SECURITIES AND EXCHANGE COMMISSION

17 CFR PART 240

Release No. 34-50700; File No. S7-40-04

RIN 3235-AJ36

CONCEPT RELEASE CONCERNING SELF-REGULATION

AGENCY: Securities and Exchange Commission.

ACTION: Concept release; Request for comment.

SUMMARY: The Securities and Exchange Commission (“Commission” or “SEC”) is publishing this concept release and seeking public comment on a range of issues related to the self-regulatory system of the securities industry. This release discusses the foundations of the self-regulatory system and new considerations that the Commission and the industry are facing. In addition, this release describes certain enhancements that could be made to the current system that could improve its operation and also discusses a variety of other potential approaches to securities industry regulation.

DATES: Mar. 8, 2005.

ADDRESSES: Comments may be submitted by any of the following methods:

Electronic comments:

• Use the Commission’s Internet comment form (http://www.sec.gov/rules/concept.shtml); or
   
• Send an e-mail to rule-comments@sec.gov. Please include File Number S7-40-04 on the subject line; or
   
• Use the Federal eRulemaking Portal (http://www.regulations.gov). Follow the instructions for submitting comments.

Paper comments:

• Send paper comments in triplicate to Jonathan G. Katz, Secretary, Securities and Exchange Commission, 450 Fifth Street, NW, Washington, DC 20549-0609.

All submissions should refer to File Number S7-40-04. This file number should be included on the subject line if e-mail is used. To help us process and review your comments more efficiently, please use only one method. The Commission will post all comments on the Commission’s Internet Web site (http://www.sec.gov/rules/concept.shtml). Comments are also available for public inspection and copying in the Commission’s Public Reference Room, 450 Fifth Street, NW, Washington, DC 20549. All comments received will be posted without change; we do not edit personal identifying information from submissions. You should submit only information that you wish to make available publicly.

FOR FURTHER INFORMATION CONTACT: Christopher B. Stone, Senior Special Counsel to the Director, at (202) 942-7938 who is in the Division of Market Regulation, Securities and Exchange Commission, 450 Fifth Street NW, Washington DC 20549-1001.

SUPPLEMENTAL INFORMATION:

Table of Contents

1. Introduction
    
2. Foundations of Self-Regulation
    
3. New Considerations
    
4. Current SRO System Attributes
    
1. Inherent Conflicts With Members, Market Operations, Issuers, and Shareholders
    
1. Inherent Conflicts with Members
    
2. Inherent Conflicts with Market Operations
    
3. Inherent Conflicts with Issuers
    
4. Inherent Conflicts with Shareholders
    
2. Inefficiencies of Multiple SROs
    
3. Intermarket Surveillance
    
4. Funding
    
1. Overview
    
2. SRO Funding Sources
    
1. Regulatory Fees
    
2. Transaction Fees
    
3. Listing Fees
    
4. Market Data Fees
    
5. Miscellaneous Fees
    
5. Alternative Regulatory Approaches
    
1. Proposed Enhancements to the Current SRO System
    
1. SRO Governance and Transparency Rulemaking
    
2. Intermarket Surveillance Enhancements
    
2. Independent Regulatory and Market Corporate Subsidiaries
    
3. Hybrid Model
    
4. Competing Hybrid Model
    
5. Universal Industry Self-Regulator
    
6. Universal Non-Industry Regulator
    
7. SEC Regulation
    
8. Other Models
    
6. SOLICITATION OF ADDITIONAL COMMENTS

I. Introduction

Self-regulation is a key component of U.S. securities industry regulation. All broker-dealers are required to be members of a self-regulatory organization (“SRO”), which sets standards, conducts examinations, and enforces rules regarding its members.¹ Most, but not all, SROs also operate and regulate markets or clearing services.² Inherent in self-regulation is the conflict of interest that exists when an organization both serves the commercial interests of and regulates its members or users.

The Securities Exchange Act of 1934 (“Exchange Act”),³ the Maloney Act of 1938 (“Maloney Act”),⁴ and the Exchange Act Amendments of 1975 (“1975 Amendments”),⁵ reflect Congress’ determination to rely on self-regulation as a fundamental component of U.S. market and broker-dealer regulation, despite this inherent conflict of interest. Congress favored self-regulation for a variety of reasons. A key reason was that the cost of effectively regulating the inner-workings of the securities industry at the federal level was viewed as cost prohibitive and inefficient.⁶ In addition, the complexity of securities trading practices made it desirable for SRO regulatory staff to be intimately involved with SRO rulemaking and enforcement.⁷ Moreover, the SROs could set standards that exceeded those imposed by the Commission, such as just and equitable principles of trade and detailed proscriptive business conduct standards.⁸ In short, Congress determined that the securities industry self-regulatory system would provide a workable balance between federal and industry regulation.⁹

Since the self-regulatory system was incorporated into the federal securities laws, the Commission has reexamined it periodically.¹⁰ While steps have been taken over time to redress perceived shortcomings, the SRO structure has been repeatedly reaffirmed both by Congress and the Commission.¹¹ In recent years, changes in the markets and in the ownership structure of SROs have generated questions about the fairness and efficiency of the current SRO structure.¹² The increased dispersion of order flow across multiple markets has produced questions of comparable regulation by SROs and the effectiveness of cross-market supervision.¹³ The increased competition among markets for listings and trading volume has applied pressure on SRO regulatory efforts and sources of funding.¹⁴ Moreover, the advent of for-profit, shareholder-owned SROs has introduced potential new conflicts of interest and issues of regulatory incentives.¹⁵ In addition, recent failings or perceived failings with respect to SROs fulfilling their self-regulatory obligations have sparked public debate as to the efficacy of the SRO system in general.¹⁶

For these reasons, the Commission is publishing this release to discuss and solicit comments on the role and operation of SROs in today’s markets. This release examines a number of issues concerning securities industry self-regulation, including: (1) the inherent conflicts of interest between an SRO’s regulatory obligations and the interests of its members, its market operations, its listed issuers, and, in the case of a demutualized SRO, its shareholders; (2) the costs and inefficiencies of the multiple SRO model; (3) the challenges of surveillance across markets by multiple SROs; and (4) the manner in which SROs generate revenue and how SROs fund regulatory operations. Finally, this release examines and seeks comment on certain enhancements to the current system and a number of regulatory approaches or legislative initiatives that could be considered by the Commission to address concerns with the current SRO model.

II. Foundations of Self-Regulation

Securities industry self-regulation has a long tradition in the U.S. securities markets. In its earliest years, the nascent U.S. securities industry was subject loosely to state laws and, in 1792, the New York broker community negotiated the historic Buttonwood Agreement to form the first organized stock market in New York.¹⁷ As the NYSE and other stock exchanges developed, trading conventions became formalized as exchange rules. In 1817, the NYSE’s Constitution was adopted and the NYSE subsequently adopted a range of rules governing its members and listed companies, including member financial responsibility rules and listed company registration and financial reporting rules.¹⁸ In 1820, a detailed set of NYSE By-Laws was adopted.¹⁹

Federal regulation of exchanges, and their formal recognition as self-regulatory organizations, followed a number of significant events, including the stock market crash of 1929 and the evidence of NYSE investigatory failures related to market manipulation highlighted at the 1934 Pecora Hearings.²⁰ In Section 6 of the Exchange Act, Congress recognized the regulatory role of exchanges, and required all existing securities exchanges, including the NYSE, to register with the Commission and to function as self-regulatory organizations.²¹

The stock market crash of 1929 also severely damaged the public reputation of over-the-counter (“OTC”) securities dealers. In 1933, in an effort to improve their collective image, OTC dealers formed the Investment Bankers Code Committee (“IBCC”), which promulgated industry best practices.²² In 1936, the IBCC was succeeded, by the Investment Bankers Conference (“IBC”), a prominent group of investment banks formed to act as a national, voluntary industry organization.²³

After experience with the IBCC and the IBC, the Commission and leaders of the investment banking community generally agreed that an industry association needed official legal status in order to effectively carry out the task of self-regulating the OTC market.²⁴ Ultimately, in 1938, the Maloney Act amended the Exchange Act by adding a new Section 15A and establishing the concept of registered national securities association SROs.²⁵ To date, the NASD and the NFA²⁶ are the only registered national securities associations.

In enacting these provisions, Congress concluded that self-regulation of both the exchange markets and the OTC market was a mutually beneficial balance between government and securities industry interests.²⁷ Through establishment of self-regulation, the securities industry was supervised by an organization familiar with the nuances of securities industry operations. In addition, industry participants preferred the less invasive regulation by their peers to direct government regulation and the government benefited by being able to leverage its resources through its oversight of self-regulatory organizations.²⁸ Moreover, the SROs had the ability to set proscriptive standards relating to just and equitable principles of trade and detailed business conduct standards.²⁹ In enacting the Maloney Act in 1938, Congress stated that an approach to securities regulation relying solely on government regulation "would involve a pronounced expansion of the organization of the Securities and Exchange Commission; the multiplication of branch offices; a large increase in the expenditure of public funds; an increase in the problem of avoiding the evils of bureaucracy; and a minute, detailed, and rigid regulation of business conduct by law."³⁰

The legislative history of the 1975 Amendments noted that, rather than adopt this purely governmental approach, Congress determined that it was "distinctly preferable" to rely on "cooperative regulation, in which the task will be largely performed by representative organizations of investment bankers, dealers, and brokers, with the Government exercising appropriate supervision in the public interest, and exercising supplementary powers of direct regulation."³¹ Similarly, in 1975, Congress stated that a principal reason for retaining a self-regulatory regime was the "sheer ineffectiveness of attempting to assure [regulation] directly through the government on a wide scale," and that, although the SROs had not always performed their role up to expectations, self-regulation generally was considered to have worked well and "should be preserved and strengthened.”³²

The Commission has periodically examined the self-regulatory system and the extent to which SROs have successfully fulfilled their statutory obligations.³³ Such analysis has sometimes resulted in SROs making changes to their structures or regulatory programs. For example, after problems surfaced regarding the floor operations of Amex specialists, the Commission sponsored the sweeping 1961-1963 Special Study.³⁴ The Special Study concluded that SROs have a natural tendency to protect member firms and that SRO regulatory operations appear to falter without the “pointed stimuli” of vigilant Commission oversight.³⁵ Among other conclusions, the Special Study found a need for a reduction in the amount of control that exchange floor members exercised over exchange regulatory operations and governance.³⁶ Moreover, the study called for a general strengthening of SRO governance.³⁷

