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U.S. Securities and Exchange Commission

Speech by SEC Staff:
Options Industry Conference – SEC Report


Annette L. Nazareth

Director, Division Of Market Regulation
U.S. Securities and Exchange Commission

Phoenix, AZ
April 23, 2004

Good morning. I am very pleased to be here again at the Options Industry Conference. I thought today I would discuss my perspective on the current state of the U.S. options markets, including the progress that has been made over the past five years since multiple listing. This progress has led to new, expanded business challenges as well as regulatory challenges for the options markets. I also will discuss issues arising from the debate over self-regulation that are applicable to the options markets as well as the equities markets.

As always, my remarks represent my own views and do not necessarily reflect the views of the Commission or my colleagues on the staff.1

I want to begin by saying that, in my view, the options markets today are an enormous success story. Over the last five years, the widespread multiple trading of equity options, new market entrants, and structural and regulatory changes, have created - and continue to create - a highly competitive environment. While I know that this is not necessarily welcome news to those of you in the thick of this competition, it is clearly of benefit to investors and, I believe, ultimately to all market participants.

As I know many of you are keenly aware, quoted and effective spreads have narrowed in multiply listed option classes, leading to lower trading costs for all market participants. One study also shows that the incidence of trade-throughs for small orders also has decreased. There also is an indication that the incidence of locked and crossed markets has gone down, with locked markets dropping even further since the full implementation of the linkage. Each of these improvements contributes to more efficient and less costly markets for investors.

We are cognizant of the increased business challenges to exchanges and their members that come from a highly competitive environment. All of you are chasing the same order flow. And, as the number of exchanges that trade equity options has increased, each exchange is under increased pressure to attract and retain order flow. This dynamic puts exchanges and their members under increased pressure to accommodate the interests, and demands, of the end users.

Consequently, exchanges have enhanced the services they provide to their end users, including providing faster and more reliable executions, lower transactions costs, and increased liquidity at the displayed quotes. Moreover, this process is not static - exchanges are continuously looking for new ways to further improve and advance the services they provide, to further increase efficiency, transparency and liquidity in their markets. However, as all of you also know, this increased competition led to the emergence of practices such as payment for order flow and internalization in the options market. These practices are an inevitable - and unfortunate - result of the increased leverage that those exchange members who control order flow have in a highly competitive environment. The Commission has recently solicited comments on whether it is necessary to take any action to mitigate potential, or actual, conflicts of interest that may impede price competition, and we are currently reviewing the comments we've received.

More troubling, though, is the possibility that competitive pressures lead exchanges to make regulatory accommodations that are not consistent with their self-regulatory obligations. This is not a merely theoretical concern. We have found a notable lack of vigilant enforcement by certain SROs. And some of this lack of vigilance appears to be the result of the new competition for order flow. I want to emphasize that regulation is not a basis on which exchanges may compete. It is not acceptable for the competitive pressures that have led to so many positive changes in the options markets to lead inadvertently or purposely to exchanges making regulatory accommodations or to underfunding their regulatory functions.

III. Potential SRO Transparency and Governance Changes

Self-regulation is one of the cornerstones of securities regulation in the United States. It is the foundation upon which the regulatory regime of the '34 Act is based and, over the years, with some notable exceptions, it has worked well. Despite the inherent conflicts of interest in self-regulation of the securities markets, self-regulation has been considered - and continues to be in my view - a better system than direct government oversight. Nevertheless, recent events have reminded us that these conflicts of interest can undermine confidence in the continued efficacy of self-regulation. Both the NYSE's executive compensation issue and its recent specialist firm settlements have demonstrated that, without sufficient safeguards, SRO conflicts of interest can become a serious problem. Consequently, the Commission has focused resources recently on considering what additional protections could be used to mitigate these conflicts.

In the Sarbanes-Oxley Act, Congress entrusted the listing markets for the nation's largest companies with heightened responsibility to set standards for the governance of these listed companies. It is not surprising then, that the Commission has been focusing on whether increased transparency and improved governance could be used to bolster self-regulation. While the focus has principally been on the equity markets, the concerns and possible solutions are equally applicable to options SROs. As many of you know, last March Chairman Donaldson wrote each of the SROs, asking them to review their governance practices in light of the standards that had just been proposed for listed companies. In that letter, the Chairman noted that, just as the NYSE and Nasdaq were demanding that publicly-traded companies meet high governance standards in order to list on their markets, SROs must demand the same standards of themselves. Furthermore, each SRO was asked to undertake an exhaustive review of its governance procedures.

