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United States General Accounting Office:
GAO:
Report to Congressional Committees:
May 2002:
Securities Markets:
Competition and Multiple Regulators Heighten Concerns about Self-
Regulation:
GAO-02-362:
Contents:
Letter:
Results in Brief:
Background:
Increased Competition Has Heightened Some Market Participants’ Concerns
about Conflicts of Interest:
Some Broker-Dealers Were Concerned about Rule Differences and Multiple
Examinations:
Market Participants Have Discussed Alternative Approaches to Self-
Regulation:
Conclusions:
Recommendations:
SEC, SRO, and Industry Comments and Our Evaluation:
Scope and Methodology:
Appendix I: Comments from the Securities and Exchange Commission:
Appendix II: Comments from the National Association of Securities
Dealers:
Appendix III: Comments from Nasdaq:
Appendix IV: Comments from the Securities Industry Association:
Abbreviations:
DEA: designated examining authority:
ECN: electronic communications network:
MOU: memorandum of understanding:
NASD: National Association of Securities Dealers:
NASDR: National Association of Securities Dealers Regulation:
NYSE: New York Stock Exchange:
SEC: Securities and Exchange Commission:
SIA: Securities Industry Association:
SRO: self-regulatory organization:
[End of section]
United States General Accounting Office:
Washington, DC 20548:
May 3, 2002:
Congressional Committees:
As competition among markets has increased, so have some market
participants’ concerns about the inherent conflicts of interest that
securities self-regulatory organizations (SRO)[Footnote 1] face in
their dual roles as market operators and regulators. One response to
increased competition—demutualization, or the conversion of SROs from
member-owned organizations to shareholder-owned corporations—has raised
questions about potential effects on conflicts of interests,
particularly in for-profit entities. Additionally, broker-dealers
Footnote 2] that are members of the two largest SROs, the National
Association of Securities Dealers (NASD) and the New York Stock
Exchange (NYSE), have continued to raise questions about the efficiency
of SROs’ rules and examinations.
Focusing on the issues market participants have identified, this report
describes how the Securities and Exchange Commission (SEC), NASD,
and NYSE have been addressing concerns about (1) the impact of
increased competition, including demutualization, on the ability of SROs
to effectively regulate members with which they compete and (2) possible
regulatory inefficiencies associated with broker-dealer membership in
multiple SROs. In addition, the report describes alternative approaches
that some securities market participants have discussed as a means of
addressing concerns about the current self-regulatory structure.
Results in Brief:
Increased competition among SROs and their members for customer
orders has heightened some members’ concerns about the conflicts of
interest inherent in the roles of SROs as both market operators and
regulators. Nasdaq—the market currently operated by NASD—
increasingly has been in competition with NASD members that operate
electronic communications networks (ECN).[Footnote 3] NYSE has faced
competition for many years from members that trade NYSE-listed
securities off of the exchange. Heightened competitive pressures have
generated concern that an SRO might abuse its regulatory authority—for
example, by imposing rules or disciplinary actions that are unfair to
the competitors it regulates. Market participants’ views differed on
whether demutualization will heighten the potential for such abuses.
Despite SRO and SEC measures that are intended to address potential
abuses of regulatory authority, these concerns persist.
Some broker-dealers that were subject to the jurisdiction of multiple
SROs were also concerned about inefficiencies associated with SRO rules
and examinations. The broker-dealers were concerned that differences
among SRO rules and rule interpretations caused inefficiencies in the
use of broker-dealers’ compliance resources. No formal process exists,
however, for addressing rule differences that might cause material
inefficiencies in the regulatory process. According to regulators, the
law does not require SRO rules to be the same, and many differences
exist for legitimate business reasons. Broker-dealers with multiple SRO
memberships also said that examinations by multiple SROs were
unnecessarily burdensome. Efforts to improve examination coordination
have not fully addressed their concerns, although such efforts
continue.
Securities market participants have discussed alternatives that would
address, at least in part, concerns about conflicts of interest and
inefficiencies in the current self-regulatory structure. SEC officials
said that the agency did not plan to dictate changes in the current
structure, preferring to let the industry reach a consensus on the need
for change and the type of change that is appropriate. Additionally,
they said that industry initiatives, such as Nasdaq’s application to
register as an exchange, were transforming the regulatory landscape. In
the meantime, SEC officials said that because the current self-
regulatory structure had been working adequately, immediate action was
not needed. Alternatives that have been discussed include having ECNs
work within the current regulatory structure by registering as
exchanges and thereby becoming SROs, as well as making more dramatic
changes to the regulatory structure, such as consolidating self-
regulation in a single entity not affiliated with any market. None of
the alternatives involving changes to the regulatory structure
currently appears to have sufficient support from market participants
for implementation.
This report recommends that the SEC Chairman work with the SROs and
broker-dealer representatives to implement a formal process for
systematically identifying and addressing material regulatory
inefficiencies caused by differences in rules or rule interpretations
among SROs and by multiple examinations of broker-dealers. The report
also recommends that, in doing so, SEC explore with the SROs and broker-
dealer representatives various methods for obtaining comprehensive
feedback from market participants, including having a neutral party
collect and assess market participants’ views.
We received comments on a draft of this report from SEC, NASD, Nasdaq,
the Securities Industry Association (SIA),[Footnote 4] and an ECN. The
respondents generally agreed with the report’s conclusions and
recommendations, however, three respondents expressed additional
concerns. The comments are discussed in greater detail at the end of
this letter, and the written comments are reprinted as appendixes I
through IV.
Background:
The federal regulatory structure of the U.S. securities markets was
established by the Securities Exchange Act of 1934 (the Exchange Act).
Congress also created SEC as an independent agency to oversee the
securities markets and their participants. Under the Exchange Act, the
U.S. securities markets are subject to a combination of industry self-
regulation (with SEC oversight) and direct SEC regulation. This
regulatory scheme was intended to give SROs responsibility for
administering their ordinary affairs, including most of the daily
oversight of the securities markets and broker-dealers.
The Exchange Act provides for different types of SROs, including
national securities exchanges and national securities associations.
Entities operating as national securities exchanges or associations are
required to register as such with SEC. As of March 31, 2002, nine
securities exchanges were registered with SEC as national securities
exchanges.[Footnote 5] As of the same date, NASD was the only
registered national securities association; NASD Regulation (NASDR) is
its regulatory arm. Although it is the SRO, NASD delegates to NASDR,
its wholly owned subsidiary, SRO responsibilities for surveilling
trading on Nasdaq and the over-the-counter market and for enforcing
compliance by its members (and persons associated with its members)
with applicable laws and rules. Nasdaq also surveils trading on its
market and refers potential violations to NASDR and SEC for
investigation. While NASD is currently the parent company of Nasdaq,
NASD is in the process of selling Nasdaq.
Recognizing the inherent conflicts of interest that exist when SROs are
both market operators and regulators, the Exchange Act states that to be
registered as a national securities exchange or association, SEC must
determine that the exchange’s or association’s rules do not impose any
burden on competition and do not permit any unfair discrimination.
[Footnote 6] SROs are also responsible for enforcing members’
compliance with their rules and with federal securities laws by
conducting surveillance of trading in their markets and examining the
operations of member broker-dealers.
The Exchange Act also mandates that securities SROs operate under
direct SEC oversight and authorizes SEC to ensure that SROs do not abuse
their regulatory powers.[Footnote 7] SEC inspects SROs to ensure that
they are fulfilling their SRO duties, focusing on, among other things,
the quality of SRO financial operations examination programs; market
surveillance, investigations, and disciplinary programs; and customer
complaint review programs. SEC also reviews rule changes proposed by
SROs for consistency with the Exchange Act and SEC rules. Finally, SEC
provides direct regulation of the markets and their participants in a
number of ways, including direct examinations of broker-dealers,
investigations into markets and their participants, disciplinary
actions for violations of the Exchange Act, and promulgation of rules
and regulations.
Increased Competition Has Heightened Some Market Participants’ Concerns
about Conflicts of Interest:
Nasdaq increasingly has been in competition with NASD members that
operate as ECNs, while NYSE has competed for many years with members
that trade its listed securities off of the exchange. This competition
has heightened some SRO members’ concerns that an SRO could abuse its
regulatory authority through rule-making processes, disciplinary
actions, or use of proprietary information. Market participants expect
that demutualization will increase the ability of exchanges and other
markets to compete both domestically and internationally, however,
their views differ on how it might affect potential abuses of
regulatory authority related to conflicts of interest. SEC generally
concluded that it is too soon to predict the effects of
demutualization. Concerns about conflicts of interest persist despite
measures by SEC and the SROs that are intended to address them.
Nasdaq’s and NYSE’s Competition with Members Creates Conflicts of
Interest:
NASD’s dual roles as the owner-operator of Nasdaq and as the primary
SRO for the 11 ECNs[Footnote 8] that compete with Nasdaq have created
conflicts of interest between NASD’s economic interests and regulatory
responsibilities, which NASD’s pending spin off of Nasdaq is intended to
mitigate (discussed further below). SEC regulations require ECNs, as
registered broker-dealers, to be members of at least one SRO.[Footnote
9] According to an ECN official, the ECNs chose NASD as their primary
SRO because the unique trading rules as well as other features of the
Nasdaq market were conducive to the growth of the ECNs’ business.
ECNs are an alternative to the Nasdaq market for trading in Nasdaq
stocks. They differ from Nasdaq and registered exchanges principally in
that they do not require an intermediary to execute orders. ECNs match
orders electronically and anonymously, while Nasdaq broker-dealers, in
their roles as market makers,[Footnote 10] act as intermediaries for
all customer orders. In deciding whether to use an ECN or a Nasdaq
market maker, customers consider such factors as execution quality,
transaction costs, and anonymity.
The number of ECNs and their share of total Nasdaq volume have grown
significantly since 1993. According to SEC, in 1993 all alternative
trading systems (including one ECN)[Footnote 11] accounted for about 13
percent of the total volume in Nasdaq securities. By October 2001, ECNs
alone accounted for over 30 percent of the total volume in Nasdaq
securities.
SEC and certain ECNs have attributed a significant part of the growth in
the volume of Nasdaq securities traded on ECNs to the SEC order-handling
rules[Footnote 12] that SEC promulgated to enhance competition and
pricing efficiency in the securities markets. Before the rules became
effective in 1997, only ECN subscribers had access to the orders and,
thus, to the prices that ECNs displayed for Nasdaq securities.
Implementation of the rules resulted in ECNs’ orders for Nasdaq
securities being displayed and accessible to the public on Nasdaq,
thereby providing the public an opportunity to obtain any better prices
that might be available on ECNs.[Footnote 13] According to one ECN,
both Nasdaq’s access to ECNs and the efficiencies that ECNs brought to
the Nasdaq market through the electronic matching of orders have
contributed to the overall growth of trading in Nasdaq securities.
NYSE, as an SRO that operates a market, has also confronted conflicts of
interest between its economic interests and its regulatory
responsibilities. Specifically, for many years the exchange has
regulated competing member broker-dealers that trade its listed stocks
off of the exchange.
Customer orders for NYSE stocks that are not sent to the floor of the
exchange to be executed are executed internally by a broker-dealer or in
an alternative market. A broker-dealer internalizes an order when it
executes a customer order for a security in house or directs the order
to an affiliated dealer, instead of sending the order to an exchange or
another market. Numerous large broker-dealers that are NYSE members
have also established relationships with regional exchange specialists
and sometimes route their orders to them instead of to NYSE. In
addition, member broker-dealers direct orders to alternative markets,
such as ECNs or third-market broker-dealers.[Footnote 14] Competition
with member broker-dealers may increase with the May 2000 rescission of
NYSE Rule 390, which had restricted off-exchange trading by NYSE
members in NYSE-listed securities.[Footnote 15]
Competition and Demutualizaton Raise Concerns Among Some Market
Participants about Regulatory Abuses:
Some SRO members expressed concern that increased competition between
SROs and their members had given SROs a greater incentive to abuse
their regulatory authority. These members were concerned that SROs
could adopt rules that unfairly impede the ability of members to
compete against the SROs—for example, by adopting rules that give
preference to noncompetitors’ orders. An official from one broker-dealer
also noted that an SRO might sanction a competing member more severely
than other members by, for instance, inappropriately concluding that the
member had failed to satisfy its best-execution obligation when it
routed an order to a competing market for execution rather than to the
SRO. ECNs have also expressed concern that an SRO, in its regulatory
capacity, could obtain proprietary information from a member and, in
its capacity as a market operator, inappropriately use the information.
