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U.S. Securities and Exchange Commission

Speech by SEC Staff:
Self-Regulation in the New Era

Remarks by

Lori Richards

Director, Office of Compliance Inspections and Examinations
U.S. Securities & Exchange Commission

NRS Fall 2000 Compliance Conference
Scottsdale, Arizona

September 11, 2000

The Securities and Exchange Commission, as a matter of policy, disclaims responsibility for any private publication or statement by any of its employees. The views expressed herein are those of Ms. Richards and do not necessarily reflect the views of the Commission, the Commissioners, or other members of the Commission's staff.

I. Introduction

Thank you. It's a pleasure to be with you this morning.

Few would disagree that the securities industry is undergoing seismic change. In all sectors of the securities industry, competitive pressures are changing long-held practices and ways of doing business. I wanted to talk with you today about compliance and self-regulation and in particular, about the role of compliance and self-regulation in this dynamic environment.

In my opinion, the securities industry has never seen such rapid change. Much of this change is being spurred by competition, which itself is being spurred by the investments in our markets made by millions of American investors. Mutual funds, investment advisers and broker-dealers are all competing aggressively to meet the needs of their customers, and are anticipating the needs of future customers, by developing new and innovative products and services, and by using technology as a new tool to help clients invest in the markets.

The competitive environment for the trading of stocks is also undergoing dramatic change. We're seeing new alliances, innovative trading systems, and sophisticated trading technologies announced routinely now. Over one-third of all trades in Nasdaq securities now occur on ECNs, and ECNs have recently begun to trade NYSE-listed securities. New firms are applying to become exchanges and self-regulatory organizations (SROs). In addition, competition has spurred the NYSE and Nasdaq to consider changing from private member organizations to for-profit companies controlled by shareholders.

The environment for the trading of listed options has also undergone dramatic change. Options exchanges have recently begun to multiply-list many options classes. That, coupled with the Commission's approval of the International Stock Exchange, the first fully-electronic options exchange and newest self-regulatory organization, has created a very competitive environment between market centers for the trading of listed options.

In this new and dynamic environment, the question that many people are asking is, will competitive pressures cause markets and market participants to pay less attention to their regulatory programs? Will compliance efforts fail to keep pace with industry growth? Will markets become lax in their surveillance and discipline of their members? And as a consequence, will market participants perform regulatory arbitrage and seek the "least regulated" market center to set up shop?

II. The Structure of our Regulatory System

A. Development of the Self-Regulatory Structure

Before we talk about the future and before I attempt to offer my opinions on these important questions regarding the future of self-regulation, let me give you a brief background on the development of the securities industry's regulatory structure.

Self-regulation has been a cornerstone in the securities industry since the very beginning. Indeed, the fundamental principle of self-discipline predates the securities laws. At its most basic level, self-regulation is the manner in which all firms self-police their own activities to ensure that they are meeting all fiduciary and other duties to their clients. In fact, the old "Shingle Theory" was founded on the principle that, if you hold yourself out to the public as offering to do business, you are implicitly representing that you will do so in a fair and honest manner.

Today of course, we are all aware that both broker-dealers and investment advisers have a duty to supervise their employees, a duty so important that it is enforceable in the breach. This duty to supervise is an important facet in the first level of self-regulation.

Well before the securities laws were adopted, firms had already banded together to create another layer of organization – stock exchanges. By 1934, each of the stock exchanges had a constitution and bylaws, which prescribed collective rules for the admission, discipline, and expulsion of stock exchange members. These rules were regarded as a contract between the organization and the member. Very early on, the NYSE had implemented a substantial system of self-regulation: it was governed by a committee that appointed other committees to carry out the business of regulating the activities of its members.

The crash of 1929 created a demand for federal intervention to regulate the markets and thereby restore public confidence in them. The proper relationship between the exchanges and a new federal regulatory agency was the subject of many weeks of intense hearings before the congressional committees drafting the legislation that came to be known as the Securities Exchange Act of 1934. Many blamed the stock market crash of 1929 and the resulting economic depression on the members of the stock exchanges. As a result, Congress required the exchanges' separate regulatory regimes to be integrated into a new regulatory framework, under which there would be federal oversight of the self-regulatory system.

B. The Creation of the SEC

The Securities Exchange Act of 1934 created the SEC and codified the existing self-regulatory system for broker-dealers. The SROs retained primary authority to regulate their members, but the SEC was given the power to suspend or revoke an exchange's registration if the exchange failed to enforce compliance by its members with the Exchange Act.

In order to extend the concept of self-regulation to the over-the-counter market, Congress passed the Maloney Act in 1938. This Act provided for the creation of associations of members to assume a regulatory role similar to that of exchanges. The only association that has registered with the SEC to date is the National Association of Securities Dealers ("NASD")

In 1975, Congress amended the 1934 Act to grant the Commission more authority over the actions of SROs. The amendments reflected Congressional endorsement of self-regulation, but with increased government oversight. For instance, the amendments directed the Commission to review SRO disciplinary proceedings and required the SEC to approve SRO rules. Finally, the amendments added disciplinary actions that the Commission could take against SROs and gave the Commission authority to enforce SRO rules when an SRO was unable or unwilling to act or when Commission action was otherwise appropriate.