In response, each SRO submitted a written report that detailed its governance practices and revealed some areas that appeared to be in need of improvement. Since that time, various SROs have convened special governance committees with mandates to examine the strengths and weaknesses of their SRO governance practices.

At about the same time, the NYSE's extension of its Chairman's employment agreement, as well as its substantial payout of his accrued compensation became widely publicized. It appears that the then-Chairman's package was set by the Compensation Committee of the NYSE Board and approved by the full Board of Directors. On paper this process may seem sound. However, the then-Chairman appears to have exercised considerable influence over the composition and operation of the Board and the Compensation Committee. In addition, it is not clear that the full NYSE Board or the Compensation Committee fully grasped the scope of the Chairman's compensation arrangements. Finally, there appears to have been a lack of transparency at the NYSE regarding the operation of the Compensation Committee, and the nature and substance of its review of compensation matters. It seems reasonably clear that had there been broader dissemination of information regarding executive compensation at the NYSE, the compensation would not have reached such extraordinary levels.

Chairman Donaldson again wrote to the heads of each of the SROs to ask for more details about the extent of public representation on their Boards and key Committees (including the Compensation Committee); the decision-making processes with respect to the nomination of directors, their assignment to Committees, and the compensation of executives; and the SROs' past practices and current plans for public disclosure of these processes and the compensation arrangements of key executives.

In addition, late last year the Commission approved significant governance changes at the NYSE. A completely independent Board of Directors now governs the NYSE, and different individuals hold the Chairman and CEO positions. Under the NYSE model, the Board obtains industry and investor input through an advisory Board of Executives that is representative of securities firms, listed companies, and investors. In addition, while the NYSE continues to act both as a market and a regulator, the regulatory function is strictly segregated from the business function, and overseen by independent Board committees.

Additional concerns about the NYSE's regulatory function were raised by the recent findings of significant securities law violations by five NYSE specialist firms. In a joint investigation, the NYSE and SEC found that, between 1999 and 2003, the five firms, through particular transactions of their registered specialists, violated federal securities laws and Exchange rules by executing orders for their dealer accounts ahead of executable public customer or "agency" orders. Through these transactions, the firms violated their basic obligation to match executable public customer buy and sell orders, improperly profited from trading opportunities, and breached their duty to serve as agents to public customer orders.

The NYSE's and all SROs' substantial role, as a marketplace and as a regulator, makes it imperative that their own governance structure be a model of good governance practices. To address these issues going forward, Commission staff now is in the process of conducting a comprehensive review of SRO governance and transparency. As quasi-governmental entities, and in light of the requirements imposed by the Sarbanes-Oxley Act, it is my belief that SROs should comply with substantially all of the transparency and disclosure requirements of public, listed companies. We hope to develop a recommendation for the Commission's consideration regarding a proposed rulemaking that would address SRO governance and transparency, including Board independence, regulatory function independence, regulatory funding, governance processes, executive compensation, and management structure.

Another area related to transparency that the Commission staff is currently interested in is enhancing the amount and quality of surveillance data that the Commission receives on a regular basis from the SROs. In this way, the Commission could potentially be in a better position to see red flags as they develop and sense when the self-regulatory process is breaking down within a particular SRO.


I expect that the Commission also will be looking more broadly at the issue of SRO structure, and in particular the effectiveness of the self-regulatory system of the securities markets. I have always believed that what makes our markets the most efficient and liquid in the world, is the industry's proven ability to innovate. As the options markets have shown, competition is the driving force behind innovation and, thus, the Commission has attempted to foster inter-market competition, pursuant to its Congressional mandate.

That being said, the Commission is tasked with ensuring that vigorous competition among markets does not undermine self-regulation. Clearly, in the current environment of fierce inter-market competition among options exchange, those charged with self-regulatory responsibility may feel competitive pressure applied by members, business people, and competing markets. I caution self-regulators to resist this pressure and remember that their duties ultimately flow from the Congressional mandate for self-regulation, not from bottom line business concerns.