For example, an SRO might obtain proprietary information about its
members’ customers and then use that information to market its services
to the customers.
Some institutional market users that were not SRO members were more
broadly concerned about how conflicts of interest in the self-regulatory
structure affected the fairness and efficiency of the securities
markets.
These market users asserted that the self-regulatory structure was
inherently biased in favor of broker-dealers that were SRO members and
owners and that SROs interpreted their rules to favor these broker-
dealers. These market users, as well as some broker-dealers, told us
that they did not believe that their concerns were addressed when these
concerns diverged from the interests of the most powerful broker-
dealers at the exchange. Market users also said that the current self-
regulatory structure ultimately impeded market-driven innovations that
could improve competition and benefit the investing public. One
investment company official cited NYSE Rule 390, which had been in
place for 20 years, as a classic example of the difficulty of repealing
an anticompetitive SRO rule.[Footnote 16]
Demutualization has heightened the concerns of some SRO members about
the potential for abuses of regulatory authority.[Footnote 17] They
expressed concern that a demutualized, for-profit market operator might
be more likely to misuse its regulatory authority or be less diligent
in fulfilling its regulatory responsibilities in a desire to increase
profits. For example, demutualized SROs might have a greater incentive
to propose rules that unfairly disadvantage members or other markets or
inappropriately sanction or otherwise discipline members against which
the SROs compete. Other SRO members expressed concern that demutualized
market operators might have a greater incentive to either insufficiently
fund or otherwise inadequately fulfill their self-regulatory
responsibilities.
However, other market participants believed demutualization could
reduce at least some conflicts and lead to needed changes in market
structure. Market users such as mutual funds asserted that by
diversifying market ownership through the sale of stock, and thus
reducing the influence of broker-dealers, demutualization could reduce
the conflicts of interest inherent in a self-regulatory structure based
on member-owned markets that regulate themselves. According to these
market users, diversifying the exchange ownership base could shift
management’s focus from the narrow interests of intermediaries to the
broader interests of all market participants, potentially benefiting
the investing public.
According to NYSE officials, demutualization and for-profit status
raise no new issues for the exchange. NYSE could demutualize or its
members could become its shareholders without any change in the
incentives that currently motivate exchange actions. That is,
demutualization does not introduce any new conflicts of interest
issues. NYSE’s chairman noted that the exchange would continue to have
a strong economic incentive to preserve its reputation as a well-
regulated entity, regardless of its organizational structure.
Demutualization Is Expected to Enhance Competitiveness, but Its Effects
on Conflicts of Interest Are Not Yet Known:
Demutualization is expected to enhance the ability of markets to compete
by enabling them to raise capital in the securities markets to fund
business efforts and by better aligning the economic interests of
markets and their owners. Under current member-owned structures,
actions markets might otherwise take to enhance their competitiveness
might be rejected or adopted very slowly by member-owners that do not
perceive a direct benefit from them. For example, member-owners (that
is, broker-dealers) that derive income from acting as intermediaries in
the trade execution process might be reluctant to support the
introduction of technology if it reduces their income from acting as
intermediaries. In contrast, shareholders of a demutualized exchange
would be expected to support cost-effective technology that improves
customer service and thus the competitiveness of the market, because
they would expect it to increase the value of their investments by
attracting more business to the exchange. To improve their
competitiveness, Nasdaq and the Pacific Exchange,[Footnote 18] as well
as several U.S. futures[Footnote 19] and foreign exchanges,[Footnote
20] have demutualized or are in the process of doing so. In 1999, NYSE
also announced plans to demutualize but subsequently postponed its
plans indefinitely.
An SEC economist said that the effects of demutualization could not be
predicted, as they depended on a balance between the competing
incentives of maximizing profits and providing effective regulation. The
balance between these incentives would differ depending on who owned
and controlled the market. Also, as under the current ownership
structure, the incentive to reduce regulatory costs would be balanced
against the risk that any resulting reduction in regulation might harm
the public’s confidence in the integrity of the market. A loss of
public confidence could ultimately reduce profitability if, for
example, investors moved their transactions to other markets.
SEC officials further explained that both for-profit and not-for-profit
SROs face inherent conflicts of interest, but noted that
demutualization has the potential to heighten or create variations of
existing conflicts of interest. SEC officials stated, for example, that
while all SROs face pressure to minimize the costs of fulfilling their
regulatory obligations, for-profit entities could be more aggressive in
promoting their commercial interests, such as by using regulatory fees
to finance nonregulatory functions. SEC officials emphasized, however,
that because conflicts of interest already exist within the not-for-
profit structure, demutualization does not necessarily require a
wholesale change in regulatory approach. They noted that the Exchange
Act has significant safeguards to address conflicts of interest and
abuses of regulatory power. Finally, in commenting on the growing trend
among SROs to contract out certain regulatory services, SEC officials
stressed that SROs are still legally responsible for fulfilling self-
regulatory obligations that are contracted out.[Footnote 21]
Regulatory Measures Exist to Address Conflicts of Interest:
NASD has attempted to address concerns about conflicts of interest by
reorganizing its regulatory operations and is in the process of selling
its market operations. In addition, NASD and NYSE officials told us
that their markets have relied on internal controls to address these
concerns. SEC has used its authority under the Exchange Act to monitor
the markets and address concerns about abuses of regulatory authority.
NASD Is Continuing to Reorganize and Has Used Internal Controls to
Address Concerns about Conflicts of Interest:
In 1996, NASD created NASDR as a separate nonprofit subsidiary to
address concerns related to the conflicts between NASD’s regulatory
functions and market operations.[Footnote 22] Beginning in March 2000,
NASD began implementing plans to sell Nasdaq to NASD members and other
investors in order to limit the common ownership of Nasdaq and NASDR. In
November 2000, Nasdaq filed an application with SEC to register as a
national securities exchange.[Footnote 23] The planned restructuring
will separate NASD and NASDR from Nasdaq and, in NASD’s view, minimize
any issues related to conflicts of interest, including those related to
demutualization.[Footnote 24] Under the restructuring, ECNs and other
broker-dealers doing business with the public (holding customer
accounts) will remain NASD members. They will continue to be regulated
by NASD but will no longer be competing against an NASD-operated
market.[Footnote 25] According to NASD, the restructuring will be
substantially complete with the sale of NASD’s remaining Nasdaq common
stock, which is expected to occur by June 2002. However, NASD will
retain an interest in Nasdaq after this date.[Footnote 26]
According to one ECN, the planned spin-off of Nasdaq will not fully
solve the conflict of interest problem because, not only will NASD
retain an interest in Nasdaq, but Nasdaq will still be NASDR’s biggest
customer for its regulatory services. As such, NASDR could face a
conflict between its ethical responsibility as a regulatory services
provider and the economic incentive to, among other things, retain its
largest revenue source. Accordingly, competitors might be concerned
that NASDR will perform its regulatory services in a way that gives
Nasdaq a competitive advantage.[Footnote 27] Also, because Nasdaq has
applied to become an SRO as part of NASD’s plan to demutualize Nasdaq,
the restructuring will not address conflicts of interest related to
market-specific regulation by the new SRO.[Footnote 28] That is, as an
SRO, Nasdaq will have regulatory authority over members that operate
or use competing markets.
In addition to adopting a structure designed to minimize conflicts
between regulation and competition, NASD’s self-regulatory functions
are subject to its internal controls and the oversight of SEC and the
NASD and NASDR boards of directors. The boards of directors, which
include public members, are intended to provide additional assurance
against abuses of regulatory authority. The NASD board, to which the
Nasdaq board will continue reporting until the spin-off is complete,
and the NASDR board both have a majority of public members, while the
Nasdaq board has an equal number of public and industry members. The
boards also receive advice from various standing advisory committees.
[Footnote 29] In addition, all NASD employees are required to sign a
statement attesting that they will not share confidential information
with any unauthorized person, inside or outside of the organization.
NASD officials described other internal procedures that should minimize
abuses of regulatory authority. According to NASD officials, NASD
generally solicits comments from its membership and the public on
regulatory rule proposals, and its board takes those comments into
account before NASD files these proposals with SEC.[Footnote 30] In its
disciplinary process, case initiation is governed by internal
procedures that require approval from a staff body independent of NASDR
enforcement and market regulation staff. After a complaint is filed,
the case is heard before a three-member body that is also independent
of these staff. If the matter is appealed, the appellate decision is
rendered by the National Adjudicatory Council, which is made up of an
equal number of industry and non-industry members.
NYSE Has Used Internal Controls to Address Concerns about Conflicts of
Interest:
An NYSE official told us that the exchange maintains strict internal
controls to address concerns about conflicts of interest between its
market operations and regulatory oversight. For example, NYSE cited
controls to prevent market operations staff from gaining access to
information on members that has been obtained for regulatory purposes.
Additionally, NYSE policy requires that regulatory staff sign a
statement attesting that they will not share confidential information
with market operations staff. NYSE policy statements also include
details on compliance with the securities laws, including the
prohibition of any unfair treatment of customers or members.
NYSE’s self-regulatory functions are also subject to the oversight of
SEC and the NYSE board of directors, which is intended to provide
additional controls against abuses of regulatory authority. The board
has 27 members—12 directors from the securities industry, 12 public
directors that are independent of the securities industry, and 3
exchange officials. The board receives advice from various standing
advisory committees, among them a committee comprising institutional
market users. According to NYSE officials, institutional market users
can voice their concerns to the board through this committee.
The NYSE disciplinary process is also governed by a three-member review
panel. A disciplinary decision by this panel can be appealed to the NYSE
Board of Directors, which renders its decision after consultation with a
special review committee whose membership is balanced between
industry and non-industry members.
SEC Has Used Its Authority to Address Concerns about Regulatory Abuses
and Related Issues:
SEC has used its authority under the Exchange Act to address concerns
about abuses of regulatory authority arising from conflicts of interest,
including those related to demutualization and other issues. SEC has
addressed such conflicts through its oversight activities, which include
reviewing and approving SRO proposals for new rules and amendments to
existing rules, reviewing SRO final disciplinary proceedings, and other
measures.
SEC reviews SRO proposals for new rules and for amendments to existing
rules to ensure that they are not anticompetitive, unfairly
discriminatory, or otherwise detrimental to the markets. Section
19(b)(1) of the Exchange Act requires SROs to file copies of proposals
for new rules and amendments to existing rules with SEC.[Footnote 31]
Once a proposal is filed, SEC is required to publish notice of the
proposal and provide an opportunity for public comment. SEC is also
required, among other things, to consider the competitive effects of
the rule. According to SEC, its rule reviews address the concerns of
some SRO members that an SRO could abuse its authority by adopting
rules that unfairly impede the ability of members to compete against
the SRO. SEC officials noted, for example, that while an SRO could
propose an anticompetitive or discriminatory rule, SEC would not approve
it.
According to officials of one ECN, SEC’s review of SRO rules, including
the public comment process, has been one of the most effective ways for
ECNs to have their concerns addressed. In particular, they said that SEC
has addressed comments ECNs have submitted in response to SRO rule
proposals. For example, ECNs expressed concerns about the
anticompetitiveness of NASD’s SuperMontage proposal, and NASD, at
SEC’s direction, modified the rule numerous times in an attempt to
address ECN concerns.[Footnote 32] More recently, another ECN expressed
concern to SEC about the competitive effects of a proposed rule that
would allow Nasdaq to charge higher transaction fees to members that
report less than 95 percent of their trades through Nasdaq but use
Nasdaq’s quotation system or make limited use of its execution systems.
