[18481]
January 28, 2005
TO: EQUITY MARKETS ADVISORY COMMITTEE No. 9-05
SEC RULES MEMBERS No. 19-05
RE: SEC CONCEPT RELEASE RELATING TO SELF-REGULATORY ORGANIZATIONS
The Securities and Exchange Commission has published for comment a concept release
relating to the role and operation of the self-regulatory system of the securities industry.1 The
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, market operations, 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. The concept release also examines a
number of regulatory approaches or legislative initiatives that could be considered by the SEC
to address concerns with the current SRO model. The most significant aspects of the Release are
summarized below.
Inherent Conflicts With Members, Market Operations, Issuers, and Shareholders
The Release states that among the most controversial features of the existing SRO system
are the inherent conflicts that exists within every SRO between its regulatory functions and its
members, market operations, listed issuers, and shareholders. The Release discusses several
aspects of these conflicts, including how these conflicts may arise. Most significantly, the
Release discusses the recent consolidation within the securities industry and the resulting
dependence of SROs on a relatively small number of firms for the bulk of their funding, as well
as the increased intermarket competition for trades and issuer listings.
The Release requests comment on several issues relating to these conflicts. For example,
the Release questions whether some of the governance changes recently made by SROs are
1 Securities Exchange Act Release No. 50700 (November 18, 2004) (“Release”). Comments on the concept release are
due to the SEC no later than March 8, 2005. The concept release can be found on the SEC’s website at
http://www.sec.gov/rules/concept/34-50700.htm.
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sufficient to effectively manage these conflicts, as well as how the SEC’s rule proposals relating
to SROs2 would address concerns regarding SRO conflicts of interest.
Inefficiencies of Multiple SRO Structure
The Release examines the “inherent inefficiency” of duplicative and potentially
conflicting regulation relating to securities industry self-regulation. It states that the existence
of multiple SROs can result in duplicative and conflicting SRO rules, rule interpretations, and
inspection regimes as well as redundant SRO regulatory staff and infrastructure across SROs.
The Release requests comment on several aspects of the inefficiencies of multiple SROs.
In particular, the Release requests comment whether the lack of intermarket rules across
markets trading the same type of securities is causing regulatory arbitrage and, if so, what is the
impact of this on the SRO system. In addition, the Release requests comment on how
significant the inefficiencies are resulting from multiple SROs overseeing the activities of the
same members.
Intermarket Surveillance
The Release discusses SRO supervision of intermarket trading, which the Release notes
has caused the SRO system to come under increasing strain. It states that because trading now
takes place in multiple active markets, it is possible for traders to hide illegal trading activity by
dispersing trades across markets. The Release requests comment on several issues relating to
intermarket surveillance and regulation, including to what extent the market model of multiple
competing SROs creates gaps in intermarket trading surveillance and what types of illicit
trading activity can be hidden from regulators by dispersing trading across multiple markets.
SRO Funding
The Release examines the funding of SRO regulatory operations. It states that one of the
key historical benefits of the SRO system is its self-funding structure, which leverages the
limited resources of the Commission. The Release also 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. The Release requests comment on several aspects of each of these
primary sources.
For example, the Release notes that under current SRO cost structures, SRO funding for
regulatory operations is not derived strictly from revenue associated with regulatory fees and
operations. The Release requests comment on whether SRO funding for regulatory operations
should be derived only from regulatory fees and, if so, how the Commission should address a
situation in which an SRO does not generate sufficient regulatory revenue to fully fund
regulatory operations. The Release also discusses how inter-market competition has impacted
SRO transaction fees and listing fee revenue and requests comment on, among other things, the
resulting effect on the SROs’ ability to fulfill their regulatory obligations. Finally, the Release
discusses issues surrounding market data revenue and requests comment on whether such
revenue should be used to cross subsidize SRO regulatory operations.
2 See Memorandum to Equity Markets Advisory Committee No. 2-05 and SEC Rules Members No. 3-05, dated
January 6, 2005 [18389] (“SRO Rule Proposals”).
