SPEAKERS CONTENTS INSERTS
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RECOVERY AND RENEWAL: PROTECTING
THE CAPITAL MARKETS AGAINST
Wednesday, February 12, 2003
U.S. House of Representatives,
Subcommittee on Capital Markets, Insurance
and Government Sponsored Enterprises,
Committee on Financial Services,
The subcommittee met, pursuant to call, at 3 p.m., in Room 2128, Rayburn House Office Building, Hon. Richard H. Baker [chairman of the subcommittee] presiding.
Present: Representatives Baker, Ose, Manzullo, Hart, Brown-Waite, Harris, Renzi, Kanjorski, Sherman, Inslee, Moore, Israel, Capuano, Lucas of Kentucky, Clay, McCarthy, Matheson, Miller of North Carolina, Emanuel, Scott, and Maloney.
Chairman BAKER. I would like to call this meeting of the Capital Markets Subcommittee to order. It is my understanding that Mr. Kanjorski is on his way and will join us momentarily. I would first like to sayas I speak, here comes Mr. Kanjorski.
This is our first meeting of the new session, and we will have a very busy agenda over the coming weeks and months. March and April are particularly going to be time-consuming for Members. But I think we have a lot of important work to do. Today is certainly exemplary of the types of issues with which the committee will be engaged.
Page 2 PREV PAGE TOP OF DOC We will be in receipt today of a report from the General Accounting Office relative to their assessments of market participants' capabilities to help preclude or, in the adverse consequence, respond to another economic terrorist assault on American soil. And from the initial reading of the report and comments of those who will participate today, although all answers have not been found, it does appear that successful improvements have been in the making. And we look forward to having the committee's assistance in helping the regulators and market participants achieve the level of security needed to ensure that no one can bring our economic system to its knees, an extraordinarily important matter, and I am certain that the committee will return to it on many occasions as circumstances require.
But I extend my welcome to the Members and certainly to the Ranking Member Mr. Kanjorski, I look forward to working with you again this session. And the gentleman is recognized for any opening statement he might make.
Mr. KANJORSKI. Thank you, Mr. Chairman. I think I will move that my full remarks be made part of the record.
Mr. Chairman, first of all, I prize the relationship for the last 8 years that you and I have had as chairman and Ranking Member of this subcommittee, and really take great pleasure in the fact that we were able to rise to the occasion in providing terrorism reinsurance and restoring investor confidence in corporate America to some degree in the last Congress.
Today we are here to examine the physical problems that may exist in a future terrorist attack on the United States and what actions and efforts we should take and what legislation will be necessary to accomplish that end. Also, as I suggested in my amendment to our policy consideration of the committee, we not only should take into consideration the physical effects of a terrorist attack on our economy and our markets, but also what economic disasters could befall the United States, and to start looking at some of the necessary actions to prevent that or to provide the legal authority for appropriate action. And some of the witnesses that are here today representing the various and sundry areas would be instrumental in examining that, because, in my estimation, I believe that terrorism can cause unreasonable and untold loss of life in America, it can cause tremendous physical damage in America, but cannot threaten the national security of America. On the other hand, economic destruction or events could bring down the American economy and, in fact, America in its entirety.
Page 3 PREV PAGE TOP OF DOC So I think that not only do we have the opportunity to look at the physical effects on the markets and what we can do to shore them up, but also anticipating what economic occurrences may occur over the next several years that could really threaten the economy of the United States. And I look forward to working very closely with you in that end, and I move that my remarks be made part of the record.
[The prepared statement of Hon. Paul E. Kanjorski can be found on page 36 in the appendix.]
Chairman BAKER. Without objection, in their entirety.
Does any other Member wish to make any opening statement at this time? If not, then I would proceed to our first panel of witnesses, and welcome Ms. Davi D'Agostino, who is the Director of the Financial Markets and Community investment Division of the U.S. General Accounting Office.
I think all Members have been provided a copy of your report. Please feel free to summarize and give us any perspectives you think would be helpful to the committee. Welcome.
STATEMENT OF DAVI M. D'AGOSTINO, DIRECTOR, FINANCIAL MARKETS AND COMMUNITY INVESTMENT, U.S. GENERAL ACCOUNTING OFFICE
Ms. D'AGOSTINO. Thank you very much, Mr. Chairman. With your permission, I would like to submit my full written statement for the record, and I would summarize my remarks orally.
Chairman BAKER. Without objection. And all witnesses' testimony will be made part of the official record. Thank you.
Page 4 PREV PAGE TOP OF DOC Ms. D'AGOSTINO. Thank you very much.
Mr. Chairman, members of the subcommittee, I am pleased to be here today before you to discuss GAO's work on the readiness of the U.S. Financial markets to respond to potential terrorist attacks. The markets are vitally important to our Nation's financial system and to our economy. The devastating attacks on the World Trade Center on September 11th revealed that our markets could be vulnerable to such events.
Today I will talk about, one, how the markets recovered from these attacks; two, the limitations that existed in participants' readiness to recover; and, three, steps that regulators have taken to assure that U.S. markets are better prepared for such attacks and what more needs to be done.
First, because the attacks occurred in the heart of Wall Street, over 70 percent of the nearly 2,800 people who lost their lives worked at financial firms such as broker/dealers and banks. The attacks damaged or destroyed over 400 buildings, and electricity and telephone services were also severely disrupted. Facing enormous obstacles, the utilities, exchanges, and firms worked around the clock and used creative solutions to reopen the markets within days of the attacks. Our report has numerous examples of the amazing efforts behind the market restoration. Still, by that Friday, September 14th, broker/dealers that normally provide 40 percent of market liquidity were not fully ready to trade, and the industry and regulators chose to test the newly established telecommunications over the weekend. On September 17th, the markets reopened, trading record volumes. In retrospect, the markets probably would not have been able to open so quickly if certain organizations had been directly hit.
Second, the attacks also revealed limitations in the disaster planning of many market participants. In some cases firms did not have backup facilities, and others had located their backups too close to their primary sites. Some firms also found that the backup telephone lines they bought from different providers were routed down the same pipes or through the same switches as their primary lines. Our reviews of 15 important exchanges, clearing organizations, ECNs, and payment system processors from February through June 2002 showed that they had taken many steps to prevent disruptions to their operations from physical or electronic attacks. Most had also invested in backup facilities or other measures to be able to recover from such attacks, but many of these 15 organizations still faced increased risk to their operations.
Page 5 PREV PAGE TOP OF DOC For example, most organizations did not have complete plans to continue operations if the staff at their primary sites were incapacitated. Some of these organizations also faced increased risk of disruption from widescale disasters because their backup facilities were nearby.
Third, the financial regulators have taken some important steps to improve the resiliency of the financial markets to recover from future disasters, but these efforts are not complete. Banking and securities regulators issued a white paper that proposed recovery practices for crucial clearing and settling functions, but they have not made a similar proposal for trading activities. To better assure that trading can also recover in a smooth and timely manner following a disaster, we recommended that SEC take a leadership role and work with the industry to develop goals and strategies to resume trading. Such strategies could be based on likely disaster scenarios and should identify the organizations that are able to trade in the event that others cannot. SEC also needs to work with the industry to identify sound recovery practices for organizations to adoptto better assure they can trade after another disaster.
There will be a need to balance the business decisions and risk management trade-offs that individual market participants make with the need for a sound, viable plan for assuring the U.S. markets can resume important trading activities when appropriate. The 9/11 attacks showed that the market's ability to reopen depends on the readiness of key broker/dealers. The plans SEC develops will have to assure that sufficient firms are available to trade, and that customers' accounts at firms unable to operate can be transferred to others who can.
We also recommended that SEC improve its program to oversee operations risks at exchanges, clearing organizations, and ECNs. These improvements included making its voluntary program rule-based, and using a portion of any future budget increases to expand and retain its experienced staff and technical resources.
Mr. Chairman, this concludes my prepared remarks, and I would be happy to answer questions at any time.
Page 6 PREV PAGE TOP OF DOC Chairman BAKER. Thank you very much.
[The prepared statement of Davi M. D'Agostino can be found on page 56 in the appendix.]
Chairman BAKER. Our next witness is Mr. Robert Colby, Deputy Director, Division of Market Regulation, from the Securities and Exchange Commission. Welcome, Mr. Colby.
STATEMENT OF ROBERT L.D. COLBY, DEPUTY DIRECTOR, DIVISION OF MARKET REGULATION, SECURITIES AND EXCHANGE COMMISSION
Mr. COLBY. Thank you. Chairman Baker, Ranking Member Kanjorski, and members of the subcommittee, I appreciate the opportunity to testify before you today regarding the efforts since the September 11th terrorist attacks to better protect U.S. financial markets and institutions, and to address issues raised in the report released today by the General Accounting Office.
As the GAO recognizes in its reports, participants in the United States financial markets made heroic efforts to recover from the devastation of the September 11th attacks, with the result that all markets reopened successfully within a week after those tragic events. Nevertheless, the Commission and other regulators in the industry have engaged in wide-ranging and intensive efforts to consider the lessons learned from the events of September 11th and strengthen the resiliency of the financial sector so that we are better prepared going forward.
Page 7 PREV PAGE TOP OF DOC Immediately after the September 11th attacks, the securities industry recognized the need to develop more rigorous business continuity plans that addressed problems of wider geographic scope and longer duration. Market participants have taken a number of significant steps to improve their resiliency, including establishing more robust and geographically disbursed backup facilities for operations in data recovery, improving crisis management procedures, and seeking telecommunications diversity.
