H.R. 354 - The Collections of Information Antipiracy Act; and
• H.R. 1858 - The Consumer and Investor Access to Information Act

In June hearings on the bills, the Commission came out in support of H.R. 1858. H.R. 1858 would prohibit the misappropriation of real-time market data and provide new federal remedies against those who violate the prohibition. The bill addresses the problem of information theft without disturbing the regulatory and contractual regimes already in place for the production and dissemination of real-time market data. The Commission has not taken a position on either S.95 or H.R. 354.

The market data issue is important to online brokerages and investors primarily because brokerages' provide certain products to certain online investors based on the cost of such data. The Commission has a statutory mandate to ensure that market data is available on terms that are "fair and reasonable" and "not unreasonably discriminatory." Earlier this year, the Commission announced that it would issue a concept release to determine whether the technological advancements of the past few years, including the Internet and online brokerage, necessitate any changes to our regulation of market data.

The Commission should receive the market data concept release sometime next month. The release will lay out in some detail the present scheme for the consolidation, dissemination, and pricing of market data, and invite public comment on a wide range of issues raised by market data. In addition, my own report to the Commission on online brokerage that I mentioned earlier will include a short discussion on how the existing market data scheme impacts online brokerage and what issues that the Commission should consider in the concept release.

Suitability Obligations and Online Investing

Returning to my report – which you knew I would – another issue I will address involves online brokers suitability obligations have to their customers. Online brokers have consistently told me that they do not believe that they have any suitability obligations because their customers direct their own investment decisions. In other words, brokers do not make recommendations to their customers and therefore, do not need to "know" their customers like traditional brokers do.

While that may be true when a broker merely provides execution services to a customer, when a broker personalizes the information that a customer sees online, the answer is not so clear cut. In fact, under some scenarios, the online broker most definitely would have a suitability obligation.

This issue becomes particularly nettlesome when you look towards future product development, which may be more imminent than we expect. I have heard from a number of firms that they collect information about their customers. According to the participants in the 1998 Deloitte & Touche sponsored survey I mentioned earlier, 100 percent of full-service firms, 62 percent of full-service discount firms, and 43 percent of deep-discount firms responding to the survey "segmented" their customers, profiling them as a particular type of investor.

Firms have indicated that they collect information about their customers because they want to send customized information. Several weeks ago, at least one major firm said that, although it has this information, it is unwilling to develop a product without knowing what suitability obligations would attach to that product.

Of course, this presents a "chicken and the egg" problem since it would be difficult to make a pronouncement on what suitability obligations would attach without knowing what the product would be.

I think the Commission would be amenable to clarifying some of these issues if we knew what the products were. Perhaps the best way to start is for us to provide guidance on what online activities do not trigger a suitability obligation.

Online Firms, Prudent Disclosures and Investor Education

In closing, I'd like to take a few minutes to discuss two related issues facing online firms: ensuring prudent disclosures and investor education. Firms and regulators clearly have common goals in these areas. Well informed and educated customers simply make good business sense. A knowledgeable customer who understands the potential risks of online trading and the difference between a market and a limit order is a conscientious investor and a desirable customer. A well-informed and educated investor also makes the Commission's job easier.

As for what makes good disclosure, my advice to firms would be to make sure to prominently display relevant information in plain English. Burying disclosure at the bottom of a webpage (even if it's the homepage) that investors are not likely to scroll down to see or hiding disclosure behind hyperlinks aren't practices I would endorse – the exception being the SEC speech disclaimer I made at the beginning.

As for investor education, I have noticed and am pleased to see that firms have stepped up their efforts in this area. Most online brokerage websites I've seen prominently display on their home pages links to educational information that is written in plain English. A number of websites contain links to SEC educational information. Again, these good business practices also serve SEC education goals.

Several of the firms that offer access to after-hours trading have also stepped up to the plate in terms of customer education and protection. I spoke at length on this subject back in April, before firms actually offered after-hours trading. I am pleased to see that firms have taken many of the steps that I mentioned in that speech. These steps include requiring customers to read special disclosure describing the unique risks posed by this illiquid trading environment, only allowing customers to enter limit orders after-hours, and making customers affirmatively opt in to trading after-hours. I would encourage other firms that plan to offer after-hours trading in the future to incorporate these features.

There are many more things I could say about technology and regulation, but I will stop here. Thank you for your attention.

http://www.sec.gov/news/speech/speecharchive/1999/spch298.htm