III. Arguments For and Against Self-Regulation

With that as background, it is clear that self-regulation has a long history in law and in practice. Nonetheless, there are many who question whether self-regulation should continue to exist. Let me briefly outline the traditional arguments for and against self-regulation.

A. Arguments for Self-Regulation

One of the primary reasons for adopting the self-regulatory structure was that the SROs were more likely to be able to respond more quickly than a government agency could to new developments in the marketplace. Employing self-regulation, the logic goes, provides the securities industry with professionals who are more knowledgeable about the intricacies involved in the marketplace and the technical aspects of regulation. This results in a more precise regulatory function.

Involving the industry in the regulatory process may be more effective than direct regulation. As former SEC Chairman William O. Douglas said, "self-discipline is always more welcome than discipline imposed from above." He summarized the benefits of self-regulation in an address before the Bond Club of Hartford in 1938 as follows: From the broad public viewpoint, such regulation can be far more effective [than direct regulation]…self-regulation…can be persuasive and subtle in its conditioning influence over business practices and business morality. By and large, government can operate satisfactorily only by proscription. That leaves untouched large areas of conduct and activity; some of it susceptible of government regulation but in fact too minute for satisfactory control; some of it lying beyond the periphery of the law in the realm of ethics and morality. Into these large areas self-government, and self-government alone, can effectively reach. For these reasons, self-regulation is by far the preferable course from all viewpoints. The ability of SROs to develop ethical standards that go beyond those which can be imposed by law is an important benefit of self-regulation in the securities industry.

John Dickinson, chairman of a committee on stock exchange regulation during the Roosevelt administration, believed that, "if governmental regulation attempts to do too much directly and to control and intervene directly in the first instance over the whole field which it covers, it is in danger of breaking down under its own weight and proving ineffective."

Finally, employing self-regulation reduces the cost to taxpayers. Under a self-regulatory structure, the industry finances a large part of their own regulation.

B. Arguments Against Self-Regulation

Despite those arguments for self-regulation, it has also been much criticized. It's been argued that regulated entities may believe that self-regulation will be less stringent than direct government regulation. In fact, the SEC recognized, in a Special Study of the Securities Markets conducted in 1963 that "[n]o business is eager for regulation…and it is only natural to expect less zeal for almost any aspect of the job on the part of a self regulator than may be true of an outsider whose own business is not involved."

SROs are affiliated with marketplaces and subject to the competitive pressures of attracting and retaining listings and they are also dependent on their members for order flow. In addition, SROs compete against each other in developing new products and trading processes. Therefore, it is said that SROs may have an incentive to concentrate their efforts primarily on the marketing side of their business as opposed to the regulatory side or that they may be lenient in imposing sanctions against members in order to avoid adverse publicity for the exchange.

Indeed, in light of these conflicts, many industry participants have suggested that the SRO function be fully separated from its marketplace. Other suggestions involve creating one overarching SRO for all broker-dealers and markets, or creating a hybrid model, where each market would have an SRO for its floor, but firms with public customers would be overseen by a single SRO. There are benefits to these approaches, but these are really difficult issues and not susceptible to easy, obvious answers. I don't take a position on which if any of these alternatives would work best, but I do believe that the goal of any consideration of structural change should be to ensure that self-regulation remains strong and vigilant.

C. SEC Oversight

That's where the SEC comes in. The SEC's oversight of SROs seeks to protect the self-regulatory process from these types of pitfalls. As Chairman Levitt explained in a press conference in 1996 announcing the Commission's enforcement action against the Nasdaq stock market: "Our securities markets operate under a "self regulatory" system. Markets serve an important public interest, and deserve public oversight; but markets are also innovative and fast moving, and easily stifled by the heavy hand of government. So Congress arrived at a formula in which the industry polices itself, with SEC oversight. This keeps us out of most day-to-day affairs, and allows us to keep our hands off, but our eyes open. And on those rare occasions when self regulation goes off track, the SEC must act in the public interest." Former Commission Chairman and later Supreme Court Justice William O. Douglas dramatically described the SEC's oversight role as akin to keeping a "shotgun, so to speak, behind the door, loaded, well-oiled, cleaned, ready for use but with the hope it would never have to be used." Douglas' proverbial shotgun in the closet has been fired when necessary. In just the last decade, the SEC has brought significant enforcement actions against SROs, including cases against the NASD and NYSE, the SROs that regulate the country's two largest markets. SRO regulatory lapses involved widespread market maker collusion on Nasdaq and a failure by the NYSE to police for widespread illegal trading by its floor brokers.

It is clear that when there are breakdowns in self-policing, the SEC must act, in order to strengthen the self-regulatory framework. The SEC will continue to hold SROs accountable when they fail to exercise vigilant regulation of their members – the reputational risk in being criticized by the SEC is one that should incentivize all market participants to the highest standards.

But, does the fact that the SEC has recently sued SROs bode poorly for the future of self-regulation as competitive and cost pressures mount?