The Commission and other financial regulators have also been devoting substantial resources to projects designed to strengthen the resilience of the financial sector. For example, the Commission, working with the Federal Reserve Board and the Office of the Comptroller of the Currency, are in an effort to identify sound practices for business continuity planning for key market participants.
This past August we published for comment a draft white paper that focused on a small but critical group of participants in the U.S. clearance and settlement system. The goal of this project is to minimize the immediate systemic effects of a widescale disruption by assuring that the key payment settlement systems can resume operation promptly following a widescale disaster, and major participants in those systems can recover sufficiently to complete pending transactions. The agencies expect to issue the final white paper next month after an additional amount of consultation with the industry, and then incorporate the sound practices into their respective forms of supervisory guidance.
In addition, Commission staff has been reviewing on an ongoing basis the efforts of the organized markets to strengthen their resiliency in the post-September 11th environment. These markets have taken a variety of steps to improve their physical security, information system protections and business continuity capabilities, and Commission staff continue to work with them to further increase the robustness of their individual plans. In addition, we have been exploring with the markets the possibility of mutual backup arrangements.
Page 8 PREV PAGE TOP OF DOC As to the resilience of securities firms, the New York Stock Exchange and the NASD have proposed rules that would require all broker/dealers to have business continuity plans that address a number of important areas. We have also been working with the relevant industry associations, the SIA and the Bond Market Association, on their members' business continuity disaster recovery efforts.
To date, the Commission's intensive efforts have focused on measuring and ensuring the resilience of the U.S. clearance and settlement system because, in our view, that infrastructure is the single most important element of the securities markets. As a practical matter, securities transactions cannot be completed in the absence of a functioning clearance and settlement system. Accordingly, the Commission has given priority to initiatives that assure the prompt implementation of vigorous business continuity plans by critical participants in the clearance and settlement system.
The GAO report recommends that the Commission do more to assure the resumption of trading by securities markets and broker/dealers following a major disaster. We share the GAO's views regarding the importance of emergency preparedness of the financial markets, and generally agree with the report's principle: that the financial market should be prepared to resume trading in a timely, fair, and orderly fashion following a catastrophe. But we believe that different, in some cases more complex, policy considerations apply to the resumption of trading than to the resumption of clearance and settlement activities. Because trading activities is relatively fungible across markets and market participants, we are of the view that individual markets and securities firms are less critical to the securities markets than the key clearance and settlement utilities. Were any single securities market to become incapacitated, for example, we believe that trading could be shifted to one or more of the remaining markets. We recognize that sufficient advanced preparation is required for such an arrangement to work smoothly and promptly, and, as I indicated earlier, Commission staff is in the midst of just such an effort.
Page 9 PREV PAGE TOP OF DOC As to the resumption of trading by securities firms, in our view, strong business incentives exist for broker/dealers to develop robust business continuity plans for their trading operations. Trading operations, of course, are inat least in good markets, are a source of significant revenue for securities firms, and few would risk a situation where their competitors are in a position to trade and they are not.
I also note that as a provision of liquidity to the market by securities firm is voluntary; they cannot be compelled to resume trading activities.
Finally, there are critical policy considerations relating to the reopening of trading markets following a major disaster that could suggest not compelling the speediest reopening. Difficult judgments may be required to strike the appropriate balance between the desire to resume trading as soon as possible and the practical necessity of waiting long enough to minimize the risks that, when trading resumes, it will be of inferior quality or interrupted by further problems.
For example, in the aftermath of the September 11th events, many praised the decision to wait until Monday, September 17th, to reopen the equity markets as it allowed market participants the preceding weekend to test connectivity in systems and thereby better assure the smooth resumption of trading.
Despite these policy concerns, we nevertheless agree with the GAO that more needs to be done to prepare the securities markets for the resumption of trading in the event of a crisis. Specifically, the Commission intends to consider whether it should identify a time frame against which markets should plan to resume trading following a widescale regional disaster. We also will continue to work with the New York Stock Exchange, NASDAQ, and other organized securities markets to develop and test mutual backup arrangements for various scenarios, and we will pursue efforts to increase the resilience of important shared information systems such as the consolidated market data stream generated for equity and options markets. Any timing goal established for the resumption of trading markets could serve as a useful resumption benchmark for securities firms as well.
Page 10 PREV PAGE TOP OF DOC In addition, the Commission will consider developing standards in conjunction with the self-regulatory organizations to help assure that broker/dealers are able to provide customers prompt access to their funds and securities even in the face of widescale regional disturbance.
The GAO report also recommends that the Commission improve its oversight of operations risk by issuing a rule to require exchanges and clearing organizations to engage in practices consistent with the Commission's automation review policy, or ARP program, and by expanding the resources dedicated to that program. The Commission recognizes the critical role that technology plays in the securities industry and specifically the importance of having in place adequate safeguards and controls over information resources to ensure reliable and timely trading services to investors.
The events of September 11th underscored the financial markets' critical and increasing dependence on the integrity of their systems' infrastructure. In light of the GAO's recommendations, we will consider alternative mechanisms to improve the effectiveness of the Commission's automation oversight, including the appropriateness of rulemaking. We will also assess the additional resources that may be necessary to accomplish the objectives of the ARP program and the GAO report.
Thank you for the opportunity to testify, and I would be happy to answer any questions.
Chairman BAKER. Thank you, Mr. Colby.
[The prepared statement of Robert L.D. Colby can be found on page 48 in the appendix.]
Chairman BAKER. Ms. D'Agostino, it appears from the basic recommendations, there were principally two things I found of interest. One was the resource limitation on ARP staffing and their ability to only review perhaps 7 of 32 particular agencies on an annual basis, which means 4-1/2 years before you would make the full cycle. So resource allocation for the technical folks we need to make that system work is essential.
Page 11 PREV PAGE TOP OF DOC But number two, and I think Mr. Colby's closing comments spoke to it briefly, is the advisability of having rulemaking as opposed to voluntary participation as a result of the ARP program findings.
It would appear to me that most of what I have read from the industry perspective is that we should be careful not to mandate something, a particular standard or a particular time line or particular steps to be taken, because each shop is different, each conducts its business in a slightly different manner. But would it not be consistent with the report that we at least by rule adopt goals; that first, after whatever event may occurand that obviously is the difficult thing to predictthat efforts should be made for an immediate operability, but subject to some period of time to test? I think the lessons of September 11 was the Monday, September 17th success. Had it opened and stumbled, I think the repercussions would have been significant. Can't we get to acould we not construct a goal, an operational plan that would not so constrain individual companies or participant, but yet set a standard in place that would be mandatory?
Ms. D'AGOSTINO. Actually the ARP program and the ARP policy is sort of like a goal. It does not have very specific technical standards to which an organization must live up, and it is not with a huge amount of specificity that programs are reviewed. It is more of a performance-based-type policy and program that they operate with now, and that would be consistent with what we are recommending.
We acknowledge, I think, in our conclusions in our report the need for flexibility and for technology to continue to evolve and to have the opportunity to avoidwell, to ensure avoidance of a one-size-fits-all or a cookie cutter approach where everybody has to do the same thing, because of course there are many technology paths just as there are for physical security solutions and other issues.
Chairman BAKER. But you do believe that the ARP findings or recommendations should be in the form of a mandatory requirement as opposed to voluntary participation?
Page 12 PREV PAGE TOP OF DOC Ms. D'AGOSTINO. Actually they are mandatory on the ECNs now. SEC did pass a rule that makes compliance with the ARP by the ECNs required. So if we made that an across-the-board requirement for all organizations subject to ARP, it would simply even it out.
Chairman BAKER. Right.
Mr. Colby, listening to our exchange, do you have a concern or caution about mandatory ARP compliance or not?
Mr. COLBY. Let me drop back and explain why the ARP program is the way it is. It was developed a number of years ago, and it is a little different for the Commission, because it was a program of looking at the computer resources and the process of examining, assessing, evaluating computer resources is something that has been developing as automation has grown. So we did it on a voluntary basis in part because we didn't want to freeze into place something that was still in an evolving state, and it stayed voluntary because on the whole, given our influence over the self-regulatory organizations that it applies to, it has worked quite effectively.
Now, within the ARP process, it assesses, processes, and controls the system development mechanisms. There is room for differing of opinions. So our people might come in and say, we think that there is this weakness in your process, and the SROs may come back and say, well, we disagree.
I think the sort of rule that the GAO is talking about is one that mandates the process, in compliance with the process, as opposed to any particular result that would come out of that evaluation.
Chairman BAKER. But the compliance for the ECNs which is mandatory was principally centered, as I understand it, on the reality that they were not open outcry systems, they were a communications-based marketplace. And as I view the markets today, we are clearly moving rapidly to emulate that structure. And it would seemed to me that verification by someone that the communication skills and abilities, whatever the platforms may be, can have functionality even after the aftermath of one of these events would be advisable.
Page 13 PREV PAGE TOP OF DOC Mr. COLBY. We absolutely agree. The ARP rules that applied to ECNs were applied in part because of their structure, but in part because they are not in the same regulatory state as the self-regulatory organizations which we examine, review their rules, and have a lot of interaction. But the ECNs are typically private organizations, for-profit organizations, and so in that sense it seems it needed to be mandatory.
