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QU.S.Securities and Exchange Commission;~ V/ashington.O.C.20549 (202) 272.2650

ReJIa%'ks of

David S. RuderChairman

United states Securities and EXchange CommissionBefore the 1988 Mutual Funds and Investment Advisers Conference

~cson, ArizonaMarch 21, 1988

A CHANGING ENVIRONMENT FOR :INVESTMENT COMPANIES

The views expressed herein are those of Chairman Ruder and do notnecessarily reflect those of the Commission, .other Commissionersor the staff.

I. The Investment Management IndustryGood Morning! It's a real pleasure to be here, in sunny

Tucson, at the 23rd Annual Mutual Funds and Investment AdvisersConference. As the size and great success of this conferenceshows, 'the investment company and adviser industry has grownenormously over the past 23 years. ~oday, it is one of thelargest and most successful sectors of the financial servicesindustry, with responsibility for managing the pension and otherinvestments of many millions of Americans.

Investment Danagement is a unique business under the law.It is a business of trust, and those in the business are held tothe highest standards of loyalty and care to their clients.Investor confidence in the investment management industry ishigh, and this confidence has been earned through many years ofhard work, excellent service, and strict adherence to fiduciarystandards.

As you are well aware, the services provided by investmentcompanies and professional money managers are extremely importantto individual Americans who don't have the sophisticat~on,information, or access needed to represent themselves effectivelyin t.oday'. markets. Mutual funds, unit trusts, variable lifeinsurance, and closed-end investment companies have become the

-vehicles through which more and more ordinary people choose toparticipat.e in the securities markets. They also give smallinvestors a chance to participate in investment opportunities

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previously limited to large investors, such as municipal bonds,money market instruments, and foreign securities.

~e environment in which investment companies and advisersoperate has chanqed dramatically, and will continue to change andbecome more competitive. The trading markets both here andabroad have also undergone .ajor changes, with the introductionof new products and new trading techniques. OUr awareness of thescope of those changes was brought home forcefully last October.The securities markets are now international markets. This meansincreased investment opportunities in foreign securities for U.S.money managers and an opportunity to reach new customersoverseas. ~t also means increased competition from foreign firmsfor u.s. investors' dollars. An additional development is thatit now appears likely that commercial banks will become fullfledged competitors in the securities industry, as Congress movesto eliminate the last vestiges of the Glass-Steagall Act. All ofthese changes provide both challenges and new opportunities.These three developments - (1) the October market break and itsaftermath, (2) internationalization, and (3) proposed repeal ofGlass-Steagall seem to me to be of particular significance.~I. The October Market Break

I know that the stock market break of last October, as wellas market conditions since then, are of great concern to all ofus. The Commission staff has completed a detailed stUdy of the

.events of last October and the Commission is engaged in effortsto make our markets more efficient and orderly. If you have been

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reading recent press reports, you may think that all we have doneis to launch a hostile takeover for the CFTC. Let me assure youthat our primary endeavor is to seek cooperative solutions to ourregulatory proble-s.

Understanding our current markets requires an understandingof recent changes in institutional investment activity. Duringthe last decade, institutions, inclUding investment companies,have amassed ever larger portfolios of equity securities.Increasingly, institutions want to trade all or a portion oftheir portfolios, not just individual securities. The creationof index options and futures made it possible, and relativelycheap, to buy or sell the equivalent of a portfolio ofsecurities. Use of the New York stock Exchange's automatedDesignated Order Turnaround system, called DOT, has also made itpossible to directly buy or sell at the same time an entireportfGlio or "basket" of stocks.

