Speech by SEC Commissioner:
Regulatory Role of Exchanges and International Implications of Demutualization
Commissioner Roel C. Campos
U.S. Securities and Exchange Commission
Armonk, New York
March 10, 2006
Good Evening. Thank you, Karel Lanoo for that very kind introduction. I also wish to thank Hal Scott and especially in his absence tonight J Weinstein. Of course, many thanks go to the sponsor of this event, Citigroup. I am always impressed at how magnificent a conference center this is. All the better to promote good and high level thinking on international items. I think many of you know that Hal Scott was one of my professors at Harvard Law School. I always look at these invitations as a way of "getting even in some way" for all the hard work that Hal Scott made me do while taking his class. Actually, I have only good things to say about Hal and his impressive research. His interest in international regulation helps promote constructive dialogue among regulators across the world and he keeps all of us thinking of how regulation might be improved. Hal is very sick with the flu tonight. I am not sure if it was hard work or too much late night entertainment that caused his illness. Just kidding! Please tell Hal that he must slow down now and then.
Before I dive into my remarks tonight, I must give the standard disclosure that the remarks I make today are my own and do not represent the Commission, the staff or my fellow Commissioners.
Seeing as David Wright has done such a marvelous job in presenting many of the current issues in the Trans-Atlantic Discourse, I will first address several of his points to provide the SEC perspective. I will then address my major topic tonight, the demutualization of American stock exchanges and international implications.
I. Deregistration of Foreign Issuers
As many of you know, the SEC has been criticized for having a rule that is so strict that it has been accused of not allowing foreign issuers to leave our markets and deregister its securities in the United States - "the roach motel" analogy - "you can check in, but you can't check out." We announced a proposal several months ago that changed the key benchmark from the number of remaining shareholders that are U.S. residents (300 in most instances) to essentially a benchmark of average daily trading volume or worldwide public float. We have received comments on this proposal from the European Commission and from other supporters of the European perspective. As David has indicated, the European view seems to be that the new benchmarks that have been proposed provide too little relief - only allowing about six European issuers to take advantage of the changes.
Well, this seems to be a case of "two ships of statistics passing each other in the night." Our staff economists and specialists from our Corporate Finance Division advised that our proposal would provide much more significant relief than the European commentary indicates. I can say that our staff and my fellow Commissioners will study carefully the calculations and numbers presented in the said commentary. It is the intention of the Agency to provide significant relief, and to make it very plausible for European and other foreign companies to leave our markets if they desire. I am sure that we will continue to have very fruitful discussions with our European counterparts on this issue.
I would add that there is a very significant reason for European and foreign issuers to remain in our markets and to have SEC registered securities. Besides having the lowest cost of capital, our markets provide the greatest number of companies anywhere in the world that might be appropriate merger or acquisition targets. In spite of what may appear to be recent protectionism, it is easier for foreign issuers to merge or to acquire U.S companies than anywhere else in the world. Of course, the currency of such mergers and acquisitions is registered U.S. stock or other securities. I think most sophisticated global companies realize that fact and, therefore, will not look to deregister and delist, and thereby leave our markets, abandoning the tremendous potential business to be had.
II. Roadmap to Removal of Reconciliation to U.S. GAAP
The fact that David did not mention this topic gives me some cheer. In the past this topic has been the first, second and third items of priority. Hopefully this means that we finally have a good understanding and trust on this issue among the international regulator community. Last year through our Chief Accountant, Don Nicolaisen, the Agency announced that it would abide by a "roadmap" approach to removing the current reconciliation requirement of foreign issuers using International Financial Reporting Standards (IFRS) for financial reporting to U.S. GAAP. This roadmap provided that if after examining financial statements produced under IFRS (the first of which will be issued in the second half of 2006) there is consistency and high quality, among other factors, the SEC would eliminate the requirement as early as possible, but no later than 2009.
Judging from many discussions since that announcement, I believe that many believed that the SEC "had something up its sleeve" or that the conditions were somehow destined not to be met. I can tell you that the Roadmap is a serious commitment on the part of our Agency. If for some reason IFRS statements are problematic (which we do not expect), we will work together with all relevant parties, including the European regulators and the Big Four accounting firms, to resolve problems. We have made it clear that we do not expect a perfect matching of the standards. Instead, we are searching for an easily identifiable and reasonable zone of difference that investors in the U.S. can understand in making comparisons between statements under U.S. GAAP and those under IFRS.