It also is a process-based approach, and so I think what they are recommending could be transferred over to the self-regulatory organizations.
Chairman BAKER. I have exhausted my time, but just one more quick question about the funding levels for the ARP program.
Mr. COLBY. Funding levels.
Chairman BAKER. Yes. Where are we? What has the Congress done in relation to that issue? And where is the agency with regard to requests for this year?
Mr. COLBY. As you know very well, we have had a funding problem over the years, and the ARP program is one of the things that has been constrained by those funds. Another practical problem that constrains that process isand this committee by moving to address itthat hiring the sort of people that go into the ARP process is quite difficult, partly because the government process for hiring is sort of skilled automation experts that we need is protracted, and partly because with the dot.com boom, these people were just not available.
Chairman BAKER. Well, your ringing endorsement of the Oxley-Baker bill has been duly noted. Thank you.
Mr. COLBY. And that is what I intended.
Chairman BAKER. Thank you very much.
Mr. KANJORSKI. Thank you very much, Mr. Chairman.
Page 14 PREV PAGE TOP OF DOC Most of your concentration has been on physical damage and a physical terrorist attack and what the implications of that are in the marketplace; is that correct?
Mr. COLBY. Our program both looks at physical and at information vulnerabilities.
Mr. KANJORSKI. But as a result of physical damage.
Mr. COLBY. Not necessarily. It also looks at the security measures that are taken with respect to cyberthreats and the like. Cyberthreats are quite difficult, of course, to predict and respond to, but it does intend to look at that, and it has been a focus of the ARP process.
Mr. KANJORSKI. If the attack on September 11th had, in fact, not taken place against the World Trade Center buildings in New York but in the Sears building in Chicago, has anyone done a study as to what the disruption of the market, if any, and the economic effect of the terrorist attack on the market, if any, would have been relative to what did happen?
Mr. COLBY. There is a very high concentration of critical financial markets in the Chicago area, and it is something that we have been focused on. Our agency, of course, is only the securities markets.
Mr. KANJORSKI. I guess I'm not directing myself, because that again goes to the question of physical damage. I am trying to say, has anybody said what the physical damage in the delay of opening the markets and functioning in a physical way in the market as compared to the economic impact of a terrorist attack was on the economy of the United States? In other words, I would like to know in that September period afterSeptember through October after the attack when we had the tremendous downturn in the market, was that a result of the economy, or was that just a result of fear in the marketplace and the failure and the time required to open the markets and get back to an orderly operation?
Mr. COLBY. I think it is indisputable that the immediate dropthere was a 3 percent drop on the day after the markets opened, was clearly a result of concern about what the terrorist attack meant. I don't think that the rest of the fall in the markets can be attributed to that directly. We have participated, but not been chiefly responsible, in economic studies done by what is now the Homeland Security Department about the economic consequences of a terrorist attack in trying to assess how the September 11th and how a possible future attack might affect the economy.
Page 15 PREV PAGE TOP OF DOC Mr. KANJORSKI. And have you participated in those, or should you participate?
Mr. COLBY. We have participated to provide our expertise, to try to give them a sense of what the impact on the markets would be. And then
Mr. KANJORSKI. If you can answer: The CIA Director today testified that the untested potential exists for an ICBM towith an atomic warhead to hit the cities on the west coast of the United States. Making the assumption that two 20-kiloton bombs were to hit either San Diego, Los Angeles, San Francisco, Portland, or Seattle, what would be the ramifications to the economy of the United States? And are we looking at that in terms ofare we just being functional and physical here in looking at how to handle the marketplace as opposed to what we have to think about the disruption of the economy?
Mr. COLBY. This level of response is the functional and physical. There are elements of the government that are looking at the broader consequences. It is being conducted in the context of the Homeland Security Department, and there is an entire community of which we are one small member whose title is The Economic Consequences of An Attack, and they are trying to both scope out what those sort of consequences would be and also what sort of steps might be necessary to respond to them.
Mr. KANJORSKI. So this committee should start thinking in terms of not only the physical consequences of terrorism, but the economic consequences of terrorism and other economic circumstances unrelated to terrorism as to what kind of structures and processes should be put in place in an anticipatory way in order to keep the economy sufficiently existing so that we don't really lose the war.
Mr. COLBY. The physical and functional is just the beginning of the process of trying to address what the consequence of a terrorist attack would be.
Chairman BAKER. Thank you, Mr. Kanjorski.
Page 16 PREV PAGE TOP OF DOC I want to recognize the gentleman from California and welcome him to his new capacity as vice chair of the capital market subcommittee. Mr. Ose.
Mr. OSE. Thank you, Mr. Chairman. Your wish is my command.
Mr. Colby, my questions really relate to the alternative means by which liquidity and transparency can be provided to the marketplace in the event of a catastrophe. If I understand the testimony of yourself and Ms. D'Agostino and the others who are going to follow, there is a certain level of redundancy between, say, New York, the Pacific, and the American and the NASDAQ and some of the other ECNs to the extent that New York Stock Exchange is prepared to trade the top 250 volumewise companies traded on NASDAQ. And I imagine there are similar relationships elsewhere. It is myI am aware that the NASDAQ folks have come forward seeking to haveI am trying to remember the language that they used, but to have the SEC designate NASDAQ as an approved marketplace for any number of reasons, one of which might be to facilitate liquidity and transparency in the event of a catastrophe.
Now, I have been working on this for 2 or 3 years. I am still interested in it. I am going to keep sending letters. I would like to know what the status is on the application that was filed in November of 2001 by the advocates for NASDAQ in terms of their application.
Mr. COLBY. NASDAQ's exchange application is still being processed. There were both practical, legal, and policy concerns. The most fundamental policy concern emanated from a concern of what an exchange should be. One of the first things we expect to do with our new chairman when he is confirmed is to move this application forward.
May I drop back and address the first part of your question, which is that we believeand I hope that NASDAQ will confirmthat from an operational standpoint, that they are just as prepared to address the sort of concerns about redundancy in their current status as they would be as an exchange. And so while there are very good reasons to be forwarding the exchange application, I am hopeful, and I think Rick Ketchum could confirm it, that the question of backing up the New York Stock Exchange and other markets is not one of the things that turns on an exchange application registration.
Page 17 PREV PAGE TOP OF DOC Mr. OSE. So what are the conditions that have yet to be resolved on this? I mean, 2 or 3 years is a long time.
Mr. COLBY. Two or three years is a long time. This is a monumental enterprise. The rules and rule changes that they submitted would fill half of this table.
Mr. OSE. Do all the rule changes still need to be vetted, or have you narrowed it down to a few?
Mr. COLBY. We have narrowed it down to a few major and a larger number of minor changes, but the minor are more minor. The sort of things that are still at issue besides the question of how much, what the nature of the market has to be, is a question of what is the scope of the registered exchange? What sort of representation must members be provided in the governance of the exchange? Because there is a statutory requirement for fair representation of members, and that has to be reconciled to a corporate, for-profit, ownership structure. Those are the primary issues.
The minor issues involve such things as what sort of short sale rules should apply, whether the exchange requirements about separation of member trading should apply to this sort of an exchange when it applies to all other sorts of exchanges. And there is a list of smaller issues, but those are the key ones.
Mr. OSE. It is my understanding that the governance issue had been resolved. And if I read, I think it was Mr. Ketchum's next testimony, they are, if I read this correctly, prepared to abide by the short sale rules that exist in NYSE today.
So, my time has expired, Mr. Chairman, but I would be following up in writing because I intend to get this thing resolved. No is an answer. But if it is no, let us get to it. All right?
Mr. COLBY. We agree. We hope to be moving it forward.
Page 18 PREV PAGE TOP OF DOC Mr. OSE. Thank you, Mr. Chairman.
Chairman BAKER. Thank you, Mr. Ose.
Chairman BAKER. Mrs. McCarthy?
Mrs. MCCARTHY. Thank you. This is my first day on this committee, so I don't know whether my questions are going to be that intelligent. But just listening towell, you both have been talking about, and then obviously with the heightened security on Friday, are we better off today than we were on September 11th? And how are we going to handle it? And just listening to the debate, and I know government runs very slowly, but just God forbid something did happen, and we are still waiting almost a year and three-quarters on waiting for some rules to come through so we can be ready to go the following day, hopefully, if we had an attack. Where are we today if something happened by the end of this weekend?
Mr. COLBY. We are much better off today than we were on September 11th, and I can give you some specific examples of things that have changed. There is still work to be done, and I think what you see is the GAO's pointing out that there is work to be done, but let us not minimize the work that has been done.
All the major markets have dropped back and looked at their resiliency and what they can be doing to continue trading in the case of a problem with their main trading site. The New York Stock Exchange will detail for you their plans for a backup trading site. NASDAQ has long had two separate locations. There are efforts well under way in the clearance and settlement system in order to create more diversity. The main processing sites have been relocated. And thereeach of the major securities firms, and I believe it is true for banks, though that is not our responsibility, have been spending the time since September 11th completely revising their business continuity plans to take into account the new realities, and many of them have already put in place more resilient operation centers. There are vastly improved coordination mechanisms betweenwithin the firm. Don Kittell will talk about the SIA's efforts with respect to command centers and business continuity planning.
Page 19 PREV PAGE TOP OF DOC And so I thinkI don't know if you would agree, Davithat we have come a very long way, but there is room to go farther.