Another example of past analysis was the Commission’s Division of Market Regulation review of the structure and costs of the SRO system in the Market 2000 Report, which was published by the Commission in 1994. The Market 2000 Report noted the impact that increasing intermarket competition and duplicative SRO rules were having on the self-regulatory system.³⁸ In addition, the report discussed the extent to which costs to support the SRO system were being fairly allocated across the markets.³⁹ The report also examined the desirability of reallocating the regulatory and market functions of SROs and the possibility of the Commission assuming a greater role with respect to the functions carried out by the SROs.⁴⁰ While the opinion advanced in the Market 2000 Report was that such changes were unlikely to improve the existing SRO system, it did not foreclose the possibility of reconsidering this position in the future in light of changed circumstances.⁴¹

Another example of past Commission analysis on this issue was in 1996 when the Commission instituted administrative proceedings against the NASD with respect to OTC market maker pricing collusion.⁴² At the same time, the Commission issued the 21(a) Report regarding the NASD and Nasdaq. In the 21(a) Report, issued pursuant to Section 21(a) of the Exchange Act, the Commission discussed at length a range of issues concerning the efficacy of the self-regulatory system and the potential problems associated with inherent SRO conflicts.⁴³ Of particular concern, in this case, was the lack of independence of the NASD regulatory staff from Nasdaq’s market operations.⁴⁴

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. Rather, it is generally considered that the SRO system has functioned effectively and has served government, industry, and investors well.⁴⁵ Notwithstanding this positive record, because of new considerations in our markets, the Commission believes it is an appropriate time to reexamine and solicit public comment on the efficacy of the system overall.

III. New Considerations

In recent years, the U.S. markets have experienced increasingly vigorous competition.   The effect of this development is that markets operated by SROs have faced increased competition from foreign trading markets and from electronic communications networks (“ECNs”) that have shifted significant amounts of market share away from the primary markets, especially with respect to Nasdaq securities. For example, the NYSE and Amex historically dominated trading in their listed securities, and market makers dominated trading in Nasdaq stocks. Today, however, in the Nasdaq market, automated market centers (such as Nasdaq's order collector, aggregator, and execution system, SuperMontage, the Archipelago exchange (“ArcaEx”), and the INET ECN) have captured more than 50% of share volume.⁴⁶ For Amex-listed stocks (for which approximately 39% of share volume now is represented by two extremely active exchange-traded funds (“ETFs”) – the QQQ and SPDR), Amex now handles approximately 21% of the volume, with the remaining balance split among Arca-Ex, INET, and others.⁴⁷ The NYSE has managed to retain approximately 80% of the volume in its listed stocks, but other market centers are raising the level of competition and reducing the NYSE’s share of trading.⁴⁸ Moreover, the NYSE and Amex have sought to add automated facilities that are integrated with and complement their traditional exchange floors.⁴⁹ In the listed options markets, the proliferation of multiple trading of options and the entry of two new electronic exchanges has raised the tempo of competition among these markets and redistributed their market share.⁵⁰

This heightened competition has benefited trading markets by spurring innovation in trading systems and responsiveness to customers.⁵¹  It has also driven down costs, including fees charged by the trading markets.⁵²  At the same time, this competition places greater strains on the self-regulatory system.⁵³  Some industry observers have posited that trading previously covered by one market’s rules may move to another market in search of lower regulatory standards.⁵⁴  Others have argued that trading across markets may be subject to inconsistent rules across several markets.⁵⁵  Some have voiced concerns about falling market share inducing SROs to reduce the rigor of their member and market supervision programs.⁵⁶  Also, concerns have been raised about SROs favoring key participants in their markets to encourage those key participants to remain active in their markets or to attract other users.⁵⁷  Shifts in market share can undermine revenues supporting an SRO’s regulatory functions, without reducing the SRO’s responsibility for supervision of its members trading across markets.⁵⁸ Shifts in trading to multiple markets also increase concerns about potential gaps in the surveillance of intermarket trading.⁵⁹

Other considerations also may alter the delicate balance of the SRO system. The conversion of some SROs to publicly traded, for profit status may increase the actual or perceived conflicts inherent in the SRO model.⁶⁰ Likewise, numerous recent SRO failings related to governance, member oversight and trading supervision raise significant concerns about the efficacy of the self-regulatory model.⁶¹ Finally, in response to the recently proposed Regulation NMS (“Reg NMS”),⁶² commenters raised serious questions about the level of market data fees, which are an important component of SRO revenues and the funding of self-regulation.⁶³ The Commission believes that it is an appropriate time to issue a concept release to examine and solicit public comment on the extent to which recent developments in our markets warrant changes to the current system.

IV. Current SRO System Attributes

This discussion focuses on the following distinctive attributes of the existing SRO system and explores how recent market changes have impacted them: (1) the inherent conflicts of interest between SRO regulatory operations and members, market operations, issuers, and shareholders; (2) the costs and inefficiencies of multiple SROs, arising from multiple SRO rulebooks, inspection regimes, and staff; (3) the challenges of surveillance of cross market trading by multiple SROs; and (4) the funding SROs have available for regulatory operations and the manner in which SROs allocate revenue to regulatory operations.

A. Inherent Conflicts With Members, Market Operations, Issuers, and Shareholders

Among the most controversial features of the existing SRO system is the inherent conflict that exists within every SRO between its regulatory functions and its members, market operations, listed issuers, and shareholders. The following discussion considers these conflicts.

1. Inherent Conflicts with Members

The SROs are responsible for promulgating and enforcing rules that govern all aspects of their members' securities business, including their financial condition, operational capabilities, sales practices, and the qualifications of their personnel.⁶⁴ In fulfilling these functions, the SROs conduct examinations on the premises of their members, monitor financial and other operational reports, investigate potential violations of rules, and bring disciplinary proceedings when appropriate. In addition, SROs must surveil trading on any markets they operate to detect rule violations and other improper practices, such as insider trading and market manipulation. Unchecked conflicts in the dual role of regulating and serving can result in poorly targeted SRO rulemaking, less extensive SRO rulemaking, and under zealous enforcement of SRO rules against members. It is also important to note that, even where an SRO structure may appear sound, successful self-regulation relies on sufficiently vigorous rule enforcement against members on the part of the SRO. If regulatory staff is disinclined to regulate members, self-regulation will fail. Thus, to be effective, an SRO must be structured in such a way that regulatory staff is unencumbered by inappropriate business pressure.

Pressures that inhibit effective regulation and discourage vigorous enforcement against members can arise for a variety of reasons, including member domination of SRO funding, member control of SRO governance, and member influence over regulatory and enforcement staff. In addition, the economic importance of certain SRO members may create particularly acute conflicts, especially in light of the consolidation of some of the largest securities firms. For example, the number of NYSE specialist firms, which are central to the NYSE’s auction trading model, has dropped from 27 in 1999 to 7 in 2002.⁶⁵ One NYSE specialist firm in 2003 accounted for over 28% of total NYSE trading volume.⁶⁶ The number of specialist firms at the CHX has dropped from 15 in 2002 to 8 in 2004.⁶⁷ Approximately 47% and 29% of the NSX’s total transaction charges were derived from one member for the years 2003 and 2002, respectively.⁶⁸ In addition, this single NSX member was responsible for generating 93% and 10% of Tape B market data revenues for the years 2003 and 2002, respectively.⁶⁹ This single NSX member was also responsible for generating 100% of NSX’s Tape C market data revenues in both 2003 and 2002.⁷⁰ In the options market, there are just over 40 specialists and market makers on the nation’s options exchanges, whereas just three years ago there were over 70.⁷¹

Thus, the current situation appears to be one in which a declining number of member firms are increasingly important to the business interests of their regulator SROs. The anecdotal evidence cited above could indicate that SROs have become more dependent on large members for their funding, potentially enabling those members to wield significant influence with respect to 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, and SRO failures to develop rules that would disrupt the business practices of important members.

The PCX’s proposal in 2001 to enter into an arrangement in which ArcaEx would become the PCX’s equity trading facility presented a particularly complicated situation in which an SRO would be affiliated with a member. ⁷² In the ArcaEx Approval Order, the Commission examined a variety of issues related to self-regulation, including the regulatory responsibilities of the PCX under the new structure and the potential for inherent conflicts to be exacerbated when an SRO is affiliated with a member. In addition, the Commission imposed certain requirements with respect to PCX and ArcaEx that were designed to ensure that the various functions of the affiliated broker-dealer were properly regulated.⁷³

In the ArcaEx Approval Order, the Commission discussed the PCX’s proposal that Wave Securities LLC (“Wave”), a wholly owned subsidiary of ArcaEx, would be a registered broker-dealer and a member of both the PCX and the NASD. Wave would have two primary functions with respect to ArcaEx. Specifically, Wave would act as an introducing broker for customers that were not PCX members and would provide sponsored access to ArcaEx. Wave would also provide an optional routing service for ArcaEx, and, as necessary, would route orders to other market centers from ArcaEx.⁷⁴

Under Section 6(b)(5) of the Exchange Act, the rules of a national securities exchange must not be designed to permit unfair discrimination between customers, issuers, brokers, or dealers.⁷⁵ The Commission noted in the ArcaEx Approval Order that the potential for unfair discrimination may be heightened if a national securities exchange or its affiliate owns or operates a broker-dealer. This is because, the Commission stated, the financial interests of the exchange may conflict with its responsibilities as an SRO regarding the affiliated broker-dealer. Moreover, the Commission described the conflict of interest that may arise if a national securities exchange (or an affiliate) provides advantages to its broker-dealer that are not available to other members, or provides a feature to all members that was designed to give its broker-dealer a special advantage. These advantages, such as greater access to information, improved speed of execution, or enhanced operational capabilities in dealing with the exchange, might constitute unfair discrimination under the Exchange Act, the Commission concluded. Thus, the Commission required that the PCX not serve as the self-regulatory organization primarily responsible for examining the Wave broker dealer.⁷⁶