III. U.S. GAAP Equivalence To IFRS
I wish to convey our appreciation to Commissioner McCreevy for supporting a strong Trans-Atlantic Dialogue. In particular, Commissioner McCreevy's support of the postponement of consideration of an equivalence evaluation for U.S. GAAP is hugely sensible and avoids the potential for serious economic problems.
IV. Regulatory Role of Exchanges And Impact of Demutualization, Globally
Worldwide, the majority of equity stock exchanges, and many derivative exchanges, have demutualized and regulatory authorities are facing the same questions regarding the appropriate regulatory framework for both the regulatory role of exchanges and the regulation of exchanges. At least 17 exchanges, or holding companies for an exchange group, across the globe have obtained public listings since 1987, with many of these demutualizations taking place during the last 5 years. These include, for example, the earliest, the OMX Group, the ASX, the Deutsch Bourse, the LSE, the ISE, and, most recently, the NYSE. As the primary market model changes, the regulatory model must morph too.
But, to what extent? How do we maintain the delicate balance between regulation and business that ensures investor protection? Does the for-profit component of these exchanges imply that additional government regulation is required to maintain the same level of regulation exercised by the exchanges themselves under the traditional mutual exchange model? Even if the market model doesn't change for a particular exchange, does the changing marketplace require a review of self-regulation?
The Commission has periodically examined the self-regulatory systems and the extent to which SROs have successfully filled their statutory obligations, often finding the regulatory framework lacking. Technological changes and industry changes, such as program trading and decimalization, also prompt reviews as to whether the current model satisfies its mandate in the modern marketplace. In addition, changes have been implemented to improve the regulatory regime following staff and Commission studies, often resulting in additional Commission involvement in the regulatory process.
The recent governance failures provide a prime example of failures in the current self-regulatory model. The SEC also has found deficiencies in the SROs efforts to enforce their rules or to exercise the SRO oversight required by the Exchange Act that stem from the competing interests behind the operation of the exchange. This phenomenon was observed in the 2005 NYSE case regarding specialists, the 2005 Nasd and Nasdaq 21(a) Report involving MarketXT, and the 2003 enforcement action against the Chicago Stock Exchange. In each of these cases it appears that regulation may have taken a back seat to business concerns. These are just a few of the instances of violations - the most egregious of which result in enforcement actions. Short fallings are often found when our inspection teams examine an SRO but they do not always rise to the level of enforcement. Sometimes the most productive regulatory tactic to improve SRO deficiencies is sending a letter to the Board, requiring a written course of action to resolve the lapses, and staff follow-up on those commitments.
Prompting the most recent review of SROs is a number of factors. Increasingly vigorous competition between exchanges, ECNs, ATSs and foreign trading markets has shifted significant amounts of market share away from the primary markets. This heightened competition has spurred innovation in trading systems and responsiveness to customers, as well as reduced trading costs. At the same time, trading in multiple markets also increases concerns about potential gaps in the surveillance of intermarket trading. Plus, loss of market share can undermine revenues supporting an SRO's regulatory functions, without reducing the SRO's oversight responsibilities.
Demutualization also has been one of the primary drivers for regulatory evolution. The addition of an SRO shareholder class through demutualization, separate from the SRO's members, creates new concerns because the Commission lacks specific authority over shareholders or other controlling persons of the shareholder-owned SRO. The Commission still retains the authority over the entity registered as an SRO and its officers and directors, but it would not have any jurisdiction over a shareholder that was not also a member.
For-profit exchanges face pressure to deliver returns to shareholders, whether by raising income or cutting costs. More aggressive competition to increase market share in trading also can result in increase use of incentive schemes that may run counter to the integrity of pricing and investor protection. Some have predicted these pressures will result in a "race to the bottom" in exchanges' regulatory standards. For example, exchanges will underfund regulation to free up the resources for other purposes, minimize the value of a regulatory culture, fine and discipline traders as a means to collect revenue or to punish their competitors, raise listing company, trading and market data fees to maximize business, and lower listing standards and surveillance parameters in order to generate or maintain revenue and encourage repeat business.