Mrs. MCCARTHY. Because my only concern is, and this will be my final question, that when we had a heightened security on Friday, then the market, I believe, dropped quite a few points on Monday and Tuesday, if I am correct. My concern is obviously the security firms, they can only do as well as the confidence of the people that are buying their stocks. So obviously they are going to do everything possible to make sure that people feel confident. And I haven't seen anything, you know, out there to the general public on talking about how well we have done and how well we came back.
I was down on Wall Street a few days after September 11th, and to me it was amazing how everybody worked together. To me it was amazing how everybody just came together to get this up, because we certainlyas horrible experience it was, and I lost an awful lot of people from Camp Fitzgerald in my district, but the bottom line is, we can't let the terrorist win, because whether they are going to attack us or not, the majority of people do believe it is going to be New York or D.C. Whether it is true or not, that is what people believe in. And we have to doI personally think we have to do a better job on just getting it out to the normal consumer that we are ready, and it is not going to affect us the way it did on September 11th.
Thank you for your testimony.
Chairman BAKER. Thank you, Mrs. McCarthy.
I didn't announce earlier, but it is a general understanding that the recognition of Members for questions will proceed based on seniority by time of arrival. So the short message is if you are here on time when the meeting starts, you have got a good chance of getting recognized early.
Mrs. MALONEY. Point of personal privilege?
Chairman BAKER. Certainly.
Page 20 PREV PAGE TOP OF DOC Mrs. MALONEY. I am not a member of the committee, but may I ask unanimous consent to place into the record a statement? I have a conflict with another meeting, and I wanted to thank my constituents, Rick Ketchum from NASDAQ and Robert Britz from New York Stock Exchange, for appearing today and for all of their work in combating terrorism and getting our financial markets ready.
Chairman BAKER. Without objection, and certainly appreciate their efforts.
Mrs. MALONEY. Thank you, Mr. Chairman, and thank you for having this hearing.
Chairman BAKER. Certainly.
Ms. HART. Thank you, Mr. Chairman. I missed, unfortunately, a big piece of the GAO testimony, so I am going to ask Ms. D'Agostino a question that she may have answered already, so bear with me.
I understand the concern, I was on the committee when we went through September 11th and all the aftermath, the concern that everybody had about everybody being able to get back to work and everything going again. As far as recommendations that the GAO has made, do you rank the actual physical proximity of the alternative place where they would work if they can't be where they are supposed to be of any high importance at all, the physical proximity of sort of the alternative? You mentioned something in the testimony about thesort of always having an alternative place to be. Is that relevant, or is that something that is important?
Ms. D'AGOSTINO. I think we would say that it is very important to have backup facilities, particularly if you are a critical organization and no alternatives exist for your services and functions. And again, we do notGAO hasn't developed a position on the right number of miles between a primary and backup facility. I mean, we haven't even considered that. But clearly from our lessons learned from the 9/11 experience, having a backup facility to handle your operations or to take you far enough away from a widescale incident is a good idea. So I think that is about where we stand on it. But we think it is important to have backup facilities.
Page 21 PREV PAGE TOP OF DOC Ms. HART. Okay. You are not going to micromanage where and how and all those sorts of things, or you have no suggestions that are really specific in that way?
Ms. D'AGOSTINO. Not about mileage, but about functionality, yes, it is a good idea to have a backup facility that can perform your critical operations in full.
Ms. HART. There was anI was just reading the testimoniesa mention of 60 percent wasn't enough; 60 percent of your operations wasn't enough.
Ms. D'AGOSTINO. I believe 60 percent of the market liquidity was ready to trade represented by broker/dealers.
Ms. HART. Okay.
Ms. D'AGOSTINO. Forty percent was not ready to trade on Friday, the 14th of September. That 40 percent was not fully ready.
Ms. HART. So would you expect them all to be fully ready? Should they all be able to be fully ready with an alternative facility?
Ms. D'AGOSTINO. I think that is a question for the SEC and the industry to work out in its strategy and plan for restoring market operations or trading operations after a disaster.
Ms. HART. Since the SEC is here, what do you think about that?
Mr. COLBY. Well, I don't think you can plan or try to compel everyone to be able to come back, because you don't know what the consequences could be. And, frankly, we don't need to because we have multiple competing providers of services. There are two positive consequences from that. The first is that many clients can just move. If one broker is not operational, they use another broker. And because of that, the brokers have very strong incentive not to have their customers leave them, so they have strong business incentives that align with the government objectives in order to be able to continue operating. And it is most true with respect to the securities firms. It is also true with respect to securities markets, because there are very few products, publicly-traded products, in this country that are traded only in one location, which gives a built-in resilience to the system.
Page 22 PREV PAGE TOP OF DOC Ms. HART. Are you hopeful then that as this issue is beingcontinues to be examined, that most organizations involved will certainly, as a matter of their own survival, make the best plan they possibly can and expend whatever resources they have at their fingertips to be able to do that? It is going to be a huge cost to them.
Mr. COLBY. It will be a huge cost, and I think we have to keep those costs in mind particularly in an environment where there is not just one central utility that is providing the service, but a number of competing entities.
It is said that the shelf life of a securities firm must be measured in weeks. If they are not operational and their competitors are, their business is gone very quickly, and it may never return. And so securities firms have an incentive to operatewhich is not to say we don't need to set guidelines and objectives and standards, but I think the incentives are aligned.
Ms. HART. Thank you, Mr. Chairman.
Chairman BAKER. Thank you, Ms. Hart.
Mr. EMANUEL. Thank you, Mr. Chairman.
As somebody representing Chicago, and as a former board member of the Chicago Mercantile Exchange, as I listen to your testimony and read the report, more and more what you seem to have talked about was the physical location. And given that more and more trading is going electronic, away from the open outcrytalking about my areawe have the options exchange and the clearinghouse most specifically that has been a concentration. I kind of recognize the problem of dealing with cyberterrorism. But given where the markets are going every day increasinglyI do think you have to worry about physical location, backup facilities, dealing with the clearinghousemy bigger concern is the electronic piece of this market, where the market really is going tomorrow, and less about the physical locations.
Page 23 PREV PAGE TOP OF DOC I am notgiven that we have the Board of Trade, the options, and the Merc and the stock exchange in Chicago, I do care about the physical locations, but if you just look at the trading future of where they are going, where handhelds are now on the floor, I am more and more interested about the electronic piece of this business and not the physical location of it.
I may have to go into a witness protection plan now that Chicago hears I could care less about the physical. I don't care less about it, but what I care about is what is going on electronically and what you are doing to protect that. And as you said, it is the most difficult part of what we have to do, and yet if you look at where trading is today and how it is moving tomorrow, it is almost purely electronic, and you could do that by each of the exchanges and go through them and talk about what their futures are like. And having sat on the Merc board, that was the preoccupation of the board for a long time, and that is where the exchange is going now.
Mr. COLBY. You are right in pointing out that the physical threats are less significant if you have an electronic market, because as long as you have dispersion between your operating centers, the market can continue. In fact, some of the markets that have physical floors, have as their backup plans an electronic market. So they recognize that, though that is not where they want to go to, but if they have to maintain their operations, they can do it electronically, which then puts a premium on cybersecurity. And this is something that it is very much a focus. It is a focus for the government, from the President's Committee on Infrastructure Protection right on through down to our level. And there have been a lot of measures taken by the various markets and clearance and settlement systems to try to assess and protect their information security.
Mr. EMANUEL. Well, I want to drive this point home, because as I look at this report, obviously you have the shadow of September 11th that hangs on it, but the truth is I don't want to protect for September 11th alone. They are not going to just do a repetition of September 11th. We have to actually prepare for the next attack that is going to be, in my view, a lot different than September 11th. And we have to deal with where our exchanges are going, where our trades are going.
Page 24 PREV PAGE TOP OF DOC And my one last comment as well as question is given that a lot of these functions todaythe clearinghouse in Chicago is really a consolidation for the different exchanges. That consolidation actually makes it at one level economically efficient and another level a far greater target forand easier to disrupt for a terrorist organization. And I don't even know if thatthat is more of a statement than a question. So, given the trends of what is going on in the industry, I want us to be thinking about the future not so much about laying in place the protections about what happened in the past and only the past. Thank you.
Chairman BAKER. Thank you, Mr. Emanuel.
Ms. BROWN-WAITE. Thank you, Mr. Chairman. I apologize for not being here sooner; I had some constituents from my district.
This question may have already been answered, but have the agencies actually reviewed the inter-agency white paper that set a goal that may be so costly and unreasonable that it would be unachievable? Have you done an economic analysis of what this recommendation would mean to the industry? And I think I would ask this to Mr. Colby.
Mr. COLBY. We have tried to do an economic analysis. We received comments on the one that was initially put out. We are in the process of revising it. We plan a process of consulting with the firms to try to assess what the impact of the revised statement would be in order to try to take into account the cost impacts.
Ms. BROWN-WAITE. But do you actually have an estimate of what the cost impacts are?
Mr. COLBY. We have a sense from the people, the firms that would be affected, of what the costs were. These are, of course, proprietary expenses. We have not made them public, but we have been pursuing with them what the costs would be.
Frankly, a lot of the cost depends on the implementation schedule, because if it is something that can be worked into their computer planning and automation development, it is much less expensive than if it has to be done immediately.
Page 25 PREV PAGE TOP OF DOC Ms. BROWN-WAITE. Thank you, Mr. Chairman. I yield the rest of my time.
