Speech by SEC Staff:
Trading Places: Mobility and the New International Financial Regulation

by

Ethiopis Tafara¹

Director, Office of International Affairs
U.S. Securities and Exchange Commission

Rendez-Vous With the AMF
Montreal, Quebec
October 15, 2007

Recent Changes to the World's Capital Markets

The recent series of actual and proposed mergers of US stock exchanges with foreign counterparts presents today's capital market regulators with the theoretical — if not currently actual — possibility of a truly global trading platform. Yet exchange mergers are only one aspect of the globalization of our capital markets, and perhaps not even the most significant aspect. Indeed, in some respects, recent and proposed mergers between stock exchanges such as the New York Stock Exchange and Euronext are a response to much broader market changes brought about by increasingly "mobile" investors, issuers and investment firms.

Mobile capital, clearly, is itself not new. Even the concept of the corporation developed in the 17th and 18th centuries was a way for the great trading houses of that era to attract the type of capital they needed to fund their overseas operations in Asia, Africa, and the New World. Investors in these early companies were drawn from wealthy families throughout Europe, and not just from the countries in which the companies were chartered.² In the 19th century, European investors funded the building of the Erie Canal and the transcontinental railroad.³ Indeed, firms such as Dow Jones and Standard & Poor's got their starts analyzing the canal and railroad industries for multinational investors seeking up-to-date information about the issuers in which they were investing.

The primacy of technology

Yet what we see today is both quantitatively and qualitatively different from the past. While cross-border investment is hardly new, in the past such investment was almost exclusively the province of the very wealthy and the very sophisticated. And even for the very wealthy and very sophisticated, investing overseas was a daunting prospect. Laws, currencies and business cultures differed, and even technology conspired to make cross-border transactions costly and uncertain. For example, Walter Wriston, the former chairman of Citicorp, once described how in the 1950s, his firm would employ a bank of telephones to maintain a connection to conduct just a single transaction on a South American market.⁴ Given the price of an international telephone call back then, even this simple technological advantage would have excluded most investors.

Today, of course, technology makes it possible for even a novice to execute a cross-border trade via a computer terminal. Indeed, many thousands of such trades are conducted each hour. In fact, from a purely technological perspective, there often is no difference today between conducting a transaction on a domestic market or a foreign market. Where exchanges have gone entirely electronic, market intermediaries — whether foreign or domestic — effectively are just nodes in a very large, relatively seamless, network. While an open-outcry trading floor might require an actual human being to be physically present in New York or Chicago to execute an order, an electronic network can allow an order to be executed from a computer terminal placed pretty much anywhere in the world.

The culture of globalization

But technological changes, as powerful as they have been, offer us only a partial picture of the vast changes that have occurred to our markets over the past several years. One quirk of history is that Congress created the SEC at precisely the same time that world capital markets were closing in on themselves. The Smoot-Hawley Tariff, the 1929 Crash, the Great Depression, and World War II suppressed international commerce of all types, and the cross-border trade in financial services was no different. Following World War II, widespread prosperity returned to the United States and this prosperity led to a large number of "average" citizens having sufficient savings to invest directly in the stock markets. That trend continues to this day, with more than half of all American households now directly or indirectly investing in securities.⁵

However, in the post-war period, most investors invested entirely or almost entirely in US stocks that were traded on US markets. Partly this was because the transaction costs of investing abroad were so high. But it was also because foreign markets were foreign. They were populated by unknown issuers, traded in strange currencies, and run under very different legal systems. In many cases, these foreign markets were also extremely risky places to do business, with economies just beginning to recover from the war. At the same time, US capital controls such as the Interest Equalization Tax made it very costly for Americans to invest in foreign securities, while foreign capital controls often made it difficult for American investors to repatriate any money they invested abroad.⁶

Today, of course, US investors are presented with a quite different environment. Technology and trade have made our world considerably smaller. Capital controls in most developed markets are a thing of the past. Furthermore, US consumers now buy foreign-made products every day. Many foreign companies are now not only household names, but in some cases major US employers. The average American investor is more "globalized" as well. International markets are now better covered by the US business media, and more Americans are likely to travel abroad for business or vacations than they might have in the past. In short, at the same time that the transaction costs of investing abroad have dropped, US investors have been increasingly exposed to, and perhaps even grown comfortable with, foreign issuers and the markets on which they trade.

