Market Structure

B. Option 2: Multiple Exchanges with Separate Boards and Information Barriers for Their Regulatory Arms (NASDR Model)

One response to the changes taking place in the securities markets is to retain the status quo. Currently, nine national securities exchanges, including the American Stock Exchange (“Amex”), Boston Stock Exchange (“BSE”), Chicago Board Options Exchange (“CBOE”), Chicago Stock Exchange (“CHX”), Cincinnati Stock Exchange (“CSE”), International Securities Exchange (“ISE”), NYSE, Pacific Stock Exchange (“PCX”) and Philadelphia Stock Exchange (“Phlx”) and one national securities association, the NASD, are registered with the SEC under Section 6 and Section 15A of the Exchange Act, respectively.[7]/ In addition, given the pending exchange application of Nasdaq and the business interest in exchange status, it is likely that the number of exchanges will increase in the future.

Each of these SROs performs two basis functions: (1) the operation and promotion of a marketplace and (2) the regulation of the market center and the broker-dealer members of the market center. These regulatory functions are broad and diverse, covering surveillance of market activity, rulemaking, auditing of member firms for compliance with rules, disciplinary actions against member firms and their associated persons for rule violations and the arbitration of disputes. By continuing this structure, marketplaces would retain their affiliated self-regulatory functions or allocate those responsibilities to another SRO pursuant to Section 17(d) of the Exchange Act.[8]/ They would be permitted to keep the functions in the same corporate entity, even if the organization decides to demutualize, or to establish the regulatory arm of the SRO in a separate affiliated entity. The SEC would continue to oversee each of the SROs. A chart depicting the current regulatory structure is attached in the appendix as Option 1.

The current regulatory system can be, at times, complex, expensive and unfair. Some of the disadvantages of the current system are described in more detail below.

Conflicts of Interest Strain Public Trust and Confidence. As Congress recognized in enacting the Exchange Act and adopting the self-regulatory model, an inherent conflict of interest exists between the regulatory and market roles of the SROs. Specifically, the interests required of an SRO to regulate itself and its members are in conflict with its interests in promoting itself. For example, an SRO may utilize its regulatory power to imposed purely anti-competitive restraints as opposed to those justified by regulatory needs. Similarly, the SRO may resist change in the regulatory pattern because of vested economic interests in its preservation or insufficient knowledge of newly developing market conventions or investor needs. Indeed, these inherent conflicts percolate into the ongoing debates concerning the market data fees and bond market transparency initiatives.

To date, self-regulation paired with SEC oversight has proven effective, through a check and balance system that has managed to contain more serious types of conflicts of interest. The rise of ATSs and the push for the demutualization of existing exchanges, however, raise the question of whether the conflicts of interest will deepen to the point where regulatory change is needed. In conjunction with the introduction of the Order Handling Rules[12]/ and Regulation ATS,[13]/ more ATSs have been developed.[14]/ These electronic trading systems increasingly have been seen as competitors to the existing SROs, attracting order flow with promises of better, cheaper and speedier executions than those of the SROs. In fact, by 2000, news reports commonly reported that ATSs accounted for 30% of the trading in Nasdaq securities;[15]/ that percentage has increased even more since then. The NASD and NYSE have recognized this competitive threat and have countered with electronic trading proposals of their own.[16]/

Although this appears to be a success story of innovation spurred on by the competition in the market, various issues remain with these developments and their relationship to the present self-regulatory structure. Under Regulation ATS, all ATSs must be registered as a broker-dealer and, therefore, must be registered with and regulated by the very SROs with whom they are competing. This regulation of direct competitors exacerbates the existing conflicts of interest inherent in the basis self-regulatory structure.

In addition to the competition from ATSs, SROs also are increasingly faced with competition from other SROs. For example, the competition between the options markets has escalated with the onset of multiple listings. Similarly, the repeal of NYSE Rule 390 is likely to accelerate competition among the NYSE, the NASD, the regional exchanges and third market firms. Such competition raises concerns about the SROs’ ability to regulate firms when they are competing for those firms’ order flow, particularly the SROs’ ability to enforce best execution obligations for that order flow.