Prior to October 19th, some institutions were usingsophisticated index arbitrage and portfolio insurance strategies.Index arbitrage is the purchase (or sale) of stocks that comprisean index and the simultaneous sale (or purchase) of futures oroptions on that index. '!'hepurpose is to capture the differencebetween the value of the index and the collective value of theportfolio of stocks comprising the index. Arbitrage usuallyreduces differences in prices between the stock index futures andstock markets by pushing up prices in the market where the buyingoccurs and pushing down prices where the selling occurs. By

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helping to achieve closer price correlations between the stockindex futures and stock markets, arbitrage facilitates the use offutures to protect or "hedge" the value of stock portfolios. Themost obvious hedging techniques involving futures is the sale ofa stock index future by the owner of a portfolio of stocks. Thestock index futures position will increase in value as the pricesof the underlying stocks decline, thus protecting the portfolioowner against market decreases without requiring the sale of theportfolio securities •

•Portfolio insurance" is a hedging strategy that was inwidespread use before the October market break. Under oneversion of this strategy, stock index futures are sold When thevalue of the portfolio decreases a certain percentage. The salesof futures are thought to be less costly and quicker than thesale of stocks, offering a way of controlling risk for a broad-based portfolio in a declining market. If the futures marketsbecome congested and too costly, some portfolio insurance planscall for the sales of stock instead of futures.

With this as background, let me describe the markets of lastOctober. During the week before October 19, so-called BlackMonday, the Dow Jones Industrial Average dropped 250 points. OnFriday, October 16, the stock market had its first triple-digit

: loss, as the Dow declined 108 points on then-record volume of 344million shares. Then, on Monday, October 19, the Dow fell 508points on volume of more than 600 million shares. On October 20,volume also exceeded 600 million shares, in an extremely volatile

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market. On the 20th, the market rallied to close up 103 points,but only after a mid-day crisis during which the Dow dropped to a1987 low of 1,708, more than 1,000 points and 37 percent belowthe August 25. 1987 all-time high of 2,722. During this mid-dayperiod, a large number of blue-chip stocks were closed fortrading on the New York Stock Exchange, with larqe imbalances onthe sell side.

What caused the market break? According to the PresidentialTask Force on Market Mechanisms, selling during the week ofOctober 12th was triggered primarily by -disappointingly poormerchandise trade figures, Which put downward pressure on thedollar in currency markets and upward pressure on long terminterest rates: and the filing of anti-takeover taxlegislation ••••" 1/

These factors, with other economic news and the Friday stockprice decline, created great selling pressure on Monday, October19th. This pressure was exacerbated on the 19th and 20th bylarge stock and futures sales by institutions pursuing a varietyof arbitrage and portfolio insurance strategies. During certaincritical trading periods on the 19th and 20th, index arbitrage orportfolio insurance, or both, accounted for between 30t and 65tof total New York stock Exchange volume in the stocks thatcomprise the S&P 500 index. These figures lead to the conclusionthat on October 19th and 20th, institutions holding multi-billion

1/ Report of Presidential Task Force on Market Mechanisms, p.29 (January 1988).

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dollar portfolios simultaneously pursued similar strategies in adeclining ~rket, causing a rush for the exits that acceleratedthe decline and most probably extended it beyond levels that canbe accounted for by fundamental economic factors alone.

Extreme stock price volatility continued through the end ofoctober. While the markets are more stable now than lastOctober, they remain more volatile than before the aarket crash,as the ~40 point loss on January 8, ~988, vividly demonstrated.

Based on the detailed study of the market break made by ourDivision of Market Regulation, the Commission believes that oursecurities market is a linked market, formed by stock indexfutures, stock index options, and stocks. Further, we believethat, under current conditions, new institutional tradingmechanisms and strategies in this linked market can causeextraordinary peak volume and volatility. ~

The Commission has recommended three broad approaches forreform of the markets: (1) expanding the capacities of themarkets: (2) increasing the coordination among the markets: and(3) retarding the volatility and volume of trading during crisisperiods.

We intend to emphasize the first two: that is, expanding thecapacities of our markets and increasing intermarketcoordination in order to make the interlinked market moreefficient. We believe that, in normal times, the derivativeindex markets perform an important economic function. Theyprovide a means by which institutions may adjust their portfolio

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positions quickly and efficiently. We do acknowledge, however,that steps need to be taken in the near term to decreaseliquidity demands and avoid the selling excesses that have causedsuch unusual volume and volatility.

