Commentary

Putting The “Market” In Stock Regulation

By Dale Oesterle
This essay was originally distributed by BridgeNews.
Why should Americans be concerned about something as seemingly esoteric as government regulation of securities markets? Because half of Americans now own stocks, and in the future even more will invest in securities to meet retirement and other financial needs.

The recent arrests of 180 people for Mafia-related stock scams suggests that investors large and small should pay attention to the Securities and Exchange Commission’s current efforts to revamp regulations meant to protect against fraud and allow securities exchanges to operate efficiently.

Unfortunately, the SEC is moving toward more government management when, in fact, markets can best guarantee both the safety and profitability of exchanges.

Since 1934, America’s securities exchanges have been required by Washington to operate as self-regulatory organizations (SROs) that police themselves under SEC supervision.

But as periodic stock scandals suggest, the SEC does both too little and too much. During quiet times the SEC relies largely on SROs to police trading floors. Customers are lulled into a false sense of security, believing the SEC is closely policing the day-to-day exchange activities.

The illusion the SEC is guaranteeing the integrity of exchanges removes an incentive for the exchanges themselves to exercise diligence, lest they lose their customers.

Then, when a scandal does occur, the SEC moves in to micromanage exchange rules, which often place costly burdens on exchanges without increasing safety.

Worse still, established exchanges have used their SRO mechanisms to stifle competition. Exchanges like the New York Stock Exchange and Nasdaq Composite are not like farmers’ markets that allow anyone to enter and trade whatever they want.

They are more like private country clubs, with a closed membership. Members make money by trading with other members for their clients. Yet members can also legally make profits by operating outside of the exchanges, which poses a competitive threat to the exchanges themselves.

The problem is that exchanges can use the threat of the discipline of SROs to deter such activities. After all, no member’s books are perfect, and a fishing expedition or disciplinary inquiry is always costly and potentially embarrassing.

The NYSE argues SRO rules consolidating the flow of stock orders are necessary to prevent the “fragmentation” of trading markets. It also argues for rules that protect the position of its members as intermediaries in large trades to give clients supposed “price improvements.” But such rules would restrain competitors.

Two developments suggest that the old system has outlived any usefulness it might have had. First, in recent years electronic trading systems, usually known as electronic communications networks, have been taking business from the Nasdaq and threaten the NYSE’s pre-eminence.

These networks now handle close to 30 percent of the orders in securities listed on the Nasdaq and almost 8 percent of the orders in all exchange-listed securities.

The SEC is requiring electronic trading systems to create their own self-regulating organizations or become subject to Nasdaq’s SRO. Neither option makes sense.

Electronic communication networks that automatically match trades by means of specialized computer software do not face the same regulatory challenges as do stock exchanges with physical trading floors. And submitting networks to a competitor’s regulatory body presents an obvious conflict of interest that will require excessive SEC oversight.

Second, competition is pressuring Nasdaq and NYSE officials to propose their exchanges change from private, member-operated associations to public, for- profit companies that sell stock to the public and thus would be owned and controlled by shareholders.

These sound initiatives are being resisted by exchange members. Shareholders would place the interests of the exchanges ahead of its members and would likely insist on adopting an efficient electronic exchange. At the same time, a for- profit NYSE and Nasdaq would be fundamentally inconsistent with self-regulation through an SRO.

Unfortunately, reforms being considered by the SEC would reduce competition. One plan would force all exchanges into an Intermarket Trading System with a single set of rules that would force the electronic communications networks to abandon services their subscribers find attractive.

What system should replace the current SROs? In order to maintain favorable reputations and attract business, America’s exchanges used to maintain internal disciplinary procedures, such as sanctioning members for misbehavior and banning trade in the stock of fraudulent companies.

Without SROs, exchanges would have a strong self-interest in monitoring the integrity of their traders, and would compete with one another to offer the most efficient, honest trading system.

The SRO regime should be abandoned, not “reformed.” The SEC’s role should be limited to ensuring that the exchanges do what they say they will do in their public releases. In short, the SEC should protect against exchange and trader fraud.

Dale Oesterle is a professor of commercial law at the University of Colorado law school, is the author of a new Cato Institute policy analysis, “Securities Markets Regulation: Time to Move to a Market-Based Approach.”