The conflict of interest is further aggravated by the pending structural changes by Nasdaq[17]/ and the demutualization plans under consideration at certain exchanges. As for-profit, public companies, a market may risk, for example, inappropriate cost-cutting of regulatory functions or anti-competitive oversight of its competitors. In addition, as public companies, these organizations must answer to their shareholders – who may include competitors of the exchange as well as competitors of the regulated members of the exchange. The for-profit structure may also raise due process concerns because the regulatory fines would flow to the SROs’ bottom line.

Duplicative and Inconsistent Regulation. As we describe below, today’s self-regulation is characterized by a high degree of redundancy and its attendant costs.

Broker-Dealer Examinations. Broker-dealers that are members of a number of SROs have been subject to multiple, overlapping SRO examinations.[18]/ In general, the requisite examinations are costly and time-consuming, and frequently more so than necessary. For example, broker-dealers commonly report a need for better trained examiners and more targeted examinations.[19]/ The frustration and costs associated with each examination is multiplied when the firm must undergo a similar examination several times by different regulators.

The SEC and the SROs have attempted to minimize some of the inefficiencies of multiple exams by establishing joint examinations programs,[20]/ but sufficient duplication remains to justify concern.[21]/ In addition, although the goals of the cooperative programs are laudable and necessary, practical coordination of the SROs on examinations has not yet been achieved.[22]/ In the joint examinations, the respective teams of examiners may agree on the format, but they remain subject to the different agendas and direction of their respective SROs.[23]/ Unlike the present process, a truly coordinated examination process must have a clear division of responsibilities and a willingness on the part of the examiners to accept the findings of another SRO’s examiners, and this may not be easily achievable given the competition among the various SROs.

Rulemaking. The redundancy problem also reveals itself in the rulemaking process. At times, broker-dealers that are subject to the oversight of multiple SROs may need to comply with multiple and inconsistent rules on the same issue. Furthermore, even when the various SROs have identical rules on a certain issue, each SRO may interpret those rules differently. The risk of such inconsistencies increases as the number of SROs increases.

Having ten existing SRO rulebooks, rather than one rulebook, increases the costs for each segment of the securities markets – the broker-dealer members, the SEC and the SROs as a group. The member broker-dealers must constantly monitor rule changes for each relevant SRO in order to maintain a working familiarity with the rules and to make any necessary modification to supervisory and compliance procedures. In addition, because any SRO rule changes must be reviewed by the SEC, the rule filing expenses of the SEC increase as the number of exchanges increase. The duplication of effort is particularly noticeable when the various SROs each separately file similar or identical rule changes. Correspondingly, the SROs as a group expend unnecessary resources internally to consider and prepare rule filings which duplicate filings of other SROs.[24]/ In all likelihood, the costs for the duplicative and inconsistent rules and rulemaking procedures will increase with the addition of any new exchanges.

Discipline and Enforcement. Like the rulemaking process, the broker-dealer members of multiple SROs must contend with inconsistent discipline and enforcement efforts from the multiple SROs. Each SRO has its own unique focus and interpretation for what activity constitutes a rule violation and what the appropriate sanction is for that violation.

Regulatory Competition. Competitive pressures may influence the regulatory decisions of the SROs. For example, to maintain its status as a tough regulator and to attract additional order flow based on its positive reputation, an SRO may resort to enforcement actions, rather than targeted remediation, to address rule violations. Similarly, the opposite situation may result. The competitive regulatory environment may encourage SROs to apply lax standards to increase their membership roles. This may lead to a race to the bottom in which marginal firms become members of the SRO which has the least rigorous standards.[25]/

Limited Feasibility. In the past, the SEC has suggested that a for-profit demutualized exchanges will need to create a separate corporate entity for their regulatory operations (see Option 2). Although the SEC has not instituted rulemaking in this regard, it appears likely that at least some changes to the status quo will be required.

An internal corporate restructuring which segregates the market and regulatory roles of any demutualized SROs may address some of the concerns about the current regulatory structure and its application to the changing marketplace. This option would be very similar to the status quo. The multiple SROs, existing and future, would continue to exist and each SRO would continue to operate and regulate its market and members. The only difference between this option and the status quo is that each of the demutualized SROs would be required to undergo a corporate restructuring much like that undergone by the NASD.