The ECN was concerned, among other things, that the rule was filed
under section 19(b)(3)(A) of the Exchange Act, under which such rules
are effective on filing.[Footnote 33] Following discussions with SEC,
NASD refiled the rule proposal under section 19(b)(2) of the Exchange
Act pursuant to which it would be subject to the public comment process
and SEC approval before becoming effective.[Footnote 34] According to
SEC officials, SROs have withdrawn rule proposals after SEC expressed
concern that the proposals might be anticompetitive.
Some market participants, although agreeing that SEC’s public comment
process provides a mechanism for addressing concerns about potentially
anticompetitive activity by an SRO, also said that SEC lacks the
resources, tools, and expertise to identify and adequately respond to
all instances of anticompetitive activity by an SRO toward member
competitors. According to one ECN, an SRO committed to a course of
anticompetitive activity through a variety of rulemaking and rule
enforcement activities may be able to achieve success, particularly in
the short term, using section 19(b)(3)(A) of the Exchange Act. This ECN
was concerned about the ability of an SRO to potentially obtain a
significant long-term competitive advantage over its member competitors
through such activities, given the quickly evolving and highly
competitive nature of the securities industry.
To ensure that SROs actions are not discriminatory or otherwise
anticompetitive, SEC also reviews SROs’ disciplinary actions during
inspections. According to SEC, these reviews address the concerns of
some SRO members that an SRO could abuse its regulatory authority by
sanctioning a competing member inappropriately or more severely than a
noncompeting member. The Exchange Act requires SROs, in administering
their affairs, to provide fair representation for members. According to
SEC, the fair application of SROs’ authority to adjudicate disciplinary
actions, including meting out fines and suspensions, may be particularly
important, because these actions can have significant ramifications for
broker-dealers. The Exchange Act provides SEC with a check on SRO
disciplinary actions that are discriminatory or otherwise
anticompetitive, requiring SROs that impose final disciplinary
sanctions on members to also file notice with SEC. Such actions are
subject to SEC’s review after appropriate notice and an opportunity for
a hearing. Upon appeal, SEC must determine whether the action is
consistent with the Exchange Act, SEC rules, and SRO rules and then
either affirm, modify, set aside, or remand the action to the SRO for
further proceedings.
SEC uses additional approaches to addressing industry concerns, such as
concept releases, special committees, and public hearings. For example,
SEC published a concept release in December 1999 to obtain views on the
fairness and reasonableness of fees charged for market information and
on the role of revenues derived from such fees in funding SROs.
[Footnote 35] In commenting on the release, some SRO members questioned
the fairness of funding SROs, which are competitors for customer order
flow, with revenues from the sale of market information. Because of the
diversity of comments received and concerns raised by the concept
release, SEC created an advisory committee on market information in
August 2000 to provide the agency further guidance. SEC officials said
they were reviewing the advisory committee’s September 2001 report and
the comments received since it was issued to determine how to address
concerns about market data.
Some Broker-Dealers Were Concerned about Rule Differences and Multiple
Examinations:
Some broker-dealers that were members of multiple SROs told us that
differences in rules and their interpretations among SROs resulted in
operational inefficiencies. While no formal process exists for ensuring
consistency among rules that might cause material regulatory
inefficiencies, regulatory officials said that the existing rule review
and public comment process has been effective in addressing related
concerns. An ongoing NASD effort could lead to the resolution of some
of these concerns but regulatory cooperation will be required as NASD’s
authority is limited to its own rules. In addition, some broker-dealers
with multiple SRO memberships said that examinations by multiple SROs
were unnecessarily burdensome. Over the years, SEC and the SROs have
taken steps to improve examination efficiency, most recently through
efforts to improve examination coordination. However, some broker-
dealers told us that these efforts have not fully addressed their
concerns.
Some Broker-Dealers Were Concerned about Inefficiencies Associated with
Differing Rules and Interpretations:
According to both market participants and regulators, SROs generally had
the same or similar rules. However, some broker-dealers with multiple
SRO memberships—principally NASD and NYSE memberships—were concerned
that differences in rules and rule interpretations among SROs were
causing operational inefficiencies. Some broker-dealers had multiple
memberships because, if they were active in more than one market, they
could choose to become members of the SROs operating those markets;
and, if they did business with the public, they were also required to
belong to NASD.[Footnote 36] Broker-dealers are subject to the
regulatory oversight of each SRO to which they belong, as well as to
the oversight of SEC and state securities regulators.
Some broker-dealers expressed concern about inefficiencies associated
with monitoring and complying with SROs’ varying rules and rule
interpretations in areas such as determining what types of customer
complaints to report, how long to retain certain written records, and
which proficiency examinations broker-dealer employees must take and
when. For example, NASD and NYSE do not use the same proficiency
examinations for order takers, sales representatives, and branch
managers. Further, NASD and NYSE rules and rule interpretations differ
on matters such as whether order takers and sales representatives must
pass the same proficiency examinations and when candidates that pass
these examinations can be promoted to branch managers. According to
some broker-dealers, to the extent that the skills and proficiency of
order takers and sales representatives affect the quality of customer
protection, these differences could result in varying levels of
customer protection among firms, while at the same time, disadvantaging
some firms in their ability to hire and retain staff.
When discussing the overall effect of differences in rules and their
interpretations with officials of several broker-dealers, they stressed
that their concerns were not about the cost of one or more specific
instances of differences in rules and their interpretations, but about
their cumulative effect on the efficient use of compliance resources.
Broker-dealers emphasized that the purpose of compliance is to protect
the integrity of the markets and investors, and the effort needed to
sort out compliance with multiple rules and rule interpretations
strains these resources. We could not assess the overall effect of
differences in rules and their interpretations because of the anecdotal
nature of the information provided.
While no formal process exists for addressing differences among SRO
rules and interpretations that might cause material regulatory
inefficiencies, SEC, NASDR, and NYSE officials told us that they have
found the existing rule review and public comment process to be
effective for addressing concerns about rules. According to SEC
officials, SEC might use this process to try harmonizing proposed SRO
rules if the agency identified significant differences or
inconsistencies in them. They said that as part of the review process
SEC staff ask SROs to justify any differences between a proposed rule
and other SRO or SEC rules. For example, SEC officials told us that
through this process they ensured that NASD and NYSE harmonized their
rules on margin requirements for day traders. SEC also worked with NASD
and NYSE to coordinate anti-money laundering and analyst disclosure
rules. According to NYSE officials, only the reporting requirements for
the money laundering rules differ. These officials also said that the
exchange is working with NASD to develop uniform sales practice and
margin rules for single stock futures.
SEC also commented that, while the review and public comment process
can address market participants’ concerns that are raised at the time a
rule proposal is filed, the burdens associated with different SRO rules
may not become apparent until long after the rules have been
implemented. SEC officials further noted that the Exchange Act does not
require that all SRO rules be uniform. They said that SROs are entitled
to set whatever rules they determine are appropriate for their markets
as long as the rules comply with the Exchange Act. SEC officials
stressed that the agency would not impede one SRO from establishing
higher standards than another, noting that many of the differing rules
exist for legitimate business reasons and reflect differences in
business models among markets. NYSE officials also told us that most of
NYSE-listed firms that do business with the public are larger broker-
dealers and that the rules imposed on larger firms are not always
appropriate for smaller firms.
An ongoing NASD rule modernization effort has identified differences
among NASD and other SROs’ rules and could lead to the resolution of
some differences. In 1998, NASD began a review to identify rules that
could be repealed or modernized. In May 2001, NASD issued a notice to
members stating that it intended to expand and build upon this review
with the goal of ensuring that NASD rules accomplish their objectives
without imposing unnecessary regulatory burdens. NASD also indicated
that it was developing an ongoing process for identifying rules with
regulatory costs that outweighed their benefits, including rules that
were obsolete because of technological changes. The SIA’s response to
the initiative discussed NASD rules that SIA concluded were
inconsistent with those of other SROs and SEC. For example, SIA’s
response[Footnote 37] cited an NASD rule on posting price quotations
that SIA concluded was inconsistent with an SEC rule on displaying
limit orders.[Footnote 38] NASD stated that it had begun the process of
meeting with other regulators, including NYSE and the states, in an
effort to coordinate inconsistencies among various rules. It also
provided other regulators with pertinent comments received in response
to its notice to members. NASD officials told us that although NASD was
coordinating its modernization efforts with other regulators and hoped
to eliminate inconsistencies among rules, NASD could address only its
own rules.
Regulators Have Improved Examination Coordination but Some Broker-
Dealers Remain Concerned about Multiple Examinations:
SEC and SROs have taken actions to improve the efficiency of SRO
examinations of broker-dealers with multiple SRO memberships. These
actions stemmed from (1) a 1976 SEC rule under which the agency assigns
responsibility for conducting a broker-dealer’s financial and
operational soundness examinations to a single SRO, called the
designated examining authority (DEA); (2) another 1976 SEC rule that
facilitated agreements among SROs to reallocate certain oversight
responsibilities; and (3) a 1995 memorandum of understanding (MOU)
among SEC, four SROs, and state regulators to coordinate examinations.
While acknowledging that coordination efforts have improved examination
efficiency, some broker-dealers said that additional improvements in
efficiency are needed.
SEC and SROs Have Improved Examination Coordination:
In its role as an SRO, NASD (through NASDR) is to periodically examine
its members’ operations[Footnote 39] every 1 to 4 years (depending on,
among other things, the size of the broker-dealer). Also in its role as
an SRO, NYSE is to conduct annual examinations of members that do
business with the public. NASD and NYSE examinations include two types
of reviews. The financial and operational review determines compliance
with requirements addressing business soundness. The sales practice
review determines compliance with requirements addressing, among other
things, the quality of trade execution, the existence of unauthorized
trading, the fairness of pricing, and fair dealings with customers, as
well as compliance with market-specific rules governing member conduct
and trade execution. SROs may also conduct cause or special purpose
examinations as necessary to address specific problems or industry
concerns.
In 1976, SEC adopted rule 17d-1, under which it designates a single SRO
as the DEA responsible for financial compliance examinations[Footnote
40] of individual broker-dealers that are members of multiple SROs.
This rule was adopted pursuant to the Securities Act Amendments of
1975, which authorizes SEC to adopt rules to relieve SROs of the
duplicative responsibility of examining their members for compliance
with the Exchange Act, its rules, and SRO rules when the broker-dealer
is a member of more than one SRO. However, because Rule 17d-1 relates
only to financial compliance examinations, the common members of NASD
and NYSE remained subject to sales practice examinations by both NASDR
and NYSE.
According to SEC officials, the agency selects the DEA for common
members based on the market the broker-dealer uses to execute a
preponderance of its customer orders or the market in which the broker-
dealer has the most memberships. As of March 31, 2002, according to
NYSE officials, NYSE was the DEA for about 250 broker-dealers that were
also members of and subject to examination by NASD. According to
NYSE, these firms represented approximately 90 percent of customer
assets in the securities industry.
Also in 1976, SEC adopted Rule 17d-2, which permitted SROs to establish
joint plans for allocating certain regulatory responsibilities that
involved their common members. Under the rule, which was also adopted
as a result of the Securities Act Amendments of 1975, all plans must be
filed with SEC for approval. SEC was to approve plans that, among other
things, fostered cooperation and coordination among SROs. For example,
SEC approved a plan in 1983 under which the American Stock Exchange,
the Chicago Board Options Exchange, NASD, NYSE, the Pacific Exchange,
and the Philadelphia Stock Exchange periodically rotate among
themselves responsibility for options-related sales practice
examinations for their common members. SEC approved other plans in the
1970s and 1980s, under which the American Stock Exchange and the
regional exchanges deferred certain regulatory responsibilities of
their common members to the DEA (either to NASD or NYSE).
