[Federal Register: December 8, 2004 (Volume 69, Number 235)]
[Proposed Rules]
[Page 71255-71282]
From the Federal Register Online via GPO Access [wais.access.gpo.gov]
[DOCID:fr08de04-34]
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Part III
Securities and Exchange Commission
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17 CFR Part 240
Concept Release Concerning Self-Regulation; Proposed Rule
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SECURITIES AND EXCHANGE COMMISSION
17 CFR Part 240
[Release No. 34-50700; File No. S7-40-04]
RIN 3235-AJ36
Concept Release Concerning Self-Regulation
AGENCY: Securities and Exchange Commission.
ACTION: Concept release; request for comment.
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SUMMARY: The Securities and Exchange Commission (``Commission'' or
``SEC'') is publishing this concept release and seeking public comment
on a range of issues related to the self-regulatory system of the
securities industry. This release discusses the foundations of the
self-regulatory system and new considerations that the Commission and
the industry are facing. In addition, this release describes certain
enhancements that could be made to the current system that could
improve its operation and also discusses a variety of other potential
approaches to securities industry regulation.
DATES: Comments should be submitted on or before March 8, 2005.
ADDRESSES: Comments may be submitted by any of the following methods:
Electronic Comments
Use the Commission's Internet comment form (http://www.sec.gov/rules/concept.shtml.
); or Send an e-mail to rule-comments@sec.gov. Please include
File Number S7-40-04 on the subject line; or
Use the Federal eRulemaking Portal (http://www.regulations.gov
). Follow the instructions for submitting comments.
Paper Comments
Send paper comments in triplicate to Jonathan G. Katz,
Secretary, Securities and Exchange Commission, 450 Fifth Street, NW.,
Washington, DC 20549-0609.
All submissions should refer to File Number S7-40-04. This file
number should be included on the subject line if e-mail is used. To
help us process and review your comments more efficiently, please use
only one method. The Commission will post all comments on the
Commission's Internet Web site (http://www.sec.gov/rules/concept.shtml
). Comments are also available for public inspection and
copying in the Commission's Public Reference Room, 450 Fifth Street,
NW., Washington, DC 20549. All comments received will be posted without
change; we do not edit personal identifying information from
submissions. You should submit only information that you wish to make
available publicly.
FOR FURTHER INFORMATION CONTACT: Christopher B. Stone, Senior Special
Counsel to the Director, at (202) 942-7938 who is in the Division of
Market Regulation, Securities and Exchange Commission, 450 Fifth Street
NW., Washington DC 20549-1001.
SUPPLEMENTARY INFORMATION:
Table of Contents
I. Introduction
II. Foundations of Self-Regulation
III. New Considerations
IV. Current SRO System Attributes
A. Inherent Conflicts With Members, Market Operations, Issuers,
and Shareholders
1. Inherent Conflicts with Members
2. Inherent Conflicts with Market Operations
3. Inherent Conflicts with Issuers
4. Inherent Conflicts with Shareholders
B. Inefficiencies of Multiple SROs
C. Intermarket Surveillance
D. Funding
1. Overview
2. SRO Funding Sources
a. Regulatory Fees
b. Transaction Fees
c. Listing Fees
d. Market Data Fees
e. Miscellaneous Fees
V. Alternative Regulatory Approaches
A. Proposed Enhancements to the Current SRO System
1. SRO Governance and Transparency Rulemaking
2. Intermarket Surveillance Enhancements
B. Independent Regulatory and Market Corporate Subsidiaries
C. Hybrid Model
D. Competing Hybrid Model
E. Universal Industry Self-Regulator
F. Universal Non-Industry Regulator
G. SEC Regulation
H. Other Models
VI. Solicitation of Additional Comments
I. Introduction
Self-regulation is a key component of U.S. securities industry
regulation. All broker-dealers are required to be members of a self-
regulatory organization (``SRO''), which sets standards, conducts
examinations, and enforces rules regarding its members.\1\ Most, but
not all, SROs also operate and regulate markets or clearing
services.\2\ Inherent in self-regulation is the conflict of interest
that exists when an organization both serves the commercial interests
of and regulates its members or users.
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\1\ 15 U.S.C. 78o15(b)(8).
\2\ Analysis in this release focuses primarily on one registered
national securities association SRO, the National Association of
Securities Dealers (``NASD'') (including its subsidiary, the Nasdaq
Stock Market (``Nasdaq'')), and those registered national securities
exchange SROs that operate equity or options markets, the American
Stock Exchange (``Amex''), the Boston Stock Exchange (``BSE''), the
Chicago Board Options Exchange (``CBOE''), the Chicago Stock
Exchange (``CHX''), the International Securities Exchange (``ISE''),
the National Stock Exchange (``NSX'') the New York Stock Exchange
(``NYSE''), the Pacific Exchange (``PCX''), and the Philadelphia
Stock Exchange (``Phlx''). Unless otherwise specifically noted,
discussion in this release does not necessarily relate to other
registered SROs, including the National Futures Association
(``NFA''), the Municipal Securities Rulemaking Board (``MSRB''), the
registered clearing agencies, and notice registered national
securities exchanges.
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The Securities Exchange Act of 1934 (``Exchange Act''),\3\ the
Maloney Act of 1938 (``Maloney Act''),\4\ and the Exchange Act
Amendments of 1975 (``1975 Amendments''),\5\ reflect Congress'
determination to rely on self-regulation as a fundamental component of
U.S. market and broker-dealer regulation, despite this inherent
conflict of interest. Congress favored self-regulation for a variety of
reasons. A key reason was that the cost of effectively regulating the
inner-workings of the securities industry at the federal level was
viewed as cost prohibitive and inefficient.\6\ In addition, the
complexity of securities trading practices made it desirable for SRO
regulatory staff to be intimately involved with SRO rulemaking and
enforcement.\7\ Moreover, the SROs could set standards that exceeded
those imposed by the Commission, such as just and equitable principles
of trade and detailed proscriptive business conduct standards.\8\ In
short, Congress determined that the securities industry self-regulatory
system would provide a workable balance between federal and industry
regulation.\9\
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\3\ 15 U.S.C. 78a et seq.
\4\ Pub. L. 75-719, 52 Stat. 1070 (1938) (codified as amended at
15 U.S.C. 78o, authorizing the U.S. Securities and Exchange
Commission to register national securities associations).
\5\ Pub. L. 29, 89 Stat. 97 (1975).
\6\ See generally S. Rep. No. 1455, 73d Cong., 2d Sess. (1934);
H.R. Doc. No. 1383, 73d Cong., 2d Sess. (1934); S. Rep. No. 1455,
73d Cong., 2d Sess. (1934).
\7\ Id.
\8\ Id.
\9\ Id.
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Since the self-regulatory system was incorporated into the federal
securities laws, the Commission has reexamined it periodically.\10\
While steps have been
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taken over time to redress perceived shortcomings, the SRO structure
has been repeatedly reaffirmed both by Congress and the Commission.\11\
In recent years, changes in the markets and in the ownership structure
of SROs have generated questions about the fairness and efficiency of
the current SRO structure.\12\ The increased dispersion of order flow
across multiple markets has produced questions of comparable regulation
by SROs and the effectiveness of cross-market supervision.\13\ The
increased competition among markets for listings and trading volume has
applied pressure on SRO regulatory efforts and sources of funding.\14\
Moreover, the advent of for-profit, shareholder-owned SROs has
introduced potential new conflicts of interest and issues of regulatory
incentives.\15\ In addition, recent failings or perceived failings with
respect to SROs fulfilling their self-regulatory obligations have
sparked public debate as to the efficacy of the SRO system in
general.\16\
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\10\ See e.g., 1961-1963 Special Study of Securities Markets.
Securities and Exchange Commission, Report of Special Study of
Securities Markets, (``Special Study''), H.R. Doc. No. 95, 88th
Cong., 1st Sess. (1963) and Market 2000: An Examination of Current
Equity Market Developments, Division of Market Regulation, U.S.
Securities and Exchange Commission (January 1994) (``Market 2000
Report'').
\11\ See e.g., Id.; infra notes 30-31.
\12\ See generally infra Section IV.
\13\ Id.
\14\ Id.
\15\ Id.
\16\ Id.
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For these reasons, the Commission is publishing this release to
discuss and solicit comments on the role and operation of SROs in
today's markets. This 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, its market operations, its 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.
Finally, this release examines and seeks comment on certain
enhancements to the current system and a number of regulatory
approaches or legislative initiatives that could be considered by the
Commission to address concerns with the current SRO model.
II. Foundations of Self-Regulation
Securities industry self-regulation has a long tradition in the
U.S. securities markets. In its earliest years, the nascent U.S.
securities industry was subject loosely to state laws and, in 1792, the
New York broker community negotiated the historic Buttonwood Agreement
to form the first organized stock market in New York.\17\ As the NYSE
and other stock exchanges developed, trading conventions became
formalized as exchange rules. In 1817, the NYSE's Constitution was
adopted and the NYSE subsequently adopted a range of rules governing
its members and listed companies, including member financial
responsibility rules and listed company registration and financial
reporting rules.\18\ In 1820, a detailed set of NYSE By-Laws was
adopted.\19\
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\17\ Robert Sobel, The Big Board, A History of the New York
Stock Market 14-27 (The Free Press 1965). The agreement generally
bound its signors to give preference to each other when buying and
selling. Id.
\18\ Id. at 30-31.
\19\ Id. at 38-40.
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Federal regulation of exchanges, and their formal recognition as
self-regulatory organizations, followed a number of significant events,
including the stock market crash of 1929 and the evidence of NYSE
investigatory failures related to market manipulation highlighted at
the 1934 Pecora Hearings.\20\ In Section 6 of the Exchange Act,
Congress recognized the regulatory role of exchanges, and required all
existing securities exchanges, including the NYSE, to register with the
Commission and to function as self-regulatory organizations.\21\
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\20\ Joel Seligman, The Transformation of Wall Street: A History
of the Securities and Exchange Commission and Modern Corporate
Finance at 1-38 (Aspen Pub. N.Y. 3rd ed. 2003).
\21\ Exchange Act Section 6, 15 U.S.C. 78f.
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The stock market crash of 1929 also severely damaged the public
reputation of over-the-counter (``OTC'') securities dealers. In 1933,
in an effort to improve their collective image, OTC dealers formed the
Investment Bankers Code Committee (``IBCC''), which promulgated
industry best practices.\22\ In 1936, the IBCC was succeeded, by the
Investment Bankers Conference (``IBC''), a prominent group of
investment banks formed to act as a national, voluntary industry
organization.\23\
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\22\ Seligman at 183-85.
\23\ The IBC, however, proved to be imperfect, because only
seventeen hundred of the nation's six thousand securities dealers
ultimately joined. While the Commission realized that this voluntary
organization was not effectively regulating the OTC market, it also
determined that direct Commission regulation of the OTC market was
not practicable. See Seligman at 183-85. While not speaking for the
whole Commission, one early Commissioner compared the prospect of
regulating the OTC market to building a structure out of sand
because ``there is no cohesive force to hold it together, no
organization with which [the Commission] could build, as
authoritatively representing a substantial element in the over-the-
counter business.'' Id.
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After experience with the IBCC and the IBC, the Commission and
leaders of the investment banking community generally agreed that an
industry association needed official legal status in order to
effectively carry out the task of self-regulating the OTC market.\24\
Ultimately, in 1938, the Maloney Act amended the Exchange Act by adding
a new Section 15A and establishing the concept of registered national
securities association SROs.\25\ To date, the NASD and the NFA \26\ are
the only registered national securities associations.
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\24\ Id.
\25\ Exchange Act Section 15A, 15 U.S.C. 78o-3.
\26\ NFA is a national securities association registered for the
limited purpose of regulating the activities of members who are
registered as brokers or dealers in security futures products under
Section 15(b)(11) of the Exchange Act, 15 U.S.C. 78o(b)(11).
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In enacting these provisions, Congress concluded that self-
regulation of both the exchange markets and the OTC market was a
mutually beneficial balance between government and securities industry
interests.\27\ Through establishment of self-regulation, the securities
industry was supervised by an organization familiar with the nuances of
securities industry operations. In addition, industry participants
preferred the less invasive regulation by their peers to direct
government regulation and the government benefited by being able to
leverage its resources through its oversight of self-regulatory
organizations.\28\ Moreover, the SROs had the ability to set
proscriptive standards relating to just and equitable principles of
trade and detailed business conduct standards.\29\ In enacting the
Maloney Act in 1938, Congress stated that an approach to securities
regulation relying solely on government regulation ``would involve a
pronounced expansion of the organization of the Securities and Exchange
Commission; the multiplication of branch offices; a large increase in
the expenditure of public funds; an increase in the problem of avoiding
the evils of bureaucracy; and a minute, detailed, and rigid regulation
of business conduct by law.'' \30\
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\27\ See supra notes 6-9.
\28\ Id.
\29\ Market 2000 Report at VI-6.
\30\ S. Rep. No. 1455, 75th Cong., 3d Sess. I.B.4. (1938); H.R.
Rep. No. 2307, 75th Cong., 3d Sess. I.B.4. (1938) (duplicate text
quoted in both reports).
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The legislative history of the 1975 Amendments noted that, rather
than adopt this purely governmental approach, Congress determined that
it was ``distinctly preferable'' to rely on ``cooperative regulation,
in which the task will be largely performed by representative
organizations of investment bankers, dealers, and brokers, with the
Government exercising appropriate supervision in the public interest,
and exercising supplementary
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powers of direct regulation.'' \31\ Similarly, in 1975, Congress stated
that a principal reason for retaining a self-regulatory regime was the
``sheer ineffectiveness of attempting to assure [regulation] directly
through the government on a wide scale,'' and that, although the SROs
had not always performed their role up to expectations, self-regulation
generally was considered to have worked well and ``should be preserved
and strengthened.'' \32\
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\31\ S. Rep. No. 94-75, 94th Cong., 1st Sess. 7, II (1975).
\32\ Id.
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The Commission has periodically examined the self-regulatory system
and the extent to which SROs have successfully fulfilled their
statutory obligations.\33\ Such analysis has sometimes resulted in SROs
making changes to their structures or regulatory programs. For example,
after problems surfaced regarding the floor operations of Amex
specialists, the Commission sponsored the sweeping 1961-1963 Special
Study.\34\ The Special Study concluded that SROs have a natural
tendency to protect member firms and that SRO regulatory operations
appear to falter without the ``pointed stimuli'' of vigilant Commission
oversight.\35\ Among other conclusions, the Special Study found a need
for a reduction in the amount of control that exchange floor members
exercised over exchange regulatory operations and governance.\36\
Moreover, the study called for a general strengthening of SRO
governance.\37\
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\33\ See e.g., supra note 10. In addition, the Commission speaks
implicitly and explicitly to self-regulatory concepts in virtually
every SRO rule that is noticed for public comment and approved
through the Commission Rule 19b-4 rule filing process. SEC Rule 19b-
4, 17 CFR 240.19b-4.
\34\ Specialist domination of the Amex resulted in a series of
scandals in the late 1950s involving market manipulations. In 1961,
the Commission launched an investigation into the trading practices
of two Amex specialists in particular. This investigation was
ultimately broadened into the Special Study. See Seligman at 281-86.
\35\ See generally Seligman at 299-348.
\36\ Id.
\37\ Id. Congress recognized that self-regulators may not always
be as diligent as desired, and, indeed, may use self-regulation as a
device to avoid regulation altogether. Nonetheless, Congress also
was of the view that members of the securities industry could bring
down to bear on the problems of regulation a degree of expertise
and, in many circumstances, expedition not expected of a necessarily
more remote governmental agency. Special Study at 693-697.
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Another example of past analysis was the Commission's Division of
Market Regulation review of the structure and costs of the SRO system
in the Market 2000 Report, which was published by the Commission in
1994. The Market 2000 Report noted the impact that increasing
intermarket competition and duplicative SRO rules were having on the
self-regulatory system.\38\ In addition, the report discussed the
extent to which costs to support the SRO system were being fairly
allocated across the markets.\39\ The report also examined the
desirability of reallocating the regulatory and market functions of
SROs and the possibility of the Commission assuming a greater role with
respect to the functions carried out by the SROs.\40\ While the opinion
advanced in the Market 2000 Report was that such changes were unlikely
to improve the existing SRO system, it did not foreclose the
possibility of reconsidering this position in the future in light of
changed circumstances.\41\
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\38\ See Market 2000 Report at III-1.
\39\ Id. at III-3.
\40\ Id. at III-5-7.
\41\ Id. at III-10. See also infra Section IV.
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Another example of past Commission analysis on this issue was in
1996 when the Commission instituted administrative proceedings against
the NASD with respect to OTC market maker pricing collusion.\42\ At the
same time, the Commission issued the 21(a) Report regarding the NASD
and Nasdaq. In the 21(a) Report, issued pursuant to Section 21(a) of
the Exchange Act, the Commission discussed at length a range of issues
concerning the efficacy of the self-regulatory system and the potential
problems associated with inherent SRO conflicts.\43\ Of particular
concern, in this case, was the lack of independence of the NASD
regulatory staff from Nasdaq's market operations.\44\
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\42\ See In the Matter of National Association of Securities
Dealers, Inc.; SEC Release No. 34-37538, August 8, 1996;
Administrative Proceeding File No. 3-9056 (``21(a) Administrative
Order''). See also Report and Appendix to Report Pursuant to Section
21(a) of the Securities Exchange Act of 1934 Regarding the NASD and
The Nasdaq Stock Market (August 8, 1996) and Securities Exchange Act
Release No. 37538 (August 8, 1996) (``21(a) Report''). The
undertakings were included in the SEC Order (``21(a) Report
Undertakings'').
\43\ See 21(a) Administrative Order Section III; 21(a) Report at
40-47.
\44\ See 21(a) Administrative Order Section III; 21(a) Report at
52-54.
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In sum, while Congress and the Commission have criticized and
modified the SRO system in the past, it has not been radically revised
or dismantled since its establishment. Rather, it is generally
considered that the SRO system has functioned effectively and has
served government, industry, and investors well.\45\ Notwithstanding
this positive record, because of new considerations in our markets, the
Commission believes it is an appropriate time to reexamine and solicit
public comment on the efficacy of the system overall.
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\45\ See e.g., supra note 10.
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III. New Considerations
In recent years, the U.S. markets have experienced increasingly
vigorous competition. The effect of this development is that markets
operated by SROs have faced increased competition from foreign trading
markets and from electronic communications networks (``ECNs'') that
have shifted significant amounts of market share away from the primary
markets, especially with respect to Nasdaq securities. For example, the
NYSE and Amex historically dominated trading in their listed
securities, and market makers dominated trading in Nasdaq stocks.
Today, however, in the Nasdaq market, automated market centers (such as
Nasdaq's order collector, aggregator, and execution system,
SuperMontage, the Archipelago exchange (``ArcaEx''), and the INET ECN)
have captured more than 50% of share volume.\46\ For Amex-listed stocks
(for which approximately 39% of share volume now is represented by two
extremely active exchange-traded funds (``ETFs'')--the QQQ and SPDR),
Amex now handles approximately 21% of the volume, with the remaining
balance split among Arca-Ex, INET, and others.\47\ The NYSE has managed
to retain approximately 80% of the volume in its listed stocks, but
other market centers are raising the level of competition and reducing
the NYSE's share of trading.\48\ Moreover, the NYSE and Amex have
sought to add automated facilities that are integrated with and
complement their traditional exchange floors.\49\ In the listed options
markets, the proliferation of multiple trading of options and the entry
of two new electronic exchanges has raised the tempo of competition
among these markets and redistributed their market share.\50\
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\46\ The figure is based on Nasdaq/UTP Plan market data (as of
September 2004).
\47\ The figure is based on Network B, CTS Activity market data
(as of September 2004).
\48\ The figure is based on Network A, CTS Activity market data
(as of September 2004). See also e.g., Ivy Schmerken, Will the
NYSE's Specialist Probe Open the Listed Market to ECNs?, Wall Street
+ Technology, July 1, 2003, at 18; Robert Sales, The Big Picture--
ECN Evolution, Wall Street + Technology, February 1, 2003, at 6.
\49\ See Securities Exchange Act Release Nos. 50173 (August 10,
2004), 69 FR 50407 (August 16, 2004) (notice of proposed rule change
proposing improvements to NYSE's existing automatic execution
facility, NYSE Direct+[reg]); and 49921 (June 25, 2004), 69 FR 40690
(July 6, 2004) (approval of proposed rule change by Amex to enhance
its Auto-Ex technology for exchange-traded funds and Nasdaq stocks
traded on the exchange).