As currently envisioned, the SRO would create a parent holding company, with at least two subsidiaries. One subsidiary would contain the regulatory arm of the SRO, which would have the SRO’s examination, rulemaking and disciplinary authority, and the other subsidiary would contain the market center. A separate and independent board would govern each subsidiary and information barriers would separate the decisionmaking of one subsidiary from the other.[26]/ The NASDR Model is pictorially represented at Option 2 of the appendix.

The NASDR Model has the advantages discussed above in reference to the status quo. Additionally, however, the corporate restructuring in this option is intended to improve upon the status quo by reducing the conflicts of interest caused by the demutualized, for-profit exchanges.

Reduces Conflicts of Interest. By strictly segregating the regulatory and market functions, this option seeks to focus each subsidiary on its respective responsibilities. The board of the market center subsidiary would concentrate on promoting the market center and maintaining its competitive status. The board of the regulatory arm would focus on the regulation. With the corporate separation and the information barriers in place, each board’s aims and goals should not infiltrate the decisionmaking of the other board, thus decreasing the likelihood of inappropriately anti-competitive regulation.

Prior Experience with NASDR Model. The SEC and the industry have experience with this type of restructuring because of the NASD’s creation of a separate, independent subsidiary, called NASD Regulation, Inc. (“NASDR”), responsible for the regulatory obligations of the NASD. Such experience provides valuable data for evaluating the NASDR Model generally and improving upon it, if necessary.

In 1996, the NASD created NASDR in response to a variety of criticisms aimed at its market and regulatory responsibilities. In 1994, amid criticism of the NASD’s self-regulatory capacities, the NASD appointed a Select Committee on Structure and Governance, chaired by former United States Senator Warren Rudman to review the regulatory and governance structures of the NASD and Nasdaq.[27]/ This Committee inquired into the appropriateness of the NASD’s structures for governance and oversight and operation of the Nasdaq stock market, the NASD’s regulatory and disciplinary processes, the extent to which the NASD provided for appropriate representation of its constituencies, and its policy and rulemaking processes.[28]/ The Committee concluded that the NASD’s governance structure “blur[r]ed the distinction between regulating the broker-dealer profession and overseeing the Nasdaq stock market.”[29]/ To correct these deficiencies, the Committee suggested that the NASD reorganize its corporate structure such that the Nasdaq market and NASD’s regulatory functions would be in separate subsidiaries of the NASD, and that the NASD and these two subsidiaries would each have 50% or greater public representation on their boards of directors. Former Chairman Levitt noted the improved regulatory oversight of the reorganized NASD, stating that “[s]ince the SEC’s historic enforcement action . . . the NASD has adopted an unprecedented number of changes to improve the fairness and efficiency of its operations.”[30]/

Minimally Disruptive. In comparison to the other possible regulatory models discussed in this paper, this option represents only minimal or incremental change from the status quo. The model does not divest any SRO of its regulatory or other functions; it merely requires the SRO to repackage its existing roles. Furthermore, this repackaging may be fairly easy to accomplish through SEC rulemaking which could set forth guidelines for the segregation of the SROs’ regulatory arms.

C. Option 3: Multiple SROs with Firms Designated to a Single SRO for Examination Purposes (DEA Model)

Conflicts May Persist. Although the internal segregation of the regulatory and market roles of the SRO may reduce conflicts of interest to a certain extent, conflicts may persist. After all, the two functions remain in the same entity and that entity as a whole has an interest in promoting its own interests. For example, if the SRO uses the holding company structure, the board of the holding company still oversees the actions of both of the subsidiaries. Furthermore, despite the corporate separation and firewalls, each of the subsidiary’s boards will consist of industry members per the Exchange Act’s fair representation requirements.[31]/ Therefore, although each board will contain different people, the actual interests of the people on each board are likely to be very similar.

Only Addresses Conflicts Issues, not Duplication and Inconsistency. This model is designed to address only one of the problems in the current regulatory structure – conflicts of interest. It does not attempt to address any of the other disadvantages of the current situation. In particular, it ignores the costly duplication and inconsistencies of multiple SROs.