Compounding this trend has been the increasing reliance the "typical" American investor places on institutions such as pension and mutual funds. Defined contribution pensions such as "401(k)" plans are now the norm for many American employees, and mutual funds offer retail investors an easy and cost-effective way to diversify their portfolio risk. Such funds also make it very easy for investors not only to invest in foreign securities (albeit indirectly), but also ameliorate through diversification some of the risks inherent in investing abroad.

There remains, of course, what economists call a "home country bias" when investing, particularly where retail investors are concerned. Nonetheless, recent data clearly shows that American investors — retail and institutional alike — increasingly invest overseas. Just between 2001 and 2005, US investor holdings of foreign securities of all types nearly doubled, from $2.3 trillion to $4.6 trillion. US investor ownership of foreign equities during this same period increased from $1.6 trillion to $3.3 trillion.⁷ Nearly two-thirds of American investors are now invested in non-US companies, a 30 percent increase from just five years ago.

Yet this is hardly just a US phenomenon. Investors in other countries, too, are increasingly comfortable investing in companies traded on markets outside their own borders — in many cases far more so than their American counterparts. By some estimates, 30 to 50 percent of all European stocks are now held by foreign investors, and in 2000 more than half the trading volume of the Tokyo Stock Exchange originated overseas.⁸

Emergence of the Transnational Stock Exchange

Given these investor trends, when combined with certain regulatory and business-model changes, cross-border mergers of stock exchanges seem more a response to a changing market environment than a cause of it.

Fundamentally, a stock exchange is just a place where a buyer meets a seller. Until the 20th century, technological limitations meant stock exchanges were mostly local or regional affairs, even where international investors were present. Originally, these exchanges were extremely local — in the New York Stock Exchange's case, first a clearing under a buttonwood tree, and then a coffee house, where brokers and dealers would gather to trade government bonds. Later, of course, technology would allow markets to become national. In a few countries (including the United States), technology and regulatory changes would even lead regional exchanges to compete with each other for issuers and investors. However, legal restrictions such as capital controls and other regulatory requirements effectively isolated markets within the confines of national borders.

Changes in legal, regulatory and business models over the past several years have brought down many of these national barriers and allowed — or in some cases, forced — exchanges to respond to the changing demands of investors and other market participants. Ironically, given some recent concerns about the "competitiveness" of US markets, it was the United States that led the way internationally in making stock exchanges more competitive with each other and more responsive to the needs of investors and issuers.

The traditional floor-based exchange is not just local, but also physically restrictive — as a practical matter, only so many people can fit on a trading floor at one time. As a policy matter, historically many exchanges also restricted the number of members as a way to limit competition. However, in 1975 Congress, concerned that separate, unconnected exchanges were leading to trading fragmentation and poor customer executions, directed the SEC to facilitate development of a national market system. As a result, the SEC required exchanges and market makers to publish their quotes and trade reports. As telecommunications technology improved, broker-dealers and others developed electronic communications networks ("ECNs") which reduced costs and added features that investors sought. Later, following evidence that Nasdaq market makers were themselves engaged in anti-competitive behavior, the SEC approved new order handling rules and promulgated Regulation ATS, which greatly enhanced the abilities of ECNs to compete with more traditional exchanges.

Today, in part as a result of these regulatory and technological changes, US exchanges and ECNs offer the most competitive order-execution services in the world. Greater competition among US stock exchanges has not only spurred even greater technological innovation, but has also led to a change in exchange business models. Rather than seek to restrict the number of members that trade on it, as exchanges historically have done, upstart ECNs and new electronic exchanges often wish to place their terminals and trading screens with as many broker-dealers, in as many locations, as possible. With electronic trading, liquidity no longer exists in a single location. Faced with this fact, the traditional member-run exchanges have encountered greater competitive pressure, as these new trading systems potentially offer investors better trade execution, at less cost. And anything that attracts investors tends to attract issuers.

In response to this new competitive environment, many exchanges around the world have demutualized. Some argue that, as for-profit corporations responsible to shareholders, demutualized exchanges may be better situated to raise capital, modernize, and compete in the global economy. But in shedding their guild-like traditional structures for the trappings of a modern company, exchanges have come under the same market logic that most other firms now face. The desire to expand market-share and attract issuers and investors has led these newly competitive exchanges to pursue mobile capital, mobile issuers and mobile liquidity wherever they can be found. Since exchanges are nodes in a rapidly expanding global capital market network, and nodes are only as powerful as the number of linkages they offer other members of the network, this competition has led exchanges to seek out alliances across borders, and, in some cases, merger partners.