\50\ In August 1999, 32% of equity options were traded on more
than one exchange. By September 2000, that number had risen to 45%.
Over the same period, the percentage of aggregate option volume
traded on only one exchange fell from 60% to 15%. See Exchange Act
Release No. 43085 (July 28, 2000), 65 FR 47918 (August 4, 2000)
(proposing to extend Exchange Act Rule 11Ac1-1 to options).
According to the Options Clearing Corporation, by September 2003,
98.3% of equity options classes traded on more than one exchange. As
of December 2003, the market shares held by options exchanges were
31.3% by the CBOE, 27.0% by the ISE, 19.8% by the Amex, 12.4% by the
Phlx, and 9.5% by the PCX. Options Clearing Corporation, 2003 Annual
Report 1 (2004). By June of 2004, the ISE's market share was 33.6%,
the CBOE's was 26.0%, the Amex's was 18.6%, the Phlx's was 11.6%,
the PCX's was 8.4% , and the BSE Boston Options Exchange (``BOX'')
facility's was 1.8%. Will Acworth, Electronic Trading Sweeps Options
Industry, Futures Industry Magazine, September/October 2004 (citing
Futures Industry Association statistics).
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This heightened competition has benefited trading markets by
spurring innovation in trading systems and responsiveness to
customers.\51\ It has also driven down costs, including fees charged by
the trading markets.\52\ At the same time, this competition places
greater strains on the self-regulatory system.\53\ Some industry
observers have posited that trading previously covered by one market's
rules may move to another market in search of lower regulatory
standards.\54\ Others have argued that trading across markets may be
subject to inconsistent rules across several markets.\55\ Some have
voiced concerns about falling market share inducing SROs to reduce the
rigor of their member and market supervision programs.\56\ Also,
concerns have been raised about SROs favoring key participants in their
markets to encourage those key participants to remain active in their
markets or to attract other users.\57\ Shifts in market share can
undermine revenues supporting an SRO's regulatory functions, without
reducing the SRO's responsibility for supervision of its members
trading across markets.\58\ Shifts in trading to multiple markets also
increase concerns about potential gaps in the surveillance of
intermarket trading.\59\
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\51\ See generally infra Section IV.
\52\ Id.
\53\ Id.
\54\ Id.
\55\ Id.
\56\ Id.
\57\ Id.
\58\ Id.
\59\ Id.
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Other considerations also may alter the delicate balance of the SRO
system. The conversion of some SROs to publicly traded, for profit
status may increase the actual or perceived conflicts inherent in the
SRO model.\60\ Likewise, numerous recent SRO failings related to
governance, member oversight and trading supervision raise significant
concerns about the efficacy of the self-regulatory model.\61\ Finally,
in response to the recently proposed Regulation NMS (``Reg NMS''),\62\
commenters raised serious questions about the level of market data
fees, which are an important component of SRO revenues and the funding
of self-regulation.\63\ The Commission believes that it is an
appropriate time to issue a concept release to examine and solicit
public comment on the extent to which recent developments in our
markets warrant changes to the current system.
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\60\ Id.
\61\ See In the Matter of Chicago Stock Exchange, Securities
Exchange Act Release No. 48566 (September 30, 2003). See also In the
Matter of Bear Wagner Specialists LLC, Securities Exchange Act
Release No. 49498 (March 30, 2004); In the Matter of Fleet
Specialist, Inc., Securities Exchange Act Release No. 49499 (March
30, 2004); In the Matter of LaBranche & Co. LLC, Securities Exchange
Act Release No. 49500 (March 30, 2004); In the Matter of Spear,
Leeds & Kellogg Specialists LLC, Securities Exchange Act Release No.
49501 (March 30, 2004); In the Matter of Van der Moolen Specialists
USA, LLC, Securities Exchange Act Release No. 49502 (March 30,
2004). See In the Matter of SIG Specialists, Inc., Securities
Exchange Act Release No. 50076 (July 26, 2004) and In the Matter of
Performance Specialist Group LLC, Securities Exchange Act Release
No. 50075 (July 26, 2004). See also Securities Exchange Act Release
No. 48946 (December 17, 2003), 68 FR 74678 (December 24, 2003)
(approving NYSE proposal to restructure NYSE corporate governance
structure).
\62\ See Exchange Act Release No. 49325 (February 26, 2004), 69
FR 11126 (March 9, 2004) (noticing proposed rulemaking for comment);
Exchange Act Release No. 49749 (May 20, 2003), 69 FR 30142 (May 26,
2004) (extending comment period and seeking additional comments).
\63\ See infra Section IV.
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IV. Current SRO System Attributes
This discussion focuses on the following distinctive attributes of
the existing SRO system and explores how recent market changes have
impacted them: (1) The inherent conflicts of interest between SRO
regulatory operations and members, market operations, issuers, and
shareholders; (2) the costs and inefficiencies of multiple SROs,
arising from multiple SRO rulebooks, inspection regimes, and staff; (3)
the challenges of surveillance of cross market trading by multiple
SROs; and (4) the funding SROs have available for regulatory operations
and the manner in which SROs allocate revenue to regulatory operations.
A. Inherent Conflicts With Members, Market Operations, Issuers, and
Shareholders
Among the most controversial features of the existing SRO system is
the inherent conflict that exists within every SRO between its
regulatory functions and its members, market operations, listed
issuers, and shareholders. The following discussion considers these
conflicts.
1. Inherent Conflicts With Members
The SROs are responsible for promulgating and enforcing rules that
govern all aspects of their members' securities business, including
their financial condition, operational capabilities, sales practices,
and the qualifications of their personnel.\64\ In fulfilling these
functions, the SROs conduct examinations on the premises of their
members, monitor financial and other operational reports, investigate
potential violations of rules, and bring disciplinary proceedings when
appropriate. In addition, SROs must surveil trading on any markets they
operate to detect rule violations and other improper practices, such as
insider trading and market manipulation. Unchecked conflicts in the
dual role of regulating and serving can result in poorly targeted SRO
rulemaking, less extensive SRO rulemaking, and under zealous
enforcement of SRO rules against members. It is also important to note
that, even where an SRO structure may appear sound, successful self-
regulation relies on sufficiently vigorous rule enforcement against
members on the part of the SRO. If regulatory staff is disinclined to
regulate members, self-regulation will fail. Thus, to be effective, an
SRO must be structured in such a way that regulatory staff is
unencumbered by inappropriate business pressure.
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\64\ See e.g., Exchange Act Sections 6(b) and 15A(b), 15 U.S.C.
78f(b) and 78o-3(b).
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Pressures that inhibit effective regulation and discourage vigorous
enforcement against members can arise for a variety of reasons,
including member domination of SRO funding, member control of SRO
governance, and member influence over regulatory and enforcement staff.
In addition, the economic importance of certain SRO members may create
particularly acute conflicts, especially in light of the consolidation
of some of the largest securities firms. For example, the number of
NYSE specialist firms, which are central to the NYSE's auction trading
model, has dropped from 27 in 1999 to 7 in 2002.\65\ One NYSE
specialist firm in 2003 accounted for over 28% of total NYSE trading
volume.\66\ The number of specialist firms at the CHX has dropped from
15 in 2002 to 8 in 2004.\67\ Approximately 47% and 29% of the NSX's
total
[[Page 71260]]
transaction charges were derived from one member for the years 2003 and
2002, respectively.\68\ In addition, this single NSX member was
responsible for generating 93% and 10% of Tape B market data revenues
for the years 2003 and 2002, respectively.\69\ This single NSX member
was also responsible for generating 100% of NSX's Tape C market data
revenues in both 2003 and 2002.\70\ In the options market, there are
just over 40 specialists and market makers on the nation's options
exchanges, whereas just three years ago there were over 70.\71\
---------------------------------------------------------------------------
\65\ LaBranche & Co. Inc., 2002 Annual Report 6 (2002).
\66\ LaBranche & Co. Inc., 2002 Annual Report 14 (2003).
\67\ Peter Chapman, Windy City Loses Another Specialist, Traders
Magazine, July 1, 2004.
\68\ NSX, 2003 Annual Report Exhibit I-12 (2004).
\69\ Id.
\70\ Id.
\71\ Eric Noll, Shifting Models of Option Market Participants,
Futures Industry Magazine, September/October 2004.
---------------------------------------------------------------------------
Thus, the current situation appears to be one in which a declining
number of member firms are increasingly important to the business
interests of their regulator SROs. The anecdotal evidence cited above
could indicate that SROs have become more dependent on large members
for their funding, potentially enabling those members to wield
significant influence with respect to their regulator SROs. This
creates the potential for failures by SROs to enforce rules against
these members, especially when compared to enforcement against other
smaller or less economically influential members, and SRO failures to
develop rules that would disrupt the business practices of important
members.
The PCX's proposal in 2001 to enter into an arrangement in which
ArcaEx would become the PCX's equity trading facility presented a
particularly complicated situation in which an SRO would be affiliated
with a member. \72\ In the ArcaEx Approval Order, the Commission
examined a variety of issues related to self-regulation, including the
regulatory responsibilities of the PCX under the new structure and the
potential for inherent conflicts to be exacerbated when an SRO is
affiliated with a member. In addition, the Commission imposed certain
requirements with respect to PCX and ArcaEx that were designed to
ensure that the various functions of the affiliated broker-dealer were
properly regulated.\73\
---------------------------------------------------------------------------
\72\ See Exchange Act Release No. 44983 (October 25, 2001), 66
FR 55225, 55229-30 (November 1, 2001) (approving SR-PCX-00-25)
(``ArcaEx Approval Order''). ArcaEx is operated by Archipelago
Exchange LLC. At the time of this approval, PCX's ownership interest
in Arca LLC consisted solely of a 10% interest in Archipelago
Holdings LLC, the parent company of Arca LLC. See 66 FR at 55225.
\73\ Id.
---------------------------------------------------------------------------
In the ArcaEx Approval Order, the Commission discussed the PCX's
proposal that Wave Securities LLC (``Wave''), a wholly owned subsidiary
of ArcaEx, would be a registered broker-dealer and a member of both the
PCX and the NASD. Wave would have two primary functions with respect to
ArcaEx. Specifically, Wave would act as an introducing broker for
customers that were not PCX members and would provide sponsored access
to ArcaEx. Wave would also provide an optional routing service for
ArcaEx, and, as necessary, would route orders to other market centers
from ArcaEx.\74\
---------------------------------------------------------------------------
\74\ Id.
---------------------------------------------------------------------------
Under Section 6(b)(5) of the Exchange Act, the rules of a national
securities exchange must not be designed to permit unfair
discrimination between customers, issuers, brokers, or dealers.\75\ The
Commission noted in the ArcaEx Approval Order that the potential for
unfair discrimination may be heightened if a national securities
exchange or its affiliate owns or operates a broker-dealer. This is
because, the Commission stated, the financial interests of the exchange
may conflict with its responsibilities as an SRO regarding the
affiliated broker-dealer. Moreover, the Commission described the
conflict of interest that may arise if a national securities exchange
(or an affiliate) provides advantages to its broker-dealer that are not
available to other members, or provides a feature to all members that
was designed to give its broker-dealer a special advantage. These
advantages, such as greater access to information, improved speed of
execution, or enhanced operational capabilities in dealing with the
exchange, might constitute unfair discrimination under the Exchange
Act, the Commission concluded. Thus, the Commission required that the
PCX not serve as the self-regulatory organization primarily responsible
for examining the Wave broker dealer.\76\
---------------------------------------------------------------------------
\75\ See Section 6(b)(5) of the Act, 15 U.S.C. 78f(b)(5).
\76\ See ArcaEx Approval Order at 55233.
---------------------------------------------------------------------------
The Commission ultimately determined that, although Wave's routing
services would be optional, Wave's order-routing function occupied a
special position with respect to ArcaEx. In the Commission's view, Wave
was uniquely linked to and endorsed by ArcaEx to provide its outbound
routing functionality. Therefore, the Commission concluded that the PCX
application of the Wave order-routing function fell within the
definition of a facility under Section 3(a)(2) of the Exchange Act \77\
and, as such, would be subject to the Commission's continuing
oversight. In particular, under the Exchange Act, the PCX would be
required to file rule changes and fees relating to the Wave order-
routing function, and Wave would be subject to exchange non-
discrimination requirements. Thus, the Commission imposed these
requirements to address the potential misuse of advantages that might
arise from an SRO member carrying out an order-routing function on
behalf of an SRO.\78\
---------------------------------------------------------------------------
\77\ The term ``facility'' when used with respect to an exchange
includes its premises, tangible or intangible property whether on
the premises or not, any right to use of such premises or property
or any service thereof for the purpose of effecting or reporting a
transaction on the exchange (including, among other things, any
system of communication to or from the exchange, by ticket or
otherwise maintained by or with the consent of the exchange), and
any right of the exchange to the use of any property or service.
(Emphasis added.) Exchange Act Section 3(a)(2), 15 U.S.C. 78c(a)(2).
\78\ See ArcaEx Approval Order at 55233-55234.
---------------------------------------------------------------------------
In the past, members also have historically controlled the boards
and the key committees of SROs. For example, in the 21(a) Report
concerning the NASD, the Commission discussed the extent to which large
members had made up a majority or substantial proportion of the NASD's
Board of Governors.\79\ Moreover, the Commission discussed the
extensive influence wielded by market maker members over the SRO's
disciplinary process due to their strong representation on the NASD's
District Business Conduct Committees (``DBCCs''), which served a
``grand jury'' function with respect to the initiation of disciplinary
proceedings.\80\ Ultimately, the Commission's settlement with the NASD
resulted in significant corporate structure changes designed to prevent
these conflicts from occurring in the future.\81\
---------------------------------------------------------------------------
\79\ See 21(a) Report at 41.
\80\ See 21(a) Report at 40-44.
\81\ See supra note 42. See also infra Section V.B.
---------------------------------------------------------------------------
Recently, the NYSE changed its governance structure to reduce
conflicts of interest with respect to members.\82\ Specifically, the
NYSE created a wholly independent board and regulatory staff that
report to an independent board committee.\83\ In addition, amendments
to the NYSE's charter mandated increased transparency of the NYSE's
operations and corporate governance.\84\ The governance changes
included the
[[Page 71261]]
establishment of a fully independent board of directors composed of 6
to 12 fully independent directors, the NYSE Chief Executive Officer
(``CEO''), and the NYSE Chairman.\85\ The concept of ``independence''
under the NYSE rules was redefined with respect to directors to exclude
essentially all persons with any relationship or association to the
exchange, an exchange member, or an exchange listed issuer.\86\ A fully
independent board committee, the Regulatory Oversight & Regulatory
Budget Committee, was established and tasked with overseeing the NYSE's
regulatory plans, programs, budget and staffing proposals on an annual
basis.\87\
---------------------------------------------------------------------------
\82\ See generally Exchange Act Release Nos. 48764 (November 7,
2003), 68 FR 64380 (November 13, 2003), and 48946 (December 17,
2003), 68 FR 74678 (December 24, 2003) (``NYSE Governance Changes
Approval'').
\83\ Id.
\84\ Id.
\85\ Id. at 74679.
\86\ Id.
\87\ Id. at 74681.
---------------------------------------------------------------------------
In an effort to ensure that the NYSE's regulatory function was
sufficiently independent, a new Chief Regulatory Officer position was
created that reports directly to the Regulatory Oversight & Regulatory
Budget Committee \88\ An additional fully independent committee, the
Human Resources & Compensation Committee, was created to set staff
compensation.\89\ Other fully independent committees included the Audit
Committee and the Nominating & Governance Committee, which was designed
to ensure that governance procedures are appropriate and to administer
the board's annual self-review process.\90\
---------------------------------------------------------------------------
\88\ Id. at 74682.
\89\ Id. at 74681.
\90\ Id. at 74680-74681.
---------------------------------------------------------------------------
Because the new definition of independent director excluded most
users of the NYSE's services, an advisory Board of Executives was also
created to ensure that NYSE constituents continued to have a meaningful
voice in the affairs of the exchange.\91\ This advisory group was to be
composed of 22 individuals representing key NYSE constituencies and
tasked primarily with advising the board on operational issues.\92\ The
Board of Directors is required to meet on at least a quarterly basis
both with and without the Board of Executives present.\93\ In approving
these amendments, the Commission noted the importance of independence
of regulatory staff from business pressures.\94\
---------------------------------------------------------------------------
\91\ Id. at 74679-74680.
\92\ Id.
\93\ Id. at 74679.
\94\ Id. at 74687.
---------------------------------------------------------------------------
As discussed further below,\95\ another recent concern is the
extent to which the profit motive of a demutualized SRO could detract
from proper self-regulation. In that regard, the Commission recently
approved SRO rule changes that permitted several SROs to convert to
for-profit entities.\96\ To avoid the potential for member shareholders
to wield an in appropriate amount of influence over the regulatory
function of the SROs, limits were imposed on the percentage that could
be controlled by any one member.\97\ SROs have put forth various
reasons for demutualizing, but a common theme is an increased ability
to more quickly respond to competitive pressures.\98\
---------------------------------------------------------------------------
\95\ See infra Section IV.A.4.
\96\ See e.g., Securities Exchange Act Release Nos. 45803 (April
23, 2003), 67 FR 21306 (April 30, 2003) (order approving the
restructuring of the ISE from a limited liability company to a
corporation); 49718 (May 17, 2004), 69 FR 29611 (May 24, 2004)
(order approving the demutualization of the PCX); and 49098 (January
16, 2004), 69 FR 3974 (January 27, 2004) (order approving the
demutualization of the Phlx).
\97\ Id.
\98\ See Securities Exchange Act Release Nos. 49451 (March 19,
2004), 69 FR 16305 (March 29, 2004) (PCX stating that by
``restructuring its business as a stock corporation with business
control and management vested in a Board of Directors, the entity
will have greater flexibility to develop and execute strategies
designed to improve its competitive position than it has under the
current membership-cooperative structure'' and that it anticipates
that ``by restructuring as a stock corporation, PCX management will
be better able to respond quickly to competitive pressures and to
make changes to its operations as market conditions warrant, without
diminishing the integrity of its regulatory programs.'') and 49098,
supra note (Phlx stating that it proposed to effect a
demutualization for a number of reasons, including to ``expand its
sources of capital and revenue; to facilitate its ability to enter
into relationships with strategic for financial partners who may be
crucial for the Exchange's future development, capital formation and
viability; to facilitate the introduction for new products and thus
potentially increase transaction volume and Exchange revenues; and
to better position itself to react to new opportunities and
challenges'').
---------------------------------------------------------------------------
In a companion release, the Commission is proposing SRO governance
and transparency measures (the ``SRO Governance and Transparency
Proposal'') to address a range of concerns, including member ownership
controls for demutualized exchanges.\99\ If adopted, the SRO Governance
and Transparency Proposal, which will be discussed in greater detail
below,\100\ would impose a variety of restrictions on shareholder owned
SROs, including effectively restricting revenue from regulatory
operations being used to pay dividends to shareholders.
---------------------------------------------------------------------------
\99\ See Exchange Act Release No. 34-50699, (November 18, 2004).
\100\ For a more detailed description of the SRO Governance and
Transparency Proposal see infraSection V.A.1.
---------------------------------------------------------------------------
The Commission seeks public comment on the following specific
questions related to conflicts in member regulation:
Question 1: To what extent are the conflicts caused by member
funding of SRO operations a concern? Has consolidation within the
securities industry, and the dependence of SROs on a relatively small
number of firms for the bulk of their funding, or other developments
exacerbated this conflict? If other developments have done so, identify
them. Is it possible to minimize these conflicts through SRO governance
initiatives that are designed to ensure greater independence of the
board and key committees from the regulated members?
Question 2: To what extent are member governance conflicts a
concern? Have the governance changes recently made by the NYSE and
other SROs to enhance their independence been effective in reducing
these conflicts? Are there other governance changes that could be made
by the SROs that would further reduce these conflicts?
Question 3: Can potential conflicts between the regulatory function
and SRO members be effectively managed through the recent enhancements
made to SRO governance and the changes proposed by the SRO Governance
and Transparency Proposal? Are there other measures the Commission
should consider?