A third possibility would involve allocating inspection responsibilities among the SROs and expanding the concept of a designated examining authority.[32]/ The Commission has used its authority under Sections 17 and 19 of the Exchange Act to allocate to particular SROs oversight of broker-dealers that are members of more than one SRO “(common members”).[33]/ For example, in order to avoid unnecessary duplication, the Commission appoints a single SRO as the DEA to examine common members for compliance with financial responsibility requirements.[34]/ When an SRO has been named as a common member’s DEA, all other SROs to which the common member belongs are relieved of the responsibility to examine the firm for compliance with applicable financial responsibility rules.[35]/ Pursuant to recent legislation, Congress has called for improved coordination of supervision of members and elimination of any unnecessary and burdensome duplication in the examination process.[36]/

Under this model, the SEC would require the DEA to expand its oversight duties of the common member. Like the current DEA program, each firm would be examined by one designated SRO, instead of multiple SROs. The DEA would be responsible for inspecting for compliance with its own rules as well as the rules of the other SROs. Like the status quo and the NASDR Model, this option would leave the current regulatory structure as is except for reallocation of examination responsibility. A chart portraying this model is attached in the appendix as Option 3.

Eliminates Duplicate Examinations. In addition to the advantages of the status quo discussed above, the DEA Model would streamline the examination process and minimize the costly, duplicative examinations performed by multiple SROs.

D. Option 4: One SRO for Member Firms: Markets Regulate Their Own Trading (Hybrid Model)

Improvement Limited to Duplicate Examinations. A disadvantage of this approach is its narrow focus. It only attempts to lessen the duplicative efforts of the SROs, leaving the conflicts of interest issues unaddressed. Furthermore, the focus on the SROs duplicative efforts is limited to broker-dealer examinations. The model fails to address the redundancies and inconsistencies in the multiple SROs’ rulemaking and enforcement initiatives.

Interpreting Another SRO’s Rules. In practice, expanding the authority of the DEA may increase costs, inconsistent action among the SROs and conflicts of interest between competing market centers. For example, the costs for each DEA may increase because each DEA must expend significant resources to maintain a working knowledge of the rules of each of the other SROs in addition to its own rules. Although the process may reduce overlapping exams, the broker-dealers may not realize significant cost savings because the DEA may find the interpretation and application of the other SROs’ rules during the examination process more difficult than the relevant SRO’s examiner. Furthermore, under this approach, the risk of inconsistent interpretation of any given rule increases. Using the expanded DEA concept, the potential exists for ten different interpretations of the rule of one SRO. Finally, by bestowing upon the DEA the front-line responsibility for interpreting and applying the rules of another SRO, this model may aggravate the conflicts between competing SROs by creating an incentive to construe another SROs rules in an anti-competitive fashion.

Conflicts of Interest Persist. Like the status quo, this option fails to address the conflict of interest concerns presented by demutualized, for-profit exchanges.

Another proposal that has received increased attention recently would restructure self-regulation on the basis of function, rather than on the basis of firm membership. Regulation would be broken down into two separate and distinct areas – one which relates to trading and markets and the other which relates to the operation of the firm and capital requirements. All the non-market-related self-regulatory functions would be combined into a single organization which could function irrespective of the various markets. Therefore, “each market would maintain the regulatory and surveillance functions solely for its own market – but member regulation, sales practices and all other aspects of intermarket trading would be overseen by a single SRO.”[37]/

Division of Responsibilities for Non-Market-Related Regulation. This single, non-market-related SRO (“Firm SRO”) would assume, for all registered broker-dealers, the rulemaking, surveillance and enforcement functions performed by the exchanges and the NASD with regard to all activities other than those specifically associated with the trading markets.[38]/ For example, only the Firm SRO – rather than ten or more SROs – would have jurisdiction over, among other things, sales practices, industry admission standards, financial responsibility requirements (like net capital and margin requirements), competence of personnel and recordkeeping rules. This Firm SRO would be assigned the responsibility for conducting examinations of broker-dealers. In addition, it would be solely responsible for disciplining infractions of the Firm SRO’s rules. The current SROs would relinquish control over all this non-market-related regulation. As a prerequisite for this model, all registered broker-dealers must be a member of this organization. The SEC would oversee all of the activities of the Firm SRO, like it does today for the NASD and the exchanges. The Hybrid Model is represented in Option 4 in the appendix.