The Commission ultimately determined that, although Wave's routing services would be optional, Wave's order-routing function occupied a special position with respect to ArcaEx. In the Commission's view, Wave was uniquely linked to and endorsed by ArcaEx to provide its outbound routing functionality. Therefore, the Commission concluded that the PCX application of the Wave order-routing function fell within the definition of a facility under Section 3(a)(2) of the Exchange Act⁷⁷ and, as such, would be subject to the Commission's continuing oversight. In particular, under the Exchange Act, the PCX would be required to file rule changes and fees relating to the Wave order-routing function, and Wave would be subject to exchange non-discrimination requirements. Thus, the Commission imposed these requirements to address the potential misuse of advantages that might arise from an SRO member carrying out an order-routing function on behalf of an SRO.⁷⁸

In the past, members also have historically controlled the boards and the key committees of SROs. For example, in the 21(a) Report concerning the NASD, the Commission discussed the extent to which large members had made up a majority or substantial proportion of the NASD’s Board of Governors.⁷⁹ Moreover, the Commission discussed the extensive influence wielded by market maker members over the SRO’s disciplinary process due to their strong representation on the NASD’s District Business Conduct Committees (“DBCCs”), which served a “grand jury” function with respect to the initiation of disciplinary proceedings.⁸⁰ Ultimately, the Commission’s settlement with the NASD resulted in significant corporate structure changes designed to prevent these conflicts from occurring in the future.⁸¹

Recently, the NYSE changed its governance structure to reduce conflicts of interest with respect to members.⁸² Specifically, the NYSE created a wholly independent board and regulatory staff that report to an independent board committee.⁸³ In addition, amendments to the NYSE’s charter mandated increased transparency of the NYSE’s operations and corporate governance.⁸⁴ The governance changes included the establishment of a fully independent board of directors composed of 6 to 12 fully independent directors, the NYSE Chief Executive Officer (“CEO”), and the NYSE Chairman.⁸⁵ The concept of “independence” under the NYSE rules was redefined with respect to directors to exclude essentially all persons with any relationship or association to the exchange, an exchange member, or an exchange listed issuer.⁸⁶ A fully independent board committee, the Regulatory Oversight & Regulatory Budget Committee, was established and tasked with overseeing the NYSE’s regulatory plans, programs, budget and staffing proposals on an annual basis.⁸⁷

In an effort to ensure that the NYSE’s regulatory function was sufficiently independent, a new Chief Regulatory Officer position was created that reports directly to the Regulatory Oversight & Regulatory Budget Committee ⁸⁸ An additional fully independent committee, the Human Resources & Compensation Committee, was created to set staff compensation.⁸⁹ Other fully independent committees included the Audit Committee and the Nominating & Governance Committee, which was designed to ensure that governance procedures are appropriate and to administer the board’s annual self-review process.⁹⁰

Because the new definition of independent director excluded most users of the NYSE’s services, an advisory Board of Executives was also created to ensure that NYSE constituents continued to have a meaningful voice in the affairs of the exchange.⁹¹ This advisory group was to be composed of 22 individuals representing key NYSE constituencies and tasked primarily with advising the board on operational issues.⁹² The Board of Directors is required to meet on at least a quarterly basis both with and without the Board of Executives present.⁹³ In approving these amendments, the Commission noted the importance of independence of regulatory staff from business pressures.⁹⁴

As discussed further below,⁹⁵ another recent concern is the extent to which the profit motive of a demutualized SRO could detract from proper self-regulation. In that regard, the Commission recently approved SRO rule changes that permitted several SROs to convert to for-profit entities.⁹⁶ To avoid the potential for member shareholders to wield an in appropriate amount of influence over the regulatory function of the SROs, limits were imposed on the percentage that could be controlled by any one member.⁹⁷ SROs have put forth various reasons for demutualizing, but a common theme is an increased ability to more quickly respond to competitive pressures.⁹⁸

In a companion release, the Commission is proposing SRO governance and transparency measures (the “SRO Governance and Transparency Proposal”) to address a range of concerns, including member ownership controls for demutualized exchanges.⁹⁹ If adopted, the SRO Governance and Transparency Proposal, which will be discussed in greater detail below,¹⁰⁰ would impose a variety of restrictions on shareholder owned SROs, including effectively restricting revenue from regulatory operations being used to pay dividends to shareholders.

The Commission seeks public comment on the following specific questions related to conflicts in member regulation:

Question 1: To what extent are the conflicts caused by member funding of SRO operations a concern? Has consolidation within the securities industry, and the dependence of SROs on a relatively small number of firms for the bulk of their funding, or other developments exacerbated this conflict? If other developments have done so, identify them. Is it possible to minimize these conflicts through SRO governance initiatives that are designed to ensure greater independence of the board and key committees from the regulated members?

Question 2: To what extent are member governance conflicts a concern? Have the governance changes recently made by the NYSE and other SROs to enhance their independence been effective in reducing these conflicts? Are there other governance changes that could be made by the SROs that would further reduce these conflicts?

Question 3: Can potential conflicts between the regulatory function and SRO members be effectively managed through the recent enhancements made to SRO governance and the changes proposed by the SRO Governance and Transparency Proposal? Are there other measures the Commission should consider?

2. Inherent Conflicts with Market Operations

In addition to conflicts with members, an SRO’s regulatory obligations may conflict with the interests of its own or its affiliate’s market operations. The SROs that operate markets (currently, all except the MSRB, the NFA, and the clearing agencies) are responsible for promulgating rules that govern trading in their markets; establishing the necessary systems and procedures to monitor such trading; identifying instances of suspicious trading, such as potential insider trading and market manipulation; and enforcing the Exchange Act, the rules thereunder, and their own rules.¹⁰¹ If an SRO identifies potential misconduct involving persons or entities within its jurisdiction, the SRO is responsible for conducting a further investigation and bringing a disciplinary action when appropriate. For potential misconduct outside its jurisdiction, an SRO is responsible for making referrals to the Commission or other appropriate agencies and assisting these agencies in their investigations.

As competition among markets grows, the markets that SROs operate will continue to come under increased pressure to attract order flow. This business pressure can create a strong conflict between the SRO regulatory and market operations functions. Because increasing inter-market competition has provided members (and those that represent their orders through members) with increasing flexibility as to where to direct order flow, SRO staff may be less inclined to enforce vigorously SRO rules that would cause large liquidity providers to redirect order flow.

For example, one hedge fund typically may account for between 1% and 2% of total daily dollar volume traded on the NYSE.¹⁰² One mutual fund complex may account for as much as 5% of the NYSE’s daily trading volume.¹⁰³ Approximately half of the 80 million exchange-listed shares executed per day on the CHX is directed to eight specialist firms.¹⁰⁴ Moreover, as of July 2004, the NSX’s market share grew to 26.2 percent of the Nasdaq market with the majority of that trading activity being generated by one member, the INET ECN.¹⁰⁵ As of May 2004, the Brut ECN's matched shares reported to the BSE represented 8.7% of overall Nasdaq trading volume.¹⁰⁶

While regulatory staff is responsible for carrying out self-regulatory obligations, they are also a component of a competitive business organization. As intermarket competition increases, regulatory staff may come under pressure to permit market activity that attracts order flow to their market. Market operations staff may also be less likely to cooperate and communicate with regulatory staff if they think such cooperation or communication will hinder their effort to attract order flow.

In addition, SROs face conflicts in regulating members that are influential in the their markets. For example, in the 21(a) Report concerning the NASD, the Commission found that Nasdaq market makers had exerted substantial influence over the affairs of the NASD through their dominant role in its governance, the administration of the NASD’s disciplinary process, and the operation of Nasdaq.¹⁰⁷ Other less favored constituencies, such as retail and institutional investors and other broker-dealers, particularly those day trading firms that heavily used Nasdaq’s Small Order Execution System (“SOES Firms”), did not have comparable representation on the key NASD boards and committees.¹⁰⁸

The Commission found that market maker influence led to a concerted effort by the NASD staff to bring disciplinary actions against SOES firms.¹⁰⁹ Indeed, the 21(a) Report concluded that the NASD made a high priority of enforcement related to violations of its SOES rules by subjecting firms to special "sweep" examinations, and devoting substantial resources to monitoring, examining, and bringing disciplinary actions for potential violations of the day trading rules.¹¹⁰ In contrast, the Commission found that the NASD was far less aggressive with respect to its enforcement of rule violations by market makers.¹¹¹

Another concern is the potential for SRO regulatory staff, in the course of developing rules and examining members, to become overly dependent on members for their understanding of market practices and to lose their independent perspective concerning these practices. A potential loss of objectivity could accompany the greater knowledge and expertise that result from having SRO regulatory staff interwoven with SRO market operations.

Also, SROs may have a tendency to abuse their SRO status by over-regulating members that operate markets that compete with the SRO’s own market for order flow.¹¹² Indeed, among other reasons, these concerns led the Commission to require the NASD to establish the Alternative Display Facility (“ADF”).¹¹³ Exchange Act rule 11Ac1-1¹¹⁴ requires that SRO members communicate their best bids and offers to an SRO and in the late 1990s broker-dealer choice as to where to post quotes in Nasdaq securities was effectively limited to Nasdaq.¹¹⁵ Thus, certain users of Nasdaq were concerned that they would be put at a distinct competitive disadvantage if they were compelled to provide their best bids and offers to the exclusive securities information processor (“SIP”) for Nasdaq securities through the new SuperMontage system.¹¹⁶ These users argued that, not only would their quotes be subject to a competing market’s trading rules, but that the situation would be rife for abuse because of Nasdaq functioning both as a regulator and competitor of the ECNs.¹¹⁷ Thus, before permitting the launch of Nasdaq’s SuperMontage, the Commission required that the NASD provide an alternative, the ADF, to Nasdaq’s SuperMontage on which to quote Nasdaq securities.¹¹⁸

The Commission specifically seeks public comment on the following questions related to conflicts with market operations:

Question 4: To what extent do conflicts exist between SRO regulatory and market operations functions? Has increased intermarket competition exacerbated this potential conflict? Are markets today attempting to use “lax regulation” as a means to attract business? Are they attempting to use “aggressive regulation” as a weapon against competitors? Is it unrealistic to expect a “cost center,” such as regulation, to resist pressure from a function that generates business revenue in a modern business enterprise?

Question 5: To what extent has internal SRO separation of these functions addressed these concerns? Has the restructuring of the NASD, and the recent governance changes of the NYSE and other SROs to enhance their independence, been effective in better insulating the regulatory function from the market function?