2. Inherent Conflicts with Market Operations
In addition to conflicts with members, an SRO's regulatory
obligations may conflict with the interests of its own or its
affiliate's market operations. The SROs that operate markets
(currently, all except the MSRB, the NFA, and the clearing agencies)
are responsible for promulgating rules that govern trading in their
markets; establishing the necessary systems and procedures to monitor
such trading; identifying instances of suspicious trading, such as
potential insider trading and market manipulation; and enforcing the
Exchange Act, the rules thereunder, and their own rules.\101\ If an SRO
identifies potential misconduct involving persons or entities within
its jurisdiction, the SRO is responsible for conducting a further
investigation and bringing a disciplinary action when appropriate. For
potential misconduct outside its jurisdiction, an SRO is responsible
for making referrals to the Commission or other appropriate agencies
and assisting these agencies in their investigations.
---------------------------------------------------------------------------
\101\ See e.g., Exchange Act Sections 6(b) and 15A(b), 15 U.S.C.
78f(b) and 78o-3(b).
---------------------------------------------------------------------------
As competition among markets grows, the markets that SROs operate
will continue to come under increased pressure to attract order flow.
This
[[Page 71262]]
business pressure can create a strong conflict between the SRO
regulatory and market operations functions. Because increasing inter-
market competition has provided members (and those that represent their
orders through members) with increasing flexibility as to where to
direct order flow, SRO staff may be less inclined to enforce vigorously
SRO rules that would cause large liquidity providers to redirect order
flow.
For example, one hedge fund typically may account for between 1%
and 2% of total daily dollar volume traded on the NYSE.\102\ One mutual
fund complex may account for as much as 5% of the NYSE's daily trading
volume.\103\ Approximately half of the 80 million exchange-listed
shares executed per day on the CHX is directed to eight specialist
firms.\104\ Moreover, as of July 2004, the NSX's market share grew to
26.2 percent of the Nasdaq market with the majority of that trading
activity being generated by one member, the INET ECN.\105\ As of May
2004, the Brut ECN's matched shares reported to the BSE represented
8.7% of overall Nasdaq trading volume.\106\
---------------------------------------------------------------------------
\102\ See Citadel Investment Group LLC Web site (https://www.citadelgroup.com/
).
\103\ Charles Forelle, Fidelity Opposes NYSE Proposal Over
Limits on ``Sweeps'' of Trades, The Wall Street Journal, August 17,
2004, at C3.
\104\ Traders Magazine, The Windy City's Auto-Ex Democracy
(March 1, 2004).
\105\ Isabelle Clary, Markets Editor, Securities Industry News,
Brut Buy May Boost Nasdaq, (September 6, 2004).
\106\ Isabelle Clary, Markets Editor, Securities Industry News,
Nasdaq Strikes Back with Brut Deal (May 31, 2004). The Brut ECN has
subsequently shifted the reporting of all of its Tape C trading
activity to Nasdaq. See Nasdaq Head Trader Alert 2004-115,
Nasdaq Completes Acquisition of Brut LLC (September 7, 2004).
---------------------------------------------------------------------------
While regulatory staff is responsible for carrying out self-
regulatory obligations, they are also a component of a competitive
business organization. As intermarket competition increases, regulatory
staff may come under pressure to permit market activity that attracts
order flow to their market. Market operations staff may also be less
likely to cooperate and communicate with regulatory staff if they think
such cooperation or communication will hinder their effort to attract
order flow.
In addition, SROs face conflicts in regulating members that are
influential in the their markets. For example, in the 21(a) Report
concerning the NASD, the Commission found that Nasdaq market makers had
exerted substantial influence over the affairs of the NASD through
their dominant role in its governance, the administration of the NASD's
disciplinary process, and the operation of Nasdaq.\107\ Other less
favored constituencies, such as retail and institutional investors and
other broker-dealers, particularly those day trading firms that heavily
used Nasdaq's Small Order Execution System (``SOES Firms''), did not
have comparable representation on the key NASD boards and
committees.\108\
---------------------------------------------------------------------------
\107\ See 21(a) Report at 40-44.
\108\ Id.
---------------------------------------------------------------------------
The Commission found that market maker influence led to a concerted
effort by the NASD staff to bring disciplinary actions against SOES
firms.\109\ Indeed, the 21(a) Report concluded that the NASD made a
high priority of enforcement related to violations of its SOES rules by
subjecting firms to special ``sweep'' examinations, and devoting
substantial resources to monitoring, examining, and bringing
disciplinary actions for potential violations of the day trading
rules.\110\ In contrast, the Commission found that the NASD was far
less aggressive with respect to its enforcement of rule violations by
market makers.\111\
---------------------------------------------------------------------------
\109\ Id.
\110\ Id.
\111\ For example, complaints related to market makers failing
to abide by the firm quote rule were effectively discouraged both by
an ineffective procedure for enforcing the rule and by the absence
of adequate sanctions for demonstrated misconduct. The Commission
found that the small number of NASD formal disciplinary actions for
market related rule violations brought against joint NYSE/NASD
member firms, which would encompass the larger firms in the
securities industry, was cause for serious concern over the NASD's
enforcement priorities. See 21(a) Report at 40-44.
---------------------------------------------------------------------------
Another concern is the potential for SRO regulatory staff, in the
course of developing rules and examining members, to become overly
dependent on members for their understanding of market practices and to
lose their independent perspective concerning these practices. A
potential loss of objectivity could accompany the greater knowledge and
expertise that result from having SRO regulatory staff interwoven with
SRO market operations.
Also, SROs may have a tendency to abuse their SRO status by over-
regulating members that operate markets that compete with the SRO's own
market for order flow.\112\ Indeed, among other reasons, these concerns
led the Commission to require the NASD to establish the Alternative
Display Facility (``ADF'').\113\ Exchange Act rule 11Ac1-1 \114\
requires that SRO members communicate their best bids and offers to an
SRO and in the late 1990s broker-dealer choice as to where to post
quotes in Nasdaq securities was effectively limited to Nasdaq.\115\
Thus, certain users of Nasdaq were concerned that they would be put at
a distinct competitive disadvantage if they were compelled to provide
their best bids and offers to the exclusive securities information
processor (``SIP'') for Nasdaq securities through the new SuperMontage
system.\116\ These users argued that, not only would their quotes be
subject to a competing market's trading rules, but that the situation
would be rife for abuse because of Nasdaq functioning both as a
regulator and competitor of the ECNs.\117\ Thus, before permitting the
launch of Nasdaq's SuperMontage, the Commission required that the NASD
provide an alternative, the ADF, to Nasdaq's SuperMontage on which to
quote Nasdaq securities.\118\
---------------------------------------------------------------------------
\112\ Securities and Exchange Commission Concept Release,
Regulation of Exchanges, S7-16-97, Exchange Act Release No. 38672
(May 23, 1997), 62 FR 30485 (June 4, 1997) (``ATS Concept
Release''). The Commission acknowledged that conflicts could become
particularly acute when an ATS member is regulated by an SRO that
operates a competing market. Id. at 30486-30487.
\113\ See Exchange Act Release No. 43863 (January 19, 2001), 66
FR 8020 (January 26, 2001); Exchange Act Release No. 42166 (November
22, 1999), 64 FR 68125 (December 6, 1999); Exchange Act Release No.
42573 (March 23, 2000), 65 FR 16981 (March 30, 2000); Exchange Act
Release No. 43133 (August 10, 2000), 65 FR 49842 (August 15, 2000);
and Exchange Act Release No. 43514 (November 3, 2000), 65 FR 69084
(November 15, 2000). The Commission received 104 comments regarding
Nasdaq's order collector, aggregator, and execution facility
(``SuperMontage'') proposal.
\114\ 17 CFR 240.11Ac1-1.
\115\ 66 FR 8020, 8052-8055.
\116\ Id.
\117\ Id.
\118\ Id.
---------------------------------------------------------------------------
The Commission specifically seeks public comment on the following
questions related to conflicts with market operations:
Question 4: To what extent do conflicts exist between SRO
regulatory and market operations functions? Has increased intermarket
competition exacerbated this potential conflict? Are markets today
attempting to use ``lax regulation'' as a means to attract business?
Are they attempting to use ``aggressive regulation'' as a weapon
against competitors? Is it unrealistic to expect a ``cost center,''
such as regulation, to resist pressure from a function that generates
business revenue in a modern business enterprise?
Question 5: To what extent has internal SRO separation of these
functions addressed these concerns? Has the restructuring of the NASD,
and the recent governance changes of the NYSE and other SROs to enhance
their independence, been effective in better insulating the regulatory
function from the market function?
Question 6: Can potential conflicts between the regulatory function
and
[[Page 71263]]
SRO market operations be effectively managed through the recent
enhancements made to SRO governance and the changes proposed by the SRO
Governance and Transparency Proposal? Are there other measures the
Commission should consider?
3. Inherent Conflicts With Issuers
Another potential SRO conflict is with listed issuers. The SROs
promulgate and administer listing standards that govern the securities
that may be traded in their markets. For corporate securities, these
rules include minimum financial qualifications and reporting
requirements for their issuers. Obtaining a listing on a prominent SRO
market provides corporate issuers with enhanced visibility and prestige
in the eyes of investors, as well as the appearance of a well-operated
and well-regulated trading market for their securities. An active
market for secondary trading in a corporation's securities benefits not
only its shareholders, but also the corporation itself through enhanced
capital-raising capacities.
SRO listing standards also have a major role in corporate
governance, particularly since the passage of the Sarbanes-Oxley
Act.\119\ Specifically, under recently adopted rules, SROs are
prohibited from listing any security of an issuer that is not in
compliance with certain standards.\120\ Each member of the audit
committee of the issuer must be independent according to specified
criteria.\121\ In addition, the audit committee of each issuer must be
directly responsible for the appointment, compensation, retention and
oversight of the work of any registered public accounting firm engaged
for the purpose of preparing or issuing an audit report or performing
other audit, review or attest services for the issuer, and each such
registered public accounting firm must report directly to the audit
committee.\122\ Moreover, each audit committee must establish
procedures for the receipt, retention and treatment of complaints
regarding accounting, internal accounting controls or auditing matters,
including procedures for the confidential, anonymous submission by
employees of the issuer of concerns regarding questionable accounting
or auditing matters.\123\ Each audit committee must also have the
authority to engage independent counsel and other advisors, as it
determines necessary, to carry out its duties and each issuer must
provide appropriate funding for the audit committee.\124\
---------------------------------------------------------------------------
\119\ Pub. L. 107-204, 116 Stat. 745 (2002).
\120\ See generally Exchange Act Release No. 47654 (April 9,
2003), 68 FR 18788 (April 16, 2003).
\121\ Id. at 18790.
\122\ Id.
\123\ Id.
\124\ Id.
---------------------------------------------------------------------------
The SROs are responsible for monitoring issuers and delisting the
securities of those that fail to meet SRO minimum requirements, but
also compete vigorously to attract and retain listings, as illustrated
recently by the high profile competition to list the Google Initial
Public Offering.\125\ This competition has been heightened by new
listing venues. For instance, the equity trading facility of the PCX,
ArcaEx, has been actively courting issuers to list \126\ and in the
Spring of 2004, Nasdaq launched a high profile dual listing program for
NYSE stocks.\127\ Moreover, there are indications that international
stock exchanges are becoming more competitive with respect to
attracting foreign companies to list on their markets (rather than on
U.S. markets).\128\
---------------------------------------------------------------------------
\125\ Andrei Postelnicu, Listing Chief Sets Sights Abroad,
Financial Times, August 23, 2004, at 25.
\126\ Andrei Postelnicu, ArcaEx launches listings drive,
Financial Times, September 16, 2004, at 22.
\127\ Nasdaq CEO: Competitive Practices Could Have Helped NYSE,
Dow Jones News Service, August 25, 2004.
\128\ Yuka Hayashi, Foreign Firms Consider Listing Shares in
Tokyo, Wall Street Journal, October 18, 2004, at C16.
---------------------------------------------------------------------------
As issuers are offered new alternatives as to markets on which to
list their securities, SROs face increasing competitive pressure to
gain and retain listings. As with SRO competition for members and order
flow, competition for issuers may cause an SRO to fail to discharge its
self-regulatory responsibilities properly. This can take the form of
admitting to trading issuers that fail to satisfy initial listing
standards; delaying the delisting of issuers that no longer satisfy
maintenance standards; failing to enforce listing standards (including
the new issuer corporate governance standards); and reducing (or even
eliminating) listing fees. This competition also can reveal itself in
an unwillingness to restrict issuer activities or impose requirements
that may be more stringent than similar rules of competitor SROs.
Another issue with respect to listings relates to conflicts
associated with listings of members' proprietary products such as
Exchange Traded Funds (``ETFs''). In some instances, the creator of a
proprietary product may be an SRO member that becomes the specialist or
primary market maker of the product. In the equity markets, the issuer
typically has authority with respect to where the stock is to be
listed. With respect to such proprietary products, the product creator
(and potentially the product's sole specialist or primary market maker)
may have significant authority as to where the product is listed. When
an SRO member is a combined member/issuer of a popular product and that
member wields authority with respect to transferring the listing of the
product to another SRO, the SRO may be disinclined to regulate that
member vigorously.
The Commission specifically seeks public comment on the following
questions related to conflicts with issuers:
Question 7: To what extent have conflicts arisen between SRO
regulatory and issuer listing functions? Has the recent increase in
competition among SRO markets for listings created incentives to admit
issuers that fail to satisfy initial listing standards or delay the
delisting of issuers that no longer satisfy maintenance standards? To
the extent increased competition for listings has caused SROs to waive
or lower listing fees, has this negatively impacted regulatory funding
and further inhibited enforcement of listing standards?
Question 8: Has the sponsorship of popular proprietary products by
member firms compounded the inherent conflicts discussed above with
both members and issuers? Specifically, are SROs disinclined to
regulate vigorously either the trading activity of popular proprietary
products or the activity of members firms that are the sponsors of such
products?
4. Inherent Conflicts With Shareholders
Another significant conflict of interest for SRO responsibilities
is with SRO shareholders. SRO demutualization raises the concern that
the profit motive of a shareholder-owned SRO could detract from proper
self-regulation. For instance, shareholder owned SROs may commit
insufficient funds to regulatory operations or use their disciplinary
function as a revenue generator with respect to member firms that
operate competing trading systems or whose trading activity is
otherwise perceived as undesirable. Moreover, as with the inherent
conflicts discussed above, this conflict can be exacerbated by
increased intermarket competition.\129\
---------------------------------------------------------------------------
\129\ It is also possible for demutualization of SROs to cause
complicated transactional issues to arise. For instance,
complications could surface if a demutualized SRO bid to purchase a
listed company. Another problematic situation could be one in which
a demutualized SRO competes with a listed company for the purchase
of a third entity. Conflicts would clearly present themselves in
these situations.
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[[Page 71264]]
A variety of ownership controls for demutualized SROs can
potentially prevent some of these conflicts.\130\ Indeed, as previously
noted, this concept release is being published in conjunction with the
SRO Governance and Transparency Proposal, which would, if adopted,
impose a variety of restrictions, including an effective restriction on
revenue from regulatory operations being used to pay dividends to
shareholders.
---------------------------------------------------------------------------
\130\ For instance, several exchanges that have converted to
shareholder-owned structures have limited the ability of any person,
including their members, to directly or indirectly own and vote more
than a certain percentage of the interest in the exchange. See e.g.,
Securities Exchange Act Release Nos. 49718 and 49098. Exchanges also
have similar limits on concentration of ownership of facilities that
are separate corporate entities from the exchange. See e.g.,
Securities Exchange Act Release Nos. 50170 and 49067. The Commission
approved these limitations on a case-by-case basis pursuant to the
rule filing process of Section 19(b) of the Exchange Act and Rule
19b-4 thereunder. 15 U.S.C. 78s(b) and 17 CFR 240.19b-4.
---------------------------------------------------------------------------
The Commission specifically seeks public comment on the following
questions related to conflicts with shareholders:
Question 9: What are the conflicts between a demutualized SRO's
regulatory responsibilities and the profit-making orientation of its
shareholders? To what extent do they heighten the inherent SRO
conflicts with members, market operations, and listed issuers discussed
above?
Question 10: Can potential conflicts between the regulatory
function and SRO shareholders be effectively managed through the recent
enhancements to SRO governance and the changes proposed by the SRO
Governance and Transparency Proposal? Or are there other measures the
Commission should take to help ensure that the effectiveness of the
regulatory function is not diminished?
B. Inefficiencies of Multiple SROs
Securities industry self-regulation carries with it an inherent
inefficiency in that it can cause duplicative and potentially
conflicting regulation. Specifically, the existence of multiple SROs
can result in duplicative and conflicting SRO rules, rule
interpretations, and inspection regimes. The system can also result in
redundant SRO regulatory staff and infrastructure across SROs.
Congress and the Commission have put in place methods for reducing
a certain amount of regulatory duplication. Pursuant to Exchange Act
Section 17(d) and Rule 17d-1,\131\ when a member belongs to more than
one SRO, the SEC shall designate the responsibility to one SRO for
examining the member for compliance with applicable financial
responsibility rules.\132\ The undesignated SRO is relieved of
responsibility for examining the member for compliance with financial
responsibility rules.\133\ In addition, Rule 17d-2 under the Exchange
Act permits SROs to establish Commission approved joint plans for
allocating regulatory responsibilities with respect to common
members.\134\ An SRO participating in such a regulatory plan approved
by the Commission is relieved of regulatory responsibilities with
respect to a broker-dealer member, if those regulatory responsibilities
have been allocated to another SRO under the regulatory plan.\135\
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\131\ 15 U.S.C. 78q and 17 CFR 240.17d-1.
\132\ 17 CFR 240.17d-1.
\133\ Id.
\134\ 17 CFR 240.17d-2.
\135\ Id.
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The options SROs, for example, have utilized a 17d-2 agreement to
reduce regulatory redundancies.\136\ The options markets' 17d-2 Plan
reduces regulatory duplication for a large number of firms currently
members of two or more of the SRO participants by equitably allocating
regulatory responsibility for a set of options sales practice rules
that are substantially identical for each of the SRO participants.\137\
---------------------------------------------------------------------------
\136\ See generally Exchange Act Release No. 49197 (February 5,
2004), 69 FR 7046 (February 12, 2004).
\137\ Under the plan, the SRO participant responsible for
conducting options-related sales practice examinations of a firm,
and investigating options-related customer complaints and
terminations for cause of associated persons of that firm, is known
as the firm's Designated Options Examining Authority (``DOEA'').
Pursuant to the plan, any other SRO of which the firm is a member is
relieved of these responsibilities during the period the firm is
assigned to a DOEA. The options 17d-2 Plan is administered by a
committee, the Options Self-Regulatory Council, which is composed of
one representative from each SRO signatory to the plan. Under the
Options 17d-2 plan, common options rules across the different
options SROs have been designated and are enforced by the DOEA. The
DOEAs for common members are assigned based on a variety of factors,
including the most equitable allocation of the regulatory burden of
carrying out the duties of the DOEA. In addition, all DOEA
assignments are made by a majority vote of all SRO participants of
the plan. Common rules covered by the plan include those related to
the opening of options accounts, the supervision of options trading,
and customer suitability for trading options. See e.g., Exchange Act
Release No. 49197 (February 5, 2004), 69 FR 7046 (February 12,
2004).
---------------------------------------------------------------------------
While the potential for the SRO system to cause regulatory
redundancies is not a novel issue for the Commission,\138\ it appears
that the inefficiencies caused by the SRO system are being aggravated
by greater market fragmentation of order flow among SROs. Thus, a
recent U.S. General Accounting Office (``GAO'') analysis is worth
discussing. In May of 2002, the GAO issued a report, which specifically
focused on the implications of market fragmentation with respect to
securities industry regulatory redundancies.\139\ It ultimately
discussed a broad range of issues related to the relationship between
self-regulation and intermarket competition for order flow. The GAO
Report recommended that the Commission work with the SROs and broker-
dealers to implement a formal process for systematically identifying
and addressing material regulatory inefficiencies caused by differences
in rules and rule interpretations among SROs and by multiple
examinations of broker-dealers.\140\ In the wake of the GAO Report, the
Commission supported the formation of a joint NASD and NYSE task force
with the mission of examining their conflicting rules and determining
how those conflicts could be resolved. The Commission has been working
with the SROs in this respect and facilitating SRO rule amendments when
appropriate.\141\
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\138\ See supra Section II.
\139\ U.S. General Accounting Office Report to Congressional
Committees, ``Securities Markets Competition and Multiple Regulators
Heighten Concern about Self-Regulation'' (May 2004) (``GAO
Report'').
\140\ GAO Report at 30.