Regulatory Implications

Today the SEC faces a very different market environment than it did 70 years ago when it was created. Issuers operate in a global market and seek capital globally. The market intermediaries the SEC regulates also operate in multiple jurisdictions and, frequently, are also regulated abroad as well. But, perhaps most importantly, today capital is both widely dispersed and mobile. More Americans than ever before invest in our capital markets and, increasingly, these investors also trade on foreign markets and invest in foreign securities.

This global capital market presents both promises and challenges to the SEC's mandate to protect investors, ensure fair, orderly and efficient markets, and facilitate capital formation. The promises include greater competition in the market for financial service providers, to the benefit of investors and issuers alike; an opportunity for investors to diversify their portfolio risk across borders more effectively and at less cost; and the ability of issuers to seek the lowest cost of capital wherever it might be. All things being equal, modern economic theory suggests such investment diversity is wise.

Of course, not all things are equal. Investing abroad entails additional costs. Under current regulations, foreign financial service providers cannot solicit US investors or offer advice unless they are registered with the US Securities and Exchange Commission. Many of these foreign firms are reluctant to do so because they are already subject to a full set of regulations at home. The result is that, when investing abroad, US investors often pay commissions twice — once to their US broker, and then again to the foreign firm that actually executes the trade. Countries also vary in the degree protection they offer investors and, perhaps most importantly, in their enforcement philosophies. Making matters worse, the same technologies that allow retail investors to look abroad for investment opportunities also allow fraudsters to look across borders for victims.

Given the trends noted earlier, some of the risks that a globalizing capital market poses are not necessarily different from the risks the Commission is grappling with under a changing domestic market environment. For example, to some extent, the effects of greater exchange competition have been felt in the United States for several years now, independent of any foreign competition, and the SEC is keenly aware that US markets must be monitored for anti-competitive behavior among various market participants. In fact, the SEC is considering a proposal by the NYSE and NASD to consolidate their self-regulatory functions in a way that would effectively insulate the new combined SRO from the business pressures of the exchanges and market intermediaries.

Other issues, however, are unique to the international environment. For many years now the Commission has been aware that the growing globalization of the world's securities markets poses unique enforcement risks where unscrupulous individuals take advantage of this US investor interest in foreign markets to defraud US investors. Historically, pursuing securities law violators when evidence has been located abroad presents challenges. It has been even more challenging for the Commission to repatriate defrauded investor assets if those assets have been secreted to another jurisdiction. In some cases, an entire industry has developed to assist those who commit securities fraud to move assets overseas and hide their activities behind shell companies.¹⁰

Likewise, issuers and market intermediaries operating in more than one jurisdiction may face unique costs in the form of different, overlapping, and sometimes even contradictory regulatory requirements. For several years now, the Commission has worked with its foreign counterparts to develop a converged regulatory approach that would minimize cross-border regulatory costs by creating an international consensus around a single set of high-quality standards. One example of this is the SEC's support for the accounting standards convergence project between the US Financial Accounting Standards Board and the International Accounting Standards Board. This convergence project has advanced so far that the Commission has just proposed a rule that would eliminate the requirement that foreign private issuers using International Financial Reporting Standards (IFRS) reconcile their disclosure statements to US Generally Accepted Accounting Principles.

Finally, cross-border exchange and market intermediary mergers themselves raise unique regulatory concerns because of the different regulatory systems that may apply to each merger partner. On one hand, as with issuers, the overlapping regulation may be inefficient and costly to the firms involved, without any real corresponding investor protection benefit. On the other, the resulting regulatory oversight may not be overlapping enough — there may be gaps in the oversight of the various national regulators, and conceivably these gaps could result in systemic problems should something go wrong.

A New Regulatory Approach for a New International Market

All of these factors can work to make the global market a scary place. Where fraud is widespread, investors become wary, and issuers are forced to pay more for their capital. If regulators are not careful, borders can become one-way valves, letting the bad guys in but keeping the good guys from pursuing wrongdoing abroad. When this happens, the resources a regulator might put into protecting investors can be wasted, since criminals might easily evade our efforts. For regulators, this presents a dilemma: we cannot effectively close our markets to the outside world, but openness could threaten our efforts to protect our market's integrity.

A tempting option might be to just give up. Regulations impose costs on issuers and financial firms. Ideally, these costs are more than offset by the benefit to investors — a benefit that accrues to issuers and firms in the form of lower capital costs and a greater willingness of investors to trade on our markets. Yet, if borders make combating fraud difficult, it can undermine even the best regulatory system, and regulations are left providing little corresponding benefit for the costs they impose on the law-abiding. When this happens, a regulator might be tempted to invoke caveat emptor.