Question 6: Can potential conflicts between the regulatory function and SRO market operations be effectively managed through the recent enhancements made to SRO governance and the changes proposed by the SRO Governance and Transparency Proposal? Are there other measures the Commission should consider?

3. Inherent Conflicts with Issuers

Another potential SRO conflict is with listed issuers. The SROs promulgate and administer listing standards that govern the securities that may be traded in their markets. For corporate securities, these rules include minimum financial qualifications and reporting requirements for their issuers. Obtaining a listing on a prominent SRO market provides corporate issuers with enhanced visibility and prestige in the eyes of investors, as well as the appearance of a well-operated and well-regulated trading market for their securities. An active market for secondary trading in a corporation's securities benefits not only its shareholders, but also the corporation itself through enhanced capital-raising capacities.

SRO listing standards also have a major role in corporate governance, particularly since the passage of the Sarbanes-Oxley Act.¹¹⁹ Specifically, under recently adopted rules, SROs are prohibited from listing any security of an issuer that is not in compliance with certain standards.¹²⁰ Each member of the audit committee of the issuer must be independent according to specified criteria.¹²¹ In addition, the audit committee of each issuer must be directly responsible for the appointment, compensation, retention and oversight of the work of any registered public accounting firm engaged for the purpose of preparing or issuing an audit report or performing other audit, review or attest services for the issuer, and each such registered public accounting firm must report directly to the audit committee.¹²² Moreover, each audit committee must establish procedures for the receipt, retention and treatment of complaints regarding accounting, internal accounting controls or auditing matters, including procedures for the confidential, anonymous submission by employees of the issuer of concerns regarding questionable accounting or auditing matters.¹²³ Each audit committee must also have the authority to engage independent counsel and other advisors, as it determines necessary, to carry out its duties and each issuer must provide appropriate funding for the audit committee.¹²⁴

The SROs are responsible for monitoring issuers and delisting the securities of those that fail to meet SRO minimum requirements, but also compete vigorously to attract and retain listings, as illustrated recently by the high profile competition to list the Google Initial Public Offering.¹²⁵ This competition has been heightened by new listing venues. For instance, the equity trading facility of the PCX, ArcaEx, has been actively courting issuers to list¹²⁶ and in the Spring of 2004, Nasdaq launched a high profile dual listing program for NYSE stocks.¹²⁷ Moreover, there are indications that international stock exchanges are becoming more competitive with respect to attracting foreign companies to list on their markets (rather than on U.S. markets).¹²⁸

As issuers are offered new alternatives as to markets on which to list their securities, SROs face increasing competitive pressure to gain and retain listings. As with SRO competition for members and order flow, competition for issuers may cause an SRO to fail to discharge its self-regulatory responsibilities properly. This can take the form of admitting to trading issuers that fail to satisfy initial listing standards; delaying the delisting of issuers that no longer satisfy maintenance standards; failing to enforce listing standards (including the new issuer corporate governance standards); and reducing (or even eliminating) listing fees. This competition also can reveal itself in an unwillingness to restrict issuer activities or impose requirements that may be more stringent than similar rules of competitor SROs.

Another issue with respect to listings relates to conflicts associated with listings of members’ proprietary products such as Exchange Traded Funds (“ETFs”). In some instances, the creator of a proprietary product may be an SRO member that becomes the specialist or primary market maker of the product. In the equity markets, the issuer typically has authority with respect to where the stock is to be listed. With respect to such proprietary products, the product creator (and potentially the product’s sole specialist or primary market maker) may have significant authority as to where the product is listed. When an SRO member is a combined member/issuer of a popular product and that member wields authority with respect to transferring the listing of the product to another SRO, the SRO may be disinclined to regulate that member vigorously.

The Commission specifically seeks public comment on the following questions related to conflicts with issuers:

Question 7: To what extent have conflicts arisen between SRO regulatory and issuer listing functions? Has the recent increase in competition among SRO markets for listings created incentives to admit issuers that fail to satisfy initial listing standards or delay the delisting of issuers that no longer satisfy maintenance standards? To the extent increased competition for listings has caused SROs to waive or lower listing fees, has this negatively impacted regulatory funding and further inhibited enforcement of listing standards?

Question 8: Has the sponsorship of popular proprietary products by member firms compounded the inherent conflicts discussed above with both members and issuers? Specifically, are SROs disinclined to regulate vigorously either the trading activity of popular proprietary products or the activity of members firms that are the sponsors of such products?

4. Inherent Conflicts with Shareholders

Another significant conflict of interest for SRO responsibilities is with SRO shareholders. SRO demutualization raises the concern that the profit motive of a shareholder-owned SRO could detract from proper self-regulation. For instance, shareholder owned SROs may commit insufficient funds to regulatory operations or use their disciplinary function as a revenue generator with respect to member firms that operate competing trading systems or whose trading activity is otherwise perceived as undesirable. Moreover, as with the inherent conflicts discussed above, this conflict can be exacerbated by increased intermarket competition.¹²⁹

A variety of ownership controls for demutualized SROs can potentially prevent some of these conflicts.¹³⁰ Indeed, as previously noted, this concept release is being published in conjunction with the SRO Governance and Transparency Proposal, which would, if adopted, impose a variety of restrictions, including an effective restriction on revenue from regulatory operations being used to pay dividends to shareholders.

The Commission specifically seeks public comment on the following questions related to conflicts with shareholders:

Question 9: What are the conflicts between a demutualized SRO’s regulatory responsibilities and the profit-making orientation of its shareholders? To what extent do they heighten the inherent SRO conflicts with members, market operations, and listed issuers discussed above?

Question 10: Can potential conflicts between the regulatory function and SRO shareholders be effectively managed through the recent enhancements to SRO governance and the changes proposed by the SRO Governance and Transparency Proposal? Or are there other measures the Commission should take to help ensure that the effectiveness of the regulatory function is not diminished?

B. Inefficiencies of Multiple SROs

Securities industry self-regulation carries with it an inherent inefficiency in that it can cause duplicative and potentially conflicting regulation. Specifically, the existence of multiple SROs can result in duplicative and conflicting SRO rules, rule interpretations, and inspection regimes. The system can also result in redundant SRO regulatory staff and infrastructure across SROs.

Congress and the Commission have put in place methods for reducing a certain amount of regulatory duplication. Pursuant to Exchange Act Section 17(d) and Rule 17d-1,¹³¹ when a member belongs to more than one SRO, the SEC shall designate the responsibility to one SRO for examining the member for compliance with applicable financial responsibility rules.¹³² The undesignated SRO is relieved of responsibility for examining the member for compliance with financial responsibility rules.¹³³ In addition, Rule 17d-2 under the Exchange Act permits SROs to establish Commission approved joint plans for allocating regulatory responsibilities with respect to common members.¹³⁴ An SRO participating in such a regulatory plan approved by the Commission is relieved of regulatory responsibilities with respect to a broker-dealer member, if those regulatory responsibilities have been allocated to another SRO under the regulatory plan.¹³⁵

The options SROs, for example, have utilized a 17d-2 agreement to reduce regulatory redundancies.¹³⁶ The options markets’ 17d-2 Plan reduces regulatory duplication for a large number of firms currently members of two or more of the SRO participants by equitably allocating regulatory responsibility for a set of options sales practice rules that are substantially identical for each of the SRO participants.¹³⁷

While the potential for the SRO system to cause regulatory redundancies is not a novel issue for the Commission,¹³⁸ it appears that the inefficiencies caused by the SRO system are being aggravated by greater market fragmentation of order flow among SROs. Thus, a recent U.S. General Accounting Office (“GAO”) analysis is worth discussing. In May of 2002, the GAO issued a report, which specifically focused on the implications of market fragmentation with respect to securities industry regulatory redundancies.¹³⁹ It ultimately discussed a broad range of issues related to the relationship between self-regulation and intermarket competition for order flow. The GAO Report recommended that the Commission work with the SROs and broker-dealers to implement a formal process for systematically identifying and addressing material regulatory inefficiencies caused by differences in rules and rule interpretations among SROs and by multiple examinations of broker-dealers.¹⁴⁰ In the wake of the GAO Report, the Commission supported the formation of a joint NASD and NYSE task force with the mission of examining their conflicting rules and determining how those conflicts could be resolved. The Commission has been working with the SROs in this respect and facilitating SRO rule amendments when appropriate.¹⁴¹

More recently, in light of issues raised in a petition for rulemaking filed by Nasdaq, the Commission published a concept release covering the regulation of intermarket trading of Nasdaq securities.¹⁴² The Intermarket Trading Concept Release discussed Nasdaq’s concern about the potential development of “regulatory arbitrage” when SRO rules are inconsistent across markets.¹⁴³ Specifically, according to Nasdaq, this type of arbitrage could result in the attraction of order flow and members to certain SROs over others because of the prospect of lax regulation.¹⁴⁴ The Intermarket Trading Concept Release sought public comment on the importance of uniformity with respect to a variety of rules related to intermarket trading of Nasdaq-listed securities, including rules related to market manipulation, illegal short selling, insider trading, fraud, front running, marking the open or close, non-compliance with the limit order display rule, and non-compliance with the firm quote rule.¹⁴⁵ The Intermarket Trading Concept Release solicited comment on whether uniform rules are necessary to prevent regulatory arbitrage.¹⁴⁶ It also noted Nasdaq’s contention that the disparities in rules between SROs pose a serious threat to investor protection and discussed Nasdaq’s request that the Commission exercise its authority under Sections 12(f)(2) and (3) of the Act¹⁴⁷ to prohibit the launch or continuation of Nasdaq trading by any market that failed to adopt adequate regulatory protections, including rules related to inter-market trading issues.¹⁴⁸

The Commission received a variety of comments in response to the Intermarket Trading Concept Release. Commenters, including certain SROs and ECNs that compete with Nasdaq for order flow, argued that there is, in fact, no unequal regulation across markets and that trading that falls within each SRO’s purview is effectively regulated.¹⁴⁹ Some commenters voiced a qualified endorsement of uniform rules in certain areas, but were careful to note that uniform rules should in no way restrict each SRO’s ability to craft rules that reinforce its own unique intra-market structures or competitive business models.¹⁵⁰ At least one commenter even supported the creation of a single independent regulator that would be responsible for regulating all broker-dealers in all markets.¹⁵¹

Thus, while the Intermarket Trading Concept Release drew out thoughtful public commentary on discrete issues related to the SRO system’s regulatory inefficiencies and redundancies, this concept release seeks public commentary on these issues in the broader context of the efficacy of the SRO system overall. Specifically, the Commission specifically seeks public comment on the following questions:

Question 11: Is the lack of intermarket rules across markets trading the same type of securities causing regulatory arbitrage and, if so, what is the impact of this on the SRO system? Should this issue be addressed through changes at the SRO system level, rather than at the individual SRO level?