IV. Can Self-Regulation Be Effective in the New Competitive Environment?

As the head of the office at the SEC that inspects broker-dealers, advisers and SROs, I may have a unique perspective from which to view the future of self-regulation in this highly competitive environment. I firmly believe that self-policing is actually better suited to a highly competitive environment, an environment in which market participants and market centers must vigorously compete for customers' business. This may sound counterintuitive because, it is said that, a highly competitive environment ostensibly encourages competitors to underfund regulatory programs and to use scarce resources to attract business rather than policing and disciplining members. Let me explain why I believe the funding of strong regulation is a competitive necessity. In a highly competitive marketplace, those markets and market participants who place the interests of the ultimate consumer – the investor – first, will stand a significant competitive advantage.

Let's focus on the markets to demonstrate this point. In my view, a marketplace offers three competitive goods---the first is a system or floor on which to trade. Markets compete by being the fastest, the cheapest, and by providing the most liquidity – these are the most oft-cited competitive factors between market centers. There are two other, equally important factors on which market centers also compete. The second is a set of trading rules – markets attempt to attract certain types of customers by implementing a trading environment beneficial to those customers and to meet their particular needs – trading rules may be designed, for example, to attract institutional customers or day trading customers.

There is another area in which market centers will increasingly compete that in my view, is equally important to the other two factors. That is by creating a trading environment that is fair and honest, and is assuredly so by close monitoring and surveillance. In the future, if a market center gains a reputation as having lax oversight and surveillance, that market will suffer the consequences. As markets evolve with greater and greater transparency, customers will be more and more knowledgeable about trading. Indeed, many customers want and need and should get qualitative information about how their orders are executed. The Commission has proposed rules that would require broker-dealers to better inform their customers about their order routing practices, where their orders are executed, and the quality of their execution. In my opinion, these customers will migrate to the markets that they believe are fair and honest, and most likely to protect their interests. This is why, in my opinion, self-regulation has a bright future in the securities industry. If a market chooses to underfund regulation, that market is literally choosing a path that threatens its very survival. Moreover, as I have said, the SEC intends to hold SROs accountable to ensure that self-regulation is vigilant.

In a highly competitive environment, failure to offer a competitive product in any of these three areas will result in customers going elsewhere. Indeed, market centers today are noticeably advocating the "fairness" or "ease of regulation" of their markets. The NYSE, for example, boasts that it is the most active self-regulator in the securities industry and that its regulatory program is part of its "brand." Several ECNs accentuate the ability to "hard code" fairness and regulation into their trading systems. For example, some boast that it is impossible to have your order traded out of sequence, or to fail to immediately display customer orders as required by the SEC's Display Rule.

My faith in the future of self-regulation is confirmed by a recent article in the Wall Street Journal on the Neuer Market in Germany. One of the ways new companies gain a good reputation is to be listed on a market with stringent listing standards and high, fair, and ethical trading rules and practices. According to the Wall Street Journal, the Neuer Market is considered the most regulated market in Europe and it is highly successful – in just three years it has swelled from two to over 300 companies. The Wall Street Journal concludes that the Neuer Market has offered two important lessons – that tough regulation can be the ally rather than the enemy of business and that protecting investors from abuse can be a key to a stock market's success.

I also think that the same thing is true for individual market participants – broker-dealers, advisers and funds – who are doing business in this new environment. You must compete on the basis of yes, your product, your advice, and your return, but just as importantly, you must also show your customers and your clients that you are protecting their interests with a vigilant self-discipline. Aggressive advertising and performance claims may attract the notice of potential customers, but long-term, to remain your customers, they need to have confidence that their interests come first. As the compliance and legal officers for your firms, you are an important part of this. You help ensure that your firms are adequately supervising employees and that problems are detected and corrected promptly and fairly. You play a key role in the success of your firm because firms that fail to exercise self-discipline risk losing their customers' trust and their business. And, in the worst cases, we are all aware of the reputational risk that can befall a firm that is the subject of an SRO or SEC enforcement action!

I strongly believe that self-regulation is an ideal regulatory framework for the securities industry for the 21st century. I think that vigilant self-regulation can and will increase the competitiveness and further the business interests of competing markets and firms. For I truly believe that the investing public will migrate to those market participants and market centers that inspire trust and confidence. And the best way to inspire trust and confidence is by ensuring that investors' interests come first.

Moreover, the success of our industry as a whole is in no small measure reliant upon our self- regulatory framework. Individual investors have invested in securities, options, and bonds in record numbers, mutual fund growth has been truly phenomenal, and investors employ the services of investment advisers and brokers with confidence. The reason for this confidence can be attributed to many factors – but I am convinced that underlying the success of the securities industry is the fact that American investors make investing choices knowing that the world's most aggressive regulatory environment is the backdrop for their investing decisions.

V. Conclusion

I would like to leave you with this final thought. The securities industry should be proud that it has prospered and served the American investor. We should all realize that compliance, self-regulation and SEC oversight are the foundations upon which investor confidence rests. Competition among firms and among markets will be fast and furious – but in this competitive landscape, strong self-regulation will be a key to success.