What specific steps can we take to expand the capacities ofthis new unified, and often turbulent, market? First, we canenhance the ability of our markets to handle trading volumesurges.

The key to this improvement will be the expansion of thestock exchange systems that receive orders electronically frombrokerage firms and in some cases execute these ordersautomatically, so that markets do not falter during peak volumeperiods due to lack of physical capacity.

In a sense, the advent of automated trading systems forstocks has increased risks for our markets, because Whenautomation breaks down the entire market is affected. I ampleased to report that a number of the stock exchanges alreadyhave increased the number of trades their automatic order routingand execution systems can accommodate. Newly establishedcommunication links between the stock, options, and futuresexchanges also will enhance information exchange about marketconditions.

At the same time, investment companies must take steps toimprove their communication systems. Investor complaints aboutinability to communicate with funds during the week of October19th are well known. Improvements are being made in investor

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communication facilities in your industry, and I applaud thisproqress.

A second important step is to increase ~e amount of marketmaking capital available in the securities markets. Among othermeasures in this area, the Commission is:

1) Examining the need to increase minimum specialistcapital requirements:

2) Encouraging market participants, including specialists,to review with their bankers the availability of additionalliquid funds in emergency situations:

3) Consulting with the Federal Reserve Board and the CFTCregarding capital availability for the stock, options, andfutures markets: and

4) Suggesting that the New York stock Exchange considercreating special areas on its floor for the trading of entirebaskets of stocks in order to relieve some of the strain on thespecialists responsible for trading individual stocks.

Even after the capacities and capital of our inteqratedmarkets are enhanced, there still may be times when marketmechanisms are under severe strain. The Commission isconsidering measures designed to retard the increased velocityand concentration of inter- and intra-market trading that in turnhas increased the probability of wild price swings.

One approach to the volatility problem is to recognize thatthe increased intensity of market trading is due in part to theqreater leverage of futures products. With low margins, large

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stock index futures positions can be established with arelatively small capital infusion, and then can be liquidatedvery quickly. In addition, the futures markets do not requirephysical settlement and do not have the abort sale restrictionsthat exist in the stock markets.

One method of slowing the futures "market, retardingexcessive accumulations of futures positions, and reducingliquidity expectations would be to raise initial margins on stockindex futures for non-market makers. The Commission basrecommended that, at least temporarily, these margins be raisedto levels barmonious with stock margin levels applicable to stockmarket professionals. This would mean initial futures margins of20 to 2S percent instead of the current level of approximately 13percent.

Other means of coping with market volatility have beensuggested. The Commission currently bas before it a ruleproposal giving the New York stock EXchange power to close itsDOT s¥stems to program trading in volatile markets. Othersolutions suggested in the various reports include imposing price-limits in the futures markets, establishing procedures forcoordinated inter-market trading halts, and delaying futuresmarket openings until the stock markets are open.. These topicsand others offer a broad range of choice to deal with marketproblems. I fervently hope that voluntary solutions can beachieved by interagency cooperation.

10III. International Markets

'!'husfar, I have discussed only our domestic markets. TheOctober JDarket 'turbulence was not limited to the U.S., but was aworldwide phenoaenon. The world's .ajor stock markets allexperienced downturns similar in scale to those in the U.s, TheOctober market break pointed clearly to the emergence of a trulyglobal market, and any examination of the extent to which today'smarkets are interconnected must include recQ9Dition that thoseconnections also extend across national boundaries.

International automation of quotation, routing, execution,clearance, and settlement systems are inevitable, and the timehas come to increase efforts toward a coordinated global marketregulatory system.

Two weeks ago I was in London where I had constructiveconversations with U.K. regulatory officials about the need forgreater coordination, and participated in a conference oninternational clearance and settlement. In February I travelledto To~yo where I had similar conversations with Japaneseofficials about cooperation and coordination. I believe the keyto sound international capital markets is to adapt the best rulesand policies of all nations to new market structures and tradingstrategies. In that regard, I believe that international marketregulation should address questions regarding} disclosurestandards: prohibitions against fraudulent activities;availability of quotation and price information; efficient andcompatible.national and international custody, clearance and

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settlement systems: broker-dealer qualifications and conduct:capital adequacy: and international surveillance and enforcementagreements. All of these areas are of current concern to theCommission.