Question 12: How significant are the inefficiencies resulting from multiple SROs overseeing the activities of the same members? In what areas do these issues primarily arise?

C. Intermarket Surveillance

Another area in which the SRO system has recently come under increasing strain because of market fragmentation is with respect to SRO and Commission supervision of intermarket trading. When order flow was largely concentrated in the primary markets, traders had limited ability to cloak illicit activity by spreading trades across markets. When trading takes place in multiple active markets, however, it is possible for traders to veil illegal trading activity by dispersing trades across markets.

The Intermarket Trading Concept Release specifically sought public comment on this topic.¹⁵² The release focused public attention on Nasdaq’s contention that its extensive audit trail data was of limited use for cross-market surveillance, because it cannot capture relevant data for executions that take place on other markets trading Nasdaq securities, and other markets do not have comparable systems that can interact with NASD’s Order Audit Trail System (“OATS”), which captures regulatory data concerning the important stages in the life of a trade.¹⁵³

The Intermarket Trading Concept Release also focused comment on the role of the Intermarket Surveillance Group (“ISG”), which is an industry organization created in 1983 to coordinate intermarket surveillance among the self-regulatory organizations by cooperatively sharing regulatory information pursuant to a written agreement between the parties.¹⁵⁴ The goal of the ISG’s information sharing is to coordinate regulatory efforts to address potential intermarket trading abuses and manipulations.¹⁵⁵ Although the ISG Agreement was not established under Section 11A or 17(d) of the Securities Exchange Act of 1934,¹⁵⁶ ISG asserts that the Commission has required new markets to become ISG members as a condition of registration, thus recognizing its importance.¹⁵⁷ ISG's full members are the Amex, BSE, CBOE, CHX, NSX, ISE, NASD, NYSE, PCX, and the Phlx (collectively "Full Members").¹⁵⁸ Each of the Full Members is an SRO for which the Commission has direct oversight.¹⁵⁹ As a result, the regulatory procedures that these SROs have developed, individually and jointly, including those developed for insider trading and certain types of market manipulation, are subject to Commission jurisdiction and are regularly examined for sufficiency.¹⁶⁰

In its petition, Nasdaq asserted that, for a variety of reasons, the data, received through ISG regarding other markets, is insufficient to enable Nasdaq to properly surveil intermarket trading activity.¹⁶¹ Nasdaq also posited that consolidated regulation of Nasdaq trading across all markets for intermarket surveillance purposes would be fundamentally more effective because of the flaws of ISG data and because the ISG is composed of some members that do not necessarily trade Nasdaq securities (including certain non-Full Members that are not regulated as SROs by the Commission).¹⁶²

In response to the Intermarket Trading Concept Release, the Commission received a variety of comments on intermarket surveillance and order audit trail issues.¹⁶³ Some commenters argued that existing audit trail systems were well designed, even though they did not interact with Nasdaq’s.¹⁶⁴ In addition, many commenters were concerned that complying with multiple SROs’ different order audit trail systems would be burdensome and expensive to implement and administer.¹⁶⁵ Other commenters argued that Nasdaq had understated the effectiveness of ISG and that the organization should be allowed to continue in its role as the facilitator of regulatory data sharing among markets.¹⁶⁶

In its comment letter, the ISG described its consolidated audit trail system, which supplements individual markets’ surveillance systems by facilitating the analysis and review of information concerning potential trading violations.¹⁶⁷ By allowing the SROs to share their regulatory information, ISG asserts, the SROs are able to view trading activity in the context of all markets’ clearing level quote and trade data.¹⁶⁸ The ISG argued that its Equity Audit Trail system provides a consolidated view across all markets of quotes and trades, including clearing information.¹⁶⁹ Moreover, ISG stated that its systems serve their purpose well and that no other market had raised the issues that Nasdaq raised in its petition.¹⁷⁰ Specifically, the ISG claimed that neither the time delays in receiving information through ISG nor the lack of a uniform synchronization protocol had proven to be problematic.¹⁷¹

In the NYSE’s comment letter, it generally supported the traditional role of the ISG.¹⁷² Moreover, the NYSE described its own order audit trail, the Order Tracking System (“OTS”), and how its rules are comparable to those of the NASD’s OATS.¹⁷³ The NYSE raised the possibility of the Commission requiring that each individual market establish an order audit trail system similar to the NYSE’s and the NASD’s and mandating that the data from these separate order audit trails be integrated into the ISG’s consolidated order audit trail.¹⁷⁴

In its comment letter in response to the Intermarket Trading Concept Release, the NASD echoed many of the concerns raised by Nasdaq in its petition. Specifically, the NASD argued that the current model of coordinated regulation results in regulatory gaps and that potential misconduct can occur across markets undetected by regulators.¹⁷⁵ It also argued that the less detailed regulatory information collected by the ISG lacks certain critical pieces of information to effectively assist SROs in regulating intermarket trading activity.¹⁷⁶

With respect to the options markets, in September of 2000, the Commission accepted settlement agreements from the Amex, CBOE, Phlx, and PCX in connection with administrative proceedings, alleging, among other things, that these options exchanges had inadequately discharged their obligations as SROs by failing to enforce compliance with certain rules, including order handling rules, reporting rules, and rules prohibiting anticompetitive conduct.¹⁷⁷ As a result, in settling the Commission’s enforcement action, the options exchanges undertook a variety of steps to prevent future self-regulatory lapses, including the design and implementation of a consolidated options audit trail system (“COATS”).¹⁷⁸ COATS would enable the options exchanges to reconstruct markets promptly, effectively surveil them and enforce order handling, firm quote, trade reporting and other rules.¹⁷⁹ The full extent to which COATS effectively enhances intermarket options surveillance is not known as of yet because the system is in the final stage of its implementation. COATS, however, suggests the potential for a consolidated audit trail for the equity markets.

While the full implementation of robust intermarket order audit trails would be a significant step forward, an order audit trail is simply a tool that can be used by regulators to better surveil for illicit trading activity. In the 2000 Options Settlement, the options exchanges undertook to design and implement, concurrent with the design and implementation of COATS, effective surveillance systems to use the newly available COATS data to enforce the federal securities laws and SRO rules.¹⁸⁰ Thus, even when COATS is fully implemented and even if a similar intermarket audit trail were developed for the equity markets, the SRO regulatory function would still play a critical role in the regulation of intermarket trading.

The Commission specifically seeks public comment on the following questions related to intermarket surveillance and regulation:

Question 13: To what extent does our market model of multiple competing SROs create gaps in intermarket trading surveillance? What types of illicit trading activity in particular can be hidden from regulators by dispersing trading across multiple markets?

Question 14: How effectively does the ISG serve as a facilitator of regulatory data sharing and surveillance coordination among SROs? Is the ISG’s order audit trail effective as a regulatory tool? How feasible would it be to require all markets to adopt order audit trails similar to those of the NYSE and the NASD and ultimately to integrate all markets’ order audit trails into the ISG’s consolidated order audit trail?

Question 15: How similar are the order audit trail systems of the NYSE and the NASD? Could they be merged into one consolidated system and what would be the benefits of such a consolidated system? Should NASD’s OATS or NYSE’s OTS requirements be extended to all equity markets to enhance the ability of SROs to surveill intermarket activity? If so, could all markets’ individual order audit trails be successfully integrated into the ISG’s consolidated order audit trail or another consolidated system? How useful a regulatory tool would the ISG’s consolidated order audit trail system be if all markets were required to adopt their own order audit trail systems and their data was required to be integrated into the ISG’s?

Question 16: To what extent is there a need for an order audit trail to provide crossover surveillance between the equities and options markets? To what extent would such crossover surveillance detect specific types of illicit trading activity?

D. Funding

Another feature of the SRO system to be discussed relates to the funding of SRO regulatory operations. One of the key historical benefits of the SRO system is its self-funding structure, which leverages the limited resources of the Commission. Experience appears to indicate that the Commission, in its current form, does not have the resources to effectively carry out on its own the full panoply of duties for which the SROs are currently responsible. In 1983, after 18 years of experience with directly regulating over-the-counter broker-dealer activity through the SEC Only (“SECO”) program,¹⁸¹ the regime was repealed.¹⁸² Congress amended the Exchange Act provisions covering direct regulation of broker dealers by the SEC and imposed compulsory SRO membership.¹⁸³

At the time of the repeal of the SECO program, the House Committee on Energy and Commerce reported to the Committee of the Whole House that the SECO program was unnecessarily costly and diverted the SEC’s limited resources away from areas of major concern, merely to duplicate the functions of the NASD.¹⁸⁴ The House Committee stated “that any attempt to put SECO regulation on a par with that provided by the NASD would require significant expenditures by the Commission for additional staff and administrative costs.”¹⁸⁵ The committee also noted that SROs were better able to maintain ethical standards for the industry and to perform certain detailed oversight functions.¹⁸⁶ The House also cited the limitations of enforcement and compliance remedies available to the Commission in comparison to the remedies available to the NASD.¹⁸⁷

In the Market 2000 Report, the Commission’s staff provided its retrospective impression of the SECO program’s performance. The staff noted its belief that the SECO experience illustrated “that the resources necessary for the Commission to assume SRO regulatory functions directly and effectively are not realistically attainable.”¹⁸⁸ The SECO experience demonstrated the important role that SROs play in maximizing the Commission’s limited resources. It also illustrated that regulation must be properly funded and have sufficient resources to be effective. In that regard, the most finely-balanced SRO structure will not ensure that SRO statutory obligations are met, if regulatory operations are insufficiently funded. Thus, SRO funding arrangements are critical to the SRO system.¹⁸⁹

1. Overview

While Congress was fairly prescriptive in its initial enactment of the Exchange Act and in subsequent amendments as to the standing responsibilities of SROs, it has not provided explicit guidance as to the proper levels or methods of funding for self-regulatory operations.¹⁹⁰ Section 6 of the Exchange Act, which addresses the registration of national securities exchanges, requires that “the rules of the exchange provide for the equitable allocation of reasonable dues, fees, and other charges among its members and issuers and other persons using its facilities.”¹⁹¹ Section 15A contains a similar provision in connection with the registration of national securities associations.¹⁹² These provisions also require that an SRO be “so organized and [have] the capacity to be able to carry out the purposes” of the Exchange Act and “to comply, and . . . to enforce compliance by its members, and persons associated with its members, with the provisions” of the Exchange Act.¹⁹³ Accordingly, while Congress provided only general guidance with respect to SRO funding, a reasonable reading of the Exchange Act indicates that it intended that regulatory funding be sufficient to permit SROs to fulfill their statutory responsibilities under the Exchange Act, and contemplated that such funding would be achieved through equitable assessments on the members, issuers, and other users of an SRO’s facilities.