\141\ See e.g., notice and comment process for the adoption of a
uniform NASD and NYSE ``branch office'' definition. Exchange Act
Release Nos. 48897 (December 9, 2003), 68 FR 70059 (December 16,
2003); 46888 (November 22, 2002), 67 FR 72257 (December 4, 2002).
---------------------------------------------------------------------------
More recently, in light of issues raised in a petition for
rulemaking filed by Nasdaq, the Commission published a concept release
covering the regulation of intermarket trading of Nasdaq
securities.\142\ The Intermarket Trading Concept Release discussed
Nasdaq's concern about the potential development of ``regulatory
arbitrage'' when SRO rules are inconsistent across markets.\143\
Specifically, according to Nasdaq, this type of arbitrage could result
in the attraction of order flow and members to certain SROs over others
because of the prospect of lax regulation.\144\ The Intermarket Trading
Concept Release sought public comment on the importance of uniformity
with respect to a variety of rules related to intermarket trading of
Nasdaq-listed securities, including rules related to market
manipulation, illegal short
[[Page 71265]]
selling, insider trading, fraud, front running, marking the open or
close, non-compliance with the limit order display rule, and non-
compliance with the firm quote rule.\145\ The Intermarket Trading
Concept Release solicited comment on whether uniform rules are
necessary to prevent regulatory arbitrage.\146\ It also noted Nasdaq's
contention that the disparities in rules between SROs pose a serious
threat to investor protection and discussed Nasdaq's request that the
Commission exercise its authority under Sections 12(f)(2) and (3) of
the Act \147\ to prohibit the launch or continuation of Nasdaq trading
by any market that failed to adopt adequate regulatory protections,
including rules related to inter-market trading issues.\148\
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\142\ Concept Release: Request for Comment on Nasdaq Petition
Relating to the Regulation of Nasdaq-Listed Securities, Exchange Act
Release No. 47849 (May 14, 2003), 68 FR 27722 (May 20, 2003)
(``Intermarket Trading Concept Release'').
\143\ Intermarket Trading Concept Release at 27724.
\144\ Id.
\145\ Id.
\146\ Id.
\147\ Exchange Act Sections 12(f)(2) and (3), 15 U.S.C.
78l(f)(2) and (3). Intermarket Trading Concept Release at 27725.
\148\ See Intermarket Trading Concept Release at 27724-27725.
---------------------------------------------------------------------------
The Commission received a variety of comments in response to the
Intermarket Trading Concept Release. Commenters, including certain SROs
and ECNs that compete with Nasdaq for order flow, argued that there is,
in fact, no unequal regulation across markets and that trading that
falls within each SRO's purview is effectively regulated.\149\ Some
commenters voiced a qualified endorsement of uniform rules in certain
areas, but were careful to note that uniform rules should in no way
restrict each SRO's ability to craft rules that reinforce its own
unique intra-market structures or competitive business models.\150\ At
least one commenter even supported the creation of a single independent
regulator that would be responsible for regulating all broker-dealers
in all markets.\151\
---------------------------------------------------------------------------
\149\ See letter from John S. Markle, Associate General Counsel,
Ameritrade Holding Company, to Jonathan G. Katz, Secretary,
Commission, pp. 2-3 (July 10, 2003) (``Ameritrade Letter''); letter
from William O'Brien, Chief Operating Officer, Brut, LLC, to
Jonathan G. Katz, Secretary, the Commission, p. 2 (June 19, 2003)
(``Brut Letter''); letter from Jeffrey T. Brown, Cincinnati Stock
Exchange, to Jonathan G. Katz, Secretary, Commission, pp. 5-6 (June
19, 2003) (``CSE Letter''); letter from Michael J. Simon, Senior
Vice President and Secretary, ISE, to Jonathan G. Katz, Secretary,
Commission, p. 2 (June 19, 2003) (``ISE Letter''); letter from Brian
F. Colby, Chairman, Intermarket Surveillance Group, to Jonathan G.
Katz, Secretary, Commission, pp. 1-2 (June 18, 2003) (``ISG
Letter''); letter from Darla C. Stuckey, Corporate Secretary, NYSE,
to Jonathan G. Katz, Secretary, Commission, pp. 4-5 (June 19, 2003)
(``NYSE letter''); letter from Meyer S. Frucher, Phlx, to Jonathan
G. Katz, Secretary, Commission, pp. 2-6 (June 17, 2003) (``Phlx
Letter'').
\150\ See Ameritrade Letter pp. 2-3; letter from Kim Bang,
Bloomberg Tradebook LLC, to Jonathan G. Katz, Secretary, Commission,
p. 2 (June 20, 2003) (Bloomberg letter); Brut letter pp. 3-4, letter
from Richard Ketchum, General Counsel, Global Corporate & Investment
Bank, Citigroup Global Capital Markets, to Jonathan G. Katz,
Secretary, Commission, pp. 7-9 (July 8, 2003) (``Citigroup
letter''); letter from Edward J. Joyce, President and Chief
Operating Officer, Chicago Board Options Exchange, Incorporated, to
Jonathan G. Katz, Secretary, Commission, p. 2 (June 30, 2003)
(``CBOE letter''); letter from Eric Schwartz, Managing Director,
Goldman Sachs & Co., and Duncan Niederauer, Co-Chief Executive
Officer, Spear, Leeds & Kellogg, L.P., to Jonathan G. Katz,
Secretary , Commission, p. 2 (July 25, 2003) (``GS/SLK letter'');
letter from Craig S. Tyle, General Counsel, Investment Company
Institute , to Jonathan G. Katz, Secretary, Commission, p. 1 (June
19, 2003) (``ICI letter''); letter from Barbara Z. Sweeney, Senior
Vice President and Corporate Secretary, NASD, to Jonathan G. Katz,
Secretary, Commission, p. 12 (June 20, 2003) (``NASD letter'');
letter from Donald D. Kittell, Executive Vice President, Securities
Industry Association, to Jonathan G. Katz, Secretary, Commission,
pp. 3-5 (June 27, 2003) (``SIA letter''); and Mary McDermott
Holland, Mark Madoff, and John C. Giesea, Securities Traders
Association, to Jonathan G. Katz, Secretary, Commission, p. 3 (June
19, 2003) (``STA letter'').
\151\ See letter from W. Hardy Callcott, SVP & General Counsel,
Charles Schwab & Co., Inc., to Jonathan G. Katz, Secretary,
Commission (July 7, 2003) (``Schwab letter'').
---------------------------------------------------------------------------
Thus, while the Intermarket Trading Concept Release drew out
thoughtful public commentary on discrete issues related to the SRO
system's regulatory inefficiencies and redundancies, this concept
release seeks public commentary on these issues in the broader context
of the efficacy of the SRO system overall. Specifically, the Commission
specifically seeks public comment on the following questions:
Question 11: Is the lack of intermarket rules across markets
trading the same type of securities causing regulatory arbitrage and,
if so, what is the impact of this on the SRO system? Should this issue
be addressed through changes at the SRO system level, rather than at
the individual SRO level?
Question 12: How significant are the inefficiencies resulting from
multiple SROs overseeing the activities of the same members? In what
areas do these issues primarily arise?
C. Intermarket Surveillance
Another area in which the SRO system has recently come under
increasing strain because of market fragmentation is with respect to
SRO and Commission supervision of intermarket trading. When order flow
was largely concentrated in the primary markets, traders had limited
ability to cloak illicit activity by spreading trades across markets.
When trading takes place in multiple active markets, however, it is
possible for traders to veil illegal trading activity by dispersing
trades across markets.
The Intermarket Trading Concept Release specifically sought public
comment on this topic. \152\ The release focused public attention on
Nasdaq's contention that its extensive audit trail data was of limited
use for cross-market surveillance, because it cannot capture relevant
data for executions that take place on other markets trading Nasdaq
securities, and other markets do not have comparable systems that can
interact with NASD's Order Audit Trail System (``OATS''), which
captures regulatory data concerning the important stages in the life of
a trade. \153\
---------------------------------------------------------------------------
\152\ Intermarket Trading Concept Release at 27724.
\153\ Intermarket Trading Concept Release at 27724. OATS is part
of an integrated audit trail system, developed by NASD. It provides
a source of timed, sequenced order events, which, when combined with
existing quotation and trading information, assists in the
surveillance of the Nasdaq market. See OATS Subscriber Manual
2004.3, 1-1 (October 4, 2004). The general objective of OATS is to
recreate daily market activity by capturing and maintaining order
data reported by member firms. OATS Subscriber Manual at 2-1.
---------------------------------------------------------------------------
The Intermarket Trading Concept Release also focused comment on the
role of the Intermarket Surveillance Group (``ISG''), which is an
industry organization created in 1983 to coordinate intermarket
surveillance among the self-regulatory organizations by cooperatively
sharing regulatory information pursuant to a written agreement between
the parties. \154\ The goal of the ISG's information sharing is to
coordinate regulatory efforts to address potential intermarket trading
abuses and manipulations. \155\ Although the ISG Agreement was not
established under Section 11A or 17(d) of the Securities Exchange Act
of 1934, \156\ ISG asserts that the Commission has required new markets
to become ISG members as a condition of registration, thus recognizing
its importance. \157\ ISG's full members are the Amex, BSE, CBOE, CHX,
NSX, ISE, NASD, NYSE, PCX, and the Phlx (collectively ``Full
Members''). \158\ Each of the Full Members is an SRO for which the
Commission has direct oversight. \159\ As
[[Page 71266]]
a result, the regulatory procedures that these SROs have developed,
individually and jointly, including those developed for insider trading
and certain types of market manipulation, are subject to Commission
jurisdiction and are regularly examined for sufficiency. \160\
---------------------------------------------------------------------------
\154\ Intermarket Trading Concept Release at 27723.
\155\ Id.
\156\ 15 U.S.C. 78k-1 or 78q(d).
\157\ See ISG letter at 1.
\158\ In its comment letter, ISG states that it has also
established an affiliate category of membership to all futures
exchanges and non-U.S. organizations to join. Moroever, ISG notes
that certain ISG affiliate members (One Chicago LLC, Nasdaq LIFFE
Markets LLC, CME Inc. and Island Futures Exchange LLC) by virtue of
their status as ``notice registered National Securities Exchanges''
and as signatories to the Addendum for Securities Futures products,
have already submitted themselves to elements of the ISG Agreement,
as amended in 1994. As such, ISG maintains they have accepted ISG as
the appropriate forum for resolving inter-market issues. See ISG
Letter p. 1-2.
\159\ Id.
\160\ Id.
---------------------------------------------------------------------------
In its petition, Nasdaq asserted that, for a variety of reasons,
the data, received through ISG regarding other markets, is insufficient
to enable Nasdaq to properly surveil intermarket trading activity.
\161\ Nasdaq also posited that consolidated regulation of Nasdaq
trading across all markets for intermarket surveillance purposes would
be fundamentally more effective because of the flaws of ISG data and
because the ISG is composed of some members that do not necessarily
trade Nasdaq securities (including certain non-Full Members that are
not regulated as SROs by the Commission). \162\
---------------------------------------------------------------------------
\161\ For instance, ISG audit trail information is clearing
level data, rather than executing firm level data. According to
Nasdaq, the ISG data time fields are not generated by clocks subject
to uniform synchronization protocols, as is the case with OATS data.
Moreover, Nasdaq states that ISG data is transmitted two days after
the trade takes place and in a format that cannot be readily
integrated into the NASD's automated surveillance systems. Nasdaq
argued that the two day delay significantly hinders NASD's ability
to investigate unlawful trading activity on a real-time basis and
can prevent NASD from obtaining non-stale regulatory information in
an ongoing investigation. Inter-Market Trading Concept Release at
27723.
\162\ Id.
---------------------------------------------------------------------------
In response to the Intermarket Trading Concept Release, the
Commission received a variety of comments on intermarket surveillance
and order audit trail issues. \163\ Some commenters argued that
existing audit trail systems were well designed, even though they did
not interact with Nasdaq's. \164\ In addition, many commenters were
concerned that complying with multiple SROs' different order audit
trail systems would be burdensome and expensive to implement and
administer. \165\ Other commenters argued that Nasdaq had understated
the effectiveness of ISG and that the organization should be allowed to
continue in its role as the facilitator of regulatory data sharing
among markets. \166\
---------------------------------------------------------------------------
\163\ See infra notes 164-176.
\164\ CSE letter at 3-7 and ISG letter at 2.
\165\ Ameritrade letter at 3; CSE letter at 17-18; ISE letter at
3-4; GS/SLK letter at 3-4; Phlx letter at 6-7; SIA letter at 4; STA
letter at 3.
\166\ Ameritrade letter at 2; Brut letter at 6; CBOE letter at
2; CSE letter at 10-13; ISE letter at 3-4; ISG letter at 2; NYSE
letter at 3-5; Phlx letter at 6-7; and SIA letter at 7.
---------------------------------------------------------------------------
In its comment letter, the ISG described its consolidated audit
trail system, which supplements individual markets' surveillance
systems by facilitating the analysis and review of information
concerning potential trading violations. \167\ By allowing the SROs to
share their regulatory information, ISG asserts, the SROs are able to
view trading activity in the context of all markets' clearing level
quote and trade data. \168\ The ISG argued that its Equity Audit Trail
system provides a consolidated view across all markets of quotes and
trades, including clearing information. \169\ Moreover, ISG stated that
its systems serve their purpose well and that no other market had
raised the issues that Nasdaq raised in its petition. \170\
Specifically, the ISG claimed that neither the time delays in receiving
information through ISG nor the lack of a uniform synchronization
protocol had proven to be problematic. \171\
---------------------------------------------------------------------------
\167\ ISG letter at 2.
\168\ Id.
\169\ Id.
\170\ ISG letter at 2-3.
\171\ ISG letter at 2-3.
---------------------------------------------------------------------------
In the NYSE's comment letter, it generally supported the
traditional role of the ISG. \172\ Moreover, the NYSE described its own
order audit trail, the Order Tracking System (``OTS''), and how its
rules are comparable to those of the NASD's OATS. \173\ The NYSE raised
the possibility of the Commission requiring that each individual market
establish an order audit trail system similar to the NYSE's and the
NASD's and mandating that the data from these separate order audit
trails be integrated into the ISG's consolidated order audit trail.
\174\
---------------------------------------------------------------------------
\172\ See generally NYSE letter.
\173\ NYSE letter at 4-5.
\174\ NYSE letter at 4-5.
---------------------------------------------------------------------------
In its comment letter in response to the Intermarket Trading
Concept Release, the NASD echoed many of the concerns raised by Nasdaq
in its petition. Specifically, the NASD argued that the current model
of coordinated regulation results in regulatory gaps and that potential
misconduct can occur across markets undetected by regulators. \175\ It
also argued that the less detailed regulatory information collected by
the ISG lacks certain critical pieces of information to effectively
assist SROs in regulating intermarket trading activity. \176\
---------------------------------------------------------------------------
\175\ NASD letter at 9.
\176\ NASD letter at 8.
---------------------------------------------------------------------------
With respect to the options markets, in September of 2000, the
Commission accepted settlement agreements from the Amex, CBOE, Phlx,
and PCX in connection with administrative proceedings, alleging, among
other things, that these options exchanges had inadequately discharged
their obligations as SROs by failing to enforce compliance with certain
rules, including order handling rules, reporting rules, and rules
prohibiting anticompetitive conduct. \177\ As a result, in settling the
Commission's enforcement action, the options exchanges undertook a
variety of steps to prevent future self-regulatory lapses, including
the design and implementation of a consolidated options audit trail
system (``COATS''). \178\ COATS would enable the options exchanges to
reconstruct markets promptly, effectively surveil them and enforce
order handling, firm quote, trade reporting and other rules. \179\ The
full extent to which COATS effectively enhances intermarket options
surveillance is not known as of yet because the system is in the final
stage of its implementation. COATS, however, suggests the potential for
a consolidated audit trail for the equity markets.
---------------------------------------------------------------------------
\177\ See Exchange Act Release No. 43268 (September 11, 2000),
File No. 3-10282, (``Options Settlement'').
\178\ See Id. at Section IV.B.e.
\179\ Id.
---------------------------------------------------------------------------
While the full implementation of robust intermarket order audit
trails would be a significant step forward, an order audit trail is
simply a tool that can be used by regulators to better surveil for
illicit trading activity. In the 2000 Options Settlement, the options
exchanges undertook to design and implement, concurrent with the design
and implementation of COATS, effective surveillance systems to use the
newly available COATS data to enforce the federal securities laws and
SRO rules. \180\ Thus, even when COATS is fully implemented and even if
a similar intermarket audit trail were developed for the equity
markets, the SRO regulatory function would still play a critical role
in the regulation of intermarket trading.
---------------------------------------------------------------------------
\180\ Id.
---------------------------------------------------------------------------
The Commission specifically seeks public comment on the following
questions related to intermarket surveillance and regulation:
Question 13: To what extent does our market model of multiple
competing SROs create gaps in intermarket trading surveillance? What
types of illicit trading activity in particular can be hidden from
regulators by dispersing trading across multiple markets?
Question 14: How effectively does the ISG serve as a facilitator of
regulatory data sharing and surveillance coordination among SROs? Is
the ISG's order audit trail effective as a regulatory
[[Page 71267]]
tool? How feasible would it be to require all markets to adopt order
audit trails similar to those of the NYSE and the NASD and ultimately
to integrate all markets' order audit trails into the ISG's
consolidated order audit trail?
Question 15: How similar are the order audit trail systems of the
NYSE and the NASD? Could they be merged into one consolidated system
and what would be the benefits of such a consolidated system? Should
NASD's OATS or NYSE's OTS requirements be extended to all equity
markets to enhance the ability of SROs to surveill intermarket
activity? If so, could all markets' individual order audit trails be
successfully integrated into the ISG's consolidated order audit trail
or another consolidated system? How useful a regulatory tool would the
ISG's consolidated order audit trail system be if all markets were
required to adopt their own order audit trail systems and their data
was required to be integrated into the ISG's?
Question 16: To what extent is there a need for an order audit
trail to provide crossover surveillance between the equities and
options markets? To what extent would such crossover surveillance
detect specific types of illicit trading activity?
D. Funding
Another feature of the SRO system to be discussed relates to the
funding of SRO regulatory operations. One of the key historical
benefits of the SRO system is its self-funding structure, which
leverages the limited resources of the Commission. Experience appears
to indicate that the Commission, in its current form, does not have the
resources to effectively carry out on its own the full panoply of
duties for which the SROs are currently responsible. In 1983, after 18
years of experience with directly regulating over-the-counter broker-
dealer activity through the SEC Only (``SECO'') program,\181\ the
regime was repealed.\182\ Congress amended the Exchange Act provisions
covering direct regulation of broker dealers by the SEC and imposed
compulsory SRO membership.\183\
---------------------------------------------------------------------------
\181\ The SECO program was implemented because neither the
Exchange Act nor the Maloney Act compelled broker-dealers to become
SRO members. In 1964, the Commission was in favor of compulsory
membership in the NASD. Congress, however, opted for Commission
regulation of broker-dealers who were not members of an association.
Congress intended the SECO regulations to mirror the substantive and
most of the procedural requirements of the NASD so that SECO firms
would not enjoy a competitive advantage over NASD members or escape
the regulation of ethical standards. Consequently, the Commission
was tasked with designing rules to promote just and equitable
principles of trade; to regulate the training and competency of
securities industry professionals; to adopt regulations regarding
broker-dealers and associated persons qualifications and training;
and to adopt standards to cooperate with associations on
qualification exams and exam fees. See Market 2000 Report VI-6.
\182\ See Pub L. 98-38; Exchange Act Release No. 20409 (November
22, 1983), 48 FR 53688(November 29, 1983).
\183\ Id. See also Exchange Act Section 15, 15 U.S.C. 78o.
---------------------------------------------------------------------------
At the time of the repeal of the SECO program, the House Committee
on Energy and Commerce reported to the Committee of the Whole House
that the SECO program was unnecessarily costly and diverted the SEC's
limited resources away from areas of major concern, merely to duplicate
the functions of the NASD.\184\ The House Committee stated ``that any
attempt to put SECO regulation on a par with that provided by the NASD
would require significant expenditures by the Commission for additional
staff and administrative costs.'' \185\ The committee also noted that
SROs were better able to maintain ethical standards for the industry
and to perform certain detailed oversight functions.\186\ The House
also cited the limitations of enforcement and compliance remedies
available to the Commission in comparison to the remedies available to
the NASD.\187\
---------------------------------------------------------------------------
\184\ H.R. Rep. No. 98-106 (1983).
