Speech by SEC Commissioner:
New Challenges in Regulating Financial Markets:
Remarks at NYU Stern
Commissioner Roel C. Campos
U.S. Securities and Exchange Commission
New York, New York
March 24, 2006
Thank you for that kind introduction Ingo (Walter). This panel could not be more timely with the numerous merger and acquisition discussions - cross-border, pan-European, and pan-American - as well as SRO regulatory deficiencies that have been fodder for the news over the last two years. I look forward to some hearty discussions!
I'd also like to thank Harvey Goldschmid for his invitation to join you today. It was extremely enjoyable to work with Harvey when he was at the Commission. Harvey, your insights and complex, long, obscure professorial examples are truly missed, but I am sure the students at Columbia are better for our loss!
I only have a few minutes to lay out some thoughts this morning before we begin the interactive portion of the panel, so forgive me if I take liberties, but I'm trying to be brief.
What is the role of exchanges? At one time, many likely would agree that exchanges were akin to a utility for garnering liquidity and enabling trading of securities. With the growth of trading, the increasing number of issuers seeking capital by listing in the marketplace, and the development of new products, the concept of "exchange as utility" waned. There was money to be had in that thar business! The amount of money was proportionate to the amount of order flow. Order flow tied into customer confidence, depth of liquidity, and the types of services offered. Arguably, modest regulatory modifications and reliance on the original self-regulation model fostered what may have been perceived as government-sponsored, exchange-monopolies.
Beginning in the 1970's, more stringent regulations and scandals, often cyclic events, resulted in a combination of increased transparency and some limitations on exchanges' flexibility as businesses, designed to gently remind the exchanges of their regulatory responsibilities. Yet, these strongholds were not truly challenged until new competitors, primarily ECNs, entered the arena. Thus, despite the significant evolution of the exchange business model over the last century, the regulatory structure continued and continues to be the model of self-regulation although designed for the original, utility-like, exchange model.
How can this be? The answer is that is cannot. Around the world, a number of exchanges and regulators have recognized this fact. We in the US are acknowledging it too. Increasingly vigorous competition between exchanges, ECNs, ATSs and foreign trading markets has shifted significant amounts of market share away from the primary markets. This heightened competition has spurred innovation in trading systems and responsiveness to customers, as well as reduced trading costs. On the other hand, trading in multiple markets has increased concerns about potential gaps in the surveillance of intermarket trading. Plus, loss of market share may translate into fewer revenues supporting an SRO's regulatory functions, without reducing the SRO's oversight responsibilities.
A primary driving force behind this recognition of an antiquated regulatory model is the demutualization of many of the worlds' exchanges. In a recent questionnaire conducted of its members - 38 of which responded - the World Federation of Exchanges noted that 11 exchanges are demutualized, 11 are publicly listed companies, 4 are privately limited companies, 7 fall into an "other" category, and only 5 are association or mutual organizations. IOSCO reports that at least 17 exchanges, or holding companies for an exchange group, across the globe have obtained public listings since 1987, with many of these demutualizations taking place during the last 5 years. Although the numbers differ, I think you catch my drift - the times are a' changing. But what does this mean for the role of exchanges?
Is the primary role of an exchange today to raise money and focus on business development or is it to provide a utilty-like venue for trading? In today's for-profit exchange, I would argue it is the former. In this context, the exchange likely is deciding whether it should be providing dividend returns to shareholders or focusing on growing its business for the long-term returns. To fund either of these objectives, exchanges must decide whether to compete or to acquire. This decision is further complicated by the notion that exchange share values may be overpriced, dictating choosing one aggressive business strategy over another. Where then does regulation fit into this exchange model?
The exchanges have argued that high quality regulation goes hand in hand with reputation, brand and investor confidence. They maintain that the product of this relationship is the cycle of continued, and hopefully increased, order flow, increased liquidity and exchange growth. Exchange competitors counter that the inherent conflicts of interest in the current self-regulation model are magnified at the for-profit exchange and cannot be overcome. This leads to the observation that reducing the conflicts of interest by separating out the regulatory function might, in fact, be better for business, garnering all of the advantages the exchanges profess to gain by retaining the regulatory function within the exchange.
And so, in addressing the role of exchanges in today's marketplace, I'd like to briefly discuss the hybrid model of self-regulation proposed in the SEC's concept release last year. Based on his recent remarks and testimony, I imagine Mark (Lackritz) will have a few words to say about this model too.
The hybrid model would split regulation into two functions. Each exchange would retain its own SRO responsibilities specific to market operations, which would include regulating and enforcing all aspects of trading, markets, and listing requirements. The remainder of regulatory functions - those relating to broker-dealers - would be carried out by a single-member SRO. The SRO either could be largely independent, arguably free from conflicts of interest, such as the NASD will be once its separation with Nasdaq is final. Or, the SRO could be a combination of multiple SROs' broker-dealer regulatory programs joined into one centrally managed entity, such as a joint entity between the NYSE and NASD.
The primary advantage to the hybrid model is the elimination of regulatory duplication and, perhaps, some of the conflicts of interest inherent in our present SRO system. In other words, the SROs would merge their broker-dealer regulatory functions through joint ownership to produce a uniform set of rules, procedures and examinations. There will still be a need to determine exactly which regulatory functions are member regulation and which are market regulation, and the Commission could aid in drawing the line, if necessary.