The Commission to date has not issued detailed rules specifying proper funding levels of SRO regulatory programs, or how costs should be allocated among the various SRO constituencies. Rather, the Commission has examined the SROs to determine whether they are complying with their statutory responsibilities. This approach was developed in response to the diverse characteristics and roles of the various SROs and the markets they operate. The mechanics of SRO funding, including the amount of revenue that is spent on regulation and how that amount is allocated among various regulatory operations, is related to the type of market that an SRO is operating. Prior to the SRO Governance and Transparency Proposal, the Commission had not proposed requiring a single regulatory structure for all SROs, and the financial structure of each individual SRO is a result of a variety of factors, including the SRO’s particular history and competitive position. Thus, each SRO and its financial structure is, to a certain extent, unique. While this uniqueness can result in different levels of SRO funding across markets, it also is a reflection of one of the primary underpinnings of the National Market System. Specifically, by fostering an environment in which diverse markets with diverse business models compete within a unified National Market System, investors and market participants benefit.¹⁹⁴

The “appropriate” amount of funding to be spent by SROs on regulatory operations is governed by a variety of factors, including the SRO’s business model, trading systems, regulatory responsibilities, and types of members. For instance, electronic marketplaces may be able to supervise trading occurring in their markets at lower cost than floor-based markets because their trading systems may capture comparatively more information associated with any given trade. Likewise, the characteristics of an SRO’s membership base may affect the appropriate level of regulatory funding and how the funding is allocated.

Potential varying levels of regulatory funding notwithstanding, all SROs must meet their statutory obligations. The Exchange Act itself, as well as the Commission's rules and automation review policies thereunder, impose on the SROs important regulatory and operational responsibilities, including most of the day-to-day responsibilities for market and broker-dealer oversight.¹⁹⁵ Satisfying these self-regulatory responsibilities requires a substantial expenditure of expertise and funds. The SROs' combined total operating expenses in 1998 were $1.68 billion¹⁹⁶ and total combined SRO operating expenses in 2003 were $2.4 billion.¹⁹⁷ As stated above, a significant benefit of self-regulation in the securities industry is that this significant cost is largely self-funded.

The Commission’s supervision of the adequacy of SRO regulatory funding presents considerable challenges. Given the inherent tension between an SRO’s role as a business and as a regulator, there undoubtedly is a temptation for an SRO to fund the business side of its operations at the expense of regulation. For example, if the “appropriate” amount of regulatory spending would seriously impair the financial stability of an SRO, that SRO would likely reduce regulatory spending rather than jeopardize its financial viability. When the Commission examines the underlying reasons for regulatory failings, it is often clear that an SRO has not allocated sufficient resources to its regulatory function. Without such failings, however, it can be difficult for the Commission to determine whether an SRO is insufficiently funding its regulatory function or simply administering an efficient regulatory program.¹⁹⁸

If the Commission’s SRO Governance and Transparency Proposal is adopted, however, it could illuminate more clearly SRO practices with respect to regulatory spending levels and allocations. Specifically, the detailed accounting of SRO revenues and expenses proposed could enable the Commission to more accurately and efficiently compare these items. Under the current reporting regime, SROs update their Form 1 annually, including an updated financial statement, but their financial information is not necessarily submitted in a comparable format.¹⁹⁹ Thus, the Commission could use this new information to assist in its effort to detect when an SRO is becoming an industry outlier in terms of relative regulatory spending levels. If the Commission made such a determination, it has the ability to pursue a range of regulatory responses, including designating that SRO for heightened Commission oversight or stronger action, such as SRO deregistration.

Although not proposed in the SRO Governance and Transparency Proposal, the Commission could also consider developing formal or informal regulatory spending guidelines for SROs. Establishing uniform guidelines for SROs generally would be a very complex task, however, given the diversity of their marketplaces and memberships and the evolving nature of regulatory oversight. While the SRO Governance and Transparency Proposal would likely result in a heightened Commission ability to detect low regulatory spending levels, it is important to note that gauging the effectiveness of an SRO’s self-regulation cannot necessarily be accurately judged by considering capital expenditures in isolation.

The Commission specifically seeks public comment on the following questions related to SRO funding generally:

Question 17: Should the Commission prescribe specific regulatory funding and allocation levels for SROs and, if so, how? Also, how would these levels be determined?

Question 18: Could enhanced transparency of SRO funding be used effectively to promote adequate SRO regulatory funding levels or would other steps be more effective in that regard? What measures could be used to promote adequate SRO regulatory funding levels?

2. SRO Funding Sources

To provide commenters a basis for considering SRO funding, this section discusses the five primary sources of SRO funding: (a) regulatory fees; (b) transaction fees; (c) listing fees; (d) market data fees; and (e) other miscellaneous fees. While each source of SRO revenue is important, this discussion will provide an extensive discussion of market data and specifically the level of fees charged for market data.

a. Regulatory Fees

SROs charge members fees for joining and maintaining membership. In addition, SROs charge regulatory fees to members that typically take the form of per member or per transaction fees and are generally allocated to funding self-regulatory operations. SROs also contract with other SROs to provide regulatory services. In 1998, regulatory fees accounted for approximately 19% of SRO revenue,²⁰⁰ while, in 2003, approximately 23% of SRO revenue was derived from such fees.²⁰¹

A recent development with respect to SRO regulatory fees was the NASD’s establishment of a Trading Activity Fee (“TAF”), to supplement the regulatory fees it historically charged its members.²⁰² The TAF assessed a transaction-based fee that was not linked to trading activity reported through Nasdaq systems.²⁰³ In approving the TAF, the Commission found that it was reasonably designed to recover the NASD’s costs related to regulation and oversight of its members.²⁰⁴ A principal factor in the Commission's approval was its explicit recognition of the NASD's broad responsibilities with respect to its members' activities, irrespective of where securities transactions take place.²⁰⁵ Specifically, the Commission noted that, as a national securities association, the NASD has the responsibility to oversee its members' finances and conduct toward their customers, except in limited circumstances where this responsibility is allocated to another SRO.²⁰⁶ The Commission further stated that the NASD's responsibility exists even if the conduct involves a transaction executed on a market not directly regulated by the NASD because it has direct responsibility to oversee the firm's dealing with the public in effecting the transactions and may also have responsibility to oversee the impact of the trading on the firm's financial condition.²⁰⁷

The Commission specifically seeks public comment on the following question related to SRO regulatory fees:

Question 19: Under current SRO cost structures, SRO funding for regulatory operations is not derived strictly from revenue associated with regulatory fees and operations. Instead, SROs cross subsidize the cost of regulatory operations with revenue that is not strictly derived from regulatory fees and operations. Should the Commission require that SRO funding for regulatory operations be derived only from regulatory fees, rather than allowing the cost of regulatory operations to be subsidized by other revenue sources? If regulatory funding should be limited strictly to revenue generated by regulatory fees, how should the Commission address a situation in which an SRO does not generate sufficient regulatory revenue to fully fund regulatory operations?

b. Transaction Fees

Another important source of revenue for SROs that operate markets is derived from fees that are associated with members’ or others’ use of the SRO’s systems, such as order routing systems, trade execution systems, and electronic connectivity services. These fees are paid by any user of an SRO’s market facilities for services, including executing, reporting, and clearing transactions. In 1998, transaction fees accounted for approximately 30% of SRO revenue,²⁰⁸ while, in 2003, approximately 27% of SRO revenue was associated with transaction fees.²⁰⁹

The intense intermarket competition for order flow has put substantial pressure on these fees. For example, greater competition among options markets has caused transaction fees to all but disappear in the options markets.²¹⁰ The equity markets have also come under intense competitive pressure to lower transaction fees. As discussed in the Reg NMS proposal, transaction fees have decreased steadily in recent years.²¹¹ In addition, most ECNs and Nasdaq are paying a per-share rebate for limit orders that become executed against incoming orders, thereby further reducing net transaction fees.²¹² Thus, not only are SRO transaction fees being driven lower, but competition is compelling certain SROs to rebate a significant percentage of transaction fees collected to market participants.

The Commission specifically seeks public comment on the following questions related to SRO transaction fees:

Question 20: SRO transaction fees have been driven sharply lower in recent years by competition. In light of that, why has the overall percentage of SRO revenue associated with transaction fees not dropped as dramatically since 1998 (approximately 27% in 2003 compared to approximately 30% in 1998)?

