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May 20, 2004
The International Organization of Securities Commissions
IOSCO 2004 Annual Meeting
Karen K Wuertz
The ownership and organizational structures of securities exchanges have been evolving for a number of years in many jurisdictions around the world. More and more exchanges are abandoning their traditional mutualized ownership structure, in which the exchange is owned by the brokers which execute trades on the exchange, and are converting to a corporate form of ownership, in which shares in the exchange may be owned by non-broker third parties. Additionally, many exchanges and related settlement systems are merging, consolidating within a single company group, or forming alliances with other exchanges and settlement systems. These changes in ownership and organizational structure have raised issues relating to the ability of a for-profit exchange properly to exercise regulatory responsibilities vis … vis brokers that execute trades on the exchange and to conduct proper surveillance on the market. These changes also raise issues relating to the adequacy of the corporate governance processes and mechanisms of exchanges, specifically relating to the ability of for-profit exchanges adequately to take into account the conflicting interests of owners, participating brokers, end-users, and the public in making decisions relating to the operation and management of the exchange. Panelists will discuss these trends and their implications for exchange regulation and governance.
Time: Thursday, 20 May, 2004, 2:00 p.m. to 3:30 p.m.
Andrew Sheng, Chairman, Securities & Futures Comm. of Hong Kong (Panel Chairman)
Many of you know me but for those who do not, I would like to tell you a bit about my background so you will understand the focus of my remarks. I have been associated with National Futures Association for close to twenty years. Aside from a brief stint at the Chicago Stock Exchange, my entire career has been primarily with a futures self-regulatory organization in the United States. My knowledge and experience lend themselves to talking about regulatory developments in the U.S. futures market but I will also do my bit to give you an overview of exchange developments and trends.
For those of you who are not familiar with the National Futures Association, we are a self-regulatory organization that oversees futures industry intermediaries in the United States. It is sometimes easier to explain what NFA does by stating what we do not do; NFA does not operate a market, we are not a trade organization and we are not a statutory regulator. We are purely and simply a self-regulatory body devoted to customer protection. We work very closely with the Commodity Futures Trading Commission; we are in fact very proud of the close working relationship that has developed between our two agencies over the past two decades.
Trends and Developments
Demutualization wasn't the only subject Bob Wilmouth talked about three years ago; he also noted that electronic exchanges would be established to compete with the traditional open-outcry exchanges and that these exchanges may adapt a less traditional approach to their self-regulatory responsibilities. That prediction has come true. As I mentioned earlier, several new electronic exchanges have been designated by the CFTC and they have all adopted a less traditional approach to their self-regulatory responsibilities. Rather than build their own SRO infrastructure, they have all outsourced those functions, most of them to NFA. We have entered into agreements with six exchanges, and are negotiating with several others. Of course, not all of these exchanges have been or will be a great success. However, it will be interesting to see what the landscape looks like three years from now.
This new world of for-profit, competitive, electronic exchanges, co-existing with the traditional brick and mortar, mutual, open-outcry markets, may provide a new level of complexity to the regulator. Even though exchanges are evolving, NFA's mission as a self-regulatory body - to ensure market integrity and to protect investors in the marketplace - has not changed and will not change.
As the marketplace changes, the conflicts of interest inherent in the self-regulatory process change as well and government regulators may need to find new ways to manage those conflicts. Conflicts of interest have always been present in any self-regulatory regime; it is how these conflicts are mitigated and managed that changes. However, as Andrew said last year in Seoul, we cannot change everything at once, we need to prioritize and balance vested interests, conflicting interests and the public interest. Any reforms need to be managed, and managed well.
Impact on Regulatory Process
Intense scrutiny of the self-regulatory process has spread to the futures industry as well, but for different reasons. The futures industry has not been rocked by scandal in recent years. To the contrary, over the last twenty years there has been a 70% reduction in customer complaints during a period in which volume on U.S. futures exchanges increased by over 1,000%. Nevertheless, CFTC Chairman Jim Newsome announced a thorough review of the current self-regulatory structure and his senior staff has undertaken an intensive fact-gathering effort. He stated that there are no particular concerns but given the number of changes that have taken place in the industry over the last 2 or 3 years, it is prudent and responsible for the CFTC to take a look at SROs and make sure that the same principles that applied when SROs were put into place apply now.
Because the CFTC inquiry is not scandal driven, it may present an opportunity to really examine how demutualization of exchanges, the emergence of for-profit exchanges and the changing roles of intermediaries have affected the conflicts of interest inherent in the self-regulatory process and how the government should best manage those conflicts of interest. Take the SRO disciplinary process as an example. The traditional regulatory concern has focused on the "fox watching the hen house" issue. Specifically, the CFTC was concerned that those serving on SRO disciplinary committees might be reluctant to impose necessary sanctions on their buddies, both because of personal relationships and a recognition that the exchange action could set a precedent that could be used against the committee members themselves. The Commission therefore required that at least half of an SRO's disciplinary committee must be drawn from membership categories different than the respondent's. That regulation certainly seems to have been a rational response to the perceived problem.