Division of Responsibilities for Market-Related Regulation. The market-related regulation may be divided between the Firm SRO and the market SROs in at least two ways. Under one variation, the Firm SRO would not have any rulemaking, surveillance or enforcement authority for access to the trading facilities, operation of the trading facilities, or the establishment and enforcement of listing or qualification standards for issuers. Each market center would have responsibility for trading-related activities, subject to SEC oversight. Therefore, the markets would continue to adopt and enforce rules as they do today, but their overall jurisdiction would be limited to trading regulation.[39]/

Under a second variation, the market SROs would retain their rulemaking authority with regard to trading activity, e.g., access to the trading facilities, operation of the trading facilities and the establishment and enforcement of listing or qualification standards, but they would not have any enforcement authority with regard to those rules. The market SROs’ authority would be similar to that of the Municipal Securities Rulemaking Board.[40]/ The Firm SRO would be vested with the authority to enforce the trading rules of the market SRO. However, the market SROs would have the limited power to determine whether a rule violation may have occurred.

Governance. Although the governance of the Firm SRO may be structured in a variety of ways, any chosen structure should satisfy several basic principles. First, the board of the Firm SRO would consist of 50% public governors. Moreover, a system should be established to ensure that the organization attracts qualified public board members. Second, the remaining 50% of the board should be representative of all members of the industry over which the SRO has disciplinary authority, i.e., all registered broker-dealers. In particular, the board selection process should ensure that smaller entities are fairly represented. This heightened fair representation requirement could be achieved through a carefully crafted nomination and voting process for selecting the board. Third, the Firm SRO members should not only be represented in the governance, but they also should be an effective and integral part of the functioning of the Firm SRO. An expanded advisory committee structure could provide the members with a voice in the new organization. Finally, it should be assumed that this organization would not in any way participate in the governance of any marketplace as such.

Strengthens Investor Confidence by Reducing Conflicts of Interest. The introduction of a Firm SRO may eliminate some inherent conflicts of interest that are caused by today’s SROs’ dual capacities as regulators and markets. The Firm SRO in charge of the non-trading regulation would no longer have any direct connection to a profit-driven pursuit and, therefore, it would have no incentive to brandish its regulatory authority in an anti-competitive fashion.

Minimizes Duplicate and Inconsistent Regulation. The consolidation of the non-market-related regulation under one roof should improve the quality, uniformity and comprehensiveness of today’s approach to non-market-related regulation of broker-dealers. For example, the economies of scale of this approach should eliminate or reduce many of the inefficiencies and unnecessary costs present in the current regulatory system.[41]/ The Firm SRO would significantly reduce or eliminate (1) duplication of examinations, inspection reports, surveillance and other areas of overlapping jurisdiction; (2) the need for the maintenance and staffing of multiple SROs; (3) the inefficiency of monitoring and complying with two or more SROs; (4) inconsistent rules and rule interpretations and inconsistent enforcement thereof; (5) and the attendant costs of each of the above to the industry.[42]/

Reduces Regulatory Competition. Replacing the oversight functions of ten competing SROs with one Firm SRO should eliminate regulatory competition at least in the non-market-related oversight functions. This should address both race to the top and race to the bottom issues.

Functional Regulation. The Hybrid Model is likely to produce beneficial regulation because it links supervisory duties to expertise, and in particular, it leaves the technical details of trading regulation to the entities best equipped to understand them.

Feasible Approach. The question remains as to whether the concept of a Firm SRO is feasible in view of the present industry structure and the traditions that accompany it. From a political standpoint, this approach is supported by some powerful interests, just as it is much opposed by others. From an operational and legal standpoint, however, the concept appears feasible.