Question 21: How has the trend of decreasing transaction fees impacted the SROs’ ability to fulfill their statutory obligations?

c. Listing Fees

Another important source of revenue for some SROs is listing fees, which are paid by issuers that list their securities on an SRO’s market. Initial listing fees are paid at the time of listing and are typically related to the amount of shares being offered. Listing maintenance fees are paid annually and are generally related to the issuers’ total shares outstanding in the listed security. In 1998, listing fees accounted for approximately 23% of SRO revenue,²¹³ while, in 2003, these fees represented approximately 20% of SRO revenue.²¹⁴ These revenues have been highly concentrated in the primary listing markets, with secondary markets charging little or no listing fee.²¹⁵ This concentration is exemplified by the fact that of the $9,182 billion worth of stocks listed on exchanges in 2002, $9,119 billion was listed on the New York Stock Exchange.²¹⁶

The Commission specifically seeks public comment on the following question related to SRO listing fees:

Question 22: To what extent has increased inter-market competition impacted SRO listing fee revenue? To what extent has this impacted the SROs’ ability to fulfill their regulatory obligations?

d. Market Data Fees

Market data revenue has traditionally been a very important component of SRO funding.²¹⁷ In 1998, market data revenue represented approximately 21% of SROs’ total revenues,²¹⁸ while, in 2003, approximately 18% of SRO revenue flowed from market data.²¹⁹ Market data revenues represented 16% of NYSE revenues and 24% of Nasdaq revenues in 2003.²²⁰ For one SRO, market data fees accounted for more than 80% of its total 2003 revenue.²²¹

In contrast to the importance of market data revenue to overall SRO funding, it is worth noting that it represents a relatively small portion of the securities industry’s total expenses. For example, in 1998, the total SRO market data revenue of $410.6 million represented a very small portion of the securities industry's total expenses for the year -- less than 1/4th of one percent.²²² In spite of revenue derived from market data playing an important role in SRO funding, some SROs rebate substantial market data revenues to the market participants that contribute to creating the market data.²²³

The U.S. equity markets are not alone in their reliance on market data revenues as a source of funding. All of the other major world equity markets currently derive large amounts of revenues from selling market information, despite having significantly less trading volume and less market capitalization than the NYSE and Nasdaq. To illustrate, the following table sets forth the respective market information revenues, dollar value of trading, and market capitalization for the largest world equity markets in 2003:²²⁴

Understanding market data pricing and the role that market data plays with respect to SRO funding is an important part of this discussion. Congress recognized that SROs would charge for market data when it gave the Commission authority in the 1975 Amendments to determine the extent to which SRO fees charged for market data are “fair and reasonable,” are “not unreasonably discriminatory,” and achieve “equitable allocation” of reasonable fees among persons who use an SRO’s facilities.²²⁵ Market information revenues serve an important and unique role in that they provide a broad source of SRO funding. The fees are paid by all users of market information, including, for example options and futures markets participants that otherwise would not contribute (through transactions services fees or listing fees) to the funding of the particular markets on whose information they rely. ²²⁶

In addition to being important to SROs, market data is also critical to market participants and investors. Market data is essential to investors and other market participants not physically present in a trading market, enabling them to make informed decisions when to buy and sell. It provides the basis for investment and portfolio decisions. And it creates confidence in the fairness and reliability of the markets. The current market data systems for equities and options collect quotes and trades from many different market centers and disseminate them to the public in a single stream of information for each security. This market information has been an essential element in the success of the U.S. securities markets. In addition to providing transparency of buying and selling interest, consolidated data is the principal tool for addressing fragmentation of trading among many different market centers, and for facilitating the best execution of investor orders by their brokers. ²²⁷ Market data fees can have a major impact on the effectiveness of the market data system. The level of these fees and their structure determines the extent that market data is available to different types of market participants and investors. And market data can have anticompetitive effects if it is sold on discriminatory terms or in an unfair fashion.²²⁸

Market data fees also support the timeliness, accuracy, and reliability of the market data being disseminated. Market data, whether consolidated or not, that is untimely or untrustworthy could harm investors and reduce confidence in the fairness of the U.S. securities markets. One of the Commission's most important market structure responsibilities is to assure the integrity of market data.²²⁹ Today, market data from all equity and options markets is highly reliable and widely used. In order to promote the wide public availability of this information, market data fees must be fair and reasonable.²³⁰ Consistent with this is the notion that such fees should at least generate sufficient revenue to provide adequate funding for the dissemination of market data.

Currently, the Commission typically reviews market data fees in the context of proposed fee changes filed by the three networks that disseminate market data in NMS stocks. These fee filings are published for notice and comment before Commission action.²³¹ After these filings are published, the Commission determines whether the fees are fair and reasonable, not unreasonably discriminatory, and otherwise consistent with the requirements of the Exchange Act.²³² Although most market data fee filings currently involve Network fees, the same standard applies and the same questions arise with regard to the market data fees of an individual SRO.

In reviewing a market data fee filing, the Commission has relied to a great extent on the ability of the Networks to negotiate fees that are acceptable to SRO members, information vendors, investors, and other interested parties. The negotiation process is buttressed by the public notice and comment procedures that accompany the Commission’s consideration of proposed rule changes.

As equities and options markets have evolved in recent years, strains began to develop in the arrangements for market data, particularly with respect to setting fees. In evaluating the issues raised, an extensive public record has been developed on the subject of market data fees in the last five years. In 1999, the Commission initiated a full-scale review of market data fees and revenues in the Market Data Concept Release. The review was prompted, in part, by the Commission's concern that retail investors might be paying too much for market data.²³³ The Market Data Concept Release included the role of revenues derived from such fees in funding the operation and regulation of markets.²³⁴ The Market Data Concept Release presented for public review a great deal of factual information on market data fees and revenues.²³⁵ In the course of that effort, the Commission emphasized that market data must be affordable for retail investors.²³⁶ At about the same time, the Networks filed proposed rule changes that reduced retail investor fees generally by 75% to 80%. The following table sets forth retail investor fees for NYSE and Nasdaq stocks in 2003 and in 1998:

The per-query fees are charged each time that a retail investor requests quote and trade information in a particular stock. The monthly fees represent limits on the total amount that a retail investor can be charged for market data in any month. Thus, for example, all retail investors currently have access to an unlimited quantity of the millions of best quotes and trades in Network A stocks during each trading day for no more than $1 per month, compared to the $5.25 that was charged before the Commission's review of market data fees.²³⁷

In reviewing the basis for evaluating market data fees, the Market Data Concept Release laid out in detail a “flexible cost-based approach” to market data fees.²³⁸ The Commission noted that terms such as "fair" and "reasonable" generally need standards to guide their application in practice, and that one such standard often used to evaluate fees is the amount of costs incurred to provide a service.²³⁹ The Commission stated that an inflexible cost-based standard, although unavoidable in some contexts, can entail severe practical difficulties.²⁴⁰ Instead, Congress, consistent with its approach to the National Market System in general, granted the Commission some flexibility in evaluating the fairness and reasonableness of market information fees.²⁴¹ Specifically, Congress articulated general findings and objectives for the National Market System in section 11A and directed the Commission to act accordingly in overseeing its development.²⁴² Congress thereby allowed the Commission to adopt a more flexible approach than ratemaking.²⁴³

To illustrate the practical difficulties of a strict, cost-of-service ratemaking approach, the Market Data Concept Release described one prior instance in which the Commission had sought to implement such an approach in 1984.²⁴⁴ In that instance, Instinet had brought a proceeding before the Commission asserting that the NASD's fee for full quotation information from all Nasdaq market participants was an unwarranted denial of access to the information.²⁴⁵ The Commission found in favor of Instinet, primarily because the NASD had failed to submit an adequate cost-based justification for the fee.²⁴⁶ The Instinet Order emphasized, however, that the scope of its decision was limited to the particular competitive context presented in the proceedings and did not apply to all market data fees.²⁴⁷

While recognizing the practical difficulties of a detailed cost-of-service approach, the Commission nevertheless concluded in the Market Data Concept Release that "the total amount of market information revenues should remain reasonably related to the cost of market information."²⁴⁸ In this regard, one of the issues on which comment particularly was requested was whether the Commission should adopt "a conceptual approach to evaluating the fairness and reasonableness of fees that, among other things, could establish a link between the cost of market information and the total amount of market information revenues."²⁴⁹ Critical to this concept was the determination of what SRO costs should be included in the cost of market data.

The Market Data Concept Release’s flexible, cost-based approach was intended to arrive at an approach to market data fees that could be implemented in a reasonably efficient manner, as opposed to a full-fledged ratemaking approach. The first step in fashioning the approach was to identify the categories of SRO costs incurred to generate and disseminate market data. All direct market data costs, such as market data recordation, communication, consolidation, and dissemination, would be included. The flexible cost-based approach would also have included in market data costs some portion of "common costs" -- those costs that support multiple SRO functions, in addition to market data, and therefore must be allocated among these services. ²⁵⁰ These common costs comprised the costs of operating the market that produced the market data and the costs of regulating that market so that the data was not inaccurate and not derived from fraudulent or abusive conduct. ²⁵¹ The Market Data Concept Release noted that there is little value to market information that is tainted by fraud, deception, or manipulation.²⁵² Moreover, the goal of producing high quality market data cannot be achieved by a poorly operated market that is prone to systems outages and delays.²⁵³

The Market Data Concept Release recognized that not all common costs should be funded by market data, and that any resulting allocation decision would be conceptually difficult.²⁵⁴ While the Market Data Concept Release’s approach to evaluating the fees of the Networks would require aggregating the allocated costs of the contributing SROs, the Market Data Concept Release specifically stated that a distribution of the revenues need not follow the costs of each SRO, but could be based on the quality of the data contributed by the SRO and its contribution to the market data stream.²⁵⁵ The Market Data Concept Release also questioned whether the rebate of market data revenues demonstrated that the existing fees were too high.²⁵⁶

In reflecting on the Market Data Concept Release and the industry’s reaction to it, the Commission gained an understanding of the serious divisions in the securities industry over how best to regulate market data. Specifically, there was a sharp division on the fairness and reasonableness of the existing fee levels of market data. In addition, there was a split of opinion as to whether market information fees should provide funding for other SRO functions such as market regulation or should be more closely related to the direct cost of producing the data. Also significant in the comments to the Market Data Concept Release were proposals that more competition be introduced to the compilation and dissemination of market data.²⁵⁷

To help resolve these divisions, the Commission established its Advisory Committee on Market Information in the summer of 2000. In its 2001 report, however, the Advisory Committee specifically rejected the flexible cost-based approach.²⁵⁸ The Advisory Committee report noted the consensus view that it was essentially a "ratemaking" approach that was unwise and, ultimately, unworkable.²⁵⁹ The Advisory Committee recommended retaining price transparency and consolidated market information as core elements of the U.S. securities markets, while adopting a “competing consolidators” model of data dissemination.²⁶⁰ Under this model, vendors and market data users would themselves consolidate the data from the various markets, with each SRO separately providing and setting fees for its own data, rather than consolidating this data through the Networks.

