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January 1, 2005

Breaking Up the System of Self-Regulation

By Gregory Bresiger

The structure of self-regulatory organizations, or SROs, such as the New York Stock Exchange, are in the cross-hairs of the nation's regulators who are weighing unprecedented change.

"In sum, while Congress and the Commission have criticized and modified the SRO system in the past, it has not been radically revised or dismantled since its establishment," says the Securities and Exchange Commission. As Traders Magazine went to press, the nation's top regulator published proposed rules and offered a concept release that could result in comprehensive reforms.

Inherent Conflicts'

The SEC is raising the question of whether an exchange can effectively regulate the same constituency it serves. The SEC said self-regulation, which already has had "inherent conflicts," is under increasing strains because of the competitive pressure of for-profit exchanges. That has pushed exchanges to be more innovative and competitive, but it also has a downside.

"This competition places greater strains on the self-regulatory system. Some observers have posited that trading previously covered by one market's rules may move to another in search of lower regulatory standards," according to the concept release. Exchanges, the SEC wrote, can be subject to unique pressures by big firms that become critical to their survival.

"For example, the number of NYSE specialist firms, which are central to the NYSE's auction trading model, has dropped from 27 to 1999 to 7 in 2002.

"One NYSE specialist firm in 2003 accounted for over 28 percent of total NYSE total trading volume," according to the concept release. The SEC also noted a similar trend on the Chicago Stock Exchange, whose number of specialist firms dropped to eight by 2004.

"The anecdotal evidence cited above could indicate that SROs have become more dependent on large members for their regulator SROs. This creates the potential for failures by SROs to enforce rules against these members, especially when compared to enforcement against other smaller or less economically influential members...," the SEC noted.

One example of this favored enforcement occurred in the late 1990s. It was cited in the paper. "Market maker influence," the SEC said, "led to a concerted effort by the NASD staff to bring disciplinary actions against SOES firms." In contrast, the report continued, "the NASD was far less aggressive with respect to its enforcement of rules violations by market makers." NYSE and NASD officials declined comment.

Bill Singer, a securities attorney and industry activist who has read the concept release, said the theme of the paper is that self-regulation is flawed. "The current system of self-regulation doesn't work. It is subject to too much political influence," he warned.