\185\ H.R. Rep. No. 98-106, at 7 (1983).
\186\ Id.
\187\ Id. at 6.
---------------------------------------------------------------------------
In the Market 2000 Report, the Commission's staff provided its
retrospective impression of the SECO program's performance. The staff
noted its belief that the SECO experience illustrated ``that the
resources necessary for the Commission to assume SRO regulatory
functions directly and effectively are not realistically attainable.''
\188\ The SECO experience demonstrated the important role that SROs
play in maximizing the Commission's limited resources. It also
illustrated that regulation must be properly funded and have sufficient
resources to be effective. In that regard, the most finely-balanced SRO
structure will not ensure that SRO statutory obligations are met, if
regulatory operations are insufficiently funded. Thus, SRO funding
arrangements are critical to the SRO system.\189\
---------------------------------------------------------------------------
\188\ See Market 2000 Report at VI-6.
\189\ As noted above, two ongoing Commission rulemakings have a
bearing on SRO funding. First, proposed Reg NMS contains a provision
that would reallocate market data revenues to encourage price
formation. The Commission is also proposing the SRO Governance and
Transparency Proposal, a rulemaking that would greatly increase SRO
transparency with respect to funding (including regulatory funding)
and funding allocations.
---------------------------------------------------------------------------
1. Overview
While Congress was fairly prescriptive in its initial enactment of
the Exchange Act and in subsequent amendments as to the standing
responsibilities of SROs, it has not provided explicit guidance as to
the proper levels or methods of funding for self-regulatory
operations.\190\ Section 6 of the Exchange Act, which addresses the
registration of national securities exchanges, requires that ``the
rules of the exchange provide for the equitable allocation of
reasonable dues, fees, and other charges among its members and issuers
and other persons using its facilities.'' \191\ Section 15A contains a
similar provision in connection with the registration of national
securities associations.\192\ These provisions also require that an SRO
be ``so organized and [have] the capacity to be able to carry out the
purposes'' of the Exchange Act and ``to comply, and * * * to enforce
compliance by its members, and persons associated with its members,
with the provisions' of the Exchange Act.\193\ Accordingly, while
Congress provided only general guidance with respect to SRO funding, a
reasonable reading of the Exchange Act indicates that it intended that
regulatory funding be sufficient to permit SROs to fulfill their
statutory responsibilities under the Exchange Act, and contemplated
that such funding would be achieved through equitable assessments on
the members, issuers, and other users of an SRO's facilities.
---------------------------------------------------------------------------
\190\ See generally Exchange Act Sections 6 and 15A, 15 U.S.C.
78f and 78o-3.
\191\ Exchange Act Section 6(b)(4), 15 U.S.C. 78f(b)(4).
\192\ See Exchange Act Section 15A(b)(5), 15 U.S.C. 78o-3(b)(5).
\193\ See Exchange Act Section 15A(b)(2) and 6(b)(1) 15 U.S.C.
78o-3(b)(2) and 78f(b)(1).
---------------------------------------------------------------------------
The Commission to date has not issued detailed rules specifying
proper funding levels of SRO regulatory programs, or how costs should
be allocated among the various SRO constituencies. Rather, the
Commission has examined the SROs to determine whether they are
complying with their statutory responsibilities. This approach was
developed in response to the diverse characteristics and roles of the
various SROs and the markets they operate. The mechanics of SRO
funding, including the amount of revenue that is spent on regulation
and how that amount is allocated among various regulatory operations,
is related to the type of market that an SRO is operating. Prior to the
SRO Governance and Transparency Proposal, the Commission had not
proposed requiring a single
[[Page 71268]]
regulatory structure for all SROs, and the financial structure of each
individual SRO is a result of a variety of factors, including the SRO's
particular history and competitive position. Thus, each SRO and its
financial structure is, to a certain extent, unique. While this
uniqueness can result in different levels of SRO funding across
markets, it also is a reflection of one of the primary underpinnings of
the National Market System. Specifically, by fostering an environment
in which diverse markets with diverse business models compete within a
unified National Market System, investors and market participants
benefit.\194\
---------------------------------------------------------------------------
\194\ See generally Exchange Act Section 11A, 15 U.S.C. 78k-1.
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The ``appropriate'' amount of funding to be spent by SROs on
regulatory operations is governed by a variety of factors, including
the SRO's business model, trading systems, regulatory responsibilities,
and types of members. For instance, electronic marketplaces may be able
to supervise trading occurring in their markets at lower cost than
floor-based markets because their trading systems may capture
comparatively more information associated with any given trade.
Likewise, the characteristics of an SRO's membership base may affect
the appropriate level of regulatory funding and how the funding is
allocated.
Potential varying levels of regulatory funding notwithstanding, all
SROs must meet their statutory obligations. The Exchange Act itself, as
well as the Commission's rules and automation review policies
thereunder, impose on the SROs important regulatory and operational
responsibilities, including most of the day-to-day responsibilities for
market and broker-dealer oversight.\195\ Satisfying these self-
regulatory responsibilities requires a substantial expenditure of
expertise and funds. The SROs' combined total operating expenses in
1998 were $1.68 billion \196\ and total combined SRO operating expenses
in 2003 were $2.4 billion.\197\ As stated above, a significant benefit
of self-regulation in the securities industry is that this significant
cost is largely self-funded.
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\195\ See generally Policy Statement: Automated Systems of Self-
Regulatory Organizations, Exchange Act Release No. 27445 (November
16, 1989), 54 FR 48703 (November 24, 1989); Policy Statement:
Automated Systems of Self-Regulatory Organizations (II), Exchange
Act Release No. 29185 (May 9, 1991), 56 FR 22490 (May 15, 1991).
\196\ See Concept Release, Regulation of Market information Fees
and Revenues (``Market Data Concept Release''), Exchange Act Release
No. 42208 (File No. S7-28-99) (December 9, 1999), 64 FR 70613, 70615
(December 17, 1999).
\197\ Data compiled from SRO 2003 Annual Reports.
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The Commission's supervision of the adequacy of SRO regulatory
funding presents considerable challenges. Given the inherent tension
between an SRO's role as a business and as a regulator, there
undoubtedly is a temptation for an SRO to fund the business side of its
operations at the expense of regulation. For example, if the
``appropriate'' amount of regulatory spending would seriously impair
the financial stability of an SRO, that SRO would likely reduce
regulatory spending rather than jeopardize its financial viability.
When the Commission examines the underlying reasons for regulatory
failings, it is often clear that an SRO has not allocated sufficient
resources to its regulatory function. Without such failings, however,
it can be difficult for the Commission to determine whether an SRO is
insufficiently funding its regulatory function or simply administering
an efficient regulatory program.\198\
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\198\ Even if the Commission were to determine that an SRO was
insufficiently funding regulation, it would then have the difficult
task of deciding whether to take extreme action (such as
deregistration of an SRO) or more measured action (such as the
NASD's 21(a) Undertaking requiring that it commit $100 million on
self-regulatory enhancements). See e.g., 21(a) Report requiring that
the NASD expend $100 million over a five year period, to enhance its
systems for market surveillance, including the development and
implementation of an enhanced audit trail, and to increase its
staffing in the areas of examination, surveillance, enforcement, and
internal audit; see also NYSE settlement in connection with Exchange
Act section 11(a), 15 U.S.C. 78k(a), violations requiring
establishment of OTS, Exchange Act Release No. 41574 (June 29,
1999), Administrative Proceeding File No. 3-9925; see also Options
Settlement requiring establishment of COATS.
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If the Commission's SRO Governance and Transparency Proposal is
adopted, however, it could illuminate more clearly SRO practices with
respect to regulatory spending levels and allocations. Specifically,
the detailed accounting of SRO revenues and expenses proposed could
enable the Commission to more accurately and efficiently compare these
items. Under the current reporting regime, SROs update their Form 1
annually, including an updated financial statement, but their financial
information is not necessarily submitted in a comparable format.\199\
Thus, the Commission could use this new information to assist in its
effort to detect when an SRO is becoming an industry outlier in terms
of relative regulatory spending levels. If the Commission made such a
determination, it has the ability to pursue a range of regulatory
responses, including designating that SRO for heightened Commission
oversight or stronger action, such as SRO deregistration.
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\199\ See Exchange Act Rule 6a-2, 17 CFR 240.6a-2, and 15Aj-1,
17 CFR 240.15Aj-1.
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Although not proposed in the SRO Governance and Transparency
Proposal, the Commission could also consider developing formal or
informal regulatory spending guidelines for SROs. Establishing uniform
guidelines for SROs generally would be a very complex task, however,
given the diversity of their marketplaces and memberships and the
evolving nature of regulatory oversight. While the SRO Governance and
Transparency Proposal would likely result in a heightened Commission
ability to detect low regulatory spending levels, it is important to
note that gauging the effectiveness of an SRO's self-regulation cannot
necessarily be accurately judged by considering capital expenditures in
isolation.
The Commission specifically seeks public comment on the following
questions related to SRO funding generally:
Question 17: Should the Commission prescribe specific regulatory
funding and allocation levels for SROs and, if so, how? Also, how would
these levels be determined?
Question 18: Could enhanced transparency of SRO funding be used
effectively to promote adequate SRO regulatory funding levels or would
other steps be more effective in that regard? What measures could be
used to promote adequate SRO regulatory funding levels?
2. SRO Funding Sources
To provide commenters a basis for considering SRO funding, this
section 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. While each source of SRO
revenue is important, this discussion will provide an extensive
discussion of market data and specifically the level of fees charged
for market data.
a. Regulatory Fees
SROs charge members fees for joining and maintaining membership. In
addition, SROs charge regulatory fees to members that typically take
the form of per member or per transaction fees and are generally
allocated to funding self-regulatory operations. SROs also contract
with other SROs to provide regulatory services. In 1998, regulatory
fees accounted for approximately 19%
[[Page 71269]]
of SRO revenue,\200\ while, in 2003, approximately 23% of SRO revenue
was derived from such fees.\201\
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\200\ Market Data Concept Release at 70625.
\201\ Data compiled from SRO 2003 Annual Reports. Note that the
NYSE 1998 Consolidated Statement of Revenue did not account for
``Data Processing Fee'' revenue. Due to an intervening change in
accounting procedures, the NYSE 2003 Consolidated Statement of
Revenue includes this item. To provide a more accurate comparison
between the 1998 and 2003 percentages, ``Data Fee Processing''
revenue was not included in total SRO revenue for the purpose of
calculating the percentage of total SRO revenue represented by
regulatory fee revenue. Based on SRO 2003 Annual Report Consolidated
Statements of Income certain items were allocated to regulatory fees
with respect to the NYSE (``Regulatory Fees'' and ``Annual
Membership Fees''), the BSE (``Members'' Dues and Fees''), the Phlx
(``Regulatory Fees''), the NASD (including Amex and Nasdaq
consolidated statements of income) (``Regulatory Fees,''
``Registration Fees,'' ``Qualification Fees,'' ``Corporate Financing
Fees,'' and ``Fines''), the PCX (``Regulatory and Registration
Fees,'' ``Archipelago Revenue: Regulatory Oversight,'' and ``Member
and Participant Dues''), the CHX (``Member Services and Fees'' and
``Member Dues''), the CBOE (``Regulatory Fees'' and ``Other Member
Fees''), and the NSX (``Regulatory Fees'').
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A recent development with respect to SRO regulatory fees was the
NASD's establishment of a Trading Activity Fee (``TAF''), to supplement
the regulatory fees it historically charged its members.\202\ The TAF
assessed a transaction-based fee that was not linked to trading
activity reported through Nasdaq systems.\203\ In approving the TAF,
the Commission found that it was reasonably designed to recover the
NASD's costs related to regulation and oversight of its members.\204\ A
principal factor in the Commission's approval was its explicit
recognition of the NASD's broad responsibilities with respect to its
members' activities, irrespective of where securities transactions take
place.\205\ Specifically, the Commission noted that, as a national
securities association, the NASD has the responsibility to oversee its
members' finances and conduct toward their customers, except in limited
circumstances where this responsibility is allocated to another
SRO.\206\ The Commission further stated that the NASD's responsibility
exists even if the conduct involves a transaction executed on a market
not directly regulated by the NASD because it has direct responsibility
to oversee the firm's dealing with the public in effecting the
transactions and may also have responsibility to oversee the impact of
the trading on the firm's financial condition.\207\
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\202\ See Exchange Act Release Nos. 46817 (November 12, 2002),
67 FR 69784 (November 19, 2002) (``TAF Proposing Release''); 47946
(May 30, 2003), 68 FR 34021 (June 6, 2003) (``TAF Approval Order'').
See also Exchange Act Release Nos. 49114 (January 22, 2004), 69 FR
4194 (January 28, 2004) (proposing to amend the TAF and extend it to
Trade Reporting and Compliance Engine (``TRACE'')-eligible and
municipal securities); 50485 (October 1, 2004), 69 FR 60445 (October
8, 2004)(approving proposal to amend the TAF and extend it to TRACE-
eligible and municipal securities).
\203\ In its filing, the NASD noted its belief that assessing
the regulatory fees only for Nasdaq transactions was no longer
appropriate for three reasons. First, on a corporate entity level,
Nasdaq was separating itself from the NASD and attempting to
register as a national securities exchange. Second, the NASD
believed that the historic regulatory fee structure was out of step
with recent changes in the markets, such as the drastic growth in
trading volumes, reductions in average trade size, decimalization,
and trading no longer remaining exclusive to the listing market.
Finally, the regulatory fee was only assessed against Nasdaq-listed
and other transactions that are reported through Nasdaq's trade
reporting system, although these fees were used to support member
regulatory activities across all markets. See TAF Proposing Release
at 69785.
The Commission received a total of 23 comment letters on the
proposal, all of which objected to the proposal, either for
substantive or procedural reasons. Commenters of the TAF proposal
argued that the NASD should not charge members for services related
to transactions on other markets, where the NASD does not provide
the relevant service. In addition, commenters argued that the TAF
proposal was anti-competitive in that it indirectly subsidized
Nasdaq by effectively reducing the cost of regulatory services the
NASD provides to Nasdaq. They also posited that the TAF could
establish a dangerous precedent under which fees could be charged by
SROs for trading activity that had little or no nexus to that SRO's
market. See TAF Approval Order at 34022-34023.
In response, the NASD clarified that the TAF was to be used only
to fund its member regulatory activities in a variety of areas such
as sales practices, examinations, financial and operational reviews,
new member applications, and enforcement wherever such member
activity occurs. In addition, the NASD argued that it regulates the
activities of its members in all securities, not simply Nasdaq
securities. The specific revenues from the TAF, the NASD stated,
would not fund regulatory activities of the Nasdaq stock Market and,
thus, not create an inappropriate regulatory subsidy. Finally, with
regard to comments that no clear nexus existed between the TAF and
the corresponding NASD regulatory responsibilities, the NASD
maintained that its mandate is broad, and that its regulatory
obligations ``exist separate and apart from any market-specific
rules and obligations.'' See TAF Approval Order at 34023.
\204\ TAF Approval Order at 34023-34024.
\205\ Id.
\206\ Id.
\207\ The Commission also stated its belief that the TAF
approval was not a harbinger for the imposition of fees on
transactions executed on markets for which an SRO either has little
or no nexus to regulatory tasks performed by the SRO or for which
the SRO has no business interest. Most SROs, the Commission
concluded, do not have the broad aegis of the NASD regarding
members' customer business, and so will not have a regulatory nexus
to support a transaction fee applicable to other markets. See TAF
Approval Order at 34023-34024.
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The Commission specifically seeks public comment on the following
question related to SRO regulatory fees:
Question 19: Under current SRO cost structures, SRO funding for
regulatory operations is not derived strictly from revenue associated
with regulatory fees and operations. Instead, SROs cross subsidize the
cost of regulatory operations with revenue that is not strictly derived
from regulatory fees and operations. Should the Commission require that
SRO funding for regulatory operations be derived only from regulatory
fees, rather than allowing the cost of regulatory operations to be
subsidized by other revenue sources? If regulatory funding should be
limited strictly to revenue generated by regulatory fees, how should
the Commission address a situation in which an SRO does not generate
sufficient regulatory revenue to fully fund regulatory operations?
b. Transaction Fees
Another important source of revenue for SROs that operate markets
is derived from fees that are associated with members' or others' use
of the SRO's systems, such as order routing systems, trade execution
systems, and electronic connectivity services. These fees are paid by
any user of an SRO's market facilities for services, including
executing, reporting, and clearing transactions. In 1998, transaction
fees accounted for approximately 30% of SRO revenue,\208\ while, in
2003, approximately 27% of SRO revenue was associated with transaction
fees.\209\
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\208\ Market Data Concept Release at 70625.
\209\ Data compiled from SRO 2003 Annual Reports. Note that the
NYSE 1998 Consolidated Statement of Revenue did not account for
``Data Processing Fee'' revenue. Due to an intervening change in
accounting procedures, the NYSE 2003 Consolidated Statement of
Revenue includes this item. To provide a more accurate comparison
between the 1998 and 2003 percentages, ``Data Fee Processing''
revenue was not included in total SRO revenue for the purpose of
calculating the percentage of total SRO revenue represented by
transaction fee revenue. Based on SRO 2003 Annual Report
Consolidated Statements of Income certain items were allocated to
transaction fees with respect to the NYSE (``Transaction Fees''),
the BSE (``Transaction Fees''), the Phlx (``Transaction Fees''), the
NASD (including Amex and Nasdaq consolidated statements of income)
(``Transaction Fees''), the PCX (``Transaction Fees and Data Service
Charges''), the CHX (``Transaction Fees''), the CBOE (``Transaction
Fees''), and the NSX (``Transaction Fees'').
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The intense intermarket competition for order flow has put
substantial pressure on these fees. For example, greater competition
among options markets has caused transaction fees to all but disappear
in the options markets.\210\ The equity markets have also come under
intense competitive pressure to lower transaction fees. As discussed in
the Reg NMS proposal, transaction fees have decreased steadily
[[Page 71270]]
in recent years.\211\ In addition, most ECNs and Nasdaq are paying a
per-share rebate for limit orders that become executed against incoming
orders, thereby further reducing net transaction fees.\212\ Thus, not
only are SRO transaction fees being driven lower, but competition is
compelling certain SROs to rebate a significant percentage of
transaction fees collected to market participants.
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\210\ See generally Concept Release: Competitive Developments in
the Options Markets. Exchange Act Release No. 49175 (February 3,
2004), 69 FR 6124, 6125 (February 9, 2004) (``Options Concept
Release'').
\211\ See supra note 62.
\212\ Most ECNs and Nasdaq pay a per-share rebate for limit
orders that become executed against incoming orders. This rebate
rewards market participants for submitting ``resting'' limit orders
that give depth to the trading book. The ECNs and Nasdaq also impose
a per-share access fee on the incoming marketable orders that
execute against the resting limit orders and thereby ``remove
liquidity'' from the book. In this way, the ECNs and Nasdaq use
access fee rebates as payment to attract liquidity to their limit
order books. Because non-subscribers cannot place limit orders on an
ECN's book and therefore cannot receive the rebates, the fees that
they pay act as a subsidy to the subscribers that place standing
limit orders on the ECN's book. See Reg NMS at 11157.
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The Commission specifically seeks public comment on the following
questions related to SRO transaction fees:
Question 20: SRO transaction fees have been driven sharply lower in
recent years by competition. In light of that, why has the overall
percentage of SRO revenue associated with transaction fees not dropped
as dramatically since 1998 (approximately 27% in 2003 compared to
approximately 30% in 1998)?
Question 21: How has the trend of decreasing transaction fees
impacted the SROs' ability to fulfill their statutory obligations?
c. Listing Fees
Another important source of revenue for some SROs is listing fees,
which are paid by issuers that list their securities on an SRO's
market. Initial listing fees are paid at the time of listing and are
typically related to the amount of shares being offered. Listing
maintenance fees are paid annually and are generally related to the
issuers' total shares outstanding in the listed security. In 1998,
listing fees accounted for approximately 23% of SRO revenue,\213\
while, in 2003, these fees represented approximately 20% of SRO
revenue.\214\ These revenues have been highly concentrated in the
primary listing markets, with secondary markets charging little or no
listing fee.\215\ This concentration is exemplified by the fact that of
the $9,182 billion worth of stocks listed on exchanges in 2002, $9,119
billion was listed on the New York Stock Exchange.\216\
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\213\ Market Data Concept Release at 70625.