In commenting on proposed Regulation NMS, a number of SROs said the current market data Networks and their fees were reasonable, while several larger markets and their adherents advocated the competing consolidator model. Many other commenters said that the fees they pay to obtain basic market data – NBBO and trades – are excessive, and are not reasonably related to the cost of producing such data.²⁶¹ As in earlier debates, some commenters said that market data fees should be limited to covering solely the costs incurred to disseminate consolidated market data, not the costs incurred by the individual SROs to produce the data and provide it to the Networks.²⁶² Other commenters said that a prerequisite for evaluating the appropriateness of funding SRO operations and regulatory costs from market data revenues was a transparent accounting of the revenues received for market data and the expenses incurred in operating and regulating the SRO’s market.²⁶³

As noted above, to provide greater transparency of SRO revenues and expenses, the Commission is proposing in the SRO Governance and Transparency Proposal to require SROs to file with the Commission public reports detailing their sources of revenues and their uses of these revenues, specifically including their costs of regulation.²⁶⁴ These reports could provide observers greater ability to evaluate the role of market data revenues in financing an SRO, and to compare these revenues to the expenses of operating and regulating their market. This information also could empower users to respond to market data fee changes on a more informed basis.

Thus, given the concerns raised in response to proposed Reg NMS regarding market data fees and because these issues are related to considerations of overall SRO funding and regulatory operations, the Commission is seeking comment on a number of issues.

Question 23: Should market data revenue be used to cross subsidize SRO regulatory operations?

Question 24: Are current market data fees significantly limiting access of market participants, investors, or other users to data? Why are certain market data fees more problematic than others, such as those associated with SRO data products that are not part of the consolidated quote stream? If so, which fees and why?

Question 25: Should the Commission reconsider the flexible, cost-based approach?

Question 26: Should the Commission consider a narrow cost-based approach that takes into account only limited costs, such as consolidation costs?

Question 27: On a conceptual basis, what should be included in the cost of generating market data?

Question 28: Are there other, better cost-based approaches? What are their potential benefits and drawbacks?

Question 29: Should the Commission require a more detailed explanation of how SROs spend the revenue generated from market data fees? Would the requirements proposed in the SRO Governance and Transparency Proposal that SROs detail their sources and uses of revenues add sufficient transparency in this area, or should more detailed reporting be mandated?

Question 30: If the Commission were to implement a revised approach to market data fees that substantially reduced this element of SRO funding, would SROs be able to raise the level of other revenue sources to remain adequately funded to comply with their statutory obligations?

Question 31: What SRO fees or other charges presently are under priced? What SRO fees or charges are over priced? On balance, are SROs over funded or under funded? What would be the impact on smaller SRO members of funding regulatory costs exclusively through regulatory fees?

Question 32: If market data fees were substantially reduced and SROs were unable to replace these revenues from other sources, would SROs be able to adequately fund their regulatory operations? If an SRO’s funding were to become insufficient because of such a decline in revenue, should that SRO lose its status as a registered SRO?

Question 33: If market data fees were substantially reduced, would this exacerbate the conflicts inherent in the SRO system – in particular, the incentive to fund business functions at the expense of regulation?

Question 34: To what extent would the enhancements proposed in the SRO Governance and Transparency Proposal mitigate these concerns about inherent conflicts? Are there other measures that could mitigate these conflicts?

Question 35: Should the Commission require that all SRO fees and charges be closely related to the cost of the SRO providing the service in question? What would be the benefits and risks of doing so?

e. Miscellaneous Fees

In addition to regulatory fees, transaction fees, listing fees, and market data fees, SROs receive revenue from a variety of miscellaneous sources as well. For instance, SROs charge fees for administering joint industry plans and market systems.²⁶⁵ SROs also derive funding from product licensing,²⁶⁶ investment gains, and fines. In 1998, these types of miscellaneous SRO fees accounted for 8% of SRO revenue,²⁶⁷ while, in 2003, 12% of SRO revenue was associated with these miscellaneous fees.²⁶⁸ This relatively significant increase (a 50% increase compared with the 1998 percentage for miscellaneous fees) may have been caused by an increase in certain SRO sources of revenue, such as derivative product licensing fees, and by the intervening establishment of SRO relationships with other markets.²⁶⁹

The Commission specifically seeks public comment on the following question related to SRO miscellaneous fees:

Question 36: In light of the recent growth in SRO revenue that is derived from miscellaneous fees, how important are these fees to SRO funding generally and will this growth trend continue? If so, how does this revenue pose conflicts with respect to the SRO regulatory function? How should these conflicts be addressed? How does it relate, if at all, to the SROs’ fulfilling their statutory obligations?

V. Alternative Regulatory Approaches

In order to focus consideration of the strengths and weaknesses of the SRO system, the following section discusses a variety of enhancements and alternative approaches, which would require either Commission or Congressional action to achieve. Specifically, this section will examine: (1) proposed enhancements to the current SRO system; (2) implementing an independent regulatory and market corporate subsidiary model; (3) implementing a hybrid model; (4) implementing a competing hybrid model; (5) implementing a universal industry self-regulator model; (6) implementing a universal non-industry regulator model; and (7) establishing direct Commission regulation of the securities industry. The discussion of each alternative examines how effectively it would manage the current SRO system’s inherent limitations.

It is important to note that this discussion does not attempt to provide an exhaustive list of every potential option and alternative approach that could be considered. The purpose of this section is to provide a discussion of what appear to be some of the more promising alternatives. Public comment sought, however, is not limited to the options and alternative approaches described herein. In addition, while this section attempts to detail the strengths and weaknesses of the various options and alternative approaches, it should be noted that such a discussion is inherently speculative. The full range of strengths and weaknesses of any given option or alternative approach would likely not be known until that approach were fully implemented.

A. Proposed Enhancements to the Current SRO System

The current SRO system has provided essential regulation of markets and members for over seven decades. Nonetheless, this system has inherent limitations that should be considered. This section discusses possible enhancements to the status quo that could be implemented to address these SRO limitations.

1. SRO Governance and Transparency Rulemaking

The Commission today is proposing an SRO Governance and Transparency Proposal.²⁷⁰ If adopted, the proposed rulemaking would strengthen SRO governance, enhance SRO disclosure and reporting requirements, and address various issues that have arisen with respect to shareholder-owned SROs.²⁷¹ The proposed governance standards would require SROs that are national securities exchanges and registered securities associations to have a majority independent board and fully independent Nominations, Governance, Audit, Compensation, and Regulatory Oversight Committees (or their equivalent).²⁷² SROs also would be required to effectively separate their regulatory function from their market operations and other commercial interests.²⁷³

With respect to the regulatory function, each SRO would be required to establish standards to assure the independence of its regulatory program. At a minimum, the regulatory function of an SRO would be required to be overseen by a Chief Regulatory Officer who reports to, and is evaluated by, an independent Regulatory Oversight Committee. Moreover, SROs would be required to provide the Commission with specified information concerning their regulatory programs on a regular basis. As part of this proposal, each SRO would be required to prepare for the Commission annual and quarterly regulatory reports that would give details regarding key aspects of the SRO’s regulatory program. As part of the annual report, each SRO also would be required to disclose employment arrangements with its Chief Regulatory Officer and other key regulatory personnel. The filing of this regulatory program information is intended to bolster the Commission’s SRO inspections program and thus would be kept confidential to the extent permitted by law.

In addition to filing quarterly and annual reports about their regulatory programs, each SRO would be required to disclose publicly information about its regulatory program and provide greater disclosure regarding revenues and expenses and staffing of its regulatory program. Finally, the SRO Governance and Transparency Proposal proposes ownership and voting concentration limits on members that are broker-dealers to mitigate the conflict of interest that would arise if a broker-dealer were to control a significant interest in its regulator or if a member could exercise too much control over the operations of the SRO.

If the proposed SRO Governance and Transparency Proposal is adopted, a number of benefits could be gained. Regulatory conflicts with members, market operations, issuers, and shareholders could be reduced. The strict reporting lines of the Chief Regulatory Officer reporting to an independent board committee could reduce the SRO regulation conflicts. In addition, the wholly independent Regulatory Oversight Committee’s sole responsibility for budgeting decisions with respect to regulatory operations could help insulate the budgeting process from business pressures.

While the Governance and Transparency Proposal could help manage a variety of the traditional SRO limitations, it would not eliminate them. For instance, conflicts could persist in spite of the majority independent board because of the influence of representatives of large members serving on the board, particularly if intermarket competition pressures continue to increase. In addition, the fact that the independent directors would necessarily rely on the expertise of the industry directors to some degree could undermine some of the structural protections put in place. Moreover, the independent directors’ own imperceptible institutional biases could compromise some of the structural protections.

Concerns regarding unequal regulation and unequal regulatory funding across markets would persist under the SRO Governance and Transparency Proposal. This would be true even if each SRO’s Regulatory Oversight Committee were to make regulatory budgeting decisions irrespective of business or other pressures. These committees would not all necessarily allocate regulatory funding in the same fashion in the different SROs; thus, regulatory inequalities could still exist. The concerns regarding conflicting SRO rules, conflicting SRO rule interpretations, conflicting SRO inspection regimes, and redundant regulatory staff and infrastructure across markets would remain under this proposal. Finally, the proposal also does not address potential intermarket trading surveillance issues.

The Commission specifically seeks public comment on the following questions related to the SRO Governance and Transparency Proposal:

Question 37: To what extent would the changes proposed in the SRO Governance and Transparency Proposal effectively manage inherent SRO limitations related to conflicts, funding, redundancies, and intermarket surveillance?

Question 38: To what extent would the changes proposed in the SRO Governance and Transparency Proposal continue to provide the benefits of the current SRO system (e.g., largely self-funded system with market specific expertise of SRO regulatory staff enhancing rule promulgation and enforcement)?

Question 39: If adopted, would the SRO Governance and Transparency Proposal enable the Commission, investors, and market participants to perceive when a particular SRO was insufficiently funding its regulatory function? If so, could this lead the SROs to develop and follow voluntary guidelines or standards with respect to regulatory spending levels?

Question 40: Would the changes proposed in the SRO Governance and Transparency Proposal more effectively manage inherent SRO limitations compared to the NYSE’s recent corporate and regulatory function restructuring²⁷⁴?

2. Intermarket Surveillance Enhancements

Another incremental improvement to the current system could be the enhancement of the Commission’s and the SROs’ ability to regulate intermarket trading activity. As discussed at length above, several equity markets have developed individual order audit trails, the options markets have developed COATS to assist in the