Legally Feasible. To create the Firm SRO, the Commission must cause today’s SROs to relinquish non-trading authority over their members and must create a new organization with the necessary self-regulatory powers. The Commission currently has at its disposal many, if not all, the legal tools necessary to implement this hybrid concept. For example, under Sections 17(d), 11A, and 19(c) of the Exchange Act, the Commission has the authority to require the existing SROs to relinquish authority over their members if so directed. In addition, the SEC’s new exemptive authority[43]/ may be used to relieve the existing SROs of any non-market-related duties which are mandated under the Exchange Act.[44]/ Similarly, the new Firm SRO may be formed as an SRO pursuant to Section 19 of the Exchange Act, just as traditional SROs are formed, and the SEC may again utilize its exemptive authority to relieve the Firm SRO of inapplicable requirements. The SEC’s use of its existing authority in this situation may require rulemaking to implement this approach.

Operationally Feasible. From an operational standpoint, the industry has the capability to implement the concept because the job to be performed by the Firm SRO is collectively being done today by the exchanges and the NASD. Thus, there is sufficient personnel with the necessary technical expertise to continue to perform the job on a consolidated basis. The existing examination and surveillance structures may be modified for utilization by the Firm SRO. Indeed, cooperative efforts among SROs and the Commission to relieve duplicative regulation are paving the way toward uniform surveillance. Finally, the current use of technology-based surveillance programs should facilitate the transfer of responsibilities to a Firm SRO.

In addition, this hybrid approach has seen a level of SEC and Congressional approval and industry support in the past. For example, former Chairman Levitt stated that he found this hybrid approach “intriguing,”[45]/ although he reserved judgment as to the best regulatory approach pending further study. Annette Nazareth, Director of the SEC’s Division of Market Regulation,[46]/ has similarly expressed her interest in the Hybrid Model. Others in the industry, including broker-dealers and SROs, also see value in this approach. For example, support for this approach has a long history with the SIA. The first SIA chairman endorsed this approach in 1973 during consideration of the national market system legislation.[47]/

Centralization of Regulatory Expertise. Another benefit of this approach is the centralization of regulatory expertise and experience in one entity. Rather than dispersing the talented regulatory staff throughout many different SROs, the experienced regulators would join the one Firm SRO, thus limiting the constant issue of inexperienced regulators.

More Effective Liaison. Because the Firm SRO will speak with one marketplace and business neutral voice, it may prove to be a more effective liaison than the multiple SROs on matters of regulatory importance with the SEC, various governmental agencies, the states, global regulators and competitors and other organizations.

E. Option 5: All-Purpose Single SRO (Single SRO Model)

Separation of Market and Surveillance. Separating the self-regulatory function of the securities markets from the operational market functions may degrade self-regulation by lessening the familiarity of the regulators with market processes. Synergy is lost when the two functions are separated.

Bureaucratic Tendencies. Any single entity which by its very nature is free from the pressure of peer competition can become intransigent and bureaucratic. Initiative and effort at self-improvement may diminish. Although Congressional and SEC oversight as well as a member-controlled decisional process should reduce that possibility, self-regulation without competition may not be a regulatory enhancement.

Boundary Issues. In some cases, the line between firm oversight issues and trading issues may be hard to draw. Some areas of oversight, like net capital, for example, may clearly fit within the jurisdiction of the Firm SRO. Other rules, however, like frontrunning, may have both trading and non-trading characteristics. For these rules, the Firm SRO and the marketplaces may both have a legitimate interest in the development, surveillance and enforcement of those rules.

Remaining Conflicts of Interest Regarding Trading. Although the conflicts of interest are reduced for non-market-related oversight, SROs still may set trading rules that disadvantage member broker-dealers that run competing markets or send order flow elsewhere. Like the current situation, the SEC’s continued oversight and scrutiny of the trading rules and their enforcement as well as antitrust laws may or may not be sufficient to limit these conflicts of interest.

The regulatory structure also could be revised by expanding the concept of the Hybrid Model discussed above. Specifically, the trading regulation – in addition to the non-market-related regulation – would be moved into a single, all-purpose SRO (“Single SRO”). Therefore, the Single SRO would be vested with all rulemaking, surveillance and enforcement responsibility for all areas of regulation. Concurrently, the exchanges and the NASD would be divested of all their self-regulatory authority, leaving each as a marketplace, much as ATSs are today. The Single SRO Model is set forth in chart form in Option 5 of the appendix.

