FLASHBACK FRIDAY: SEC Raises Stakes in Self-Regulation


Should the equity market have a sole regulator? And if so, who should it be?


That was the question being raised back in 2005. In the wake of Regulation National Market System the buy-side, sell-side and others were asking whether or not should the exchanges regulate the market and themselves or not. Or should a single “supreme” regulator watch over the world’s largest equity trading markets?

What eventually evolved in terms of regulation is what the market has now – a hybrid form of semi-self regulation with the exchanges having the Self-Regulatory Organization (SRO) status and for the most part managing their own affairs. But the SROs are subject to oversight by the Securities and Exchange Commission and the Financial Industry Regulatory Authority.

But 13 years later, the debate remains if the current system of policing and checks and balances works. There are some that argue the current set-up is akin to foxes (the exchanges) guarding the henhouse (the marketplace) and this presents an inherent conflict of interest. The SROs counter that they are in the best position and encompass the breadth of market participants to watch over the market and protect its best interests.

Jamie Selway

So, which is it?

Jamie Selway, former Head of Market Structure at ITG and now a market consultant told Traders Magazine that he was a fan of the single market-neutral regulator model.

“And I think it’s an ideal role for FINRA. The reality is that FINRA is doing a lot of this (policing/regulation) today, via outsourcing relationships,” Selway said. “Streamlining things would eliminate a lot of redundancy and reduce costs for broker-dealers, hence making FINRA more effective.”

With the Consolidated Audit Trail now beginning to take shape and prompting universal market dialogue, Selway thought now seems a logical time to revisit this regulator/regulation question.

“As for the SEC, I think it’s good to see them doing more with their own rules and less with NMS Plans of SROs,” he continued, citing as examples SEC involvement in the access fee pilot compared to the tick size pilot. “But we shouldn’t abandon the notion of self-regulation completely.”

One long-time market participant turned consultant who requested anonymity told Traders Magazine said that for the most part, the equity exchanges and market nearly have a single regulator already – agreeing with Selway on who that should it should be.

“I think FINRA has done a great job of consolidating the bulk of the regulatory functions under one roof  and most exchanges already outsource some or most of their obligations to FINRA,” the veteran said. “In fact, if you look at most exchange rulebooks you’ll notice a remarkable resemblance to FINRA’s rulebook, and that’s not by accident. It’s more cost-effective for FINRA to enforce a common set of rules when it comes to most SRO functions, so the exchanges generally copy FINRA’s.”

That said, there are times and exceptions when the exchanges themselves are in the best position to regulate themselves – such as when exchanges have rules that fall outside the ordinary. The veteran cited NYSE rules that govern its own floor participants as an example of when it is better for the exchange to keep that type of functionality in-house.

“So, you end up with the best of both worlds—SROs police any behavior that’s unique to them while FINRA watches everything else,” he added, admitting the current hybrid or current system is working. “I’d have to say, if it ain’t broke don’t fix it.”

But what about the exchanges? What do they have to say?

Nasdaq’s Matthew Sheahan, Head of Communications in its Global Information Services unit said the exchange declined to comment on the matter but pointed to previous public statements for clarity on the topic. They referred to the following:



The New York Stock Exchange didn’t respond to an email seeking comment.

Brad Bailey, Celent

Brad Bailey, analyst at market consultancy Celent, a division of Oliver Wyman added he too agreed with Selway and the market veteran about the harmony inherent in the current hybrid governance methodology despite many rumblings over the years.

“This (system) has been debated for many years from a variety of perspectives. Even if there are elements of the current system are not ideal, the reality from a cost and expertise perspective alone, make the current system quite compelling,” Bailey said.

He also seconded the notion of the exchanges being able to self-regulate – at least themselves.

“I believe they are. I think the current structure makes the most sense from constituency and operational perspective,” Bailey said. “The current system has been flexible enough to deal with many elements of the fragmentation of volume and the rapid growth in exchanges since the original Traders Magazine article (see below) was written. The exchanges leverage their own expertise, industry knowledge, the needs of their market participants to create rule making that flows up to the SEC. The exchanges are in the best position to establish standards, conduct their business and monitor their client bases. While there are inherent conflicts of interests, the very varying needs of different exchange client segments (transactional, issuers, other services) acts as somewhat of balance. In cases where the SROs do not fulfill their obligations it is incumbent on the SEC to investigate, and if necessary act.”

The following article first appeared in the April 2005 edition of Traders Magazine

The SEC Raises Stakes in Self-Regulation

By Gregory Bresiger

The future of SROs may soon become as heated as the debate over Reg NMS. Dozens of comment letters are now pouring into the Securities and Exchange Commission from trading executives and average investors over the regulators’ SRO proposed rule change and concept release.

The SEC proposals have raised at least two dicey issues: Should self-regulation be trashed, with a single neutral regulator taking over from the various SROs? And, with exchanges demutualizing, who should be allowed on an SRO’s board of directors?

Investigate Abuses

“I fully support any SEC rules or actions that might remove authority of the exchanges to police themselves and to place that responsibility with an independent oversight authority with full power to investigate abuses and impose appropriate penalties,” writes Henry Gwiazda, Ph.D., an academic who once worked for the U.S. National Archives and Records Administration.

The SEC, in a concept release, is raising the issue of the single neutral regulator that would take over from SROs. That is opposed by many trading officials who have filed letters. For example, the NYSE writes that, “A radical rearchitecture of the current system is the wrong way to resolve concerns. Governance and coordination initiatives that have already occurred, plus enhacements to the current model, make more sense.”

But the SEC is also considering a more moderate reform: keeping SROs, but imposing stiff new disclosure and membership requirements. “The Commission believes that requiring SRO boards to have a majority of independent directors…should help address the conflicts of interest that otherwise might arise when persons with a nexus to the SRO are involved in key decisions,” according to the SEC’s proposed Fair Administration Rules (FAR) release.

But several trading organizations, in comment letters, say that these proposed SRO rules requirements would hinder their ability to seek out the best people. Indeed, Archipelago, in a consortium letter sent with Nasdaq and four other exchanges, writes, “We believe that all marketplaces, subject to the Commission’s oversight, should have greater flexibility to develop their own approaches to independence, based upon a definition that focuses on materiality of a director’s relationship to the market, and board composition than the FAR would permit.”

Kevin O’Hara, Archipelago’s general counsel told Traders Magazine: “We are huge proponents of independence. The overwhelming majority of our board is independent, but the SEC’s narrow definition of independence would make it difficult for SRO boards.” The proposed SRO changes, the letter said, would depart from the premises of the self-regulatory provisions of the 1934 Securities Act.

Outside Directors

The NASD, in its filing, called for a revision of the proposed independent director rules. It argues that it should not “preclude the participation of individuals who may have relevant experience and expertise, and yet may have recently served as outside directors of member firms.” It also promised to move quickly in correcting its apparent conflict – the continued ownership of Nasdaq.

Rosenblatt Securities, an agency-only firm and NYSE floor broker, in a comment letter, argued that, despite several scandals, self-regulation at times has been very effective in detecting violations.



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