Clearly, one of the chief problems that arise with a for-profit exchange is ensuring adequate funding for the regulatory program with a subset of this issue being to determine what may constitute appropriate uses for regulatory income. And, one cannot forget the conflicts of interest due to self-listing. Competitors to a for-profit exchange are not only the broker-dealers who may offer, use or have invested in competing services but also the listed companies who also exist in that realm. In response to all of these fears, the for-profit exchange will argue that the concerns are unwarranted because the exchange has a commercial interest in preserving the confidence that traders and investors have in their brand name.
So, you ask, what do we, the regulator, do to address all of these changes while preserving investor protection? A year ago, the Commission issued a concept release concerning self-regulation in recognition of developments in the marketplace and the changes in SRO ownership structures. The Commission sought comment on the role and operation of SROs in today's markets and also proposed a number of alternative regulatory and legislative approaches that could be considered by the SEC to address concerns with the current SRO model. These models included: governance and transparency improvements to the status quo; independent regulatory and market corporate subsidiaries; a hybrid model; competing hybrid models; a universal industry self-regulator; a universal non-industry regulator; and, direct SEC regulation of the industry. At the same time, the Commission issued a proposal regarding governance and transparency issues surrounding SROs, again responding to the changing marketplace and the rise of for-profit exchanges.
I'd like to take a moment to examine two of these models. Let me turn first to the concept of an independent regulatory and market corporate subsidiary. Here the idea would be to increase SRO independence through mandated SRO internal restructuring, similar to the NASD's most recent model, prior to Nasdaq's move for independence. With the recent creation of NYSE Regulation as a subsidiary of the NYSE Group, separate from the NYSE market subsidiary, the regulatory landscape at the NYSE also falls into the model of separating the regulation and the market within a holding company structure. In this structure, ideally the regulatory staff reports directly to the corporate parent's board, ensuring not only the appearance but also the operation of separate entities. This model reduces the conflict of interest issues present in the current self-regulator model but does not eliminate them entirely. As part of the larger whole, the regulatory subsidiary will not be immune from the business pressures placed on the SRO as a whole.
Funding concerns will differ under this model. The SRO will be expected to contribute to the regulatory funding through continued subsidization so a ready source of funding will exist. The question will be how much control over that funding is held by the parent versus the subsidiary. This model will not reduce the duplicative regulation of multiple SROs, however, unless multiple SROs determined to merge these functions through joint ownership. It also would preserve the synergies created by the simultaneous oversight of a market and the broker-dealers participating on that market.
Specifically, with respect to the new NYSE Group, some have argued that the exchange should go further than this model and spin out the regulatory subsidiary so that it would be independent and not under a common holding company with the market operations. Certainly, the approved NYSE regulatory structure improved from the original proposal in that the Board of NYSE Regulation will have a majority of independent directors instead of sharing the majority independent directors with the holding company board.
This leads me to the second of the models for self-regulation proposed in the SEC's concept release that I will discuss: the hybrid model. This model would split regulation into two functions. Each exchange would retain its own SRO responsibilities specific to market operations, which would include regulating and enforcing all aspects of trading, markets, and listing requirements. The remainder of regulatory functions - those relating to broker-dealers - would be carried out by a single-member SRO. The SRO either could be independent, arguably free from conflicts of interest, such as the NASD will be once its separation with Nasdaq is final. Or, the SRO could be a combination of multiple SROs' broker-dealer regulatory programs joined into one centrally managed entity.
The primary advantage to this model is the elimination of regulatory duplication and, perhaps, some of the conflicts of interest inherent in our present SRO system. In other words, the SROs would merge their regulatory functions through joint ownership to produce - and I quote from the recent remarks of SIA President Mark Lacritz - "one rule book, one set of procedures, one set of examinations." There will still be a need to determine exactly which regulatory functions are member regulation and which are market regulation. The Commission might need to opine on where to draw the line.
Plus, by maintaining the market regulation within the SRO, the innovation and market expertise that stem from the daily and regular interaction between the market and its members is preserved. One could argue that you will lose some of the expertise that derives from the current model. Plus, difficulties may arise in communication and coordination between the single SRO performing member regulation and the exchange performing its own market regulation - an issue that has arisen in the UK following its regulatory rehaul.