Concurrent with proposed legislation[Footnote 41] and related hearings,
SEC, four SROs,[Footnote 42] and the state securities regulators
[Footnote 43] entered an MOU in November 1995 to coordinate broker-
dealer examinations. The MOU provided for the SROs and states (through
the North American Securities Administrators Association) to meet
requests from broker-dealers to coordinate specified on-site regulatory
examinations. In responding to these requests, SROs were to share
information and devise ways to avoid duplication. To the extent
practicable, sales practice examinations conducted by the DEA and any
other SROs were to be conducted simultaneously with the DEA’s financial
and operational examination. Cause examinations that resulted from
customer complaints or other matters were not subject to the MOU, nor
were the examinations that SEC conducted to evaluate the quality of SRO
oversight. However, the MOU encouraged coordination and cooperation for
all examinations to the extent possible.
An SEC official told us that the agency closely monitors and assesses
SRO examination coordination. According to SEC and SRO officials,
representatives of SEC, all SROs, and the states attend annual summits
to discuss examination coordination, review examination results from the
prior year, and develop plans for coordinating examinations for the
coming year. In addition, regional SEC staff and SRO compliance staff
are to meet quarterly to discuss and plan examination coordination, and
SRO examiners are to meet monthly to plan specific examinations of
common members. At these latter meetings, examiners are expected to,
among other things, collaborate on fieldwork dates, document requests,
and broker-dealer entrance and closeout meetings. SROs also are to
share their prior examination reports before beginning fieldwork.
Under the 1995 MOU, SEC agreed to maintain a computerized database to
monitor examination coordination. SEC developed the criteria for
coordinated examinations under the MOU as well as a database to track
the number of broker-dealers that requested and received coordinated
examinations. Under SEC criteria, examinations are coordinated when the
SROs have at least 1 day of concurrent fieldwork at the targeted broker-
dealer. An SEC official told us, however, that concurrent fieldwork was
only one measure of coordination and did not completely reflect the
quality of coordination. However, using this measure, SEC calculated
that from 1997 through 2000 an average of 90 percent of those
requesting coordinated examinations received them and that in 2000 96
percent of requestors received coordinated examinations. According to
SEC officials, requests for coordinated examinations could not be
honored because other scheduled examinations took longer than expected
or because examiners had been reassigned to previously unscheduled
cause examinations.
Some Broker-Dealers Have Remained Concerned about Multiple
Examinations:
SEC’s most recent efforts to address concerns about multiple
examinations have focused on improving examination coordination. In a
June 1998 report,[Footnote 44] SIA concluded that, although SEC and the
SROs had made considerable progress toward improving examination
coordination for broker-dealers with multiple SRO memberships, more
work remained to be done to reduce duplication of efforts. In
discussions with us, some broker-dealers expressed continued
dissatisfaction with inefficiencies associated with multiple
examinations. For example, although examinations could take a few
weeks, according to some broker-dealers, when all examination steps
(including both pre- and post-examination) were taken into account,
firms could be subject to some part of the examination process
continuously throughout the year, even with coordination. Because of
the anecdotal nature of the information provided, we could not
determine the extent to which multiple examinations caused
inefficiencies or the extent to which efforts to address inefficiencies
through improved coordination were successful.
SRO data show that broker-dealers’ participation in the coordinated
examination program has been declining. For example, the total number
of NYSE and NASD member firms participating in the program declined
from about 63 percent in 1998 to about 54 percent in 2000. According to
SEC officials, these numbers do not necessarily indicate problems with
the coordinated examination program, since broker-dealers opt in or out
of the program for many reasons. SEC officials told us that some broker-
dealers that have tried the coordinated examination program have
concluded that it is more efficient for them to have two separate
examinations. They said that an average of five broker-dealers
participating in the coordinated examination program leave the program
each year, typically because they lacked the space to accommodate the
larger teams that accompany concurrent examinations or otherwise found
the examinations to be disruptive to their operations. For example, some
broker-dealers have concluded that it is not efficient for them to have
staff with expertise in different areas of the firm’s operations (such
as sales practices and finance) available to interact with examiners at
the same time.
SEC officials told us that they were aware of broker-dealers’ concerns
about examination coordination and that these concerns had been
addressed on a case-by-case basis. SEC officials stated that they often
sought informal feedback from individual broker-dealers and industry
trade groups and would continue to urge broker-dealers to discuss
examinations and the examination process with SEC and SRO staff. SEC
officials also said that in mid-2001, the agency began a pilot program
to coordinate the examinations of one large broker-dealer. The pilot
includes SEC, NYSE, NASDR, the Chicago Board Options Exchange, and a
number of state regulators. SEC expects the program to help determine
whether the agency can enhance information sharing among regulators and
alleviate any burdens associated with broker-dealers being examined by
multiple regulators.
Market Participants Have Discussed Alternative Approaches to Self-
Regulation:
Securities market participants have discussed alternative approaches to
self-regulation that would address, at least in part, concerns about the
current self-regulatory structure. SEC officials said that the agency
did not plan to dictate changes in the current structure to address
these concerns but instead preferred that market participants reach a
consensus on whether a need for change existed and, if so, the type of
change that would be appropriate. One alternative would expand the DEA
program beyond financial compliance to cover sales practices. An
alternative some ECNs have discussed for addressing their concerns
involves registering as exchanges and becoming SROs. Also, the broader
securities industry has discussed alternatives that would more
dramatically change or replace the current self-regulatory structure.
These alternatives were detailed in an SIA report published in January
2000[Footnote 45] and included consolidating responsibility for broker-
dealer self-regulation and cross-market issues in a single entity not
affiliated with any market (hybrid SRO model), consolidating all self-
regulation—market-specific and broker-dealer—in a single entity (single
SRO model), or having SEC assume all the regulatory functions currently
performed by SROs (SEC-only model). At this time, none of these models
appears to have the support from market participants needed for
implementation.
SEC Does Not Plan to Dictate Change:
According to SEC officials, the agency does not plan to dictate changes
to the regulatory structure. SEC officials told us that they believed
the agency had the authority it needed to make changes but preferred
that the industry reach a consensus on whether the need for change
existed and, if so, what type. Additionally, they said that industry
initiatives, such as Nasdaq’s application to register as an exchange,
were transforming the regulatory landscape. They elaborated that if
Nasdaq became an exchange, it would separate from NASD, mitigating ECN
concerns about conflicts of interest. In the meantime, SEC officials
said that the current self-regulatory structure had been working
adequately and that immediate action was not needed. SEC noted that
members could initiate improvements through their SROs, express
opposition to a proposed course of action directly to the SRO, or voice
their concerns to SEC. Additionally, broker-dealers could respond to
proposed SRO rules both through SRO committees and during the public
comment process and could also use their membership in organizations
such as SIA to lobby for change.
The DEA Program Could Be Expanded:
The Exchange Act provisions under which SEC assigns a single SRO as
DEA with responsibility for financial compliance examinations could be
amended to include sales practice examinations. The result would be that
each broker-dealer would have only one examining SRO, thereby
eliminating examinations by multiple SROs. However, this approach
would not address the conflicts of interest that arise when SROs that
operate a market regulate competitors or the differences in rules and
rule interpretations among SROs.
SEC opposed a provision to expand the DEA program that was included in
proposed 1995 legislation.[Footnote 46] In related congressional
hearings, the then SEC chairman testified that, while SROs currently
monitor trading activities in their own markets, the provision would
seem to require that DEAs also monitor trading in other SROs’ markets,
which could be costly and significantly less effective than the current
system. The chairman also pointed out that while an SRO has
considerable incentive to enforce its own rules, its incentive to
enforce the rules of other SROs might not be as strong. He stated that
requiring an SRO to enforce the rules of another SRO would be
inconsistent with section 19(g) of the Exchange Act, under which each
SRO is to enforce compliance with its own rules.
Some market participants have also discussed a proposal that would allow
broker-dealers, rather than SEC, to select their DEAs. NASD officials
were concerned that this proposal could threaten NASD’s ability to
provide affordable regulatory services to small firms. NASD officials
said that, under this proposal, the large broker-dealers might select
NYSE as their DEA, while the small ones might select NASD. NASD would
then lose the revenue from large broker-dealers that currently
subsidizes the cost of regulatory services for smaller broker-dealers.
For example, according to NASD officials, the smallest NASD member pays
$600 in annual fees, but the average examination for such a broker-
dealer costs from $7,000 to $10,000. According to NASD officials,
allowing broker-dealers to select their DEAs could threaten the
existence of NASD and thousands of small broker-dealers.
ECNs Could Become SROs:
An ECN or other alternative trading system could become an SRO by
registering as an exchange and in doing so would avoid regulation by a
competing SRO. Having each ECN become an SRO would reduce conflicts
of interest that can arise when SROs that operate a market regulate
ECNs. However, this alternative would not address the regulatory
inefficiencies that result from broker-dealers having multiple SRO
memberships. Three ECNs—Island, Archipelago, and NexTrade—have explored
becoming securities exchanges, although no formal filings are currently
before SEC. Archipelago has since become a facility of the Pacific
Exchange.
NASD officials expressed a general concern that, if SROs proliferate,
regulatory information would be reported to different regulators without
adequate coordination. Because no one regulator would see all relevant
information, abuses could continue undetected. They were further
concerned that competition among regulators—to be distinguished from
competition among markets—could lead to a race to the lowest regulatory
standards and undermine investor confidence in the securities markets.
Other market participants have observed that by marketing the quality of
their services to potential clients, competing regulators could create
higher regulatory standards. One ECN emphasized that SEC’s existing SRO
oversight programs focus on assessing whether regulatory service
providers meet acceptable levels of performance.
Broker-Dealers and Cross-Market Rules Would Be the Responsibility of a
Single Entity (the Hybrid SRO Model):
The SIA report endorsed replacing the current self-regulatory structure
with the hybrid SRO model, a proposal that was discussed in the early
1970s. Under the hybrid SRO model, a single entity unaffiliated with any
market would be created to assume responsibility for broker-dealer
oversight and cross-market rules, including those related to sales
practices, industry admissions, financial responsibility, and cross-
market trading. Individual SROs would remain responsible for market-
specific rules such as those related to listings, governance, and
market-specific trading.
Although some SIA members said it was premature to revamp the current
regulatory structure, the majority supported the hybrid SRO model
because they believed that it would reduce member-related conflicts of
interest and SRO inefficiencies. According to SIA, potential conflicts
of interest would be reduced because the new SRO would not be affiliated
with a competing market. Eliminating duplicative SRO examinations would
reduce inefficiencies in areas such as rulemaking, examinations, and
staffing. SEC officials agreed that consolidating member regulation
into one SRO was an advantage of the hybrid SRO model. They noted that
the industry was moving toward a hybrid model as Nasdaq separated from
NASD and NASD contracted to provide regulatory services to more SROs.
Although NASD officials told us that they did not have an official
position on the hybrid SRO model, NASD has supported the concept of
separating market-specific and member regulation in the past. In
February 2000 testimony, the then NASD chairman noted that NASD’s
separation of Nasdaq and NASDR is the first step toward “the right
regulatory model: the hybrid SRO model.”[Footnote 47]
In stating its opposition to self-regulatory changes, the NYSE chairman
said that spinning off NYSE regulation into an unaffiliated regulatory
entity would weaken investor protection and do irreparable harm to the
NYSE brand name. He noted that funding a separate regulatory body
independent of the exchange would eliminate economic efficiencies and
synergies that result from the integration of regulation into the NYSE
market as a whole. NYSE officials told us that because the hybrid model
separates member from market-specific regulation, the hybrid regulator’s
examinations would not review the operations of the entire broker-dealer
and thus would be less effective than examinations conducted under the
current regulatory approach. NYSE officials also said that the exchange
had postponed its plan to demutualize for several reasons, including
concern that such action might have had the negative consequence of
forcing NYSE to separate its regulatory and market functions. SIA agreed
that the disadvantages of the hybrid SRO model included the model’s
inability to address market-specific conflicts of interest. SIA and
others concluded, however, that the advantage of having personnel with
specialized knowledge overseeing market operations outweighed this
disadvantage.
According to the SIA report, SIA attempted to gather data showing that
the hybrid SRO model would be a cost-effective approach to self-
regulation. However, it was unable to obtain the data it needed from
the SROs. In the absence of active support from NYSE and SEC for the
model, SIA is not currently pursuing it as a means of addressing market
participants’ concerns about conflicts of interest and regulatory
inefficiencies.
