Time for Comprehensive Review of Market Regulation, Says SEC’s Gallagher

Securities and Exchange Commission member Daniel Gallagher called on Thursday for a comprehensive study of how markets are set up – and how they regulate themselves.

The review, he said, should include examination of how the securities industries regulates itself – and whether self-regulation by stock exchanges works in a world where algorithms trade “decimalized securities at speeds measured in microseconds.”

“I believe it is time to undertake a comprehensive market and regulatory structure review, including a review of the self-regulation paradigm as a whole,’’ he said at the annual market structure conference of the Securities Industry and Financial Markets Association.

Re-examining how national exchanges operated by NYSE Euronext, Nasdaq OMX Group, Direct Edge and Global Markets regulate themselves – or outsourcing that work to the Financial Industry Regulatory Authority, a body that oversees brokers — is necessary, he said, because the commission is overloaded. And the exchanges themselves might not have the wherewithal to effectively analyze their own operations.

“I say this not despite the Commission’s unprecedented current workload, but in fact because of it,’’ he said. “To say that the Commission’s resources are stretched thin by the workload imposed by” the 2010 Dodd-Frank Wall Street Reform Act “is an understatement.”

But even the exchange operators, who are “self-regulatory organizations,” may be stretched thin. Rule-making, for instance, requires “meaningful economic analyses.”

“I’m under no illusion as to the onus this places on SROs – cost-benefit analysis isn’t easy, it isn’t quick, and it isn’t cheap. If self-regulation is to remain viable, however, it is necessary,’’ he said.

If “self-regulation is to continue to play a central role in securities regulation, SROs must be committed to ensuring that the rules they send to the Commission for approval are the result of the same degree of rigorous analysis as the Commission applies to its own rules,’’ he said. “There has been significant progress on this issue lately, but there is still a long way to go.’’

Gallagher questioned whether the exchange oeprators have the resources “and, just as importantly, the willingness” to perform sufficiently rigorous analyses to support proper rulemaking on how markets will operate.

The commission’s review of rule filings, he said, is “not meant to be a rubber stamp” for what exchange operators propose. The proposals have to be “fully vetted and pass legal muster.’’

The last time the commission, he noted, undertook a formal, thorough evaluation of the equity markets, the result was in a report released in January 1004 that tried to assess what markets would look like in 2000.

  • But that 450-page report made no mention, he said, of these technical developments that have radically reshaped markets:
  • “Internet”
  • “Web-site”
  • “www”
  • “dot com” [use “.com” in version to be posted online]
  • “High frequency trading”
  • “Dark pools”

That Market 2000 Report’s “basic finding” was, he said, that stock markets “are operating efficiently within the existing regulatory structure.’’

But, to show how much has changed he said, the “basic finding” on Apple Computer was “that it was a struggling has-been left behind by the personal computing industry.’’

He tried to engage the audience of market professionals at the New York Marriott Downtown. But not a single question was posed on his proposal for a comprehensive review of market structure and regulation.

But “you should be careful about what you wish for,” said Brandon Becker, executive vice president and chief legal officer of TIAA-CREF.

If self-regulatory organizations are held to the same standards as government agencies in maintaining “minimum rules of the road,” decisions won’t get made. Political jockeying, litigation and the like will slow down the process of adapting to changing market structures, he said.

There is “no upside for any SRO to be the weak link in our complex fragmented system,’’ said Eric W. Noll, executive vice president, Transaction Services U.S., for the NASDAQ OMX Group.

That’s because the markets themselves will enforce discipline on exchanges to be reliable and operate fairly and reliably.

“If people don’t like what we say or do, we lose order flow,’’ Noll said.