Funding may also be a little more difficult under the hybrid model requiring some creativity. Maybe, broker-dealers could be required to pay directly for the cost of their supervision with a fixed cost as well as a variable cost based on the complexity of their operations and history of regulatory problems. Exchanges could pay a fixed amount based on the number of members they have or a variable amount based on the volume of trading.
Despite the challenges, at this time, I favor the hybrid model for the simple reasons that (1) elimination of duplication will greatly add to the quality and efficiency, while reducing the costs, of regulation of broker dealers and (2) conflicts of interest should be minimized.
Turning to the International scene, IOSCO has been examining the issue of demutualization as well. At the Technical Committee meeting held last month, IOSCO determined to publish a report for consultative purposes updating a 2001 issues paper. In preparing the report, IOSCO sought detailed information from its member jurisdictions through a questionnaire asking them to describe the relevant exchange structure, ownership and business model, regulatory issues raised and information about exchange linkages and clearing and settlement arrangements.
The report reveals that, similar to the US, many jurisdictions have taken the approach that exchange regulation of exchanges, in particular for-profit exchanges, must include regulation or oversight regarding: governance arrangements, separation of functions within an exchange, restrictions on ownership, oversight arrangements (including arrangements to deal with self-listing), and transfer/removal of regulatory functions. For example, most jurisdictions have a requirement for exchanges to have "public" or "independent" directors, although the definition of these terms differs. Also, the Markets in Financial Instruments Directive in the EU (which will be implemented in November 2007) requires all EU exchanges operating regulated markets to have arrangements - implicitly, governance arrangements - to identify and manage the potential adverse consequences of any conflict of interest between the regulated market, its owners or its operators and the sound functioning of the market.
b. International Approaches
With respect to separation of functions, several jurisdictions have required the establishment of separate regulatory divisions that have no involvement in the commercial or business activities of the exchange. Australia and the US are two such jurisdictions. As noted a moment ago, the creation of NYSE Regulation by the NYSE as a not-for profit subsidiary of the NYSE Group is the most recent example of this requirement, but even before announcing that it would demutualize, the NYSE separated its market and regulatory functions within the mutual organization.
Ownership restrictions for for-profit SROs have been handled in various ways abroad. While most jurisdictions do not require or prohibit any particular type of ownership, most of them do have shareholder ownership restrictions. Italy, for example, has fitness and propriety requirements for shareholders and a 5% threshold for a shareholder disclosure requirement and a notification to the regulator requirement. In fact, this is another area whether the Market in Financial Instruments Directive will come into play in 2007. The Directive will require member states to require persons who are in a position to exercise significant influence over the management of regulated exchanges to be suitable, and to refuse to approve proposed changes to controlling interests where there are grounds for believing that the change would pose a threat to the sound and prudent management of the market.
With respect to government oversight, some foreign regulators, such as Malaysia and Singapore regularly assess whether the exchange has sufficient resources to carry out is regulatory functions effectively. The notion of oversight also calls into the question of oversight for self-listed exchanges. In Canada, any initial or ongoing listing matter or complaint of a competitor must be immediately brought to the attention of the conflicts committee who must notify the regulator. Lastly, the report notes that regulators must consider the appropriate model of regulation in today's marketplace: what alternatives balance the needs of regulation, business and investor protection? Although I have focused primarily on two models - the separate market and self-regulator under one roof and the single broker-dealer member regulator - it is worth noting that other countries have taken different approaches to this issue. For example, following the demutualization and merger of the stock exchange and futures exchange, the Hong Kong regulatory authority assumed the role of front-line regulator of exchange participants.
Whatever the right model, it is likely that demutualization will lead to a transfer of some regulation away from the exchanges to the government regulators or some independent and/or new regulatory body. Despite assurances to the contrary, the for-profit SRO faces too many conflicts of interest to keep regulation first on its list of priorities.
Going forward, the regulatory equation is further complicated by cross-border exchange linkages and alliances. Electronic trading gives exchanges considerable scope to build cross-border, even global, businesses. The development of cross-border trading and the creation of multinational exchange groups raise a considerable challenge for regulators to maintain an appropriate regulatory framework while fostering market development.