\214\ Data compiled from SRO 2003 Annual Reports. Note that the
NYSE 1998 Consolidated Statement of Revenue did not account for
``Data Processing Fee'' revenue. Due to an intervening change in
accounting procedures, the NYSE 2003 Consolidated Statement of
Revenue includes this item. To provide a more accurate comparison
between the 1998 and 2003 percentages, ``Data Fee Processing''
revenue was not included in total SRO revenue for the purpose of
calculating the percentage of total SRO revenue represented by
listing fee revenue. Based on SRO 2003 Annual Report Consolidated
Statements of Income certain items were allocated to listing fees
with respect to the NYSE (``Listing Fees''), the BSE (``Listing
Fees''), the NASD (including Amex and Nasdaq consolidated statements
of income) (``Issuer Services''), and the CHX (``Listing Fees'').
\215\ The recent increase in intermarket competition for equity
listings has raised issues related to listing fees and SRO funding.
In early 2004, for example, the Nasdaq Stock Market launched a dual
listing program to attract NYSE-listed issuers and offered a one
year waiver of all entry fees and annual fees for NYSE-listed
companies that became dually listed. Craig Karmin, Nasdaq Recruits
Six NYSE Firms to Dual Listings, Wall Street Journal, January 13,
2004, at C1.
\216\ See Commission, 2003 Annual Report, 140 (2004).
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The Commission specifically seeks public comment on the following
question related to SRO listing fees:
Question 22: To what extent has increased inter-market competition
impacted SRO listing fee revenue? To what extent has this impacted the
SROs' ability to fulfill their regulatory obligations?
d. Market Data Fees
Market data revenue has traditionally been a very important
component of SRO funding.\217\ In 1998, market data revenue represented
approximately 21% of SROs' total revenues,\218\ while, in 2003,
approximately 18% of SRO revenue flowed from market data.\219\ Market
data revenues represented 16% of NYSE revenues and 24% of Nasdaq
revenues in 2003.\220\ For one SRO, market data fees accounted for more
than 80% of its total 2003 revenue.\221\
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\217\ As noted above, while the level of fees charged by the
SROs for market data was not directly addressed in Reg NMS, broad
industry interest in the issue was apparent from the comments
received by the Commission in response to Reg NMS. Thus, while each
source of SRO revenue is important, this discussion examines market
data extensively and specifically examines the level of fees charged
for market data. Various commenters in response to Reg NMS stated
that market data revenues are an important source of funding for
SROs and should therefore not be capped or reduced. See letter from
William J. Brodsky, Chairman and Chief Executive Officer, The
Chicago Board Options Exchange, Inc., to Jonathan G. Katz,
Secretary, Commission, p. 9 (July 1, 2004) (``Reg NMS CBOE
letter''); letter from David A. Herron, Chief Executive Officer,
Chicago Stock Exchange, to Jonathan G. Katz, Secretary, Commission,
pp.18-19 (June 30, 2004); and letter from David Humphreville,
President, The Specialist Association, to Jonathan G. Katz,
Secretary, Commission, p. 17 (June 30, 2004). One Reg NMS commenter
believed that, in absence of market discipline, the Commission and
SROs must ensure that the collection and allocation of revenues to
different regulatory functions maximize investor protections at a
reasonable cost. See letter from Huw Jenkins on behalf of UBS
Securities LLC, Managing Director, Head of Equities for the
Americas, to Jonathan G. Katz, Secretary, Commission, p. 10 (June
30, 2004) (``Reg NMS UBS letter''). An SRO commenter stated that it
is consistent with the purpose and intent of Section 11A of the
Exchange Act for a significant portion of the market data revenue to
be used by SROs for operations and regulation because such costs are
directly related to the quality of the market data disseminated. See
Reg NMS CBOE letter, p. 9.
\218\ Market Data Concept Release at 70625.
\219\ Data compiled from SRO 2003 Annual Reports. Note that the
NYSE 1998 Consolidated Statement of Revenue did not account for
``Data Processing Fee'' revenue. Due to an intervening change in
accounting procedures, the NYSE 2003 Consolidated Statement of
Revenue includes this item. To provide a more accurate comparison
between the 1998 and 2003 percentages, ``Data Fee Processing''
revenue was not included in total SRO revenue for the purpose of
calculating the percentage of total SRO revenue represented by
market data fee revenue. Based on SRO 2003 Annual Report
Consolidated Statements of Income certain items were allocated to
market data fees with respect to the NYSE (``Market Data Fees''),
the BSE (``Communications, Net Note B''), the Phlx (``Security Price
Data and Floor Charges''), the NASD (including Amex and Nasdaq
consolidated statements of income) (``Market Data Fees''), the PCX
(``Peripheral Equipment and Market Data Fees''), the CHX (``Market
Data Fees''), the CBOE (``OPRA Income''), and the NSX (``Market Data
Fees'').
\220\ Data compiled from NYSE and NASD 2003 Annual Reports.
\221\ See NSX, 2003 Annual Report Exhibit I-12 (2004).
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In contrast to the importance of market data revenue to overall SRO
funding, it is worth noting that it represents a relatively small
portion of the securities industry's total expenses. For example, in
1998, the total SRO market data revenue of $410.6 million represented a
very small portion of the securities industry's total expenses for the
year--less than 1/4th of one percent.\222\ In spite of revenue derived
from market data playing an important role in SRO funding, some SROs
rebate substantial market data revenues to the market participants that
contribute to creating the market data.\223\
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\222\ See Market Data Concept Release Appendix.
\223\ See Reg NMS at 11179.
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The U.S. equity markets are not alone in their reliance on market
data revenues as a source of funding. All of the other major world
equity markets currently derive large amounts of revenues from selling
market information, despite having significantly less trading volume
and less market capitalization than the NYSE and Nasdaq. To illustrate,
the following table sets forth the respective market information
revenues, dollar value of trading, and market
[[Page 71271]]
capitalization for the largest world equity markets in 2003: \224\
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\224\ Table data is derived from the 2003 annual reports of the
various markets and from statistics compiled by the World Federation
of Exchanges.
----------------------------------------------------------------------------------------------------------------
Market
Data revenues Trading volume capitalization
(millions) (trillions) (trillions)
----------------------------------------------------------------------------------------------------------------
London................................................. $180 $3.6 $2.5
NYSE................................................... 172 9.7 11.3
Nasdaq................................................. 147 7.1 2.8
Deutsche Bourse........................................ 146 1.3 1.1
Euronext............................................... 109 1.9 2.1
Tokyo.................................................. 60 2.1 3.0
----------------------------------------------------------------------------------------------------------------
Understanding market data pricing and the role that market data
plays with respect to SRO funding is an important part of this
discussion. Congress recognized that SROs would charge for market data
when it gave the Commission authority in the 1975 Amendments to
determine the extent to which SRO fees charged for market data are
``fair and reasonable,'' are ``not unreasonably discriminatory,'' and
achieve ``equitable allocation'' of reasonable fees among persons who
use an SRO's facilities.\225\ Market information revenues serve an
important and unique role in that they provide a broad source of SRO
funding. The fees are paid by all users of market information,
including, for example options and futures markets participants that
otherwise would not contribute (through transactions services fees or
listing fees) to the funding of the particular markets on whose
information they rely. \226\
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\225\ See Exchange Act Sections 6(b), 11A(c), and 15A(b), 15
U.S.C. 78f(b), 78k-1(c), and 78o-3. Two provisions of the Exchange
Act directly address market data fees. Section 11A(c)(1)(C) grants
rulemaking authority to the Commission to assure that all securities
information processors may obtain market information from an
exclusive processor of that information (i.e., the processors for
the three Networks) on terms that are fair and reasonable. Section
11A(c)(1)(D) also grants rulemaking authority to the Commission to
assure that all persons may obtain market information on terms that
are not unreasonably discriminatory. The Commission applies these
standards in reviewing fee filings submitted by exclusive processors
for the three consolidated networks that disseminate market data in
NMS stocks. The three Networks are (1) Network A, which disseminates
data in stocks listed on the NYSE; (2) Network B, which disseminates
data in stocks listed on Amex and the regional exchanges; and (3)
Network C, which disseminates data in stocks listed on Nasdaq. The
Commission also applies these standards in reviewing market data
filings submitted by individual SROs.
\226\ See Market Data Concept Release at 70628.
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In addition to being important to SROs, market data is also
critical to market participants and investors. Market data is essential
to investors and other market participants not physically present in a
trading market, enabling them to make informed decisions when to buy
and sell. It provides the basis for investment and portfolio decisions.
And it creates confidence in the fairness and reliability of the
markets. The current market data systems for equities and options
collect quotes and trades from many different market centers and
disseminate them to the public in a single stream of information for
each security. This market information has been an essential element in
the success of the U.S. securities markets. In addition to providing
transparency of buying and selling interest, consolidated data is the
principal tool for addressing fragmentation of trading among many
different market centers, and for facilitating the best execution of
investor orders by their brokers.\227\ Market data fees can have a
major impact on the effectiveness of the market data system. The level
of these fees and their structure determines the extent that market
data is available to different types of market participants and
investors. And market data can have anticompetitive effects if it is
sold on discriminatory terms or in an unfair fashion.\228\
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\227\ Reg NMS at p.11176.
\228\ In the past, SROs have attempted to distribute market data
in ways that could potentially harm competitors. For example, in
proposing a new ``depth of book'' market data product, Liquidity
Quote, the NYSE asserted that it would incorporate a downstream data
consolidation restriction clause into its agreements with market
data vendors for the product that would prohibit its being
integrated with any other market data product. A variety of anti-
competition arguments were raised in connection with this proposal
and, ultimately, the Commission approved the proposal, but made the
approval expressly contingent upon the NYSE not applying the
downstream restrictions that were in its vendor agreements at the
time of the approval. See generally Exchange Act Release Nos. 47091
(December 23, 2002), 68 FR 133 (January 1, 2003); 47614 (April 2,
2003), 68 FR 17140 (April 8, 2003).
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Market data fees also support the timeliness, accuracy, and
reliability of the market data being disseminated. Market data, whether
consolidated or not, that is untimely or untrustworthy could harm
investors and reduce confidence in the fairness of the U.S. securities
markets. One of the Commission's most important market structure
responsibilities is to assure the integrity of market data.\229\ Today,
market data from all equity and options markets is highly reliable and
widely used. In order to promote the wide public availability of this
information, market data fees must be fair and reasonable.\230\
Consistent with this is the notion that such fees should at least
generate sufficient revenue to provide adequate funding for the
dissemination of market data.
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\229\ When Congress mandated the creation of a national market
system, it stated that ``communication systems, particularly those
designed to provide automated dissemination of last sale and
quotation information with respect to securities, will form the
heart of the national market system.'' H.R. Rep. No. 94-229, 94th
Cong., 1st Sess. 93 (1975). While Congress did not specifically
mandate the creation of a consolidated market data processor system,
the Commission has recently emphasized the benefits of consolidated
market data, particularly for retail investors. See Reg NMS at
11177.
\230\ See Exchange Act Section 11A(c)(1)(C). 15 U.S.C. 78k-
1(c)(1)(C).
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Currently, the Commission typically reviews market data fees in the
context of proposed fee changes filed by the three networks that
disseminate market data in NMS stocks. These fee filings are published
for notice and comment before Commission action.\231\ After
[[Page 71272]]
these filings are published, the Commission determines whether the fees
are fair and reasonable, not unreasonably discriminatory, and otherwise
consistent with the requirements of the Exchange Act.\232\ Although
most market data fee filings currently involve Network fees, the same
standard applies and the same questions arise with regard to the market
data fees of an individual SRO.
---------------------------------------------------------------------------
\231\ Several Reg NMS commenters believed that the existing
notice and comment process for effecting market data fee changes
does not facilitate informed and meaningful public and industry
participation and comment. See letter from Gary Cohn, Managing
Director, Goldman, Sachs & Co., to Jonathan G. Katz, Secretary,
Commission, p. 12 (July 19, 2004) (``Reg NMS Goldman letter'');
letter from Carrie E. Dwyer, Charles Schwab & Co., Inc., to Jonathan
G. Katz, Secretary, Commission, p. 9 (June 30, 2004) (``Reg NMS
Schwab letter''); letter from Marc Lackritz, President, Securities
Industry Association, to Jonathan G. Katz, Secretary, Commission,
pp. 24 and 26 (June 30, 2004) (``Reg NMS SIA letter''); and letter
from Mary McDermott-Holland, Chairman, John C. Giesea, President/
CEO, The Security Traders Association, to Jonathan G. Katz,
Secretary, Commission, p. 15 (June 30, 2004) (``Reg NMS STANY
letter''). A few of these commenters also believed that these
procedures, which provide that market data fee changes are effective
upon filing, gives excessive power to self-interested parties. See
Reg NMS Schwab letter, p. 9; Reg NMS SIA letter, p. 26; and Reg NMS
STANY letter, p. 15. The SIA also stated that ``[t]he fact that the
Commission may abrogate the proposal and require refiling does not
equate to a substantive review or challenge to the fees charged, and
has not proved such in the past.'' See Reg NMS SIA letter, p. 26.
The SIA and STANY also suggested that this is responsible, in part,
for excessive market data fees. See Reg NMS SIA letter, pp. 3 and
26-27; STANY letter, p. 15. Schwab recommended amending Commission
rules and the joint-SRO plans to eliminate the ``effective upon
filing'' process for market data fee changes, including changes that
would impact the treatment of market data users and market data
distribution policies. See Reg NMS Schwab letter, p. 9. Schwab also
recommended that the Commission require the joint-SRO plans to file
material policy changes as rule changes that require public notice
and comment prior to adoption. See Reg NMS Schwab letter, p. 9.
Although fees charged by SROs to members generally are effective on
filing, market data fees charged to the public are published for
notice and comment before approval. See Exchange Act Rule 19b-4, 17
CFR 240.19b-4.
\232\ See Exchange Act Section 11A, 15 U.S.C. 78k-1; Exchange
Act Rule 11Aa3-2, 17 CFR 240.11Aa3-2.
---------------------------------------------------------------------------
In reviewing a market data fee filing, the Commission has relied to
a great extent on the ability of the Networks to negotiate fees that
are acceptable to SRO members, information vendors, investors, and
other interested parties. The negotiation process is buttressed by the
public notice and comment procedures that accompany the Commission's
consideration of proposed rule changes.
As equities and options markets have evolved in recent years,
strains began to develop in the arrangements for market data,
particularly with respect to setting fees. In evaluating the issues
raised, an extensive public record has been developed on the subject of
market data fees in the last five years. In 1999, the Commission
initiated a full-scale review of market data fees and revenues in the
Market Data Concept Release. The review was prompted, in part, by the
Commission's concern that retail investors might be paying too much for
market data.\233\ The Market Data Concept Release included the role of
revenues derived from such fees in funding the operation and regulation
of markets.\234\ The Market Data Concept Release presented for public
review a great deal of factual information on market data fees and
revenues.\235\ In the course of that effort, the Commission emphasized
that market data must be affordable for retail investors.\236\ At about
the same time, the Networks filed proposed rule changes that reduced
retail investor fees generally by 75% to 80%. The following table sets
forth retail investor fees for NYSE and Nasdaq stocks in 2003 and in
1998:
---------------------------------------------------------------------------
\233\ The Internet had greatly expanded the opportunity for
retail investors to obtain access to real-time market data through
on-line accounts with their broker-dealers, and investor demand for
this data had grown exponentially. For example, the Market Data
Concept Release noted that the revenues derived from fees applicable
to retail investors had grown from $3.7 million in 1994 to $38.9
million in 1998, and represented approximately 9% of total market
data revenues. Market Data Concept Release at 70614 and 70631.
\234\ See generally Id. at Section IV.
\235\ The Appendix, for example, included 16 tables setting
forth all of the different subscriber fees of the Networks, the
revenues, expenses, and distributions of the Networks, and the
revenues and expenses of each of the individual SROs that are
participants in the Networks. In addition, the Market Data Concept
Release included information to help the public assess whether the
level of market data fees remained fair and reasonable. For example,
the release noted that even prior to creation of the national market
system and the Networks, market data revenues were an important
source of SRO funding--market data revenues represented 14.7% of the
NYSE's total revenues in 1975, compared to 15.3% in 1998. Market
Data Concept Release at 70621. As noted above, market data revenues
represented 16.0% of NYSE revenues in 2003. In addition, although
the total amount of market data revenues had grown substantially in
recent years, the increase was proportional to the increase in other
SRO revenues. In 1994, market information revenues amounted to
$246.1 million and represented 20% of SRO funding. In 1998, such
revenues amounted to $410.6 million and represented 21% of SRO
funding. The Commission noted that ``the growth in market
information revenues has simply kept pace with the growth of other
SRO revenues during the prolonged expansion in trading volume of the
last five years. The SROs are no more, but also no less, dependent
on market information revenues today than they were in 1994.''
Market Data Concept Release at 70615. Moreover, the percentage
growth in market data revenues from 1994 to 1998 was 67%, but had
not kept pace with the percentage growth in the securities
industry's total revenues during this major expansion of trading,
which was 139%. Id. at 70626.
\236\ The Commission noted that one of the most important
functions of the Commission is to assist retail investors in
accessing the information they need to protect and further their own
interests. Moreover, the Commission stated that communications
technology had progressed so that broad access to real-time market
information should be an affordable option for most retail
investors. This information, the Commission believed, could greatly
expand the ability of retail investors to trade securities. The
Commission stated its intention that to assure that market
information fees applicable to retail investors do not restrict
their access to market information and that such fees must be non-
discriminatory when compared with the fees charged to professional
users of market information. Market Data Concept Release at 70614.
----------------------------------------------------------------------------------------------------------------
NYSE Nasdaq
-------------------------------------------------------------------------
2003 1998 2003 1998
----------------------------------------------------------------------------------------------------------------
Per Query............................. \1/4\[cent] to \3/4\[cent]....... 1[cent] \1/2\[cent] 1[cent]
Monthly............................... $0.50 to $1.00................... $5.25 $1.00 $4.00
----------------------------------------------------------------------------------------------------------------
The per-query fees are charged each time that a retail investor
requests quote and trade information in a particular stock. The monthly
fees represent limits on the total amount that a retail investor can be
charged for market data in any month. Thus, for example, all retail
investors currently have access to an unlimited quantity of the
millions of best quotes and trades in Network A stocks during each
trading day for no more than $1 per month, compared to the $5.25 that
was charged before the Commission's review of market data fees.\237\
---------------------------------------------------------------------------
\237\ See Network C / NASD-2003-132, Securities Exchange Act
Release No. 48386 (August 21, 2003), 68 FR 51618 (August 27, 2003)
(extending pilot program for reduced non-professional NQDS user
fee); Network C / NASD-2002-117, Securities Exchange Act Release No.
46446 (August 30, 2002), 67 FR 57260 (September 9, 2002) (extending
pilot program for reduced non-professional NQDS user fee); Network C
/ NASD-2001-56, Securities Exchange Act Release No. 44788 (September
13, 2001), 66 FR 48303 (September 19, 2001) (extending pilot program
allowing for reduced non-professional NQDS user fee); Network C /
NASD-2001-32, Securities Exchange Act Release No. 44363 (May 29,
2001), 66 FR 30254 (June 5, 2001) (permanently approving reduced
Level 1 Service fees for non-professional users on a monthly and per
query basis); Network B / CTA-01-01, Securities Exchange Act Release
No. 44047 (March 7, 2001), 66 FR 15151 (March 15, 2001) (reducing
the initial ticker charge at each customer location from $21.50 to
$13.50 and thereby creating a uniform charge for each location);
Network C / NASD-00-47, Securities Exchange Act Release No. 43190
(August 22, 2000), 65 FR 52460 (August 29, 2000) (establishing pilot
program for reduced non-professional NQDS user fee); Network C /
NASD-00-19, Securities Exchange Act Release No. 42715 (April 24,
2000), 65 FR 25411 (May 1, 2000) (extending pilot program for
reduced Level 1 Service fees for non-professional users on a monthly
and per query basis and further reducing the Level 1 Service monthly
fee for non-professionals); Network B / CTA/CQ-99-02, Securities
Exchange Act Release No. 42138 (November 15, 1999), 64 FR 63350
(November 19, 1999) (reducing the Network B non-professional
subscriber flat service rate, permanently approving and reducing
tiered pay-for-use rates for non-professional subscribers, and
allowing non-professional subscribers to pay the lower of the pay-
for-use or flat rates); Network A / CTA/CQ-99-01, Securities
Exchange Act Release No. 41977 (October 5, 1999), 64 FR 55503
(October 13, 1999) (reducing, inter alia, the Network A non-
professional subscriber flat service rate, permanently approving and
reducing tiered pay-for-use rates for non-professional subscribers,
and allowing non-professional subscribers to pay the lower of the
pay-for-use or flat rates); Network C / NASD-99-25, Securities
Exchange Act Release No. 41499 (June 9, 1999), 64 FR 32910 (June 18,
1999) (establishing pilot program for reduced Level 1 fees for non-
professional users on a monthly and per query basis); Network C /
NASD-99-17, Securities Exchange Act Release No. 38608 (May 12,
1997), 62 FR 27095 (May 16, 1997) (increasing monthly subscriber fee
for Level 1 Service); Network B / Securities Exchange Act Release
No. 29879 (October 29, 1991), 56 FR 56430 (November 4, 1991)
(increasing Network B professional and non-professional subscriber
fees); and Network A / Securities Exchange Act Release No. 29863
(October 25, 1991), 56 FR 56429 (November 4, 1991) (increasing
Network A professional and non-professional subscriber fees).