Chairman BAKER. Thank you very much.
Mr. SCOTT. Yes. Thank you, Mr. Chairman.
In the wake of 9/11, of course, we have put together the Department of Homeland Security. I would be interested in knowing both of your opinions.
What do you see the role that the new Homeland Security Department will play in ensuring that we have continuity in the event of another terrorist attack and in preparation, particularly as it relates to business continuity and investor confidence?
Mr. COLBY. The topic of business continuity and investor confidence is one that is important to the homeland security. To date, they have been interacting with the group that was set up before the Homeland Security Department called the Financial and Banking Information Infrastructure Committee, chaired by the Treasury Department, of which we, the bank regulators and a number of other agencies, are part.
They have been working through this group in order to try to coordinate policies and improve the development. But from our interaction with them, it is very clear that this is a matter that is of concern to that Department.
Mr. SCOTT. Are you satisfied with what the Department of Homeland Security is doing or projected to be doing to ensure that our markets will continue to operate? Is there anything else you would recommend?
Mr. COLBY. My sense is that they are taking this very seriously, and it is going to be one of the important items on their agenda.
Mr. SCOTT. Okay. Thank you Mr. Chairman.
Chairman BAKER. Thank you, Mr. Scott.
Page 26 PREV PAGE TOP OF DOC Ms. Harris.
Ms. HARRIS. Thank you, Mr. Chairman.
With a follow-up to Ms. Brown-Waite's question concerning technology, is there an overall assessment concerning cyberterrorism and how this would affect the financial markets?
And then secondly, how would you characterize the state of preparedness with regard to future terrorist attacks and how they will affect our financial markets?
Mr. COLBY. I did not hear the last question, I'm sorry.
Ms. HARRIS. How would you characterize the state of preparedness of our financial markets with respect to future terrorist attacks?
Mr. COLBY. Cybersecurity is, obviously, more amorphous than physical threats because with physical threats you can assess a particular location or building and say, what happens if that was damaged?
Threats can come in a variety of different shapes and forms, but there are very active efforts on the part of the financial institutions and the self-reporting organizations that are dependent on informationand the securities markets are, at base, an information businessto protect themselves from the threats that could disable their operations or create polluted information flows within the system.
So our sense isand we are not alone in looking at this, but a number of consultants and advisers have looked at itit is something that you need to stay focused all the time, but the efforts that have been dedicated to it have been very extensive and effective.
The overall state of preparedness has come a long way. We are in much better shape than we were on September 11, but there is more to be done. I think that both the agencies that are in charge of it, the self-regulatory organizations that operate trading markets and oversee members, and the financial firms themselves, are all very focused on preparedness at the very highest levels of their institutions. It went from being one more cost item to being a critical matter for each of these institutions.
Page 27 PREV PAGE TOP OF DOC Chairman BAKER. Thank you, Ms. Harris.
Mr. INSLEE. Thank you.
I wanted to ask about your findings on the automated review group, the ARP. You seemed to suggest thatand I missed your oral testimony, I am just reading here, I am sorrybut you seem to suggest that there were inadequate resources to really complete some fundamental reviews. I think you noted that there were only 7 out of 32, if I read your testimony right, that have been completed, which to me was a pretty glaring failure given the risk to these markets.
Is thatfrom your review, is that simply a result of lack of resources and appropriations to the SEC? Is there some other inhibition? What is the reason for that failure?
Ms. D'AGOSTINO. The resourcesthe automation program could use more resources and more experience levels. The problem isand this is true pretty much throughout the government, it is not unique to the SEC; even GAO has some challenges in this area of human capitalgetting good technical people and being able to pay them enough to retain them.
In saying that, I don't mean to belittle our recommendation. It is not just an SEC problem, but it is an important program, we think, from the standpoint of the markets. It is the only oversight program going that does what it does. It has been particularly challenged in terms of being able to handle high turnover rates, low staffing levels, sometimes as low as three to four people. They are now up to 10, I believe, to handle 32 market organizations.
As I think our report mentioned, Federal standards recommend reviewing high-risk organizations once every year or two. This puts the SEC program in a kind of straits.
Mr. INSLEE. This is one of the reasons we were concerned when the administration tried to cut the SEC budget, at least below what it was promised. We hope at the end of this budget cycle that sanity is restored and we get resources for getting this done. Thank you for letting us know about that.
Page 28 PREV PAGE TOP OF DOC Ms. D'AGOSTINO. Thank you.
Chairman BAKER. Mr. Renzi?
Mr. RENZI. Thank you, Mr. Chairman.
Thank you, Ms. D'Agostino and Mr. Colby. I appreciate your time and the detail and the professionalism of your report.
I come from the wildlands of Flagstaff, Arizona, and recently I had an opportunity to sit in on a contingency where a regional attack was simulated at the Northern Arizona University dome. We had the firemen and we had the police out there, and we had helicopter crews come in. It was a regional attack.
I learned that the rail runs through Flagstaff and the major highways run through Flagstaff, and a big gas oil line runs through Flagstaff. I also learned that a communications hub is in that area, one that goes all the way to communicate to the east coast.
I said to myself, if we had a regional attack and it knocked out the ability of L.A. to trade in New York, and we set up this bicoastal confrontation between the L.A. investors not being able to invest if the market stayed openor would it close? What would happen if all of a sudden we had this East-West conflict based upon regional attacks, particularly in the West, if you don't mind?
Ms. D'AGOSTINO. From a telecommunications standpoint?
Mr. RENZI. Telecommunications, and a communications hub.
Ms. D'AGOSTINO. The telecommunications infrastructure network involves more than single paths for communications to go through, and many different options for switching. So it is not clear that
Mr. RENZI. That one would be knocked out
Ms. D'AGOSTINO. You would have to really know where everything is.
Page 29 PREV PAGE TOP OF DOC Mr. RENZI. When you look at the manufacturing industry and you look at upstream suppliersI am sure you look at upstream suppliers or vendors who provide you with integral portions of what it takes for you to do businesshave you looked from a contingency standpoint at all those integral nodes; not only communications, then, since we are able to go on a different path, but all the upstream providers that are integral to your operation from a contingency standpoint, like a manufacturer operation would look upstream?
Ms. D'AGOSTINO. GAO has not done such a review, to my knowledge.
Mr. COLBY. You as the securities markets are supported by a lot of suppliers that provide various services. Some of them are regulated, some are not.
We have been looking at the regulated ones within the limitations of our resources, and we have been talking to the securities firms about themselves checking about the resilience of their providers, their service providers, because they rely on vendors of various types. So since September 11 there has been an extensive amount of back-checking about resilience.
Mr. RENZI. Right. Any great organization has an Achilles' heel. That is what I am going for here. I am just a small businessman from Arizona is all, but my instincts tell me that if we look at the stock market and we look at other avenues to attack the stock markets, which is in the direct crosshairs of the terrorists, that next time they are going to be smart enough to attack somewhere that directly affects the stock market without attacking New York. So in your course of discussions and development on this, I would urge you to maybe take a look upstream. Thank you.
Chairman BAKER. Thank you, sir.
Mr. ISRAEL. Thank you, Mr. Chairman. I apologize for being late. The Committee on Armed Services has a hearing in conflict with this, so I have been shuffling back and forth.
Page 30 PREV PAGE TOP OF DOC Several weeks ago I visited with a local company in my district called Applied Visions. They are working with the Defense Advanced Research Projects Agency to develop software that would protect financial institutions and others against a cyberattack, and helps people assess the likelihood of a cyberattack.
One of the things that I learned at that meeting was that some financial institutions in the New York area, I believe the New York Stock Exchange and others, have created a kind of voluntary association, a kind of collective self-defense pact against cyberterrorism. They work together to monitor potential attacks, and then they alert each other if they believe an attack is imminent against any of those that are included in that group.
The problem is that if they are aware of a potential attack against a financial institution outside of that group, there is not much that they can do about it. They do not necessarily share that data. So here you have a group that has the potential of protecting a large number of financial institutions against a cyberattack, but does not have the wherewithal or the ability or willingness to alert the broader community.
I was wondering whether in your research you were aware of that group, and whether you can make specific suggestions on how it can be broadened to provide the greatest extent of protection to the largest number of financial institutions, rather than a select few.
Mr. COLBY. That is not the only group operating, fortunately. There are other channels to get the information out. There are a variety of information dissemination groups, ISACs they are called. There is one in the securities world operated by SIAC.
Also, on the government level there is a process developed through this FBIIC channel so when a regulator learns of something that affects a regulated entity, they communicate it up so that at a much higher level you can look and see, if there is a pattern here. Once the pattern is identified, the threat can be communicated back down to all people that might be potentially threatened.
Page 31 PREV PAGE TOP OF DOC Mr. ISRAEL. Are they required to communicate that threat?
Mr. COLBY. There is not a specific rule that requires it, but in practice it is expected and it does happen, because there is a interconnection between the securities firms and their self-regulators; maybe not quite daily, but a very close interaction beyond that; so this sort of communication is expected to be communicated into the channels and madeand it has happened. It has happened where the firm will say, look, we have just had a problem. The regulators then say a firm has just had a problem. We think it is internal, but we then canvass and check and see if anyone else is having the problems in order to identify whether it is a generalized problem or infectious, or an internal glitch.