However, the SEC's mandate makes this impossible. The SEC is charged with three overarching goals: protecting investors, making sure our markets are fair, orderly and efficient, and promoting capital formation. Closing our markets to outsiders and keeping our investors locked at home does not achieve any of these goals. Yet protecting investors from fraud while assuring them that they are getting the best investment opportunities available, and the best information upon which to base their choices, is a challenge. Meeting this challenge will require much greater coordination among the world's securities regulators than is now the case.

For the past two decades, the SEC has been at the forefront of building relationships throughout the world to better protect investors. These relationships have developed to the point where the next step may be possible — forging an alliance of like-minded regulators. While countries vary in their approaches to securities regulation, there are other jurisdictions that share the SEC's passion for investor protection and market integrity. The protections these markets offer investors mirror our own. If the SEC and its counterparts can build mechanisms that make our oversight and enforcement systems seamless, I believe that foreign financial service providers operating in the US should be able to substitute compliance with their home jurisdiction's regulations for compliance with our own through a system of selective mutual recognition.

Reciprocal and selective mutual recognition would end duplicative regulation and lower the cost of capital for US companies, but, more importantly, it would also increase investment opportunities while enhancing US investor protection and the SEC's ability to pursue securities law violators abroad. But before such an alliance is possible, certain bridges must be built. The SEC's investor protection mandate is ironclad, and the Commission must be confident that foreign partners share the same legal powers and regulatory philosophy. This assurance might take the form of a "comparability assessment" by which the SEC and a potential partner trade information about their regulations and how those regulations are enforced, to help ensure that our objectives and philosophies are the same. It might also include enhanced enforcement and prudential information-sharing arrangements to help ensure that, if fraud should occur, each will help the other prosecute the offenders and seek redress for defrauded investors.

This is a departure from past policies, but one I believe is worth taking. Our current regulatory approach is based on a model built when markets were local affairs. Now, the majority of US investors also look overseas for investment opportunities. The SEC's duty as the investor's advocate requires nothing less than that we face up to this new reality.

Endnotes

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¹ The Securities and Exchange Commission disclaims responsibility for any private publication or statement of any SEC employee or Commissioner. This speech/article expresses the author's views and does not necessarily reflect those of the Commission, the Commissioners, or members of the staff.

² John Micklethwait and Adrian Wooldridge, The Company: A Short History of a Revolutionary Idea 21-36 (2003).

³ Alfred D. Chandler, Jr., The Visible Hand: The Managerial Revolution in American Business 29, (1977).

⁴ Walter B. Wriston, The Twilight of Sovereignty: How the Information Revolution is Transforming Our World, 41-42 (1992).

⁵ Immediately following the First World War, US stock markets also expanded, as large numbers of retail investors invested in securities after having first been exposed to the market through the purchase of government War Bonds. However, following the 1929 Crash, this trend would reverse itself. See B. Mark Smith, A History of the Global Stock Market from Ancient Rome to Silicon Valley, 111 ( 2003).

⁶ B. Mark Smith, A History of the Global Stock Market from Ancient Rome to Silicon Valley, 167-168.

⁷ US Treasury data.

⁸ B. Mark Smith, A History of the Global Stock Market from Ancient Rome to Silicon Valley, 261, 289-290.

⁹ Amadi, Amir Andrew, "Equity Home Bias: A Disappearing Phenomenon?", Table 1 (May 5, 2004). Available at SSRN: http://ssrn.com/abstract=540662. Domestic investor holdings of foreign securities is calculated by the foreign equity assets held by the country divided by its stock market capitalization and foreign equity assets adjusted for its foreign equity liabilities, expressed as a percentage.

¹⁰ As an example of how securities fraud has become "disaggregated" across borders, with different elements of a securities fraud broken up among different "service providers," SEC staff have found that "legal service providers" in some countries market themselves over the Internet as providing others with assistance in establishing corporations or bank accounts in offshore jurisdictions, with oblique references to the jurisdictions' lack of enforcement information-sharing arrangements with other countries. See Ethiopis Tafara and Robert J. Peterson, "A Blueprint for Cross-Border Access to U.S. Investors: A New International Framework," 48 Harvard J. Int. L 36 (Winter 2007).

http://www.sec.gov/news/speech/2007/spch101507et.htm