---------------------------------------------------------------------------
[[Page 71273]]
In reviewing the basis for evaluating market data fees, the Market
Data Concept Release laid out in detail a ``flexible cost-based
approach'' to market data fees.\238\ The Commission noted that terms
such as ``fair'' and ``reasonable'' generally need standards to guide
their application in practice, and that one such standard often used to
evaluate fees is the amount of costs incurred to provide a
service.\239\ The Commission stated that an inflexible cost-based
standard, although unavoidable in some contexts, can entail severe
practical difficulties.\240\ Instead, Congress, consistent with its
approach to the National Market System in general, granted the
Commission some flexibility in evaluating the fairness and
reasonableness of market information fees.\241\ Specifically, Congress
articulated general findings and objectives for the National Market
System in section 11A and directed the Commission to act accordingly in
overseeing its development.\242\ Congress thereby allowed the
Commission to adopt a more flexible approach than ratemaking.\243\
---------------------------------------------------------------------------
\238\ Market Data Concept Release at 70629-70632.
\239\ Id. at 70619.
\240\ Id.
\241\ Id.
\242\ Id.
\243\ Id.
---------------------------------------------------------------------------
To illustrate the practical difficulties of a strict, cost-of-
service ratemaking approach, the Market Data Concept Release described
one prior instance in which the Commission had sought to implement such
an approach in 1984.\244\ In that instance, Instinet had brought a
proceeding before the Commission asserting that the NASD's fee for full
quotation information from all Nasdaq market participants was an
unwarranted denial of access to the information.\245\ The Commission
found in favor of Instinet, primarily because the NASD had failed to
submit an adequate cost-based justification for the fee.\246\ The
Instinet Order emphasized, however, that the scope of its decision was
limited to the particular competitive context presented in the
proceedings and did not apply to all market data fees.\247\
---------------------------------------------------------------------------
\244\ See generally Securities Exchange Act Release No. 20874
(April 17, 1984), 49 FR 17640 (April 24, 1984) (``Instinet Order'').
\245\ Id.
\246\ Id.
\247\ Id. The Market Data Concept Release then related the long
process that ensued to arrive at a cost-based fee:
The practical difficulties of implementing this strict, cost-of-
service approach are demonstrated by the subsequent history of the
fee involved in the Instinet Order (later named the ``NQDS'' fee).
In August 1985, the NASD proposed a revised fee of $79 per month.
The Commission did not approve this proposal, but instead instituted
proceedings to determine whether it should be disapproved, based
primarily on the question whether the fee included some costs that
were inconsistent with the Instinet Order. In September 1986, the
NASD proposed another NQDS fee of $50.75 per month. This proposal
was supported by an extensive and complex ratemaking analysis. It
included a comprehensive allocation of costs to pools consisting of
six resources and eleven services. The major categories of costs
were summarized as (1) operational costs, which were allocated to
the six resource pools based on identifiable personnel, equipment,
and physical facilities dedicated to those operations, (2) systems
and product/service development costs, which were allocated to the
six resource cost pools based on the historical or anticipated level
of effort to be devoted to the respective resources, (3) overhead
and general and administrative costs, which were allocated directly
to resource and service cost pools to the extent that a causal
relationship existed between those resources or services and the
incurrence of the affected costs, and (4) residual overhead and
general and administrative costs, which were allocated to resource
and service cost pools based on the total cost input base.
The Commission had not acted on this proposal when the NASD, in
July 1990, proposed yet another NQDS fee of $50 per month. This fee,
however, included last sale information in addition to quotation
information. The Commission approved the fee in October 1990.
Notably, the Commission did not undertake any cost-based explanation
of the $50 fee, nor did it express any opinion on the extensive
cost-of-service analysis that had been included in the NASD's
September 1986 proposal. Instead, it noted that, ``in reviewing the
fairness and reasonableness of the proposal, the Commission finds it
significant that the proposed fee of $50 is the result of
negotiations among the concerned parties after protracted
proceedings.'' The $50 fee approved for NQDS information in 1990 has
remained unchanged up to the present.
Market Data Concept Release at 70623 (footnotes omitted).
---------------------------------------------------------------------------
While recognizing the practical difficulties of a detailed cost-of-
service approach, the Commission nevertheless concluded in the Market
Data Concept Release that ``the total amount of market information
revenues should remain reasonably related to the cost of market
information.'' \248\ In this regard, one of the issues on which comment
particularly was requested was whether the Commission should adopt ``a
conceptual approach to evaluating the fairness and reasonableness of
fees that, among other things, could establish a link between the cost
of market information and the total amount of market information
revenues.'' \249\ Critical to this concept was the determination of
what SRO costs should be included in the cost of market data.
---------------------------------------------------------------------------
\248\ Id. at 70627.
\249\ Id. 70615.
---------------------------------------------------------------------------
The Market Data Concept Release's flexible, cost-based approach was
intended to arrive at an approach to market data fees that could be
implemented in a reasonably efficient manner, as opposed to a full-
fledged ratemaking approach. The first step in fashioning the approach
was to identify the categories of SRO costs incurred to generate and
disseminate market data. All direct market data costs, such as market
data recordation, communication, consolidation, and dissemination,
would be included. The flexible cost-based approach would also have
included in market data costs some portion of ``common costs''--those
costs that support multiple SRO functions, in addition to market data,
and therefore must be allocated among these services.\250\ These common
costs comprised the costs of operating the market that produced the
market data and the costs of regulating that market so that the data
was not inaccurate and not derived from fraudulent or abusive conduct.
\251\ The Market Data Concept
[[Page 71274]]
Release noted that there is little value to market information that is
tainted by fraud, deception, or manipulation.\252\ Moreover, the goal
of producing high quality market data cannot be achieved by a poorly
operated market that is prone to systems outages and delays.\253\
---------------------------------------------------------------------------
\250\ As the Commission described in the Market Data Concept
Release, under the flexible, cost-based approach, the information
that the SROs provide to the Networks would not be considered cost-
free. Before quotations and transaction reports can be consolidated
and made available to the public, an organized market must provide a
mechanism for facilitating the buying and selling of securities in a
fair and orderly manner. In addition, the SROs must establish,
monitor, and enforce trading rules, as well as otherwise regulate
their markets to prevent fraudulent and manipulative acts or
practices. The SROs incur substantial costs in performing these
functions, and they contribute substantially to the value of the
information. Id. at 70627.
\251\ In contrast to costs incurred to operate and regulate
markets, the flexible, cost-based approach set forth in the Market
Data Concept Release excluded those SRO costs that did not directly
contribute to the quality of market data. These included the costs
of member regulation (e.g., sales practice and net capital
requirements) and those costs directly associated with other SRO
services. Advertising and marketing expenditures were specifically
excluded from market data costs.
\252\ Market Data Concept Release at 70627.
\253\ For example, in times of significant price volatility and
spikes in trading volume, it is critically important that the
markets remain fair and orderly and that investors continue to have
access to a timely stream of market information.
---------------------------------------------------------------------------
The Market Data Concept Release recognized that not all common
costs should be funded by market data, and that any resulting
allocation decision would be conceptually difficult.\254\ While the
Market Data Concept Release's approach to evaluating the fees of the
Networks would require aggregating the allocated costs of the
contributing SROs, the Market Data Concept Release specifically stated
that a distribution of the revenues need not follow the costs of each
SRO, but could be based on the quality of the data contributed by the
SRO and its contribution to the market data stream.\255\ The Market
Data Concept Release also questioned whether the rebate of market data
revenues demonstrated that the existing fees were too high.\256\
---------------------------------------------------------------------------
\254\ Market Data Concept Release at 70628-70629.
\255\ Market Data Concept Release at 70628.
\256\ Market Data Concept Release at 70630-70632.
---------------------------------------------------------------------------
In reflecting on the Market Data Concept Release and the industry's
reaction to it, the Commission gained an understanding of the serious
divisions in the securities industry over how best to regulate market
data. Specifically, there was a sharp division on the fairness and
reasonableness of the existing fee levels of market data. In addition,
there was a split of opinion as to whether market information fees
should provide funding for other SRO functions such as market
regulation or should be more closely related to the direct cost of
producing the data. Also significant in the comments to the Market Data
Concept Release were proposals that more competition be introduced to
the compilation and dissemination of market data.\257\
---------------------------------------------------------------------------
\257\ See generally Report of the Advisory Committee on Market
Information: A Blueprint for Responsible Change (September 14,
2001), Section V (available at http://www.sec.gov) (``Advisory
Committee Report''). The Advisory Committee Report includes a
comprehensive description of the arrangements for disseminating
market data to the public, including the terms, fees, and revenues
of the Plans.
---------------------------------------------------------------------------
To help resolve these divisions, the Commission established its
Advisory Committee on Market Information in the summer of 2000. In its
2001 report, however, the Advisory Committee specifically rejected the
flexible cost-based approach.\258\ The Advisory Committee report noted
the consensus view that it was essentially a ``ratemaking'' approach
that was unwise and, ultimately, unworkable.\259\ The Advisory
Committee recommended retaining price transparency and consolidated
market information as core elements of the U.S. securities markets,
while adopting a ``competing consolidators'' model of data
dissemination.\260\ Under this model, vendors and market data users
would themselves consolidate the data from the various markets, with
each SRO separately providing and setting fees for its own data, rather
than consolidating this data through the Networks.
---------------------------------------------------------------------------
\258\ See Advisory Committee Report.
\259\ In the view of a majority of the Advisory Committee, ``the
`public utility' cost-based ratemaking approach is generally
disfavored today. It is resource-intensive, involves arbitrary
judgments on appropriate costs, and creates distortive economic
incentives. Accordingly, the Advisory Committee recommends that the
Commission not adopt a cost-based approach for determining whether
market information fees are consistent with the Exchange Act * * *
Furthermore, the Advisory Committee does not recommend any specific
changes to the standard under which the Commission reviews market
data fees and revenues, or to the manner in which it conducts this
review.'' Advisory Committee Report at Section VII.D.3.
\260\ Advisory Committee Report at Section V.
---------------------------------------------------------------------------
In commenting on proposed Regulation NMS, a number of SROs said the
current market data Networks and their fees were reasonable, while
several larger markets and their adherents advocated the competing
consolidator model. Many other commenters said that the fees they pay
to obtain basic market data--NBBO and trades--are excessive, and are
not reasonably related to the cost of producing such data.\261\ As in
earlier debates, some commenters said that market data fees should be
limited to covering solely the costs incurred to disseminate
consolidated market data, not the costs incurred by the individual SROs
to produce the data and provide it to the Networks.\262\ Other
commenters said that a prerequisite for evaluating the appropriateness
of funding SRO operations and regulatory costs from market data
revenues was a transparent accounting of the revenues received for
market data and the expenses incurred in operating and regulating the
SRO's market.\263\
---------------------------------------------------------------------------
\261\ Many commenters, mostly securities firms and associations,
believed that the Commission failed to address the main underlying
problem, which they believe to be the root of the economic and
regulatory distortions that the Commission is trying to address--
whether the current fees for market data are excessive in relation
to the actual cost of collecting and disseminating market data. See
letter from Daniel M. Clifton, Executive Director, American
Shareholders Association, to Jonathan G. Katz, Secretary,
Commission, ASA Letter, p. 2 (June 10, 2004) (``Reg NMS ASA
letter''); letter from Kim Bang, President and Chief Executive
Officer, Bloomberg Tradebook, LLC, to Jonathan G. Katz, Secretary,
Commission, pp. 2 and 8-9 (June 30, 2004) (``Reg NMS Bloomberg
letter''); letter from C. Thomas Richardson, Citigroup Global
Markets, Inc., to Jonathan G. Katz, Secretary, Commission, pp. 4 and
15 (July 20, 2004) (``Reg NMS Citigroup letter''); Reg NMS Goldman
Sachs Letter, pp. 2 and 10; letter from Samuel F. Lek, Chief
Executive Officer, Lek Securities Corporation, to Jonathan G. Katz,
Secretary, Commission, (no page numbers) (May 24, 2004) (``Reg NMS
Lek letter''); letter from Thomas N. McManus, Managing Director and
Counsel, Morgan Stanley, to Jonathan G. Katz, Secretary, Commission,
pp. 3 and 21 (August 19, 2004) (``Reg NMS Morgan Stanley letter'');
letter from David Colker, Chief Executive Officer and President,
NSX, to Jonathan G. Katz, Secretary, Commission, pp. 6-7 (June 29,
2004) (``Reg NMS NSX letter''); Reg NMS Schwab letter, p. 2; Reg NMS
SIA letter, pp. 3 and 22; and Reg NMS STANY letter, p. 14.
A range of commenters believed that the current level of market
data fees warranted review. See letter from Ellen L. S. Koplow,
Executive Vice President and General Counsel, Ameritrade, Inc., to
Jonathan G. Katz, Secretary, Commission, Letter, pp. 3 and 10 (June
30, 2004) (``Reg NMS Ameritrade letter''); letter from James J.
Angel, Ph.D., CFA, Associate Professor of Finance, McDonough School
of Business, to Jonathan G. Katz, Secretary, Commission, Letter I,
p. 5 (June 30, 2004)(``Reg NMS Angel letter''); Reg NMS ASA Letter,
p. 2; Reg NMS Bloomberg Letter, pp. 2 and 8-9; letter from William
O'Brien, Chief Operating Officer, Brut, LLC, to Jonathan G. Katz,
Secretary, Commission, pp. 21-23 (July 29, 2004) (``Reg NMS Brut
letter''); Reg NMS Citigroup Letter, p. 15; letter from W. Leo
McBlain, Chairman, Financial Information Forum, and Thomas J.
Jordan, Executive Director, Financial Information Forum, to Jonathan
G. Katz, Secretary, Commission, p. 3 (July 9, 2004)(``Reg NMS FIF
letter''); letter from Richard M. Whiting, Executive Director and
General Counsel, Financial Services Roundtable, to Jonathan G. Katz,
Secretary, Commission, pp. 6-7 (June 30, 2004) (``Reg NMS FSR
letter''); Reg NMS Goldman Sachs letter, pp. 2 and 10; letter from
Ari Burstein, Associate Counsel, Investment Company Institute, to
Jonathan G. Katz, Secretary, Commission, pp. 21-22 (June 30, 2004)
(``Reg NMS ICI letter''); Reg NMS Lek letter (no page numbers); Reg
NMS Morgan Stanley letter, pp. 3 and 21-22; Reg NMS Nasdaq letter,
pp. 4 and 24-26; Reg NMS NSX letter, pp. 6-7; Reg NMS Schwab letter,
p. 2; Reg NMS SIA letter, pp. 3 and 22; Reg NMS STANY letter, p. 14;
and Reg NMS UBS letter, p. 10.
\262\ Many commenters believed that market data revenues should
not be used to fund regulatory costs of the SROs. See Reg NMS
Citigroup letter, pp. 15-16; Reg NMS FIF letter, p. 3; Reg NMS
Goldman Sachs letter, p. 11; Reg NMS Schwab letter, p. 3; and Reg
NMS SIA letter, pp. 3 and 23.
\263\ Some Reg NMS commenters believed that market data fees are
not transparent enough to allow a proper assessment of the
appropriateness of fees charged because SROs' operating costs and
use of revenues are not revealed. See Reg NMS Ameritrade Letter, pp.
10-11; letter from W. Hardy Callcott, to Jonathan G. Katz,
Secretary, Commission, pp. 2-3 (May 6, 2004) (``Callcott letter'');
Reg NMS Goldman Sachs letter, p. 11; Reg NMS Schwab letter, p. 7;
Reg NMS SIA letter, pp. 22-23 and 25; and Reg NMS STANY letter, pp.
14-15.
---------------------------------------------------------------------------
As noted above, to provide greater transparency of SRO revenues and
[[Page 71275]]
expenses, the Commission is proposing in the SRO Governance and
Transparency Proposal to require SROs to file with the Commission
public reports detailing their sources of revenues and their uses of
these revenues, specifically including their costs of regulation.\264\
These reports could provide observers greater ability to evaluate the
role of market data revenues in financing an SRO, and to compare these
revenues to the expenses of operating and regulating their market. This
information also could empower users to respond to market data fee
changes on a more informed basis.
---------------------------------------------------------------------------
\264\ See supra note 99.
---------------------------------------------------------------------------
Thus, given the concerns raised in response to proposed Reg NMS
regarding market data fees and because these issues are related to
considerations of overall SRO funding and regulatory operations, the
Commission is seeking comment on a number of issues.
Question 23: Should market data revenue be used to cross subsidize
SRO regulatory operations?
Question 24: Are current market data fees significantly limiting
access of market participants, investors, or other users to data? Why
are certain market data fees more problematic than others, such as
those associated with SRO data products that are not part of the
consolidated quote stream? If so, which fees and why?
Question 25: Should the Commission reconsider the flexible, cost-
based approach?
Question 26: Should the Commission consider a narrow cost-based
approach that takes into account only limited costs, such as
consolidation costs?
Question 27: On a conceptual basis, what should be included in the
cost of generating market data?
Question 28: Are there other, better cost-based approaches? What
are their potential benefits and drawbacks?
Question 29: Should the Commission require a more detailed
explanation of how SROs spend the revenue generated from market data
fees? Would the requirements proposed in the SRO Governance and
Transparency Proposal that SROs detail their sources and uses of
revenues add sufficient transparency in this area, or should more
detailed reporting be mandated?
Question 30: If the Commission were to implement a revised approach
to market data fees that substantially reduced this element of SRO
funding, would SROs be able to raise the level of other revenue sources
to remain adequately funded to comply with their statutory obligations?
Question 31: What SRO fees or other charges presently are under
priced? What SRO fees or charges are over priced? On balance, are SROs
over funded or under funded? What would be the impact on smaller SRO
members of funding regulatory costs exclusively through regulatory
fees?
Question 32: If market data fees were substantially reduced and
SROs were unable to replace these revenues from other sources, would
SROs be able to adequately fund their regulatory operations? If an
SRO's funding were to become insufficient because of such a decline in
revenue, should that SRO lose its status as a registered SRO?
Question 33: If market data fees were substantially reduced, would
this exacerbate the conflicts inherent in the SRO system--in
particular, the incentive to fund business functions at the expense of
regulation?
Question 34: To what extent would the enhancements proposed in the
SRO Governance and Transparency Proposal mitigate these concerns about
inherent conflicts? Are there other measures that could mitigate these
conflicts?
Question 35: Should the Commission require that all SRO fees and
charges be closely related to the cost of the SRO providing the service
in question? What would be the benefits and risks of doing so?
e. Miscellaneous Fees
In addition to regulatory fees, transaction fees, listing fees, and
market data fees, SROs receive revenue from a variety of miscellaneous
sources as well. For instance, SROs charge fees for administering joint
industry plans and market systems.\265\ SROs also derive funding from
product licensing,\266\ investment gains, and fines. In 1998, these
types of miscellaneous SRO fees accounted for 8% of SRO revenue,\267\
while, in 2003, 12% of SRO revenue was associated with these
miscellaneous fees.\268\ This relatively significant increase (a 50%
increase compared with the 1998 percentage for miscellaneous fees) may
have been caused by an increase in certain SRO sources of revenue, such
as derivative product licensing fees, and by the intervening
establishment of SRO relationships with other markets.\269\
---------------------------------------------------------------------------
\265\ For example, the NASD operates both the Central
Registration Depository (``CRD'') System for registered
representative registration and the Investment Advisor Registration
Depository (``IARD'') system. In addition, certain SROs earn fees
from the administration of the consolidated data networks.