Mr. ISRAEL. One final question. Do either of you believe that the current systems that are available to assess threat are effective, or do we need to improve the software or improve other systems so that we are better equipped to assess a potential cyberattack against financial institutions?
Ms. D'AGOSTINO. I know there are a number of software options out there. I know some very large multinational corporations have even developed their own threat and risk assessment and risk management software.
The important thing is the inputs into the decision-making models that the software represents. That would involve some good intelligence information about the threats and who is targeting you and what kinds of possible scenarios. It is development of reasonable and, I guess, viable scenarios for you to play out, then, through the software.
So just as important as software solutions are getting that good data and those viable scenarios to input through those models and get you some reasonable outputs to assess then, and to make decisions on your security solutions.
Mr. ISRAEL. Very good. Thank you. I yield back, Mr. Chairman.
Page 32 PREV PAGE TOP OF DOC Chairman BAKER. Thank you, Mr. Israel.
I want to express to each of you and the agencies you represent my appreciation for your appearance and your work.
Mr. MANZULLO. Mr. Chairman.
Chairman BAKER. Sorry. You are recognized. I apologize.
Mr. MANZULLO. Thank you.
Thank you for coming. I am sorry I was not here for the testimony.
Ms. D'Agostino, as I read the testimony, on page 4 it is absolutely startling that companies that are professionals in back-ups and redundancy systems for the purpose of security and storage of equipment in many cases never took the time to track the path or switches, so that a company's main path or switch would also be the same path or switch of the company hired for the redundant system.
That is pretty dumb. I don't understand how a security company could hold itself out as being an expertand I see some guys back there nodding their heads, ''Yes, maybe we got ripped off.'' ask for your money back.
But even under a situation where there had been, for example, a fire in the building and not an act of terrorism, this statement is absolutely startling. I am not one big into licensing for professionals, but in your investigation, the people that install these redundant systems for backup of material, et cetera, are they held to a particular licensing standard or a degree of education? Is there some kind of a professional path, or do they just have a nice white business card with a nice emblem and their name is printed in gold?
Ms. D'AGOSTINO. We don't really have any information. We didn't do any work on that. I think in some cases, as was relayed to us, the backup or alternate providers of telecommunications actually did have at one time separate lines and paths; but then later after the contract, sometime later and without notifying the client, moved the paths into the same lines as Verizon.
Page 33 PREV PAGE TOP OF DOC Mr. MANZULLO. That would be a breach of contract, as far as I am concerned.
Ms. D'AGOSTINO. We
Mr. MANZULLO. That is none of yourbut that is extremely serious, because the companies hired to do this areboy, I woke you government employees up there, didn't I? Everybody is nodding and saying yes.
I don't have a very technical background and don't understand a lot of these terms that are used in communications, but I justwhat I see here is a good-faith effort on the part of these houses to back up their system. You don't anticipate an emergency such as September 11, but they do anticipate somebody getting into their system and screwing up their lines. They do anticipate, you know, a flood or water getting into the basement, or a lightning strike, or a surge, or a fire on their premises.
Here in good faith they hire these firms, and initially, as you said, there are separate lines. Then the lines get merged by the security firms. I consider that to be a very serious breach, and there has to be a tremendous amount of responsibility that is placed upon those companies before setting up a system like that.
You don't have to respond to that. This is more of a comment.
Mr. COLBY. I would just say this is something that came as a surprise to many, including the firms that believed that they had built redundancy. Apparently, as Davi said, they contracted for different systems. They were told by the contract providers what the routes were. The routes were different when they contracted for them, but apparently there was a freedom under the contracts to subcontract, and sometimes in the course of the subcontracting, they got routed through paths that were not diversebut now steps have been taken to help address this. One includes development by the Securities Information Automation Corporation of its own network. Bob Britz, who is testifying later, is a co-president of that organization and may be able to give you more information on that.
Page 34 PREV PAGE TOP OF DOC But realizing in hindsight this was a problem, there have been proactive steps taken to create diverse alternatives to the existing telecommunications
Mr. MANZULLO. But it would be hindsight by the houses. They are not charged with that type of knowledge, and certainly how could it be hindsight by the people putting in the security systems when it does not take but a second grade education to figure out that you have a separate path? I am a pilot, I am not current in my license, but in large aircraft you always have a redundancy system so if something breaks down, you can go onto something else without depending upon those lines.
Maybe I am being hard on these companies, but perhaps I am not. If you contract for security, and you get two lines, and then somebody brings those two lines into one to save some money, I just think that is a very serious breach of ethics. Thank you.
Chairman BAKER. Thank you, Mr. Manzullo.
I do appreciate your appearance here today, the work you have done, but also wish to make it clear that from the committee perspective we understand this is an ongoing and continual responsibility.
In the scope of your services if you identify things that the Congress should respond to, whether it be legislative authority, and certainly matters relating to necessary funds to conduct these activities, the committee would like to continually be informed of those needs so we may be appropriately responsive. We certainly don't want to do anything that contributes to exacerbating a very difficult circumstance when this eventually may reoccur. Thank you very much for both being here.
At this time, I would ask that panelists from the second panel come up to the table. Good afternoon and welcome. I certainly appreciate each of your appearances here this afternoon.
In order to move us along, I would begin by introducing our first witness, Mr. Richard Ketchum, President of the NASDAQ. We certainly welcome your participation here this afternoon.
Page 35 PREV PAGE TOP OF DOC
STATEMENT OF RICHARD G. KETCHUM, PRESIDENT, NASDAQ STOCK MARKET
Mr. KETCHUM. Thank you, Mr. Chairman. Thank you, members of the subcommittee. I want to congratulate you on having this hearing. It is clearly timely, and I think the oversight this committee provides on this critical issue is very, very important. I appreciate this opportunity to describe the steps that NASDAQ has taken to ensure our business continuity in the event of another catastrophic event.
Any analysis of industry preparedness must first review the market's response to the 9/11 attacks. Because our main and backup technology centers are located outside Manhattan, it is important to note at the outset that at no time following the disaster that occurred on September 11 were NASDAQ's systems inoperative. At the time of the 9/11 attacks, trading was suspended, but NASDAQ systems and network continued to operate, and indeed provided an opportunity for testing for the firms that operate in our marketplace. Therefore, our primary concern regarding reopening the markets after 9/11 related to our ability to connect with the firms that are active in NASDAQ and bring liquidity and ordered flow to our marketplace.
Following the 9/11 attack, we worked closely with the SEC, Treasury, Federal Reserve, the NASD and the New York Stock Exchange, as well as key member firms, to resume trading as soon as possible. That cooperation was an important factor in reopening the markets and restoring investor confidence. I am very proud of the efforts of so many talented people at NASDAQ who worked tirelessly with so many others in the financial services community to bring our markets back on that Monday, 9/17, safely and without incident.
While the events of September 11 did not fundamentally change NASDAQ's understanding of the potential range of threats to the financial services sector, they amplified awareness of the potential reach that could be exerted by such threats. NASDAQ has implemented a fully developed business continuity disaster recovery plan that will allow the continued trading of NASDAQ securities in the event that one of the NASDAQ data facilities is rendered inoperative.
Page 36 PREV PAGE TOP OF DOC In short, we believe that disasters are managed not only by hardening potential points of failure, but also by building redundancies wherever possible into the entire trading network, and by regular testing of those backup capabilities.
Geographic diversification of redundant facilities is a core component of NASDAQ's business continuity strategy. Our redundant data facilities are located hundreds of miles from one another in differing geologic and climatic zones, so that the same natural event has a low likelihood of impacting both sides. NASDAQ also decreases its vulnerability by operating from separate utilities and local telecommunications services.
While we are confident that our system's designs and contingency plans contain appropriate levels of redundancy, NASDAQ appropriately works with member firms to support them in enhancing their backup capabilities as well. In that connection, NASDAQ, working with the NASD, has submitted a ruling filing, as has the New York Stock Exchange, that would require broker/dealers trading in NASDAQ securities to engage in appropriate business continuity planning. As a result of each of these ongoing efforts, I am sure that our equities markets are more resilient than they were on September 11, 2001.
We have also worked closely with the GAO as it evaluated NASDAQ's preparedness and developed its findings and recommendations. We generally share their view on the need to develop goals, strategies, and sound practices to improve the resiliency of trading functions and enhance the SEC's funding for technology and staff.
We are also working with the SEC and the New York Stock Exchange to develop a plan under which NASDAQ and the New York Stock Exchange can trade each other's securities in the event of a disaster that rendered either market inoperable.
It is important to emphasize that these plans are only a final layer of protection for the U.S. Securities markets. The first line of defense for stock markets will always be their own backup systems, and the continued operation of each market has to be the first priority.
Page 37 PREV PAGE TOP OF DOC In conclusion, following September 11, the U.S. Financial industry demonstrated its resilience and resolve to maintain the most liquid and stable markets in the face of terrible challenges. Truly, NASDAQ's trading network has demonstrated its unique value as part of that infrastructure. However, our work is not done. NASDAQ, the government, and the financial services industry will need to continue to work in concert to ensure that trading can resume following a catastrophic event.
Thank you again for providing me this opportunity to describe the steps NASDAQ has taken, and I would, of course, be happy to answer any questions from the committee.
Chairman BAKER. Thank you, Mr. Ketchum.
[The prepared statement of Richard G. Ketchum can be found on page 278 in the appendix.]