Rather than simply cautioning self-regulators though, I would like to note that the Commission staff will continue to surveil the SRO processes and structures to ensure that regulatory staff is sufficiently insulated from business pressures. There are a number of potential self-regulatory structures that could achieve these goals, and we need not consider a "one size fits all" approach. I will touch upon just a few of these alternative approaches today. One approach that has been effectively employed is the SRO contracting out much of its self-regulatory responsibilities. For instance, the ISE has engaged in a private contract with the NASD for the performance of regulatory examinations and other oversight activities of its members. This arrangement does not, however, eliminate the conflicts in self-regulation because the ISE retains the legal responsibility for such regulation. Nasdaq has proposed using a similar contractual arrangement if the Commission approves its registration as an exchange.

The "Holding Company" Model involves the creation by each exchange of a separate not-for-profit affiliate that would be responsible for the exchange's regulatory obligations. The NASD, with its Nasdaq and NASD Regulation subsidiaries, currently employs this model. Applying this model more broadly would not reduce the number of SROs, although it would structure the regulatory function so that SROs could merge these functions through joint ownership. In addition, because this model would continue to link the functions of an SRO with a particular market, the market would have both commercial and legal incentives to cooperate with its regulatory affiliate. A variation of the "Holding Company" model is the "new NYSE" model - where an independent Board directly oversees functionally (but not structurally) separate market and regulatory units.

As you know, other more significant changes to existing models have been advocated by some. For example, some believe that there should be a Super-SRO, which would be responsible for all exchanges for both member regulation and market regulation. This model would have advantages, such as allowing for the development of a market-wide consolidated audit trail. However, the Super-SRO would lack the markets' competitive incentive to demonstrate that they are effective regulators in order to increase investor confidence.

The so-called "Hybrid SRO" Model has generated a fair amount of industry support in the past. Under this model, a single SRO would be responsible for member regulation and cross-market trading rules, and each exchange would retain responsibility for market regulation.

It is important to note that an SRO's inherent conflicts of interest could also be affected by demutualization. If shareholders were no longer members, it is possible that the direct conflict of interest that exists when an exchange is owned by those it regulates could be reduced when an exchange demutualizes. On the other hand, it may not change, because the desire to attract order flow may still create the same pressure to ensure a regulatory friendly environment. The question is whether the need to generate profits for shareholders creates a new conflict with an exchange's self-regulatory responsibilities. For example, would a shareholder-owned exchange commit sufficient resources to regulatory operations? Could the exchange use its disciplinary function as a revenue generator? A complicating factor is that the Commission's authority over those who control shareholder-owned exchanges is less clear than its authority over shareholders that are also members.

To allay some of these concerns that the staff has, we have been considering what additional or different requirements may be appropriate for shareholder-owned SROs. For example, other countries have limited percentage of voting shares that any single shareholder can control. Another option is to consider whether controlling shareholders should be required to submit to the Commission's jurisdiction. Further, we might consider Commission rules that would restrict the use of revenue generated from regulatory operations to pay dividends. We could also put procedures in place to ensure that member broker-dealers have a sufficient voice in the disciplinary process.

As I previously noted, the appropriate regulatory structure for one SRO may not be appropriate for others, given their different owners, membership, sizes, and regulatory responsibilities. For all SROs, however, the challenge before the Commission and the SROs is to develop structures that help assure SRO regulatory programs are effective and insulated from any undue influence from potentially conflicting business or member pressures.


Let me close on a supportive note for the options SROs. The challenges that the options SROs and their regulatory staff are currently facing are well known at the Commission. Multiple listing of options and inter-market competition has in some ways increased the relative power of SRO members in that they can now move their business to another exchange if they find one SRO's regulation onerous. As a policy point, however, let me make perfectly clear that an SRO regulatory race to the bottom is unacceptable. The Commission will continue to hold SROs to the highest of standards to protect investors. SRO regulatory staff is a critical link in the federal regulatory regime, and to the extent you need assistance in communicating this message to members, I encourage you to seek the Commission's assistance. SROs and the Commission have the common goals of enforcing the securities laws and protecting investors and in that respect the Commission is always there to support you.



Modified: 05/11/2004