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Alternative Regulatory Approaches
The Release discusses a variety of regulatory approaches or legislative initiatives that
could be considered by the SEC to address concerns with the current SRO model. Specifically,
the Release examines: (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. For each approach, the
Release requests comment on the extent to which changes proposed in the SRO Rule Proposals
effectively manage inherent SRO limitations and whether these proposed changes would
continue to provide the benefits of the current SRO system.
Proposed Enhancements to the Current SRO System
The Release notes that while the current SRO system to date has provided essential
regulation, the system has inherent limitations that should be addressed. The Release discusses
possible enhancements that could be implemented to address SRO limitations. The Release also
discusses the SRO Rule Proposals and states that, 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.
Independent Regulatory and Market Corporate Subsidiaries
The Release states that another approach would be to require that all SROs create
independent subsidiaries for regulatory and market operations. Under this model, regulatory
staff of each SRO would be placed within an independent regulatory subsidiary, which would
report directly to the corporate parent’s board. Substantially all regulatory operations would be
housed in the regulatory subsidiary, including examination, rulemaking, and enforcement
responsibilities. All market operations responsibilities would be placed within an independent
market subsidiary.
Hybrid Model
Another option would be the Commission’s designation of a market neutral single self-
regulatory organization (“Single Member SRO”) to regulate all SRO members with respect to
membership rules. The Single Member SRO would be solely responsible for promulgating
membership rules, inspecting members for compliance with “member” rules, and taking
enforcement action against those members that fail to comply. Each SRO that operates a market
(“Market SRO”) would be solely responsible for its own market operations and market
regulation.
Competing Hybrid Model
Under the competing hybrid model, Market SROs would exist as in the pure hybrid
model and market regulation would be conducted separately from member regulation. Instead
of one Single Member SRO, however, this approach would permit the existence of multiple
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competing member SROs (“Competing Member SROs”), which would be required to be
registered with the Commission and, thereby, authorized to provide member regulatory
services. Under this approach, each Market SRO member would also have to be a member of
one of the Competing Member SROs. The Competing Member SROs would be responsible for
promulgating member rules, inspecting members for compliance with those rules, and taking
enforcement action against those members that fail to comply. Under this approach, Market
SROs would retain their market regulatory responsibilities.
Universal Industry Self-Regulator
Another approach would require the establishment of a universal industry self-regulator
(“Universal Industry Self-Regulator”). Under this model, one industry self-regulatory
organization would be responsible for all market and member rules for all members and all
markets. The current SROs’ self-regulatory authority would be transferred to the Universal
Industry Self-Regulator, including member and market rulemaking, member and market
surveillance, and member and market rule enforcement. Under this approach, all member
firms would be registered directly with the Universal Industry Self-Regulator, all markets
would be non-SROs registered with the Universal Industry Self-Regulator, and the markets’
self-regulatory authority would be eliminated.
Universal Non-Industry Regulator
Another approach would be the establishment of a universal non-industry regulator
(“Universal Non-Industry Regulator”). Under this approach, one non-industry entity would be
designated to be responsible for all markets and member regulation for all members and all
markets. As with the Universal Industry Self-Regulator, this model would require all member
firms to be registered with the Universal Non-Industry Regulator. The Universal Non-Industry
Regulator would be solely responsible for promulgating member and market rules, inspecting
for compliance with those rules, and taking enforcement action with respect to member and
market rules. The Release notes that, while not exactly analogous, this model could resemble
the regulatory regime recently adopted for audits of public companies, which puts authority in
the hands of the Public Company Accounting Oversight Board.
SEC Regulation
The final proposed alternative would be the termination of the SRO system in favor of
direct Commission regulation of the industry. Under this approach, the Commission would be
solely responsible for the regulation of all members and all markets. All member firms and
markets would be required to register directly with the Commission under this model. The
Commission would be responsible for the promulgation of detailed member and market rules,
the surveillance of members and markets, and the enforcement of member and market rules.
Ari Burstein
Associate Counsel