Like the Hybrid Model, the Single SRO should (1) decrease duplicative and inconsistent regulation; (2) centralize regulatory experience; (3) act as a more effective liaison to other organizations; and (4) be legally and practically feasible. In addition, the Single SRO would be advantageous for the following reasons:

Eliminates Remaining Regulatory Competition and Conflicts of Interest. The already reduced regulatory competition and conflicts of interest of the Hybrid Model will be completely eliminated in the Single SRO because all self-regulation, including trading and non-trading oversight, would be vested in a single entity.

Erases Boundary Issues of Hybrid Model. Placing all regulatory responsibilities in one entity eliminates any jurisdictional overlap.

Level Playing Field Among Competing Markets. Regulation ATS defined an ATS as an exchange which does not “set rules governing the conduct of subscribers other than the conduct of such subscribers’ trading on such organization” or “discipline subscribers other than by exclusion from trading.”[48]/ Stripping an exchange of its self-regulatory obligations makes it equivalent to an ATS. Therefore, the competitive position of each trading system in the market will solely depend upon its products and services, not its regulatory status.

Broader – if Not Deeper – Knowledge of Regulated Entities. By overseeing all market participants – traditional broker-dealers and trading systems alike – the Single SRO would have a comprehensive perspective of the securities industry. The deeper knowledge of the industry, however, may escape the regulator as described below in the disadvantages section.

F. Option 6: Single Regulatory Organization (SEC-Only Model)

The Single SRO has many of the same disadvantages of the Firm SRO, including the risks of bureaucracy. The Single SRO, however, may have additional weaknesses, as described below.

Risk of Being Redundant of SEC. Farther removed from real industry concerns, the Single SRO could become a superfluous layer of regulation that adds little to the oversight provided by the SEC. Although the self-regulatory governance structure of the Single SRO may limit the risk, it can not be completely eliminated as a possible concern.

No Synergy with New Business Systems. Under the current regulatory system and even with the Firm SRO, the technical details of trading regulation remain with the entities actually engaged in the trading activity. By removing the trading regulation to a remote entity, the synergy between the trading systems and the regulation is lost. For example, as exchanges and other market participants innovate, their systems would not be as well designed for easy surveillance because regulators could no longer shape development of the technology. The coordinated and concurrent innovation of the trading systems and their corresponding surveillance programs is forfeited.

Finally, a more drastic suggestion involves abolishing the concept of self-regulation entirely and expanding the duties of the SEC to cover all the regulatory responsibilities currently performed by the SROs, including the direct oversight of the market centers and broker-dealers. The SEC would become the sole rulemaker, examiner and enforcer for the industry. The SROs would be stripped of their self-regulatory responsibilities, thereby becoming mere marketplaces.[49]/ Firms would no longer be subject to the oversight of any SROs, just the SEC. Firms and exchanges would only influence the ultimate regulatory standards through the comment process at the SEC or through Congressional action. A chart representing the SEC-Only Model is located at Option 6 of the appendix.

Avoids Limitations of Self-Regulation. By abolishing self-regulation entirely, any concerns associated with self-regulation are also eliminated. The inherent limitations in allowing an industry to regulate itself are well known:

the natural lack of enthusiasm for regulation on the part of the group to be regulated, the temptation to use a façade of industry regulation as a shield to ward off more meaningful regulation, the tendency for businessmen to use collective action to advance their interests through the imposition of purely anti-competitive restrains as opposed to those justified by regulatory needs, and a resistance to changes in the regulatory pattern because of vested economic interests in its preservation.”[50]/

With oversight limited to the SEC as the sole regulator, these disadvantages of self-regulation would no longer be a concern.

Ends Duplicative and Inconsistent Regulation. Because the SEC would replace the regulatory activities of ten existing SROs, duplicate examinations, multiple and overlapping rules and conflicting interpretations and disciplinary actions would end, along with their associated costs.

Regulatory Expertise. Increasing the already considerable power of the SEC would serve to augment its status in the U.S. and the global securities industry. Furthermore, the more powerful and potentially more prestigious SEC could attract and keep talented staff, rather than competing with other regulators for that expertise.