Within an international framework it is, of course, alsotrue that invest.ent companies and investment advisers play a keyrole in the increasing global securities markets. Today, thereare over 100 U.S. funds, both open and closed-end, with more than$22 billion in assets, that invest principally in foreiqnsecurities. These funds have made foreiqn investing practicaland popular witb individual investors. We are also witnessingthe growth of foreiqn competition within the united States. Morethan 200 foreiqn firms are registered with the Commission asinvestment advisers. Many advise ERISA accounts regardingfore1qn portfolio investments and some act as advisers orsubadvisers to our new foreign portfolio funds.

So far, only five foreiqn investment companies proper areregistered for sale to investors in the U.S., perhaps becauseSection 7(d) of the 1940 Act continues to serve as a barrier toentry. That section prohibits any investment company notorganized in the u.s. from publicly offering securities unless itfirst obtains a Commission order reciting, among other things,that the provisions of the Investment Company Act can beeffectively enforced against the foreign fund. This standard hasbeen especially difficult for funds organized in civil, asopposed to common law, countries. In 1984 the Commission

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recommended legislation to amend section 7(d) in order to make iteasier for foreign funds to enter our markets. Z/ We are alsoexploring informally with Canada and .embers of the EuropeanCommunity the possibility of bilateral treaties for thereciprocal sale of investment company shares, a concept favoredby the European Federation of Investment Companies and also ofinterest to the Japanese.

In the meantime, we are continuing to work closely withforeign regulators to share information, coordinate our rules,and cooperate in performing our regulatory oversight andenforcement tasks.IV. Glass-Steagall Reforms

Major changes are also underway here at home throughproposals to modify or repeal the Glass-Steagall Act. Thesechanges are likely to affect your industry by permitting banks toengage in securities activities. I am pleased to say that itseems likely that if Glass-Steagall reform occurs, compromisesreached with the banking regulators will result in continuance ofinvestor protections.

The walls of Glass-Steagall have been under assault forsome time and banks have made many inroads into the securitiesbusiness without being subject to regulation under the securities

Z/ ~ Memorandum of the Securities and Exchange Commission inSupport of the Operating Foreign Investment CompanyAmendments Act of 1984, submitted to Congress with theapproval by the Commission in conjunction with the issuanceof Investment Company Act Release No. 13691 (December 23,1983). Although submitted to Congress, the proposedlegislation has not been introduced.

13laws. For example, banks are now underwriting and dealing incommercial paper, u.s. government securities, and asset-backedsecurities. They are sponsoring real estate investment trusts(REITs), and engaging in private placements of corporate debt,loan participations and sales, and interest rate and currencyswaps. Horeover, Glass-Steagall applies only to activitieswithin the United States. Banks are aggressively pursuingsecurities activities abroad, such as underwriting and dealing incorporate debt and equity. In the area ~at concerns you themost, banks, as a practical matter, are already widely marketingmutual funds and unit trusts to their depositors. GlaSS-Steagallonce was thought to be a complete barrier to such activities, buttoday it is a barrier full of gaping holes.

In December, I testified before the House and Senate Bankingcommittees regarding proposed legislation that would repeal theGlass-Steagall Act. I stated that the Commission could notsupport repeal of the Glass-Steagall Act unless the investorprotection concerns arising from increased bank securitiesactivities are simultaneously addressed. To ensure investorprotection, I said that bank securities activities must besubject to Commission regulation.

I also testified that if banks are permitted to underwriteand distribute investment company securities, the InvestmentCompany Act and the Investment Advisers Act must be amended sothat the protections of those acts are applied to banks. Becausethose two acts were drafted in the context of the separation

14between bankinq and securities mandated by Glass-steagall, theydo not'adequately address the investor protection concerns thatwill arise if banks are permitted to enqaqe generally in theinvestment company business.