Markets and Broker-Dealers Would Be Regulated by One Entity (the Single
SRO Model):
The SIA report also discussed the single-SRO model as a means of
addressing concerns about both conflicts of interest and regulatory
inefficiencies. Under this model, a single SRO would be vested with
responsibility for all regulatory functions currently performed by the
SROs, including market-specific and broker-dealer regulation. According
to SIA, the single SRO model could eliminate the conflicts of interest
and regulatory inefficiencies associated with multiple SROs, including
those that would remain under the hybrid SRO model. However, SIA did not
endorse this alternative, primarily because of the risk that self-
regulation would become too far removed from the functioning of the
markets—a point of view that was similar to NYSE’s comments on the
hybrid model.
In addition, and in contrast to broker-dealer regulation, SEC officials
said that it might not be appropriate or feasible to give a single SRO
responsibility for surveilling all the markets because of differences
in the way trades are executed in each. That is, Nasdaq, NYSE, and other
markets have different rules that reflect their different ways of
executing trades. SEC has taken the position that SROs should continue
to have ultimate responsibility for enforcing rules unique to the SRO
or relating to transactions executed in the SRO’s market. Market
operators have generally shared this view.
SEC Would Assume All Regulatory Responsibility (the SEC-Only Model):
The SEC-only model would address concerns about conflicts of interest
and regulatory inefficiencies by eliminating all self-regulation. Under
this model, SEC would assume all the regulatory functions currently
performed by SROs. Under a variation of this alternative that is not
discussed in the SIA report, SEC would assume just NASD’s obligation to
regulate ECNs and other alternative trading systems. SIA did not endorse
the SEC-only model because doing so would eliminate self-regulation of
the securities industry, taking with it the expertise that market
participants contribute. SIA also expected the SEC-only model to be more
expensive and bureaucratic, because implementing it would require
additional SEC staff and mechanisms to replace SRO regulatory staff and
processes. In addition, according to the report and SEC, a previous SEC
attempt at direct regulation was not successful, owing to its high cost
and low quality (relative to self-regulation), convincing SEC and other
market participants that it was not a feasible regulatory approach.
[Footnote 48]
Conclusions:
As competition continues to drive the evolution of the securities
markets, concerns about the conflicts of interest inherent in the
current self-regulatory structure have grown in importance. Such
concerns, if not effectively addressed, could undermine the cooperative
nature of self-regulation and erode confidence in the fairness of the
securities markets. As a result, an ongoing challenge for SEC and the
SROs will be to respond effectively to both real and perceived
conflicts of interest.
The extent of the regulatory burden generated by differences in SROs’
rules and their interpretation and by multiple examinations of broker-
dealers is unknown. Obtaining a better understanding of related concerns
could help address the dissatisfaction some broker-dealers have
expressed with the current self-regulatory structure. For example,
differences in rules and their interpretations have been used to
justify the need for multiple examinations. As a result, the success of
efforts to address concerns about multiple examinations could be
related to how concerns about differences in rules are addressed. To
improve its understanding of broker-dealers’ concerns, SEC could work
with NASD, NYSE, and other market participants to identify and address
differences in rules that might cause material inefficiencies in the
regulatory process. SEC could also work with these market participants
and through its ongoing pilot program to better assess whether further
improvements in examination coordination could address the most
significant problems associated with multiple examinations of broker-
dealers. As part of these efforts, SEC could instruct the SROs to
provide the agency with formal assessments of broker-dealers’
satisfaction with the coordinated examination program, including
determining why some broker-dealers choose not to participate and why
others terminate their participation, and of market participants’
specific concerns about rules. For example, a survey that is
representative of broker-dealers and that is administered by a neutral
party could be used to determine the nature and extent of concerns
about rules and examinations. Such information might also be useful to
SEC and the industry in assessing the effectiveness of the current
regulatory structure.
Some broker-dealers and market participants believe that the concerns
raised by changes in the markets warrant further examination of
alternatives for revising the self-regulatory structure. In contrast,
SEC has observed that the regulatory landscape is in the process of
transformation and that, thus far, the current self-regulatory
structure has been working adequately. Without additional SEC and
industry support, major changes are not expected.
Recommendations:
We recommend that the chairman, SEC, work with the SROs and broker-
dealer representatives to implement a formal process for systematically
identifying and addressing material regulatory inefficiencies caused by
differences in rules or rule interpretations among SROs and by multiple
examinations of broker-dealers. In doing so, we recommend that SEC
explore with the SROs and other market participants various methods for
obtaining comprehensive feedback from market participants, such as
having the SROs use a neutral party to independently collect and assess
market participants’ views.
SEC, SRO, and Industry Comments and Our Evaluation:
We requested comments on a draft of this report from the heads, or their
designees, of SEC, NASD, Nasdaq, NYSE, SIA, and three ECNs. We received
written comments from SEC, NASD, Nasdaq, and SIA that are summarized
below and reprinted in appendixes I through IV. In addition, we
received oral comments from the general counsel of one ECN on March 18,
2002; they are also summarized below. Finally, we received technical
comments from SEC, NASD, NYSE, SIA, and a second ECN that are
incorporated into the report as appropriate. The third ECN did not
provide comments. The respondents generally agreed with the conclusions
and recommendations in the draft report, however, three respondents
expressed additional concerns.
SEC officials endorsed our recommendations and indicated that the
agency would work closely with NASD and NYSE to implement them. NASD,
which also agreed with our recommendations, highlighted its efforts to
resolve issues caused by differences in rules or rules interpretations
through it rule modernization project. NASD noted that its authority is
limited to addressing NASD rules and cited the importance of SEC
participation to further efforts to reduce inconsistencies in rules.
Nasdaq commented that the draft report generally provided an accurate
characterization both of the debate about conflicts of interest between
the primary SROs—NYSE and Nasdaq—and their respective markets and of
some of the steps that are being taken to mitigate those conflicts.
However, Nasdaq also said that the report largely overlooked a serious
challenge to the integrity of the self-regulatory system—that is, the
alignment of regional stock exchanges with ECNs for trading Nasdaq
stocks. Nasdaq commented that these alignments have copied Nasdaq’s
“competing dealer” market structure without also adopting the safeguards
necessary to regulate such a market. While this issue may deserve
additional attention, our report focused on concerns about potential
abuses of regulatory authority by SROs that regulate members against
which they compete for order flow rather than on the broader issues of
competition among markets or the quality of self-regulation SROs
provide. The draft report did note that SEC assesses the quality of all
the SROs’ regulatory programs, which includes those of the regional
exchanges. It also stated that the concerns addressed were identified
through a variety of means, including discussions with Nasdaq officials
and other market participants, and that they did not represent all
existing concerns.
SIA agreed with the report’s conclusions and recommendations but also
expressed concern that SROs often file rule changes with SEC without
prior public notice or opportunity for comment. As a result, affected
firms learn of proposed rule changes only when the rules are published
for comment in the Federal Register. SIA expressed a similar concern
about rule interpretations or clarifications that inadvertently impose
new substantive obligations on members, noting that SROs also issue
these changes without any public notice or opportunity for comment.
Accordingly, SIA suggested that market participants be engaged at the
outset of the regulatory dialogue in order to produce more balanced,
resource-efficient regulation. We recognize that the need for public
comment must be balanced against the need for SROs to expeditiously
implement rules that can affect their competitiveness and that SEC and
the industry have been attempting to balance these sometimes conflicting
demands. To the extent that the timing of the public comment process is
a factor causing differences in rules and their interpretations, this
issue could be explored as part of SEC’s and the industry’s efforts to
implement our recommendations.
The ECN that provided oral comments on the draft report focused on
concerns about conflicts of interest in the self-regulatory structure as
SROs increasingly compete with the members they regulate. The ECN
commented that the report did not capture the full extent of the
“dysfunction” and competitive conflict in the current self-regulatory
structure, emphasizing its concern that ECNs had no viable alternative
to being regulated by a competitor. The final report includes some
additional information the ECNs provided in response to the draft that
further illustrates the nature of their concerns.
Scope and Methodology:
To review how SEC, NASD, and NYSE are addressing concerns about (1) the
impact of increased competition, including demutualization, on the
ability of SROs to effectively regulate members with which they compete
and (2) possible regulatory inefficiencies associated with broker-dealer
membership in multiple SROs, we reviewed relevant securities laws and
SRO rules, SEC concept releases and studies, SEC and SRO proposed rule
changes, an NASDR rule modernization notice, industry and academic
studies and research papers, and articles in academic and industry
publications. We also reviewed comment letters received on releases and
proposals published in the Federal Register. In addition, we interviewed
officials of two federal agencies (the Commodity Futures Trading
Commission and SEC); three SROs (NASD (including Nasdaq and NASDR), the
National Futures Association,[Footnote 49] and NYSE); three ECNs; the
Arizona Stock Exchange; two industry associations (SIA and the
Investment Company Institute[Footnote 50]); three investment companies
that manage mutual funds or pension funds; eight registered broker-
dealers (in addition to the three ECNs); and two industry experts. We
also identified the concerns that are addressed in the report through
these document reviews and interviews. As a result, the concerns
identified do not necessarily represent all those that exist. Our
review focused on the two largest SROs in the equities markets—NASD and
NYSE—because concerns related to the dual role of SROs as market
operators and regulators applied primarily to these SROs. They were
also the SROs that were the subject of concerns about the efficiency of
SRO rules and examinations affecting members that belong to multiple
SROs. Our review focused primarily on the securities markets because
the issues that have arisen in these markets have not yet surfaced to
the same extent in other markets.
To describe alternative approaches that some securities market
participants have discussed as a means of addressing concerns about the
current self-regulatory structure, we reviewed industry and academic
studies and research papers, articles in academic or industry
publications, and congressional hearing records. We discussed the
alternatives identified with the officials cited above.
We did our work in Chicago, IL; New York, NY; and Washington, D.C.,
between October 2000 and March 2002 in accordance with generally
accepted government auditing standards.
We will send copies of this report to other interested congressional
committees. We will also send copies to the chairman of SEC, chairmen
and chief executive officers of NASD and Nasdaq, president of NASDR,
chairman and chief executive officer of NYSE, chairman and president of
SIA, and the three ECNs. Copies will be made available to others upon
request.
For any questions regarding this report please, contact me at (202) 512-
8678, hillmanr@gao.gov, or Cecile Trop, Assistant Director, at (312)
220-7705, tropc@gao.gov. Key contributors include Roger Kolar, Melvin
Thomas, Sindy Udell, and Emily Chalmers.
Signed by:
Richard J. Hillman:
Director, Financial Markets and Community Investment:
[End of section]
List of Congressional Committees:
The Honorable Paul S. Sarbanes:
Chairman:
The Honorable Phil Gramm:
Ranking Minority Member:
Committee on Banking, Housing and Urban Affairs:
United States Senate:
The Honorable Michael G. Oxley:
Chairman:
The Honorable John J. LaFalce:
Ranking Minority Member:
Committee on Financial Services:
House of Representatives:
The Honorable W. J. “Billy” Tauzin:
Chairman:
The Honorable John D. Dingell:
Ranking Minority Member:
Committee on Energy and Commerce:
House of Representatives:
[End of section]
Appendix I: Comments from the Securities and Exchange Commission:
United States:
Securities And Exchange Commission:
Washington, DC 20549:
April 2, 2002:
Richard J. Hillman:
Director, Financial Markets and Community Investment:
United States General Accounting Office:
441 G Street, N.W.
Washington, DC 20548:
Dear Mr. Hillman:
We appreciate the opportunity to comment on the General Accounting
Office's ("GAO") draft report entitled Securities Markets: Competition
and Multiple Regulators Heighten Concerns About Self-Regulation, GAO-02-
362.