Now, though, members of the brokerage community may feel that the potential conflict of interest in the SRO disciplinary process has a different twist. With firms trading a wide range of OTC products and seeking to internalize order flow, firms can feel that they are being regulated by exchanges that are actually their competitors.
Clearly, in both the futures and securities industries, self-regulation is under very close scrutiny. Given the need to shore up public confidence and the changes occurring in the markets, it is very possible that the self-regulatory structure may change significantly in the next few years. The CFTC study is one of three about which I am aware; there may be others.
With self regulation under such close scrutiny, it is worthwhile to look at some of the alternatives that are available going forward.
The most radical, and least likely, restructuring of the SRO process would be the elimination of SROs altogether, or at least a reduction in their role. Such a move would not be without precedent. However, in the U.S., the role of the SROs in both the futures and securities industries is so deeply imbedded, and the resources of the government regulators already so strained, that a major reallocation of responsibilities from the SROs to the government seems unlikely. In fact, at least on the futures side, the recent trend has been just the opposite. Over the last several years, the CFTC has been delegating more and more of its frontline regulatory responsibility to NFA.
Another alternative, but not a better one, would be to reduce or eliminate the "self" in the process of self-regulation.
The danger here is that a "private regulator" could become a privately funded bureaucracy - the structure lacks any real fiscal discipline. The very structure of an SRO imposes a discipline on spending that helps bring private sector efficiency to the business of regulation. There's no need to strive for greater efficiency, to be smart in allocating resources, if the private regulator has basically unfettered ability to tax the industry it regulates.
If reducing the role of self-regulation or taking the self out of self-regulation are bad ideas, then what are some good ones?
Some have suggested that self-regulatory duties should be divorced from the operation of a marketplace and vested in an independent SRO. That may be flattering, but I'm not sure it's the right response, at least not now. The exchanges argue that they have a huge stake in maintaining their market's reputation and that certain regulatory functions, such as market surveillance, are core to their brand and their business model. I'm not sure that the argument applies as well to regulatory functions that don't pertain to a particular market. For example, promotional material issues, capital requirements, supervision, books and records are all areas that SROs have to audit for and none of them pertain to the reputation of a particular market. Nonetheless, suggesting that exchanges should be completely out of the self-regulation business strikes me as going too far. If a particular exchange chooses to outsource its regulatory functions, that's their business decision, but it shouldn't be mandated by the government.
The last thing I'll mention may sound odd coming from an SRO but I think we can hold the SRO's feet to the fire by enhancing the oversight function of the government agencies. I think the agencies need to reconsider their enforcement philosophy regarding SROs. Obviously, both the CFTC and the SEC have the authority to bring enforcement actions against SROs that haven't done their jobs correctly. Historically, that authority has been used only in extreme cases, where there has been a highly publicized calamity or meltdown. The agencies need to examine whether that makes sense, whether smaller lapses by SROs shouldn't result in smaller, but more frequent, enforcement actions.
In May 2000, the IOSCO SRO Consultative Committee presented a paper entitled Model for Effective Regulation. The paper set forth the general principles for self-regulation, such as industry knowledge and motivation, and why self-regulation should be considered in regulatory frameworks. The SRO Consultative Committee decided at their 2003 mid-year meeting in London that it was appropriate to revisit and update the 2000 paper. Last autumn, we sent out a survey to all SROCC members. The survey sought information regarding the functions of the SRO, their corporate and governance structures, their rulemaking process, oversight, and other activities. A final draft of this updated paper has been submitted to the SRO Consultative Committee and we hope to present and publish this paper shortly.
When going through industry papers and research on SROs and regulatory developments, and in analyzing the survey data, several general themes emerge, despite the varying responsibilities and differing structures of the survey respondents. These themes, somewhat unsurprisingly, reflect the important elements of self-regulation that were elaborated in the 2000 Model for Effective Self-Regulation.
SROs are committed to protecting investors and the public interest. Market participants need to know that the markets are well regulated, that there are rules in place, meaningful surveillance to ensure compliance with those rules and vigorous enforcement actions if the rules are violated. SRO members need to be deterred from wrongful conduct and they need to believe in the fairness of the process, in the impartiality and independence of the SRO, in the rulemaking process and enforcement of its rules. Members have to believe that the SRO's regulatory and enforcement authority can't and won't be used as a competitive weapon.
Whatever the changes are to come, it is critical to preserve the "self" in self-regulation. Self-regulation has worked well for many decades and a contributing factor to its success is reliance on the industry's own expertise and by having industry participation in the creation of rules that are effective, reasonable and practical.
Effective regulation is the best way to assure public confidence, and we have all seen what happens to markets that lose the public's confidence. The best way to preserve that confidence is to deserve it - to ensure that the highest levels of integrity are demanded of all market participants and intermediaries.
When property implemented, self-regulation is an effective and efficient form of regulation. IOSCO Committees and their respective working groups should therefore continue to recognize and incorporate self-regulatory approaches in the guidelines or standards they develop.