At Senator Proxmire's request, the Commission staff met withthe Federal bank requlators to draft leqislative lanquaqeaddressinq the Commission's investor protection concerns. Thecompromise reached was included in the version of S.1886, theGlass-Steagall reform bill sponsored by Senators Proxmire andGam, that was approved on Karch 2nd by the Senate BankinqCommittee.

Under the compromise, banks would be required to conduct~securities activities throuqh broker-dealer subsidiaries oraffiliates, with certain exceptions:

First, a bank could conduct primary private placements, solonq as sales were limited to certain types of institutions andto individuals with a net worth over $S million.

Second, a bank could effect transactions for itstraditional trust accounts unless it both solicited brokeraqe andreceived transaction-related compensation. For other bank~iduciary accounts, such as mana qed aqency accounts, securitiessafekeepinq accounts, and self-directed IRAs, a bank couldprovide brokeraqe only if it neither solicited brokeraqe norreceived transaction-related compensation.

Third, a bank could enqaqe in municipal revenue bondactivities, but a bank with a securities affiliate would be

15required to conduct both general obligation and municipalrevenue bond underwriting in a registered broker-dealer.

Fourth, there would also be exceptions from securitiesregulation for networking arrangeaents with broker-dealers,sweep accounts, transactions for employee benefit plans and for abank's affiliates, and for banks that effected fewer than 1,000transactions per year.

In the investment company area, the compromise contains thefollowing provisions:

First, banks that advise mutual funds would be required toregister with the Commission as investment advisers and to besubject to Commission regulation and inspections. A bank,however, could register a separate department or division as anadviser.

Second, banks' custody and lending arrangements withaffiliated investment companies would be permitted only inaccordance with rules adopted by the Commission.

Third, investment companies would be precluded frompurchasing. securities in an underwriting where some or all of theproceeds would go to repay a borrowing from an affiliated bankentity, except that such activity could take place in conformitywith Commission regulations.

Fourth, the standards for eligibility as independentdirectors would be tightened by defining affiliated bankofficers, directors, and employees of banks that provide servicesto a fund as "interested persons." ,

16Fifth, the Commission would be given express additional

authority to require disclosure concerning the absence of Federaldeposit insurance for mutual funds.

The Commission now supports repeal of the Glass-SteagallAct, if it is accompanied by the investor protection amendmentsto S.1886 worked out in the compromise between the Commission andthe Federal banking agencies. Under these conditions, theCommission believes Glass-Steagall reform will lead to increasedcompetition in the financial services industry, withoutdiminishing important investor protections.

Now you may wonder Why in the world the SEC Chairmansupports repeal of Glass-Steagall. Well, for starters, we thinkinvestors will be better protected with the compromiselegislation we worked out than by continuation of the ~ factocircumvention and creative regulatory interpretation that has

"eroded Glass-steagall. To my mind, it has not been a healthydevelopment for the Commission to lose control over the bankingsegment of the securities industry -- not healthy, that is, ifyou want securities regulation to do the job intended byCongress.

In short, either with us or without us, with the blessing ofthe Congress or without it, Glass-Steagall is likely to crumble.The Commission is seeking to have the event occur in a sensibleway, for the benefit of investors. I urge you to do the same --to focus on the larger, public policy issues, and help to make

17sure that the changes are sound and provide protection toinvestors.v, Conclusipn

Changed market CODditions and increased competition at homeand abroad vill increase both the opportunities and challenges~aced by the investment company and adviser industry. As thesecurities markets become more complex and international inscope, as trading and investment strategies become moresophisticated, as information processing and analysis becomedominated by autaaation and expertise, investors will continue toseek out professional money management services. They will lookto investment companies and advisers to help them cope withtoday's volatile markets, where speed and immediate access arecritical.

This industry has an enviable record of innovation andquality service to investors. It is a well-run industry, and welike to think it is well-regulated, too. It is well positionedto meet and beat the competition in the coming years. The keywill be maintenance of investor confidence and trust. That isbest achieved, as it has been to date, by hard work, excellentservice, and strict adherence to fiduciary standards.