We commend the GAO for its considerable efforts in investigating market
participants' concerns regarding the impact of increased competition on
the ability of self-regulatory organizations ("SROs") to effectively
regulate members with which they compete, and the potential for
regulatory inefficiencies associated with broker-dealer memberships in
multiple SROs. With respect to the latter area, the Report highlights
the concerns of some broker-dealers with multiple SRO memberships that
differences in SRO rules and their interpretations result in
operational inefficiencies and that examinations by multiple SROs are
unnecessarily burdensome. The Report generally recommends that the
Commission work with the SROs and other market participants to identify
and address any material regulatory inefficiencies and unnecessary
burdens.
Inefficiencies Associated with Differing Rules and Interpretations
Among SROs:
As the report recognizes, the Commission staff has worked on several
fronts over the past few years to harmonize SRO rules that address
similar behavior. In reviewing SRO rule proposals, for example, the
Commission staff evaluates any significant differences or
inconsistencies between the specific proposal and other existing or
proposed SRO rules. In particular, the Division staff generally asks
the particular SRO to justify any differences between its proposal and
the rules of another SRO or the Commission. The rule review process,
including the public comment process, has been relatively effective in
addressing broker-dealers' concerns about inconsistent or conflicting
regulations. Nevertheless, the process can only work to address market
participants' concerns raised at the time a rule proposal is filed. The
burdens associated with different SRO rules may not become apparent
until long after the rules have been implemented.
Accordingly, we agree with the GAO that it would be helpful for the
SROs to gather information on a more formal basis about potential
regulatory inefficiencies created by differing SRO rules. To implement
the GAO's recommendation, we intend to write to the New York Stock
Exchange ("NYSE") and the National Association of Securities Dealers
("NASD") to ask them to conduct a representative survey of their
members to elicit their members' specific concerns, and to provide the
Commission with the results. We understand that the NASD is already
conducting a comprehensive review of its rules, including hiring an
outside consultant to assist it in evacuating the results of' its
survey.
Certain Broker-Dealers' Concerns About Multiple Examinations:
As noted by the GAO, the Commission staff and the relevant SROs have
improved the coordination of regulatory examinations over the past
several years. The Commission staff closely monitors and assesses
examination coordination by the SROs. In fact, the Commission staff and
SRO officials meet regularly to address, among other things,
examination coordination. In addition, Commission and SRO officials and
state securities regulators attend annual summits to discuss exam
coordination, to review exam results from the prior year, and to
develop plans for coordinated exams for the coming year. Furthermore,
the Commission staff has conducted a number of new coordination efforts
in an effort to make examinations more effective and efficient. While
the Commission staff informally seeks feedback from individual broker-
dealers and from industry trade groups regarding coordination, we will
ask the NYSE and NASD to consider conducting a survey of their members
to aid in assessing broker-dealer satisfaction with the coordinated
examination program.
Conclusions:
While we continually strive to eliminate regulatory inefficiencies,
there may be occasions when different rules or examinations by
different expert regulators may be desirable. Markets, for instance,
may wish to have different rules to reflect their differing market
structures, and certain SROs may wish to have higher standards than
others. Nevertheless, we agree with the GAO that it would be helpful to
implement a more formal process to identify unnecessary regulatory
inefficiencies, and so we intend to work closely with the NASD and the
NYSE to implement your recommendation. These efforts should dovetail
with the efforts of Commissioner Glassman, who -- at Chairman Pitt's
request -- is spearheading a review of the Commission's rules in an
effort to modernize them.
Thank you for the opportunity to comment, and for the courtesy shown to
the staff during the course of your study.
Sincerely,
Signed by:
Annette L. Nazareth:
Director:
Division of Market Regulation:
Signed by:
Lori Richards:
Director:
Office of Compliance Inspections and Examinations:
[End of section]
Appendix II: Comments from the National Association of Securities
Dealers:
NASD:
National Association of Securities Dealers, Inc.
Robert R. Glauber:
Chairman & Chief Executive Officer:
1735 K Street NW:
Washington, DC 20006-1500:
202-728-8000:
April 1, 2002:
Mr. Richard J. Hillman:
Director, Financial Markets and Community Investment:
General Accounting Office:
Washington, D.C. 20548:
Dear Mr. Hillman:
This letter provides our comments on GAO's draft report Securities
Markets: Competition and Multiple Regulators Heighten Concerns About
Self-Regulation (GAO -02-362). Thank you for the opportunity to offer
these comments.
Your report covers an important issue for the regulation of the
securities markets: whether conflicts of interests faced by self-
regulators that operate markets can harm self-regulation. We agree with
the significance the report places on this issue. While the concept of
an SRO necessarily involves some potential conflicts, NASD has taken
great pains to minimize conflicts between regulation and market
operation. During the period covered by this report, the NASD owned
Nasdaq. To deal with possible conflicts caused by an ownership
structure that has a market and its self-regulator under one roof, we
formed NASD Regulation in 1996 as a separate subsidiary with its own
board of directors. In the last year we have completed the further step
of divesting ownership of Nasdaq, subject to SEC action to register
Nasdaq as a separate exchange. Although we, like other self-regulators,
employ strict internal controls to minimize the problem of potential
conflicts, we alone among US self-regulators have taken the
extraordinary steps of first, organizationally separating regulation
and market operation and subsequently, divesting ownership of the
market.
The NASD's commitment to strong, effective regulation of the industry
is shown not only by our unique structure and our internal controls,
but also by the significant resources we deploy toward that end. For
example, in 2001, NASDR spent about $400 million, about a quarter of
which was for regulation of Nasdaq. In addition, Nasdaq spent about $15
million on its own internal regulatory operations, such as listing
qualification. We believe that this resource commitment is unmatched in
the industry.
In addition to our unique structure and massive resource commitment, we
also are leaders in using technology to improve regulation of the
industry, and are hard at work on using it to improve further both
field examinations and market surveillance. For example, our INSITE
(Integrated National Surveillance and Information Technology
Enhancements) Surveillance system will provide the most advanced risk-
based field examination capability of any securities regulator or self-
regulator. It uses sophisticated statistical analysis and data mining
techniques to spot risk in member firms, tracking member activity from
internal NASDR databases and from clearing firm data to find unusual
activity patterns. INSITE detects changes in the sales practice,
trading, underwriting and financial responsibility areas of member firm
operations, and sets red flags for early regulatory intervention,
outside of the traditional, calendar driven cycle. Our district staffs
are now piloting INSITE, and by mid-year, it will be fully implemented
in each District Office.
We are also enhancing our market surveillance systems, particularly ADS
and SONAR, already some of the most sophisticated in the industry. ADS
(Advanced Detection System) is a parameter break detection and
discovery tool used to find suspicious activity using pattern
recognition across the trades and quotations in the Nasdaq database. It
integrates data mining, pattern matching, and visualization techniques
into one large-scale application that is now used for problem detection
in trade reporting, market integrity, best execution, and front
running. SONAR (Securities Observation, News Analysis, and Regulation)
monitors the markets exhaustively and accurately for indications of
insider trading and fraud and pulls together all the information needed
for the analyst to deal with the problems he or she finds. It includes
a text-mining tool for use on financial press and EDGAR filings, allows
fast, easy change of financial models, and deploys an expert system to
spot problems. I would like to reiterate Mary Schapiro's invitation to
you and your staff to see a demonstration of these important regulatory
advances.
The draft GAO report (at page 27) makes the following recommendations:
We recommend that the Chairman, SEC, work with the SROs and broker-
dealer representatives to implement a formal process for systematically
identifying and addressing material regulatory inefficiencies caused by
differences in rules or rule interpretations among SROs and by multiple
examinations of broker-dealers. In doing so, we recommend that SEC
explore various methods for obtaining comprehensive feedback from
market participants, including use of a neutral party to independently
collect and assess views on the effectiveness of SEC and SRO
regulations.
We agree with the recommendation and point out (as noted in the report)
that we have been working through our Rule Modernization Project to
resolve issues caused by differences in rules or rule interpretations,
but we can only address our own rules. We believe that the
participation of the SEC would further the effort to reduce
inconsistencies. In addition, we endorse the idea of seeking
comprehensive feedback from market participants, which is also a goal
of our Rule Modernization Project.
Our detailed comments on your draft are contained in the attached
document, which makes specific recommendations on the report's language
we believe should be changed. [Attachment omitted]
Thank you again for the opportunity to comment on your draft. If you
have any questions, please do not hesitate to contact me or Mary
Schapiro.
Sincerely,
Signed by:
Robert R. Glauber:
[End of section]
Appendix III: Comments from Nasdaq:
NASDAQ®:
The Nasdaq Stock Market, Inc., an NASD Company:
Richard G. Ketchum:
President:
richard.ketchum@nasd.com:
1735 K Street, NW:
Washington, DC 20006:
202-728-8020:
Fax: 202-728-8075:
March 27, 2002:
Mr. Richard J. Hillman:
Director:
Financial Markets and Community Investment:
U.S. General Accounting Office:
Washington, DC 20548:
Re: March 12, 2002 Draft Report on Securities Markets "Competition and
Multiple Regulators Heighten Concerns and Self-Regulation"
Dear Mr. Hillman:
I appreciate the opportunity to share with you the views of the Nasdaq
Stock Market, Inc. ("Nasdaq") regarding the captioned Draft Report. We
believe that the Draft Report generally provides an accurate
characterization of the debate with respect to potential conflicts of
interest between the primary self-regulatory organizations ("SROs") and
their respective affiliated markets and some of the steps being taken
to mitigate those potential conflicts. We believe that by focusing
primarily on Nasdaq and the New York Stock Exchange, however, the Draft
Report largely overlooks one of the more serious challenges to the
integrity of the self-regulatory system-the participation in that
system by regional exchanges that have aligned themselves with
electronic communications networks ("ECNs"). These regional markets
have copied the Nasdaq competing dealer market structure without also
adopting the regulatory safeguards necessary to regulate properly such
a market.[Footnote 51] We believe that these "exchange light" market
models could lead to a regulatory race to the bottom whereby broker-
dealers, in an effort to cut costs, move to thinly regulated markets to
avoid the cost of regulation. Ultimately, such a move, which is
becoming more likely in the increasingly competitive market for trading
Nasdaq securities, could undermine investor confidence in the markets.
In this respect, and as discussed further below, we respectfully
disagree with the premise of your statement on page 27 of the Draft
Report that the GAO focused on the NASD and NYSE "because concerns
related to the dual role of SROs as market operators and regulators
applied primarily to these SROs." It is our hope that in response to
this letter you will examine the potential detrimental impact on the
self-regulatory system of recent alignments between regional registered
national securities exchanges and ECNs.
Threat of Exchange Light Regulation to Self-Regulatory System:
The CSE Model:
One SRO regulatory model warranting further GAO attention because of
its potential detrimental impact on the self-regulatory system involves
that of the Cincinnati Stock Exchange ("CSE"), which is expanding its
program to trade Nasdaq securities. Nasdaq contends that the CSE has
attempted to copy the Nasdaq competing dealer regulatory structure to
attempt to attract ECNs and market makers while lacking the resources
and many of the important investor protections that are necessary for
adequately regulating such a market[Footnote 52]
Based on public financial information that the CSE provides to the SEC,
it is evident that the CST's total expenditures are less than 1/10 of
those that Nasdaq spends on regulation alone in a given year.
Presumably not all of the CST's budget goes to fund its regulatory
program. The CSE itself has claimed that its regulatory function is as
robust as and in some instances more robust than that of the Nasdaq
Stock Market, and yet the financial realities make the accuracy of
those statements highly suspected[Footnote 53] The GAO may wish to
determine how much the CSE actually spends on regulation in a given
year to determine the relative proportion of the exchange's resources
that are committed to regulation.
But funding is not the only element necessary for a robust regulatory
program. One of the more important aspects of a regulatory program is
the existence of an order audit trail. Ills common knowledge in the
industry that order information with respect to Nasdaq securities must
be reported to the NASD's OATS system. The OATS rules and technical
specifications have been vetted by the STC and by the industry through
the public notice and comment process. OATS information, supplemented
by trade reporting information, wish analyzed by a highly trained
NASDAQ regulatory staff to surveil for violations of Nasdaq and SEC
rules.