By maintaining the market regulation within the SRO, the hybrid model preserves some of the innovation and market expertise that stems from the daily and regular interaction between the market and its members, although some undeniably will be lost. Plus, difficulties may arise in communication and coordination between the single SRO performing member regulation and the exchange performing its own market regulation.
Funding may also be more challenging under the hybrid model, requiring some creativity. Maybe, broker-dealers could be required to pay directly for the cost of their supervision with a fixed cost as well as a variable cost based on the complexity of their operations and history of regulatory problems. Exchanges could pay a fixed amount based on the number of members they have or a variable amount based on the volume of trading.
Despite the challenges, at this time, I favor the hybrid model for the simple reasons that (1) elimination of duplication will greatly add to the quality and efficiency, while reducing the costs, of regulation of broker dealers and (2) conflicts of interest should be minimized. In the meantime, however, I encourage the NYSE and NASD to continue their efforts to harmonize current rules and reduce regulatory duplication to the extent possible.
Even so, given the academic setting today, I wonder, however, whether even the hybrid model goes far enough. Should market surveillance also be spun out of the exchange into an independent entity? What would that entity look like and how would it interact with the exchanges and the SEC?
The Australians and Canadians have taken a long leap down this road. Perhaps their experiences can provide a template for US exchanges.
Following the example of the Australians, the Toronto Stock Exchange (TSX) demutualized in 1999. As a part of that process, the Exchange determined to establish a separate division for regulatory services (TSX RS) to enhance transparency and accountability and to facilitate effective oversight by the Ontario Securities Commission (OSC) of the TSX's regulatory functions. It was proposed that the division would be a separate cost center but not a separate subsidiary with its own board of directors, at least, not initially. At the time, the question was voiced as to whether a separate subsidiary, with a board of directors whose fiduciary duties are to the subsidiary, would lead to any appreciable differences in the delivery of market regulation services. Hmmm, sounds a bit like the discussions surrounding NYSE Regulation's evolution, Rick (Ketchum).
Anyhow, the TSX RS was designed to operate on a cost recovery basis (ie., not for-profit) with a segregated budget. It would charge users directly for its services. In addition, the TSX RS would be overseen by a special Regulation Committee of the Board of the TSX with special reporting lines from the COO of TSX RE to the OSC.
Three years later, the TSX and the Investment Dealers Association of Canada (IDA) proposed, and the OSC approved, a jointly-owned SRO, Market Regulation Services, Inc., or RS Inc., to act as a regulation service provider for the TSX, the Canadian Venture Exchange, and any other recognized exchanges or alternative trading systems wishing to contract with RS Inc. for market regulation services. With the approval of the OSC, the TSX amended its SRO obligations to exclude the activities within the scope of the new regulatory contract with RS Inc. Specifically, RS Inc. administers the exchanges' market conduct and trading requirements and monitors and enforces compliance with these requirements by the exchanges' members, their directors, officers, employees, affiliates and representatives. In addition, RS Inc. acts as a regulation services provider for quotation and trade reporting systems and alternative trading systems.
The new SRO is governed by 11 directors - 5 independent, 5 non-independent and the president of RS Inc. Funding of the not-for-profit SRO follows a market-by-market fee calculated on the same basis for trading on any regulated venue, regardless of model. Staff was projected at 90 persons with anticipated outsourcing of certain business functions but I am uncertain as to current staffing levels.
The new SRO remains subject to oversight by the relevant securities regulators, including approval of its rules and periodic oversight examinations, with an eye to ensuring RS Inc. meets the appropriate standards for regulation including fair access, fair representation, systems and financial capacity, market integrity and compliance with the statutory rules. Admittedly, RS Inc. is not completely separated from all of the exchanges it regulates. It is likely that exchanges in this position - in Canada and elsewhere - would argue that the joint-venture, ownership structure allows them to retain a necessary, albeit reduced, hand in the regulation of the exchange, and perhaps exchanges generally, and its members.
Going one step further, is this idea of excising all regulation from the exchange more intriguing in the environment of cross-border mergers, acquisitions, and common ownership structures? Would it allow for better synergies between regulators of the various co-owned and/or acquired markets or easier business combinations between exchanges if the regulatory concerns were not in the mix? Moreover, can exchanges with a common holding company better allocate resources to regulation by eliminating duplicative costs? The possibility of a cross-border exchange transaction is now a "when" as opposed to an "if" so we'd best be thinking about these issues. Indeed, this is one of the reasons I enjoy participating in these conferences where we can throw all issues on the table for discussion.
Even though I encourage everyone to think outside the box with regard to the range of structural alternatives and the advantages or disadvantages offered by each, I am willing to face the facts. Currently, it is unlikely that any country is going to acquiesce to its primary market being foreign owned and/or overseen by a foreign regulator. This issue is in the forefront as people speculate about business combinations between the LSE and the NYSE or Nasdaq. The scuttlebutt suggests that it is more probable that a holding company structure is proposed through which the home regulator is not supplanted but retains jurisdiction over "its" exchange, thereby preserving nationalism while promoting business growth. Even EuroNext, for example, which maintains its five European exchanges under a single Dutch holding company, did not merge the exchanges, thus sidestepping this regulatory quandry.
Well, I could continue for the entire period allotted to the panel so I will conclude my remarks there. I have raised a number of questions regarding the role of exchanges, particularly in light of globalization, that I hope we will get to today. Thank you. Ingo…