In the US, some have suggested that the development of electronic trading will ultimately result in two market centers - the NYSE and the Nasdaq. Will the fast-paced level of electronic development and the heightened competition lead to more markets or a concentration of markets, both in the US and globally? Shortly after the announcement of the proposed mergers of the NYSE with ARCA and the Nasdaq with Instinet, market participants began to buy pieces of the regional markets, presumable to provide themselves with alternative venues for trading if the feared duopoly were to be approved and, as projected, competition came to a halt. In addition, a new ECN was announced. During the period from announcement to approval, additional deals have been consummated or, at least, contemplated. Broker-dealers have bought pieces of ATSs, hedge funds and clearance and settlement operations all in an effort to hedge their bets as trading becomes a fungible service and they seek to make their profits elsewhere.
It appears European exchanges may face a similar fate. The previously discussed Market in Financial Instrument Directive will eliminate the so-called concentration rule exposing EU member exchanges to competition from electronic trading systems and investment banks. In other words, they will undergo the same challenges US markets faced with the advent of the ECN. The question is whether the result will be an initial increase in the number of EU market centers and service providers followed by a consolidation as the dominant players emerge.
As this scenario plays out in the US and EU, is the end game a few dominant markets worldwide or a larger number of highly competitive players? How soon until the NYSE makes a bid on the LSE? Alas, if I were a betting manů Or, is fragmentation of the global market environment a possibility and how nervous should that make us?
c. Acquisition or Mergers of Cross-Border Exchanges
Let's take just a minute to noodle on some of the possible regulatory concerns that might arise if a deal were to be struck between the LSE and NYSE or, for that matter, the Deutsche Bourse and the Nasdaq, in other words: between two cross-border exchanges. Before I begin, I remind you that this is just my supposition and not the analysis of the staff or Commission. Okay, as I see it, depending on the direction and type of transaction, SEC involvement could be limited. For example, I would think that no Commission approval would be required prior to a joint venture, unless changes were made to trading rules in connection with the joint venture.
Likewise, if the US-registered exchange were to acquire the foreign-registered exchange, no Commission approval of any rule changes would be required prior to an acquisition by the publicly-traded parent companies of the US-registered exchange. Any accompanying stock acquisition or tender offer, however, would require registration of the stock with the SEC. Perhaps there would be some sort of exemption. The Williams Act, Regulation M-A, the US proxy rules, and the cross-border tender offer rules may apply too, as well as the Hart-Scott-Rodino Act. I would think this scenario would be the same for an acquisition of a US-registered exchange by a foreign-registered exchange except that there would need to be prior Commission approval of changes to the US exchange's rules. In addition, I question whether there would be any exemption from registration for a stock acquisition in this proposed transaction.
How should all of this make me feel as a regulator? I think the bottom line is that no country is going to allow its primary market to be foreign owned and/or overseen by a foreign regulator without a fight. It is more likely that a holding company structure is proposed through which the home regulator is not supplanted but retains jurisdiction over the target exchange - a move that bodes well for nationalism and politicians. But there is more to it than appearances. We, as regulators, are not concerned simply about deferring to a foreign regulator or requiring foreign exchanges to register in our jurisdiction. We are concerned about what that registration means with respect to our investors.
The US is one of the only jurisdictions where you still have competition between orders and competition between markets. For investors, that is unique; and, that is good. Further, corporate governance, market access, and many of our investor protections rules are written into the SRO rules. In the US, each of the SRO's must file a rule change with the Commission when it intends to alter its rules. Much of the SEC's regulatory influence is brought to bear in this process. If the Commission did not have jurisdiction over the exchange, all of these rules, particularly the investor protection rules, would need to be made a part of the SEC's rules. Yet, even this step would not resolve the issue for exchanges that did not register in the US. US investors would still be exposed. So, the rules might need to be imposed directly on the market participants, including the broker-dealers and so forth. I think you understand the dilemma.
The issue doesn't stop with investor protection either. Our regulatory framework over the SROs is designed not only to protect but also to ensure we have a marketplace that is inherently fair so that everyone can participate in it equally. The structure cannot be too complex, preventing the ordinary investor from participating in it on his or her own. An investor shouldn't have to be a market structure expert to trade stocks and dealers should not have an advantage over the retail investor. To meet that goal, everyone must have fair access to the markets. For all of these reasons it is essential that the model of SRO regulation, be it self-regulation or some combination of self- and government regulation, works efficiently and effectively.