The CSE has claimed that its own audit trail method, which it refers to
as Firm Order Submission ("FOPS"), is superior to OATS. Yet, we do not
believe that an adequate independent assessment has been made to
determine whether FOPS is insufficient for the proper surveillance of
the CSE as it enters the market for Nasdaq securities. If FOPS is
insufficient, we believe there is some doubt as to whether the CST's
regulatory program is insufficient for surveillance that market. If the
CST's order audit trail and its regulatory program as a whole are
insufficient, we believe that investors could be exposed to trading
abuses by market professionals, which ultimately could undermine
investors' confidence in the entire self-regulatory system. Therefore,
we respectfully request that the GAO work with the STC in assessing
whether the CST's resources, rules and systems are adequate for
properly regulating the CSE. In its examination, the GAO may wish to
ask the CSE the following questions:
* Does the CST have the necessary rules in place to ensure that
customer orders are protected from overreaching by professional
traders? How will the CST's recent proposal to remove a number of
important customer protection rules with respect to Nasdaq securities
(SR-CSE-01-04) impact those safeguards?
* Does the CST have the necessary systems in place to surveil
adequately for trading abuses by an expanded member base?
* What is the underlying purpose of FOPS? (i.e., was it developed and
is it used for the purpose of reconstructing markets to surveil for
trading abuses or does it primarily serve other, non-regulatory
functions?)
* Does FOPS allow for the prompt and efficient reconstruction of
markets or does it require a substantial degree of manual processing?
* Is FOPS mandatory? If so and a CST member fails to comply, what CST
rules is it violating?
* If FOPS is a voluntary system, has the CSE put in place alternative
safeguards to ensure that any information lost regarding orders that
members choose not to put into the system is captured through other
automated means?
* Are any modifications to FOPS necessary to adapt it to trading in
Nasdaq securities?
* What data elements does FOPS capture? In particular, does FOPS
include all trades between the dealer and its customers? Does it track
orders originated by or received by a dealer even if those orders are
not sent to the CSE's limit order book? If FOPS does not in itself
capture all necessary data elements to reconstruct trading activity,
does the CST use data gathered from other systems (e.g., trade
reporting and trade comparison information) to supplement the FOS audit
trail?
* Does the CST have the necessary regulatory staff in place to analyze
the data from FOS and any other supplemental data?
* Have the FOS rules and technical specifications been sufficiently
vetted and, if necessary, approved by the STC staff?
We believe that unsatisfactory or incomplete answers to the above
questions, in the absence of sufficient remedies by the CSE, could lead
to regulatory problems that could damage investors' confidence in the
self-regulatory system.
The PCX/ARCA Model:
Another regulatory model worth examining is the PCX/ARCA model. In
October of 2001, the STC approved a proposal by the Pacific Exchange
("PCX") to establish an affiliate of the Archipelago ECN as a facility
of the PCX.[Footnote 54] To our knowledge, the approval of the PCX/ARCA
arrangement marks the first time the SEC has permitted a market to
operate as a registered securities exchange without important
components of the market being owned or controlled by a regulated
entity. Rather the regulation of the new Archipelago Exchange
("ArcaEx") is based principally on a complex series of contractual
arrangements. Should there ever be a regulatory problem involving one
or more of the affiliates of ARCA, Nasdaq contends that the real-time
regulation of the ArcaEx could be compromised and the STC's oversight
of that market could be held at bay while the SEC staff and the courts
attempt to untangle the myriad of commercial agreements upon which that
regulation is based.
One prime area for future dispute concerns the line dividing ArcaEx's
quasi-regulatory role in regulating the day-to-day operation of the
ArcaEx market and PCX's role as the SRO of that market. We believe this
issue can only be resolved by a definitive statement by the SEC, the
PCX or by a court explaining which ArcaEx business activities are and
which are not "inconsistent with the regulatory and oversight functions
of the PCX and PCXE", the phrase used by PCX/ARCA to define ARCA's
regulatory reach. In the order approving the ARCA/PCX arrangement, the
STC attempted to clarify the meaning of this phase by stating: "This
means that Archipelago Exchange LLC will not interfere with the PCX's
self-regulatory responsibilities." This explanation is merely
tautological, however, and does nothing to describe what PCX's self-
regulatory responsibilities are with respect to the regulation of
ArcaEx.
We believe that the legal/regulatory battle that could result from the
ambiguity of PCX's regulatory duties vis-a-vis ArcaEx, even though the
arrangement is unique to PCX/ARCA, could injure investor confidence in
the self-regulatory model. PCX/ARCA's planned merger with Redi ECN will
only further complicate the regulatory picture of the ARCA
conglomerate. Although we are hopeful that PCX will file with the SEC a
rule proposal for effecting such a substantial merger, we are not aware
that any has been filed to date. We believe that the absence of STC-
approved rules that discuss the regulatory treatment of Redi as a PCX
affiliate will add further uncertainty to the self-regulatory system.
Therefore, we respectfully request that the GAO examine the regulatory
structure of PCX/ARCA, including its pending merger with Redi, to
determine whether adequate safeguards have been put in place to offer
regulatory certainty with respect to that market.
In examining the PCX/ARCA/Redi regulatory model the GAO may wish to
review the regulatory structure in place for ArcaEx's affiliated broker-
dealer, WAVE. WAVE, for those PCX members that choose to use it, will
serve as the sole means for routing orders off of ArcaEx. PCX members
that choose not to use WAVE will be prohibited from using certain
ArcaEx order types that are available to WAVE users. At the same time,
WAVE will also serve as an introducing broker to offer users direct
access to ArcaEx. Finally, the same WAVE will operate an ECN for
securities not eligible to be traded on ArcaEx. The SEC was so
concerned about the potential for a conflict of interest between the
ARCA conglomerate and WAVE, that the SEC determined that certain
functions of WAVE made it a facility of the PCX and, therefore, subject
to regulation as an exchange. With respect to other functions that the
same affiliate performed, however, the SEC applied the much more
lenient broker-dealer regulatory structure. We believe that this
bifurcated regulatory structure based on functions combined with the
contractual nature of ArcaEx's regulation raise a number of troubling
regulatory issues. We believe that these issues should be thoroughly
examined by the GAO to determine what impact they may have on the self-
regulatory structure.
We would like to thank you again for allowing us to provide you with
our thoughts on these complex and important issues. If we can be of
further assistance, please do not hesitate to call.
Respectfully,
Signed by:
Richard Ketchum:
[End of section]
Appendix IV: Comments from the Securities Industry Association:
Securities Industry Association:
120 Broadway:
New York, NY 10271-0080:
(212) 608-1500:
Fax (212) 608-1604:
1401 Eye Street, NW:
Washington, DC 20005-2225:
(202) 296-9410:
Fax (202) 296-9775:
April 3, 2002:
Mr. Richard Hillman:
Director, Financial Markets and Community Investment:
U.S. General Accounting Office:
441 G Street, N.W.
Washington D.C. 20548:
Dear Mr. Hillman:
The Securities Industry Associations[Footnote 55] ("SIA") appreciates
the opportunity to comment on the draft report of the United States
General Accounting Office ("GAO") entitled Securities Markets:
Competition and Multiple Regulators Heighten Concerns about Self-
Regulation ("GAO Report" or "Report").
SIA commends the GAO for undertaking this important and timely review
of the existing regulatory structure. As noted in the Report, industry
participants are facing a high degree of unnecessary duplication,
inconsistency and inefficiencies associated with the current multiple
self-regulatory organization ("SRO") structure.
Although each SRO clearly has its own regulatory responsibility and
agenda, duplicative and conflicting regulation across SROs is both
inefficient and costly. Such rules yield little benefit while depleting
valuable administrative and economic resources from all segments of the
securities industry. Specifically, broker-dealers that are members of
more than one SRO are often subject to multiple and inconsistent rules
on the same subject, as well as each SRO's varying interpretation of
what constitutes a rule violation and what the appropriate sanction (if
any) is for a violation. Customers likewise may be confused as they
"shop" for the brokerage that supplies services according to the rules
and interpretations of a given SRO. By reducing existing redundancy and
discrepancies, the totality of self-regulatory costs for broker-
dealers, including the cost of compliance and supervision will be
reduced significantly, thereby allowing member firms to utilize
resources more efficiently and effectively to benefit investors.
Similarly, there will be corresponding cost savings to the SROs since
each expends valuable staffing and operating resources to monitor and
examine broker-dealer activity on identical or similar subjects.
Indeed, SROs as a group expend unnecessary resources internally to
consider and prepare rule filings which duplicate filings of other
SROs.
Notwithstanding the SEC and some SROs' attempts to identify and address
some of these issues, inconsistent and redundant rulemaking still
persists. Indeed, as acknowledged in the GAO Report, no formal
regulatory process exists for assuring consistency among rules. Nor is
it enough to point to the existing rule review and public comment
process as the solution to these difficulties. The fact is SROs often
file rule changes with the SEC without affording interested parties any
prior public notice or opportunity for comment. Consequently, affected
firms first learn of a proposed change upon its publication in the
Federal Register well into the regulatory dialogue. This absence of
industry vetting is particularly troublesome in the case of SRO
"clarification" or "informational" releases through which SROs may
inadvertently impose new substantive obligations upon members without
providing for any public notice or comment prior to implementation.
SIA, therefore, supports the GAO's recommendation that the SEC work
with the SROs and broker-dealer community to implement a formal process
for systemically identifying and harmonizing material regulatory
inefficiencies caused by differences in rules or rule implementations
among SROs. We would further suggest engaging market participants at
the outset of the regulatory dialogue, which we believe will produce
more balanced, resource-efficient regulation that ultimately benefits
investors, regulators and broker-dealers alike.
As with the duplicative rulemaking by multiple SROs, the redundancy
problem also reveals itself in the broker-dealer examination context.
As noted by the GAO, multi-member firms are subject to multiple,
overlapping SRO examinations, which are costly and extremely time
consuming. Although the SEC and SROs have attempted to minimize some of
the inefficiencies of multiple examinations by establishing joint
examination programs, sufficient duplications remain since the
practical coordination of the SROs on examinations has not yet been
achieved. For example, in a joint examination, the respective teams of
examiners may agree on the format, but remain subject to the different
agendas and directions of their respective SROs. There often is neither
a clear division of responsibilities nor a willingness on the part of
the examiners to accept to the findings of another SRO examiner.
Consequently the objectives of the joint examination process are not
often realized. SIA, therefore, also would support any efforts to
better coordinate the examination process in order to alleviate the
burdens associated with multi-regulator examinations of broker dealers.
Again, we thank you for the opportunity to respond to the GAO draft
report and to work with your staff on this matter. If you have any
questions or require further information, please feel free to contact
me at (212) 618-0568.
Sincerely,
Signed by:
Amal Aly:
Vice President & Associate General Counsel, SIA:
cc: Cecile Trop, Assistant Director, Financial Markets & Community
Investment, GAO:
[End of section]
Footnotes:
[1] SROs have an extensive role in regulating the U.S. securities
markets, including ensuring that members comply with federal securities
laws and SRO rules. SROs include all the registered U.S. securities
exchanges and clearing houses, the National Association of Securities
Dealers, and the Municipal Securities Rulemaking Board.
[2] Broker-dealers are individuals or firms that buy and sell
securities for customers or for themselves.
[3] ECNs are electronic trading systems that automatically execute
matching buy and sell orders. They are a type of alternative trading
system—an automated market in which orders are centralized, displayed,
matched, and otherwise executed.
[4] SIA is a trade group that represents broker-dealers of taxable
securities. SIA lobbies for its members’ interests in Congress and
before SEC and educates its members and the public about the securities
industry.
[5] The exchanges were the American Stock Exchange, Boston Stock
Exchange, Chicago Board Options Exchange, Cincinnati Stock Exchange,
Chicago Stock Exchange, International Securities Exchange, NYSE,
Philadelphia Stock Exchange, and Pacific Exchange.
[6] Sections 6(b) and 15A(b) of the Exchange Act set forth,
respectively, the standards that national securities exchanges and
national securities associations must meet.
