Self Regulation: The US Experience

1. Self Regulation: The US Experience Ethiopis Tafara US Securities & Exchange Commission

2. History of Self-Regulation • Securities Exchange Act of 1934 • SEC created in aftermath of 1929 stock market crash • NYSE largest of about 30 exchanges in 1934 • Over 80% of US securities trading in dollar volume • Congress let stock exchanges continue to regulate own activity • SEC to watch over exchanges

3. NASD: Expanded Self-Regulation • 1938: Congress created the concept of national securities association • Regulated the market for “over the counter” stocks not traded on any exchange • National Securities Dealers Association (NASD) is the only major registered securities association today • All broker-dealers conducting business with the public are members of the NASD • Partially owns and operates NASDAQ stock market • When broker-dealers are members of both NASD and other exchange(s), one SRO is designated examining authority

4. Registered US Exchanges • Currently 9 registered US exchanges • New York Stock Exchange (NYSE) • American Stock Exchange • Philadelphia Stock Exchange • Boston Stock Exchange • Chicago Stock Exchange • Chicago Board Options Exchange • Cincinnati Stock Exchange • International Securities Exchange • Pacific Stock Exchange

5. Standards for Self-Regulation • Exchange Act requires SROs to meet a number of standards, including: • Ability to comply with securities laws and enforce its members´ compliance • SRO rules must give all members fair representation in selection of its directors and administration of its affairs • Must have rules designed to prevent fraud and promote “just and equitable principles of trade” • Must have fair procedure for bringing disciplinary actions against its members and associated persons • Rules must not impose unnecessary burden on competition

6. SEC´s Role • SEC covers every aspect of self-regulation: • SRO must file proposed rule changes with SEC • Rules do not take effect until SEC approval • SEC examines SROs • Members can appeal SRO disciplinary actions to SEC • SEC can directly enforce SRO rules if SRO unable or unwilling to do so • SEC can bring enforcement action against SROs • Rare, but threat of such action gives SEC leverage • SEC has brought significant enforcement action against both the NASD and NYSE within past 5 years

7. Advantages of Self-Regulation • Technical Expertise • Market professionals may better understand technical aspects of exchange regulation • Flexibility • SRO may have greater ability to adapt to new developments • Greater Acceptance of Rules • SRO members elect their directors and participate in rulemaking; may cause greater willingness to comply with rules • Cost Savings to Federal Government • More than 5,000 registered broker-dealers of varying complexity • Nearly 600,000 registered securities professionals

8. Disadvantages of Self-Regulation • Conflicts of Interest • Securities exchanges are both business ventures and regulatory bodies; may not enforce rules if detrimental to business • Antitrust Implications • Members of an SRO are collectively regulating their own behavior; danger of collusive behavior that hurts customers • Due Process Concerns • Members regulated by individuals exercising a form of governmental power, yet may not have all procedural rights that would apply if the government were the disciplinary body

9. SEC Concept Release • Recent SEC concept release (34-50700)addresses concerns regarding role and operation of SROs, including: • Conflicts of interest between SROs´ regulatory obligations and interests of members, market operations, listed issuers, and, in the case of a demutualized SRO, shareholders • Costs and inefficiencies of the multiple SRO model • Challenges of surveillance across markets • Manner in which SROs generate revenue and how SROs fund regulatory operations

10. Conflicts of Interest • With Members • Trend: Declining number of member firms increasingly important to their regulator SROs´ business interests • Creates inappropriate business pressure on regulatory staff • With Market Operations • Trend: Increasing competition among markets creating pressure to attract order flow • Creates pressure for permissive market activity or over-regulation of competitors

11. Conflicts of Interest, cont´d. • With Issuers • Trend: SROs simultaneously responsible for monitoring issuers and delisting securities while competing to attract and retain listings • With Shareholders • Trend: SRO demutualization creates additional conflict regarding profit motive of a shareholder-owned SRO • May commit insufficient funds to regulatory operations or use disciplinary function as revenue generator with respect to member firms that operate competing trading systems

12. Costs and Inefficiencies • Existence of multiple SROs can result in duplicative and conflicting rules, rule interpretations, and inspection regimes • The system can also result in redundant SRO regulatory staff and infrastructure across SROs • May be aggravated by trend toward greater market fragmentation of order flow among SROs

13. Intermarket Surveillance & Funding • Intermarket Surveillance • Trading in multiple active markets facilitates veiling illegal activity by dispersing trades across markets • Funding • Self-funding structureleverages limited SEC resources • SEC supervision of SRO regulatory funding adequacy is challenging, given temptation for SROs to fund business operations at regulation´s expense • Hard to know whether an SRO is insufficiently funding its regulatory function or simply administering an efficient regulatory program

14. Alternative Approaches • Enhance current SRO system • Strengthen governance, enhance disclosure and reporting requirements • Enhance SEC´s and SROs’ ability to regulate intermarket trading activity • Mandated SRO internal restructuring • Increase SRO regulatory independence, e.g., byrequiring all SROs create independent subsidiaries for regulatory and market operations

15. Alternative Approaches, cont´d. • Hybrid model • Designation of a market neutral single SRO (“Single Member SRO”) to regulate all SRO members with respect to membership rules • Each SRO that operates a market (“Market SRO”) would be solely responsible for its own market operations and market regulation • Competing hybrid model • Multiple competing member SROs (“Competing Member SROs”), required to register with the SEC and authorized to provide member regulatory services

16. Alternative Approaches, cont´d. • Universal industry self-regulator • One industry SRO responsible for all market and member rules for all members and all markets • Universal non-industry regulator • One non-industry entity designated as responsible for all markets and member regulation for all members and all markets • SEC regulation • Termination of the SRO system in favor of direct SEC regulation