Chairman BAKER. Our next witness is Mr. Robert Britz, president and chief operating officer, New York Stock Exchange.
STATEMENT OF ROBERT G. BRITZ, PRESIDENT AND CO-CHIEF OPERATING OFFICER, NEW YORK STOCK EXCHANGE
Mr. BRITZ. Thank you, Mr. Chairman. I appreciate the opportunity to be here before you and before the distinguished members of this committee.
As the president of the Exchange, I lead the Exchange's Equities Group, which is responsible for the day-to-day operation of our trading floor, our data processing sites, our technical infrastructure, software development, and our information business. I also head the Exchange's International Group, which is responsible for maintaining relationships with international non-U.S. Companies, as well as securing new non-U.S. Listings.
Page 38 PREV PAGE TOP OF DOC In addition to that, I am chairman and CEO of the Securities Information Automation Corporation, or SIAC, which has been referred to once or twice already today.
On behalf of the NYSE and our chairman, Dick Grasso, I thank the subcommittee for providing this forum to discuss business continuity and contingency planning in conjunction with the release this afternoon of the report of the GAO on that issue.
The report released by the GAO today is the result of more than 17 months of work that included reviewing business continuity plans and the physical and information security measures of the NYSE and SIAC. GAO conducted a dozen visits and follow-up telephone calls with us. We would like to thank the GAO staff for their professionalism throughout this important review.
The NYSE has developed forward-looking business continuity strategies that harden our physical and information technology infrastructure and improve our ability to withstand or recover from a disaster.
Our approach consists of three components: to prevent an attack or natural catastrophe, to withstand them, and to recover from them. In close cooperation with Federal, State, and local law enforcement, the Exchange has expanded its physical security perimeter. We have also taken measures to increase the screening of all people, package delivery, and mail that enters the NYSE or our data centers, and we have instituted a more restrictive policy on visitors and deliveries.
The NYSE employs a rigorous information technology structure to ensure the reliability of all information we receive, process, and disseminate to the world every day. We employ external perimeters, firewalls, intrusion detection, and international access controls, and we conduct penetration testing using so-called friendly hackers.
SIAC chairs the Financial Services Information-Sharing Analysis Center, which was referred to earlier, and that works with government agencies to identify and assess potential threats. All of our facilities have emergency generator backup and store water on site to enable continued operations after the loss of power or water. If we lose natural gas service, we can operate on fuel oil.
Page 39 PREV PAGE TOP OF DOC Our primary trading floor is actually five distinct trading floors located in four different buildings. Trading can be moved from one location to another as may be necessary, a so-called compaction exercise.
Our plans include redundant, active data centers served by different power grids and multiple telecom central offices, with each site sharing the daily processing load generated by trading about 1.4 billion shares a day. All of our facilities have backup power generators and UPS. We have a backup trading floor that was instituted post-9/11, developed at a cost of approximately $25 million. This alternative venue would support the trading of all NYSE-listed securities in a very conventional market structure model on a next-day basis after an event that disabled the primary trading floor.
The NYSE and SIAC have launched Secure Financial Transaction Infrastructure, SFTI. That has been referenced once or twice already today. It is a primary extranet servicing the financial industry. It provides diverse, fully redundant routing to the SIAC data centers for member firms, national market participants that are connected to the NYSE, to the American Stock Exchange, the National Market System, and DTCC's IT infrastructure as well.
Following September 11, 2001, U.S. equity trading was interrupted because many broker/dealers lost their connectivity to the markets due to the damage suffered by a major central telecommunications switching facility at Ground Zero. SFTI addresses this by enabling member firms to connect to the NYSE's data centers via private fiberoptic connections to multiple access centers, so-called carrier hotels, throughout the New York metropolitan area, as well as in Boston and Chicago.
SFTI possesses no single point of failure. All of SFTI's equipment, connections, power supplies, network links, and access centers are redundant, and its architecture features independent, self-healing fiberoptic rings. If a SFTI fiber pathway is compromised, financial data traffic is simply rerouted.
Page 40 PREV PAGE TOP OF DOC The NYSE is ready to trade the top NASDAQ stocks, approximately 250, which account for, we believe, 80 percent of the average daily volume in the unlisted market. All NYSE systems have been modified and can support the four character symbols used by such unlisted stocks so that there is no need for modification of the broker/dealer systems. Because the NYSE's capacity is today about five times our average daily volume, the incremental volume associated with trading these NASDAQ stocks can well be absorbed.
The NYSE is committed to ensuring that the U.S. capital markets remain the envy of the world, and to insulate them from interruption by attack or natural catastrophe by protecting them from threats, by creating an infrastructure that can withstand attack or catastrophe, and by developing contingency plans that enable quick recovery.
In the event a terrorist attack or catastrophe achieves penetration and takes out our real-time infrastructure, the NYSE is able to resume trading in a timely, fair, and orderly fashion that will ensure that every single one of America's 85 million investors has access to our member firms and to us.
Mr. Chairman, I want to thank you for the opportunity to present this testimony, and I would be happy to answer any questions you or the committee members may have.
Chairman BAKER. Thank you, Mr. Britz.
[The prepared statement of Robert G. Britz can be found on page 40 in the appendix.]
Chairman BAKER. Our next participant is Mr. Donald Kittell, executive vice president, Securities Industry Association.
STATEMENT OF DONALD D. KITTELL, EXECUTIVE VICE PRESIDENT, SECURITIES INDUSTRY ASSOCIATION
Page 41 PREV PAGE TOP OF DOC
Mr. KITTELL. Thank you, sir. Thank you, Mr. Chairman and Ranking Member Kanjorski, and members of the committee. I appreciate the opportunity to describe for you the significant progress that securities firms have made in response to 9/11.
The most significant outcome of 9/11, in my mind, was the realization that we are under attack. 9/11 did not occur in our own backyard, it occurred in our own front yard. What has been the impact of that realization? We now know that the danger is real. We assume that additional attacks will happen. We are sensitive to the expanded range of potential scenarios impacting both physical and cybersecurity that exist. We agree with the comments of the earlier discussion about cybersecurity.
We have established industry command centers which are linked with other centers in municipal, State, and Federal Government, homeland security, as well as other industry sectors. We are engaged in a long-term strategy to disperse industry infrastructure. We are making significant investments in effective backup facilities which are currently being tested. We have recognized that disaster recovery is the responsibility of the entire enterprise of a firm and not just its information technology or operations groups. We recognize that we are dependent on external critical service providers, such as telecom, transportation, power, and municipal services such as police and fire.
We cannot say that we can defend against any and all attacks; we can say that we understand the threat and have taken significant steps towards prevention and recovery.
I would like to highlight three aspects of the industry's efforts. First, the financial services sector is sharing resources through the Financial Services Sector Coordinating Council. This group represents over 20 trade associations and industry organizations, many of whom did not speak to each other prior to 9/11, but are now sharing continuity planning resources.
Page 42 PREV PAGE TOP OF DOC An example of the effectiveness of this group is the coordination of efforts across the sector with financial services regulators, so we have 15 financial services regulators with a single point of contact to 20 or more industry associations.
A third example is the coordination of the Financial Services Information Sharing and Analysis Center, which Bob Britz just talked about, which addresses cybersecurity attacks, which gives us the ability to communicate with each other in a rapid fashion.
The second important aspect I would highlight is the positive relationship between the private sector and the financial services sector. This relationship was remarkably effective in the immediate response to 9/11, and it continues to be so in the industry's efforts to strengthen resiliency over the last year and a half.
An example of that is the dialogue on the Financial and Banking Information Infrastructure Committee, or FBIIC, that Bob Colby referred to earlier; the financial services regulators, chaired by the U.S. Treasury and the FSSC that I referred to earlier representing the private sector.
The second example is the white paper dialogue between the regulators and the industry on clearance and settlement infrastructure, which was discussed earlier. There were actually two papers on clearance and settlement, both which raised significant questions and industry participants referred to with thoughtful comments. There is continuing dialogue on this. I think Mr. Colby said the next version of the second white paper would be out within a month, and we look forward to continuing that dialogue with the regulators.
The third important aspect that I would highlight is the positive contribution of the GAO. We worked with the GAO, notably on Y2K 2 years ago. We found their input to be extremely constructive. We have had the opportunity to review a draft of the report released today, and although I have not had the opportunity to review this with our member firms, I do want to make the following comments.
Page 43 PREV PAGE TOP OF DOC First, we agree with the GAO findings that business continuity plans need to be improved over the pre-9/11 status. I also note that the period of the GAO study was, I believe, February to June of 2002, and a great deal has happened since that time.
We also agree with the specific areas for improvement highlighted in the GAO report, such things as improved backup facilities, greater geographic dispersion, and so on.
Secondly, SIA agrees that the clearance and settlement facilities are critical to an effective resiliency plan. We forwarded our comments on the white paper, and we are very pleased with the results so far of the organizations involved in clearance and settlement.
We also agree with GAO that the trading facilities are also critical to an effective resiliency plan. There is no better example than the effort to open the market following 9/11.
We also agree with the SEC's comments that the regulatory environment around the trading function is different than the regulatory environment around clearance and settlement. However, we are very confident that those issues can be resolved, and that the firms certainly do not believe that there should be any less emphasis on trading facilities than on clearance and settlement.
Finally, SIA supports additional funding for the SEC as a general matter, but particularly including its oversight of business continuity.