I would note that many of these same goals underlie foreign regulatory regimes, but the package varies. I believe those differences matter. They are some of the same reasons driving the competition between the markets in the US - the reasons that investors feel confident they will receive a level of service, protection and liquidity at one market versus another. Accordingly, I find conferences such as this and the dialogue carried out through IOSCO and other forums to be invaluable as a resource for thinking about these issues.
d. Short-term Solutions
While I am enthusiastically exploring all of these issues tied to self-regulation, and believe that the SEC has to move quickly to address these issues in their entirety, I believe we must start by speeding up our short-term solutions. Those measures include the improvement of coordination in examinations between and by regulators and the elimination of duplicative and inconsistent regulation of broker-dealer members by the exchanges.
Our Office of Compliance Inspections and Examinations has been working with the NYSE, the NASD, various state regulators and the industry to coordinate examinations in order to ensure that regulatory and compliance resources are expended efficiently and firms are not subject to duplicative and burdensome examinations. For example, during the first three quarters of 2005, 101 examinations were conducted of firms that are dual members of NASD and NYSE. Of these, 56 firms requested coordination and 55 of those 56 (98%) were successfully coordinated. Forty-five firms preferred no coordination and this request was honored.
This is not to say that a firm will not be exposed to multiple examinations at the same time. If the NYSE is reviewing net capital compliance, and the NASD is exploring anti-money laundering issues, the Commission will not examine for these issues (without cause) but may inspect for revenue-sharing violations. However, it is worth noting that in determining which issues to review, the regulators are combining their analysis to determine where risks lay and thus which areas merit review in a particular year. This coordinated approach should produce a pool of topics that divided among the regulators should reduce the overall number of examinations.
Yet, the coordination is not only to eliminate the number of examinations and duplicative examinations but also to minimize the amount of duplicative document gathering and production required of a member firm. If the scope of documents requested in the course of examinations by two regulatory authorities overlaps, even if the subject matter of the examination does not, our goal is to share the produced documents between the regulators. The firm should not be required to expend the resources to gather and produce the same materials twice. Our objective is to improve efficiency and reduce burdens on market participants while remaining consistent with our mandate to protect investors.
A second short-term solution involves the elimination of duplication and inconsistent regulation of broker-dealers by the exchanges within their existing self-regulatory frameworks. The NYSE and the NASD have been in discussions over the past few months regarding the harmonization of their broker-dealer rules. In the recent Commission approval order of the NYSE/ARCA merger, the NYSE undertook to work with the NASD and securities firm representatives to achieve that goal. In addition, the NYSE represented that it would use its best efforts, in cooperation with the NASD, to submit to the Commission within one year proposed rule changes reconciling inconsistent rules and a report setting forth those rules that have not been reconciled. Clearly, this commitment is headed in the right direction despite stopping short of moving to one of the two long-term solutions I discussed earlier. Of course, at this time, I would prefer that the hybrid model be the short-term landing pad but I recognize that large-scale changes like this can take time.
In the future, other improvements need serious consideration. For example, I wonder whether all market surveillance should not also be spun out of exchange structures to be completely independent. With cross-border exchanges on the horizon, would such a model increase or decrease regulatory concerns surrounding acquisitions and mergers? However, that's a topic for another day.
Thus, for now, I urge both the NASD and the NYSE to continue in their efforts to harmonize their rules with the end game of creating a single regulator for broker-dealers, be it a joint venture or some other entity. I appreciate that a joint venture limited to broker-dealer regulation may not eliminate all conflicts of interest that arise from the lack of purity between business concerns and regulatory obligations within a single market and would therefore be an issue that needs addressing. However, I believe that one might be able to construct a joint arrangement that significantly mitigates the conflict issues, even if it does not eliminate them, to the extent to which the resulting efficiencies outweigh the remaining conflicts. To that end, I commend both the NYSE and the NASD for their efforts to date. I encourage both SROs to set aside the personnel, control-person and brand-type issues that revolve around such a venture between two big players. There are lots of hurdles but I feel they can be overcome.
On that note, I'd like to conclude my remarks and wish you Bon Appetite!