Self Regulation: The US Experience

Ethiopis TafaraUS Securities & Exchange

Commission

History of Self-Regulation Securities Exchange Act of 1934

SEC created in aftermath of 1929 stock market crash

NYSE largest of about 30 exchanges in 1934

Over 80% of US securities trading in dollar volume

Congress let stock exchanges continue to regulate own activity

SEC to watch over exchanges

NASD: Expanded Self-Regulation

1938: Congress created the concept of national securities association

Regulated the market for “over the counter” stocks not traded on any exchange

National Securities Dealers Association (NASD) is the only major registered securities association today

All broker-dealers conducting business with the public are members of the NASD

Partially owns and operates NASDAQ stock market When broker-dealers are members of both NASD and other

exchange(s), one SRO is designated examining authority

Registered US Exchanges Currently 9 registered US exchanges

New York Stock Exchange (NYSE) American Stock Exchange Philadelphia Stock Exchange Boston Stock Exchange Chicago Stock Exchange Chicago Board Options Exchange Cincinnati Stock Exchange International Securities Exchange Pacific Stock Exchange

Standards for Self-Regulation Exchange Act requires SROs to meet a

number of standards, including: Ability to comply with securities laws and enforce its

members´ compliance SRO rules must give all members fair representation in

selection of its directors and administration of its affairs Must have rules designed to prevent fraud and promote

“just and equitable principles of trade” Must have fair procedure for bringing disciplinary

actions against its members and associated persons Rules must not impose unnecessary burden on

competition

SEC´s Role SEC covers every aspect of self-

regulation: SRO must file proposed rule changes with SEC

Rules do not take effect until SEC approval SEC examines SROs Members can appeal SRO disciplinary actions to SEC SEC can directly enforce SRO rules if SRO unable or

unwilling to do so SEC can bring enforcement action against SROs

Rare, but threat of such action gives SEC leverage SEC has brought significant enforcement action against both

the NASD and NYSE within past 5 years

Advantages of Self-Regulation Technical Expertise

Market professionals may better understand technical aspects of exchange regulation

Flexibility SRO may have greater ability to adapt to new developments

Greater Acceptance of Rules SRO members elect their directors and participate in

rulemaking; may cause greater willingness to comply with rules

Cost Savings to Federal Government More than 5,000 registered broker-dealers of varying

complexity Nearly 600,000 registered securities professionals

Disadvantages of Self-Regulation Conflicts of Interest

Securities exchanges are both business ventures and regulatory bodies; may not enforce rules if detrimental to business

Antitrust Implications Members of an SRO are collectively regulating their

own behavior; danger of collusive behavior that hurts customers

Due Process Concerns Members regulated by individuals exercising a form of

governmental power, yet may not have all procedural rights that would apply if the government were the disciplinary body

SEC Concept Release Recent SEC concept release (34-50700)

addresses concerns regarding role and operation of SROs, including:

1. Conflicts of interest between SROs´ regulatory obligations and interests of members, market operations, listed issuers, and, in the case of a demutualized SRO, shareholders

2. Costs and inefficiencies of the multiple SRO model 3. Challenges of surveillance across markets 4. Manner in which SROs generate revenue and how

SROs fund regulatory operations

Conflicts of Interest With Members

Trend: Declining number of member firms increasingly important to their regulator SROs´ business interests

Creates inappropriate business pressure on regulatory staff

With Market Operations Trend: Increasing competition among markets

creating pressure to attract order flow Creates pressure for permissive market activity or

over-regulation of competitors

Conflicts of Interest, cont´d. With Issuers

Trend: SROs simultaneously responsible for monitoring issuers and delisting securities while competing to attract and retain listings

With Shareholders Trend: SRO demutualization creates additional

conflict regarding profit motive of a shareholder-owned SRO

May commit insufficient funds to regulatory operations or use disciplinary function as revenue generator with respect to member firms that operate competing trading systems

Costs and Inefficiencies Existence of multiple SROs can result in

duplicative and conflicting rules, rule interpretations, and inspection regimes

The system can also result in redundant SRO regulatory staff and infrastructure across SROs

May be aggravated by trend toward greater market fragmentation of order flow among SROs

Intermarket Surveillance & Funding Intermarket Surveillance

Trading in multiple active markets facilitates veiling illegal activity by dispersing trades across markets

Funding Self-funding structure leverages limited SEC resources SEC supervision of SRO regulatory funding adequacy is

challenging, given temptation for SROs to fund business operations at regulation´s expense

Hard to know whether an SRO is insufficiently funding its regulatory function or simply administering an efficient regulatory program

Alternative Approaches Enhance current SRO system

Strengthen governance, enhance disclosure and reporting requirements

Enhance SEC´s and SROs’ ability to regulate intermarket trading activity

Mandated SRO internal restructuring Increase SRO regulatory independence, e.g., by

requiring all SROs create independent subsidiaries for regulatory and market operations

Alternative Approaches, cont´d. Hybrid model

Designation of a market neutral single SRO (“Single Member SRO”) to regulate all SRO members with respect to membership rules

Each SRO that operates a market (“Market SRO”) would be solely responsible for its own market operations and market regulation

Competing hybrid model Multiple competing member SROs (“Competing

Member SROs”), required to register with the SEC and authorized to provide member regulatory services

Alternative Approaches, cont´d. Universal industry self-regulator

One industry SRO responsible for all market and member rules for all members and all markets

Universal non-industry regulator One non-industry entity designated as responsible

for all markets and member regulation for all members and all markets

SEC regulation Termination of the SRO system in favor of direct SEC

regulation