The securities industry has built on its commitment to operational recovery, its experience on Y2K, and other industrywide projects to effectively address the threats posed by terrorist attacks. The efforts of individual organizations, the coordination of activities across all the sectors in the financial services sector, the positive relationship with the regulators, with the oversight of the Congress and the GAO, is a strong combination for an effective response to terrorism.
Page 44 PREV PAGE TOP OF DOC We have accomplished a great deal in the last year and a half. We understand there is more to be done. We are committed to the task ahead.
Chairman BAKER. Thank you very much, sir.
[The prepared statement of Donald D. Kittell can be found on page 290 in the appendix.]
Chairman BAKER. Our next witness is Mr. Micah Green, president of the Bond Market Association. Welcome, Mr. Green.
STATEMENT OF MICAH S. GREEN, PRESIDENT, THE BOND MARKET ASSOCIATION
Mr. GREEN. Thank you, Mr. Chairman and Mr. Kanjorski.
Mr. Chairman, I want to thank you for the opportunity for us to give our testimony, and really congratulate you for the leadership you have shown on this issue, and for the work of the SEC and other regulators in working with the industry to try to move on this important issue.
I will touch briefly on the business continuity issue, but want to spend most of my oral remarks telling you about the bond markets and how they responded at the time of 9/11, beyond, and then looking to proposals that could affect the future.
Briefly on business continuity plans, I would frankly associate myself with the remarks of Mr. Kittell. We have worked very closely with the SIA to provide the bond market perspective on the issue of business continuity, and we have been participating in the coordinating councils.
Page 45 PREV PAGE TOP OF DOC We, too, have set up a management council within our organizations working with our members to create redundancy, and frankly working within the association to create the ability to communicate with our membership, because what we learned at that time is that communicating within the breadth of the industry was almost as important as the industry itself communicating with its customer base. So I would really stand by what our colleagues at SIA said about business continuity planning.
But let me relate it to the bond markets, because the bond markets are very different in the way they operate versus the equity market.
Unlike the centralized, exchange-traded New York Stock Exchange and other equity markets, the bond markets are inherently a decentralized, over-the-counter market, which means it is a dealer-to-dealer marketplace. People buy and sell bonds when they want to buy them, where they want to buy them. There are hours of trading, but frankly, it is a 24-hour marketplace.
The New York marketplace right now is starting to wind down. The Japan and other Asian marketplaces are starting to crank up. About 11 hours from now, the London and other European markets will crank up. It is a never-ending cycle.
In fact, an interesting thing to remember in 9/11, much of the trading that occurs in the bond markets, particularly in the repurchase agreement market, which is the funding mechanism for many of the trades, actually occurs before 9 o'clock in the morning. So when that first plane hit the World Trade tower at 8:46 a.m. And hit the largest inter-dealer/broker of all, Cantor Fitzgerald, there were hundreds of billions of dollars of transactions that had already occurred that day.
In fact, daily volume in the bond markets is over $600 billion a day. There are almost $20 trillion of bonds outstanding, and it is a very actively traded market. So when those planes hit, it was not just about getting the markets back open; it was also about figuring out what took place that went down with those towers, so the effect on the clearance and settlement process. And figuring out how to get the bond markets back open was as much about trying to reconcile what had occurred so those trades could be completed and those trades could be closed.
Page 46 PREV PAGE TOP OF DOC Interestingly, while the stock markets were able to open up through these heroic events on Monday, September 17, the bond markets, because of their decentralized character, were able to get back up and running on an orderly basis at 8 a.m. on Thursday morning, September 13. Interestingly, though, bonds never stopped trading. There were trades done in the afternoon of 9/11. The Fed, the Federal Reserve, in its exercising of monetary policy, came to the marketplace to provide liquidity to the marketplace in the government securities market on 9-12.
So, as you see, the bond markets can operate differently. Because of their role in the financial system, keeping markets open is crucially important.
It is a good segue into a proposal that is now pending coming out of the Municipal Securities Rulemaking Board in their post-9/11 efforts. They have recommended to grant them the authoritythe Municipal Securities Rulemaking Board, a self-regulatory organization governing just the municipal securities marketto grant them the authority in the case of an emergency to, by regulation, halt trading in those markets.
The reaction of our association has been one of strong opposition to that, because we believe, frankly, in the time of an emergency is when you want markets open. You want capital to flow as smoothly and as easily as possible, so we oppose it philosophically.
We do understand, though, that policymakers such as yourselves or the SEC or other regulators may want some degree of authority if the worst, the unthinkable, God forbid, ever happens again, much worse than 9/11. So the Bond Market Association, while we have a philosophical opposition to a self-regulatory organization, or frankly, any authority, saying decentralized debt markets should be halted by law, we realize you may have an interest in having some Federal authority.
We could live with a governmental authority, not a self-regulatory authority but a governmental authority, at the highest possible level to deal with emergencieswe can't tell you what authority that is because of the unique nature of the regulatory scheme covering the bond markets generally, franklyworking with the President's Working Group, which includes the SEC, the Treasury, the Fed, including the Chicago markets, so that there is a coordinated response, and that authority should be narrowly defined so that it is absolutely under a severe catastrophe. It is not about a breakdown of any computer system or a breakdown of any trading system, but it really has to be a catastrophe, because in times of stress, we need markets open. In times of stress, we need capital to flow. Because of the unique, decentralized nature of the bond markets, they are able to more naturally operate in those circumstances. We believe they should be open as much as possible.
Page 47 PREV PAGE TOP OF DOC That would really conclude my oral remarks. I would be happy to answer any questions you would have.
Chairman BAKER. Thank you, Mr. Green.
[The prepared statement of Micah S. Green can be found on page 185 in the appendix.]
Chairman BAKER. I would ask the counsel and members, my side has pretty much decided. I have just a few questions that I would pose for the record for a written response. Mr. Kanjorski may have a comment or two.
In order to use our time efficiently, I would conclude our hearing, because we have a series of three votes which would keep us for a bit.
Does anyone have any objection?
Mr. KANJORSKI. No, Mr. Chairman.
Chairman BAKER. If I may, let me just pose a few questions.
Also, the record will remain open for Members to, in writing, submit further inquiries at their leisure. That certainly would be preserved.
Chairman BAKER. Mr. Scott, do you have any comment?
Mr. SCOTT. Just one question, sir.
Chairman BAKER. One second, and we will try to get to you.
I noted in the GAO report, Mr. Britz, that there is a comment that the SEC has asked the New York Stock Exchange and NASDAQ to take steps to ensure their information systems can conduct transactions and securities that the other organizations trade. However, under this strategy the NYSE does not plan to trade all NASDAQ securities, and neither exchange has fully tested its own or its members' abilities to trade the other exchange's deals.
Page 48 PREV PAGE TOP OF DOC Given our time constraints, I don't expect a discussion on it at the moment, but if you can address that section of that report and tell us what is planned; or perhaps since the date of the report has that been addressed.
Secondly, I would like each of your opinions concerning the GAO's observation that the SEC did not make mandatory the ARP program rules, but expected the changes that they recommended and the clearing organizations to comply with the various information technology and operations practices voluntarily.
I would like to get back from you a statement if there is a problem with mandatory compliance, the reasons therefore; or if there isn't, is there some general review by your respective bodies as to when or if the SEC should adopt such mandatory compliance?
And then thirdly, the presentation of the white paper expected in a month, I don't know if we will have another hearing on the matter, but certainly we would like to have industry communication to us about the outcomes of modifications made and agreements reached as a result of the next white paper.
Chairman BAKER. Mr. Kanjorski.
Mr. KANJORSKI. Mr. Chairman, I want to congratulate the panel for a great report to us.
The only thing, Mr. Britz, I recently visited the chairman's office in October. I am worried about the electronic controls on the thermostat.
Chairman BAKER. Mr. Scott.
Mr. SCOTT. One of the thingsone of the conclusions that was reached in a report released today was the length of time that our markets could stay down, that we could absorb certain lengths of times. I want to say with that how proud I think all America was that we were able to get back up and running so quickly after that devastating hit. But it did go on to say that there is a certain amount of time before the economy will be affected.
Page 49 PREV PAGE TOP OF DOC Do we have any idea of how long that delay would be before the economy is really affected in terms of days, that it would be negatively affected?
Mr. BRITZ. I am not an economist, Congressman, so I would be very loath to say it is 2 days, 4 days, or 6 days. I will say, coming out of 9/11, we were down from the 11th until the 17th. If we were to have the same kind of circumstance occur again, I am very confident that our markets would be up in a day or two; or let me put it this way, technically they would be able to be up in a day or two. There may be policy considerations as to why that is not a good idea.
From an infrastructure point of view, I think we have put in place the kind of backup and contingency planning and infrastructure that would not give rise to the 4- or 5-day kind of outage that we had on September 11, 2001.
Mr. GREEN. I would just add that if the system of payments is affected, Congressmanand, for example, if the Federal Reserve cannot come to market to add liquidity because the marketplace is closed, that has an immediate effect on the macroeconomy. But in the microeconomy, an investor who wants to sell security because they need cash to pay a kid's tuition bill, that affects them immediately when they need that money, so you need to open markets as quickly as possible.
Chairman BAKER. Thank you each for your participation. There will be further follow-up questions in the offing, but we do request your continued information flow to the committee to help us understand our circumstance. Thank you.
[Whereupon, at 4:53 p.m., the subcommittee was adjourned.]