[7] Sections 6, 15A, and 19 of the Exchange Act establish a statutory
scheme for national securities exchanges and associations that vests
both types of entities with almost identical self-regulatory
responsibilities and imposes virtually the same oversight requirements
on SEC.
[8] According to Nasdaq, as of March 25, 2002, the 11 ECNs were
Archipelago, Attain, BTrade, Brut, GlobeNet, Instinet, Island,
MarketXT, NexTrade, REDIBook, and Track ECN. In addition to these ECNs,
other alternative trading systems exist, such as the Portfolio System
for Institutional Trading, also known as POSIT.
[9] Under SEC regulations, an ECN must be registered either as a broker-
dealer or as a national securities exchange that has the full
regulatory responsibilities of an SRO. 17 C.F.R. § 242.301 (2001).
[10] A market maker maintains a market in a security by standing ready
to buy or sell that security on a regular and continuous basis at
publicly quoted prices.
[11] In 1993, SEC referred to automated screen-based trading systems
used by institutions and broker-dealers, including what are now called
ECNs and alternative trading systems, as proprietary trading systems.
Of the current ECNs, only Instinet existed at that time.
[12] The order-handling rules are SEC Rule 11Ac1-4 (the Display Rule)
and amendments to Rule 11Ac1-1 (the Quote Rule).
[13] In March 2000, SEC approved a Nasdaq rule change that allows ECNs
to connect to the Nasdaq automated linkage for trading NYSE and
American Stock Exchange-listed stocks, thereby allowing public access
to these markets that is similar to that available for Nasdaq stocks.
[14] Third-market broker-dealers are NASD members that trade exchange-
listed securities without being members of the exchange.
[15] Adopted in 1976, NYSE Rule 390 was subsequently amended to apply
only to stocks listed on NYSE as of April 26, 1979. Subject to many
exceptions, the rule prohibited exchange members from dealing in NYSE-
listed securities away from a national securities exchange. SEC
approved the repeal of the rule on May 5, 2000.
[16] According to SEC, NYSE Rule 390’s restrictions on off-board
trading had been criticized as an inappropriate attempt to restrict
competition among market centers. According to NYSE, the rule was
intended, at least in part, to encourage broker representation of
customer orders and to maximize the opportunity for investors’ orders
to interact with one another in a central location, the theory being
that in these ways customers would receive better order execution.
[17] Although the motivations for demutualization are the same across
markets, demutualization may not raise the same concerns outside the
U.S. securities markets because of differences in market structure. For
example, Commodity Futures Trading Commission officials told us that
demutualization in the U.S. futures markets has raised fewer concerns
related to conflicts of interest than it has in the U.S. securities
markets because, due to the current structure of the markets, futures
exchanges and their members generally have not been direct competitors.
[18] In October 1999, the Pacific Exchange filed a proposal with SEC to
separate its equities operation into a wholly owned corporate
subsidiary, which SEC approved in May 2000. Subsequently, the exchange
entered into a partnership with Archipelago Holdings, Inc., to allow a
subsidiary—the Archipelago Exchange—to operate as a facility of the
Pacific Exchange for trading equity securities. In September 2000, the
Pacific Exchange announced its plan to convert into a for-profit stock
corporation. In October 2001, SEC approved the rules allowing the
facility to operate.
[19] On November 13, 2000, the Chicago Mercantile Exchange became the
first U.S. financial exchange to demutualize. On November 17, 2000, the
New York Mercantile Exchange completed its demutualization. The Chicago
Board of Trade was still in the process of demutualizing on March 31,
2002.
[20] Among the many foreign exchanges that have demutualized are the OM
Stockholm Exchange (in 1993); the Australian Stock Exchange (in 1998);
and in 2000, the Stock Exchange of Hong Kong, Bourse de Montreal,
London Stock Exchange, and Toronto Stock Exchange.
[21] For example, the International Securities Exchange has contracted
with NASDR to provide regulatory services.
[22] The Rudman Commission recommended the restructuring in a 1995
report. The Commission was established to review the governance of NASD
in response to allegations of collusion among Nasdaq market makers to
fix prices.
[23] Subsequently, Nasdaq filed three amendments to its initial filing,
most recently on January 8, 2002. As of that date, Nasdaq’s application
was pending before SEC.
[24] To avoid concerns related to conflicts of interest involving the
regulation of competing members, the Toronto Stock Exchange and the
Montreal Exchange separated their market regulatory functions from
their for-profit business functions.
[25] NASD will still own the American Stock Exchange and will thus
continue to regulate exchange members competing with that market.
[26] According to NASD, NASD’s interest, if any, in Nasdaq common stock
after the spin-off will depend on the extent to which the warrants for
common stock that NASD sold as part of the transaction remain
unexercised. Since some of the warrants need not be exercised until
June 28, 2005, NASD’s final interest in Nasdaq common stock might not
be known until then. In addition, according to NASD, NASD will retain a
controlling interest in Nasdaq through its ownership of voting
preferred stock until Nasdaq becomes a registered exchange. Upon Nasdaq
becoming a registered exchange, the voting preferred stock will be
automatically redeemed. NASD currently owns 100 percent of the
nonvoting Nasdaq preferred stock and may continue to do so after the
spin-off is complete. However, should Nasdaq complete an initial public
offering or other offering of equity securities, it must buy back the
nonvoting preferred stock with the proceeds from the offering.
[27] According to NASD, its 10-year contract with Nasdaq can be
terminated in the first 5 years for cause only. In the next 5 years,
the contract can be terminated for cause or if Nasdaq is able to
internalize the services provided by NASD or obtain them for
significantly lower cost from a third party.
[28] SROs’ regulatory responsibilities can generally be described as
either broker-dealer/member-specific or market-specific. Member-
specific regulation generally includes on-site examination of broker-
dealers’ compliance with financial and sales practice rules, while
market-specific regulation generally includes market surveillance and
the enforcement of exchange trading rules.
[29] NASD has a formal plan that governs the relationship among the
NASD, NASDR, and Nasdaq boards and that is intended to ensure the
independence of the NASDR and Nasdaq boards.
[30] In contrast, according to an NASD official, Nasdaq’s market
structure rule proposals follow the procedure used by other SROs that
operate a market—the rules are typically discussed with membership
committees but are not sent out for public comment before being
submitted to SEC.
[31] In January 2001, SEC proposed a rule to allow SROs to implement or
alter trading rules (other than those related to major market structure
initiatives) without waiting for SEC approval, provided that the SROs
had procedures for effective surveillance of activity covered by the
trading rules and for enforcement of the rules. According to SEC, the
proposed rule would foster innovation by allowing SROs to move more
quickly and would reduce the regulatory burden of SROs as well as help
them maintain their competitiveness. As of March 31, 2002, the rule had
not been adopted.
[32] On October 1, 1999, Nasdaq filed proposed rule changes with SEC to
establish order display and collection facilities and to modify its
primary trading platform, collectively referred to as the SuperMontage
proposal. Various aspects of the proposal were widely criticized as
unfair or anticompetitive. After numerous amendments, SEC approved the
proposal on January 19, 2001.
[33] Although rule proposals filed under section 19(b)(3)(A) of the
Exchange Act are effective on filing, they are also subject to a 21-day
comment period that begins at the time the notice of the filing is
published in the Federal Register. The Exchange Act authorizes SEC,
within 60 days of an SRO’s filing of a rule under section 19(b)(3)(A),
to annul the rule change and require that the rule be refiled under
section 19(b)(2) of the Exchange Act.
[34] Notice of Filing of a Proposed Rule Change by the National
Association of Securities Dealers, Inc., Relating to Member Transaction
Fees, Securities and Exchange Commission Release No. 34-45506 (proposed
Mar. 5, 2002).
[35] SEC Concept Release: Regulation of Market Information Fees and
Revenues, Securities Exchange Act Release No. 34-42208 (Dec. 9, 1999).
[36] According to NASD, more than 5,500 broker-dealers were NASD
members as of March 31, 2002. According to NYSE, about 250 of these
were also NYSE members with public customers.
[37] Comment letter from the SIA regarding Special NASD Notice to
Members 01-35—Request for Comments on Rule Modernization Project (July
31, 2001).
[38] Limit orders are orders to buy or sell securities at specific
prices (or better).
[39] In addition to SRO examinations, a broker-dealer may also be
subject to examinations by each state where it has offices and by SEC.
[40] The DEA is responsible for examining member broker-dealers for
compliance with the Exchange Act and SEC and SRO rules and regulations
related to financial responsibility, including SEC net capital and
customer account protection rules.
[41] The proposed legislation was called the Capital Markets
Deregulation and Liberalization Act of 1995 (H.R. 2131). Although the
proposal did not become law, a provision that required SEC to improve
coordination was subsequently included in the National Securities
Market Improvement Act of 1996, which became section 17(k) of the
Exchange Act.
[42] The four SROs that entered into the MOU were the American Stock
Exchange, the Chicago Board Options Exchange, NASD, and NYSE.
[43] The North American Securities Administrators Association agreed to
the MOU on behalf of state regulators. The association is an
organization of state, provincial, and territorial securities
administrators in Canada, Mexico, and the United States that is devoted
to investor protection and efficient capital formation.
[44] SIA surveyed its members about examinations done in 1997, the
first full year that the MOU was in effect, and reported the results in
Regulatory Examination Survey Report, SIA, June 1998.
[45] Reinventing Self-Regulation, White Paper of the Securities
Industry Association’s Ad Hoc Committee on Regulatory Implications of
De-Mutualization, Jan. 5, 2000.
[46] The provision, which did not become law, was included in the
Capital Markets Deregulation and Liberalization Act of 1995, H.R. 2131,
104th Cong. (1995).
[47] Testimony by Frank Zarb, chairman, NASD: Committee on Banking,
Housing and Urban Affairs; United States Senate (Washington, D.C.: Feb.
29, 2000).
[48] In 1965, SEC became responsible for direct regulation of a small
number of broker-dealers that traded only in the over-the-counter
market. This program, called the Securities and Exchange Only, or SECO
program, was designed to provide participating firms with a regulatory
alternative to NASD. In 1983, SEC concluded that the industry would be
better served if the program were discontinued, because needed
improvements would be costly and not an efficient use of agency
resources.
[49] The National Futures Association is an SRO that is responsible,
under Commodity Futures Trading Commission oversight, for qualifying
commodity futures professionals and for regulating the sales practices,
business conduct, and financial condition of its member firms.
[50] The Investment Company Institute is a trade group that represents
mutual funds.
[51] The Draft Report at page 24 mentions without elaboration the
NASD's concern that competition among regulators could lead to a race
to the lowest regulatory standards and undermine investor confidence in
the securities markets.
[52] For a broader discussion of Nasdaq views with respect to the CSE
regulatory model see letters to Jonathan Katz, Secretary, SEC, from
Richard Ketchum, President, Nasdaq (January 9, 2002) and from Edward S.
Knight, Executive Vice President and General Counsel, Nasdaq (March 6,
2002).
[53] See letter to Jonathan Katz, Secretary, SEC, from Jeffrey T.
Brown, Vice President Regulation and General Counsel, CSE (January 24,
2002).
[54] Exchange Act Release No. 44983, October 25, 2001 (order approving
File No. SR-PCX-00-25) (PCX/ARCA Order). Many of the concerns raised
below were also discussed in Nasdaq's comments to the SEC on the
proposed merger between PCX and ARCA. See letters to Jonathan Katz,
Secretary, SEC, from Richard Ketchum, President, Nasdaq (June 4, 2001,
and January 22, 2001).
[55] The Securities Industry Association brings together the shared
interests of nearly 700 securities firms to accomplish common goals.
SIA member firms (including investment banks, broker-dealers, and
mutual fund companies) are active in all U.S. and foreign markets and
in all phases of corporate and public finance. The U.S. securities
industry manages the accounts of nearly 80 million investors directly
and indirectly through corporate, thrift, and pension plans, and
generates $358 billion of revenue. Securities firms employ
approximately 760,000 individuals in the United States. More
information about SIA is available on its home page: [hyperlink,
http://www.sia.com].
[End of section]
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