\266\ For example, Nasdaq receives licensing fees from regional
exchanges that report trades in Nasdaq-100 Index Tracking Stock.
Nasdaq, 2003 Annual Report 43 (2004).
\267\ Market Data Concept Release at 70625.
\268\ Data compiled from SRO 2003 Annual Reports. Note that the
NYSE 1998 Consolidated Statement of Revenue did not account for
``Data Processing Fee'' revenue. Due to an intervening change in
accounting procedures, the NYSE 2003 Consolidated Statement of
Revenue includes this item. To provide a more accurate comparison
between the 1998 and 2003 percentages, ``Data Fee Processing''
revenue was not included in total SRO revenue for the purpose of
calculating the percentage of total SRO revenue represented by
miscellaneous fee revenue. Based on SRO 2003 Annual Report
Consolidated Statements of Income certain items were allocated to
miscellaneous fees with respect to the NYSE (``Facility and
Equipment'' and ``Investment Income''), the BSE (``Interest'' and
``Other''), the Phlx (``Clearing and settlement,'' ``Dividend and
Interest,'' and ``Other''), the NASD (including Amex and Nasdaq
consolidated statements of income) (``Dispute Resolution Fees'' and
``Other Revenue''), the PCX (``Archipelago Revenue: Original
Consideration Amortization,'' ``Communications,'' and ``Other''),
the CHX (``Interest'' and ``Other''), and the CBOE (``Interest'' and
``Other'').
\269\ E.g., the Amex's affiliation with the NASD and Arca's
affiliation with the PCX.
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The Commission specifically seeks public comment on the following
question related to SRO miscellaneous fees:
Question 36: In light of the recent growth in SRO revenue that is
derived from miscellaneous fees, how important are these fees to SRO
funding generally and will this growth trend continue? If so, how does
this revenue pose conflicts with respect to the SRO regulatory
function? How should these conflicts be addressed? How does it relate,
if at all, to the SROs' fulfilling their statutory obligations?
V. Alternative Regulatory Approaches
In order to focus consideration of the strengths and weaknesses of
the SRO system, the following section discusses a variety of
enhancements and alternative approaches, which would require either
Commission or Congressional action to achieve. Specifically, this
section will examine: (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. The discussion of each alternative examines how
effectively it would manage the current SRO system's inherent
limitations.
It is important to note that this discussion does not attempt to
provide an exhaustive list of every potential option and alternative
approach that
[[Page 71276]]
could be considered. The purpose of this section is to provide a
discussion of what appear to be some of the more promising
alternatives. Public comment sought, however, is not limited to the
options and alternative approaches described herein. In addition, while
this section attempts to detail the strengths and weaknesses of the
various options and alternative approaches, it should be noted that
such a discussion is inherently speculative. The full range of
strengths and weaknesses of any given option or alternative approach
would likely not be known until that approach were fully implemented.
A. Proposed Enhancements to the Current SRO System
The current SRO system has provided essential regulation of markets
and members for over seven decades. Nonetheless, this system has
inherent limitations that should be considered. This section discusses
possible enhancements to the status quo that could be implemented to
address these SRO limitations.
1. SRO Governance and Transparency Rulemaking
The Commission today is proposing an SRO Governance and
Transparency Proposal.\270\ 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.\271\ The proposed governance standards would
require SROs that are national securities exchanges and registered
securities associations to have a majority independent board and fully
independent Nominations, Governance, Audit, Compensation, and
Regulatory Oversight Committees (or their equivalent).\272\ SROs also
would be required to effectively separate their regulatory function
from their market operations and other commercial interests.\273\
---------------------------------------------------------------------------
\270\ See supra note 99.
\271\ Id.
\272\ Id.
\273\ Id.
---------------------------------------------------------------------------
With respect to the regulatory function, each SRO would be required
to establish standards to assure the independence of its regulatory
program. At a minimum, the regulatory function of an SRO would be
required to be overseen by a Chief Regulatory Officer who reports to,
and is evaluated by, an independent Regulatory Oversight Committee.
Moreover, SROs would be required to provide the Commission with
specified information concerning their regulatory programs on a regular
basis. As part of this proposal, each SRO would be required to prepare
for the Commission annual and quarterly regulatory reports that would
give details regarding key aspects of the SRO's regulatory program. As
part of the annual report, each SRO also would be required to disclose
employment arrangements with its Chief Regulatory Officer and other key
regulatory personnel. The filing of this regulatory program information
is intended to bolster the Commission's SRO inspections program and
thus would be kept confidential to the extent permitted by law.
In addition to filing quarterly and annual reports about their
regulatory programs, each SRO would be required to disclose publicly
information about its regulatory program and provide greater disclosure
regarding revenues and expenses and staffing of its regulatory program.
Finally, the SRO Governance and Transparency Proposal proposes
ownership and voting concentration limits on members that are broker-
dealers to mitigate the conflict of interest that would arise if a
broker-dealer were to control a significant interest in its regulator
or if a member could exercise too much control over the operations of
the SRO.
If the proposed SRO Governance and Transparency Proposal is
adopted, a number of benefits could be gained. Regulatory conflicts
with members, market operations, issuers, and shareholders could be
reduced. The strict reporting lines of the Chief Regulatory Officer
reporting to an independent board committee could reduce the SRO
regulation conflicts. In addition, the wholly independent Regulatory
Oversight Committee's sole responsibility for budgeting decisions with
respect to regulatory operations could help insulate the budgeting
process from business pressures.
While the Governance and Transparency Proposal could help manage a
variety of the traditional SRO limitations, it would not eliminate
them. For instance, conflicts could persist in spite of the majority
independent board because of the influence of representatives of large
members serving on the board, particularly if intermarket competition
pressures continue to increase. In addition, the fact that the
independent directors would necessarily rely on the expertise of the
industry directors to some degree could undermine some of the
structural protections put in place. Moreover, the independent
directors' own imperceptible institutional biases could compromise some
of the structural protections.
Concerns regarding unequal regulation and unequal regulatory
funding across markets would persist under the SRO Governance and
Transparency Proposal. This would be true even if each SRO's Regulatory
Oversight Committee were to make regulatory budgeting decisions
irrespective of business or other pressures. These committees would not
all necessarily allocate regulatory funding in the same fashion in the
different SROs; thus, regulatory inequalities could still exist. The
concerns regarding conflicting SRO rules, conflicting SRO rule
interpretations, conflicting SRO inspection regimes, and redundant
regulatory staff and infrastructure across markets would remain under
this proposal. Finally, the proposal also does not address potential
intermarket trading surveillance issues.
The Commission specifically seeks public comment on the following
questions related to the SRO Governance and Transparency Proposal:
Question 37: To what extent would the changes proposed in the SRO
Governance and Transparency Proposal effectively manage inherent SRO
limitations related to conflicts, funding, redundancies, and
intermarket surveillance?
Question 38: To what extent would the changes proposed in the SRO
Governance and Transparency Proposal continue to provide the benefits
of the current SRO system (e.g., largely self-funded system with market
specific expertise of SRO regulatory staff enhancing rule promulgation
and enforcement)?
Question 39: If adopted, would the SRO Governance and Transparency
Proposal enable the Commission, investors, and market participants to
perceive when a particular SRO was insufficiently funding its
regulatory function? If so, could this lead the SROs to develop and
follow voluntary guidelines or standards with respect to regulatory
spending levels?
Question 40: Would the changes proposed in the SRO Governance and
Transparency Proposal more effectively manage inherent SRO limitations
compared to the NYSE's recent corporate and regulatory function
restructuring? \274\
---------------------------------------------------------------------------
\274\ See Exchange Act Release Nos. 48946 (December 17, 2003),
68 FR 74678; 48764 (November 7, 2003), 68 FR 64380 (November 13,
2003) (regarding NYSE governance and regulatory function
amendments).
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[[Page 71277]]
2. Intermarket Surveillance Enhancements
Another incremental improvement to the current system could be the
enhancement of the Commission's and the SROs' ability to regulate
intermarket trading activity. As discussed at length above, several
equity markets have developed individual order audit trails, the
options markets have developed COATS to assist in the surveillance of
order flow in the options markets, and the ISG has developed a clearing
level order audit trail. Full implementation of a more robust
intermarket order audit trail for both the options and equity markets
could enhance the surveillance of intermarket order flow. It would not
by itself, however, manage any of the other inherent SRO limitations,
including conflicts, regulatory redundancies, and funding problems. In
addition, even with a consolidated order audit trail, the Commission
would have to be vigilant in determining whether the SROs used it to
enhance surveillance and regulation of intermarket trading.
The Commission specifically seeks public comment on the following
questions related to intermarket surveillance enhancements:
Question 41: To what extent would the establishment of a more
robust intermarket surveillance regime more effectively manage inherent
SRO limitations related to conflicts, funding, redundancies, and
intermarket surveillance?
Question 42: To what extent would enhancing intermarket
surveillance continue to provide the benefits of the current SRO system
(e.g., largely self-funded system with market specific expertise of SRO
regulatory staff enhancing rule promulgation and enforcement)?
Question 43: To what extent is COATS serving as an effective tool
for enhancing intermarket surveillance?
Question 44: To what extent should COATS be used as a template for
the establishment of a consolidated order audit trail for the equity
markets?
Question 45: To what extent are SROs effectively using intermarket
order audit trail data to enhance surveillance?
Question 46: What are examples of illicit intermarket trading
activity that can be engaged in undetected by regulators?
B. Independent Regulatory and Market Corporate Subsidiaries
Another approach would be to increase SRO regulatory independence
through mandated SRO internal restructuring. One option would be to
require that all SROs create independent subsidiaries for regulatory
and market operations. This model could resemble the NASD corporate
structure that was devised in the wake of the joint Department of
Justice and SEC investigation into OTC market maker pricing collusion
that resulted in a Commission enforcement action.\275\ Among the most
important NASD Undertaking resulting from the settlement was a
corporate restructuring of the NASD and the establishment of an
independent regulatory corporate subsidiary, NASD Regulation, Inc.
(``NASDR'').\276\
---------------------------------------------------------------------------
\275\ See 21(a) Administrative Order and 21(a) Report.
\276\ See 21(a) Report at 50-55.
---------------------------------------------------------------------------
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.
This model would provide a more clear organizational separation
than most SROs currently exhibit. It would help strengthen an
independent attitude in the regulatory subsidiary, which could address
conflicts with members, market operations, issuers, and shareholders.
This approach might establish even more clearly defined divisions
between the regulator and the market functions than the proposed SRO
Governance and Transparency Proposal. While the SRO Governance and
Transparency Proposal relies on corporate reporting lines to insulate
the regulator function, this model would house the regulator and market
in distinct corporate subsidiaries that would be governed by separate
boards.
As with making incremental changes to the current system, however,
this model would not alleviate all SRO limitations. A primary purpose
of the regulatory subsidiary would be supervising the competitive
market subsidiary. Thus, the independent regulatory subsidiary would
still be a component of a larger competitive enterprise and subject to
business pressure on some level. With respect to regulatory funding,
the influence of major members, issuers, and shareholders, and
increased intermarket competitive pressure could still have a
detrimental impact on the regulatory budgeting process. Even though an
independent board committee would be responsible for budgeting
decisions, there would still be reliance on major members and the
market operation for funding. As with the approaches already described,
the self-funding of regulatory operations by each SRO would cause a
continued degree of unequal funding and unequal regulation across
markets. Moreover, conflicting SRO rules, conflicting SRO rule
interpretations, conflicting SRO inspection regimes, redundant SRO
regulatory staff and redundant regulatory infrastructures across
markets would remain. This approach also could reduce market specific
knowledge on the part of regulatory staff by removing it on a corporate
level from market operations. In addition, the intermarket trading
surveillance issues in the system would persist.
The Commission specifically seeks public comment on the following
questions related to the separate market and regulatory subsidiary SRO
structure model:
Question 47: To what extent would the implementation of the
separate market and regulatory subsidiary SRO structure model
effectively manage inherent SRO limitations related to conflicts,
funding, redundancies, and intermarket surveillance?
Question 48: To what extent would the separate market and
regulatory subsidiary SRO structure model continue to provide the
benefits of the current SRO system (e.g., largely self-funded system
with market specific expertise of SRO regulatory staff enhancing rule
promulgation and enforcement)?
Question 49: To what extent is the separate market and regulatory
subsidiary SRO structure model effective in managing inherent SRO
limitations specifically with respect to the NASD?
C. Hybrid Model
Another option, which would require significant system
restructuring, 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, including
rules governing members' financial condition, margin practice, handling
of customer accounts, registered representative registration, branch
office supervision, and sale practices. 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'')
[[Page 71278]]
would be solely responsible for its own market operations and market
regulation.
This approach would have a variety of sub-options with respect to
the Market SROs' role in surveillance of the market and enforcement of
``market'' rules. For instance, the Market SROs could maintain all of
the functions that SROs currently carry out with respect to their
market operations, including promulgating market rules, conducting
market surveillance, and taking enforcement action with respect to
violations of market rules. Alternatively, the Market SROs could be
responsible for promulgating rules and conducting surveillance, but
enforcement actions could be referred to the Single Member SRO. Another
option would limit the Market SROs' responsibility to market rule
promulgation and the Single Member SRO would be responsible for all
other market surveillance and enforcement functions.
As with the approaches already discussed, this Hybrid model could
improve upon the current system in a variety of respects. For instance,
because the Single Member SRO would not be affiliated with a particular
market, inherent conflicts that exist between the regulatory function
and market operation of an SRO would be reduced. It would also
eliminate duplicative regulation with respect to membership rules. This
approach could result in beneficial synergies by the centralization of
membership regulation, while maintaining the value of having market
regulatory staff embedded within the Market SROs. The Single Member SRO
would also potentially serve as a more effective liaison with the SEC,
Congress, and international entities on behalf of the industry because
it would be a single, market neutral voice. Depending on the extent to
which the Single Member SRO was delegated responsibility under this
approach for intermarket surveillance, cross-market surveillance could
be simplified and enhanced.
As with other models, this approach has limitations. For example,
this approach could reduce self-regulatory knowledge of business
practices by removing the Single Member SRO from market operations. In
addition, this model would raise a ``boundary issue'' between member
and market rules, in that every SRO rule would have to be characterized
as either a ``member'' or ``market'' rule. Some rules, such as those
related to member capital requirements, would likely be categorized as
member rules, because they are unrelated to direct trading activity and
deal with requirements imposed on members in support of trading
operations. In contrast, certain rules, such as those related to the
priority of orders on a market's trading floor or system, would clearly
be characterized as trading rules. A variety of other rules, however,
such as those related to front running or margin requirements, could be
categorized as either ``market'' or ``member'' rules because they
embody elements of both types of rules.
While this Single Member SRO approach could reduce certain
conflicts, it would not resolve the conflicts arising from member
funding, and control, and from reliance on industry members for
business experience. Also, conflicts would persist unabated in the
Market SROs. As noted above, sub-issues with respect to the duties of
the Market SROs would have to be determined and the extent of this
conflict would depend on the extent of the Market SRO's regulatory
responsibility. For instance, the Market SRO's role in market rule
promulgation, market surveillance, and market rule enforcement would
have to be determined.
The concerns about unequal funding and unequal regulation of
members would be substantially reduced. Specifically, unequal funding
and unequal regulation with respect to member regulation would be
eliminated because only one Single Member SRO would exist. However,
other funding issues could arise. Either the Single Member SRO would be
required to depend solely on regulatory fees for funding or the Market
SROs would have to contribute to the Single Member SRO from listing,
market data, and market operation revenues. Determining the absolute
and relative amounts of these contributions would raise difficult
issues. Specifically, an allocation formula would have to be devised
for determining the relative amount that each Market SRO owed annually
for funding the Single Member SRO. The formula could be weighted based
on a host of complex and potentially subjective factors, including
trading volume, average member size, number of members, type of
security traded on the market, and type of business (e.g., agency or
proprietary) engaged in by the SROs' members. The concern about unequal
funding and unequal regulation would also persist with respect to the
Market SROs. Although, inconsistent member rules, staff, and
infrastructure would be eliminated, inconsistent market rules, staff,
and infrastructure would remain.
The Commission specifically seeks public comment on the following
questions related to the Hybrid SRO structure model:
Question 50: To what extent would the implementation of the Hybrid
model more effectively manage inherent SRO limitations related to
conflicts, funding, redundancies, and intermarket surveillance?
Question 51: To what extent would the Hybrid model continue to
provide the benefits of the current SRO system (e.g., largely self-
funded system with market specific expertise of SRO regulatory staff
enhancing rule promulgation and enforcement)?
Question 52: How would the Single Member SRO be funded under the
Hybrid approach?
Question 53: To what extent would the boundary issue with respect
to ``member'' and ``market'' rules be a concern in implementing the
Hybrid approach? Which types of rules would be subject to the
``boundary'' problem (i.e., which types of rules could be categorized
either as ``market'' or ``member'' rules)? How should these
``boundary'' issue rules be categorized and why?
Question 54: In establishing itself, should the Single Member SRO
draw personnel, facilities, or other assets from the existing SROs? If
so, would the Market SROs from which personnel, facilities, or assets
were drawn be able to replace those resources? Would there be any
conflicts of interest with respect to Single Member SRO personnel
allegiance to their former Market SROs?
Question 55: To what extent should the Market SROs or the Single
Member SRO under the Hybrid approach be responsible for market rule
promulgation, market surveillance, and enforcement of market rules?
D. Competing Hybrid Model
Another approach involving a significant departure from the current
system would be a derivative of the Hybrid approach. Under this
approach, Market SROs would exist as in the pure Hybrid approach and
market regulation would be conducted separately from member regulation.
Rather than one Single Member SRO, however, this approach would permit
the existence of multiple 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. A Competing Member SRO would charge
its members a regulatory fee. Because of the potential disparity in
bargaining
[[Page 71279]]
power between the Competing Member SROs and individual brokerage firms,
this regulatory fee would likely need to be subject to appropriate
oversight, including Commission approval. The Competing Member SROs
would be responsible for promulgating the range of member rules
described in the Hybrid discussion, inspecting members for compliance
with member rules, and taking enforcement action against those members
that fail to comply. Under this approach, as with the pure Hybrid
approach, Market SROs would retain their market regulatory
responsibilities.
Under this approach, members of Competing Member SROs would have
the right to periodically switch Competing Member SROs. A limit on the
frequency with which members could switch between Competing Member SROs
would likely need to be imposed for a variety of reasons. For instance,
members could conceivably avoid being effectively regulated by
switching between Competing Member SROs whenever regulatory action
loomed. Further, Competing Member SROs may not vigorously regulate
important members that are able to switch to another Competing Member
SRO, if the members believe they can receive more lenient regulation
from a different Competing Member SRO. In addition, longer Competing
Member SRO experience with a particular member would likely result in
increased institutional knowledge and potentially more effective
regulation.
As with the pure Hybrid model, this approach would have a variety
of sub-issues to be resolved with respect to the Market SROs' role in
promulgating market rules, conducting surveillance of the market, and
enforcement of market rules. For instance, the Market SROs could
maintain all of the functions that SROs currently carry out with
respect to their market operations. Alternatively, the Market SROs
could be responsible for promulgating market rules and conducting
market surveillance, but enforcement actions could be referred to the
Competing Member SRO of the offending Market SRO member. Another option
would be the Market SROs being responsible solely for market rule
promulgation and the Competing Member SROs being responsible for all
other market surveillance and enforcement functions. This approach
would also require considering whether Competing Member SROs should be
required to have uniform membership rules to ensure uniformity of rules
governing the membership of each market and to limit the potential for
regulatory arbitrage. In addition, difficult issues would have to be
addressed with respect to the criteria for a Commission determination
as to whether a Competing Member SRO was ``authorized'' to provide
member regulation.
This model carries with it a variety of benefits. For example, as
with the pure Hybrid model, if uniform membership rules were required,
this approach could significantly reduce conflicts and inconsistent
application and enforcement with respect to membership rules. In
addition, it would concentrate membership regulatory expertise in a
small number of entities, while continuing to foster market specific
expertise in the regulatory staff embedded in Market SROs. As with the
Hybrid model, the Competing Member SROs could be more effective
liaisons with the SEC, Congress, and international entities on behalf
of the industry.
This approach would be a compromise between the Single Member SRO
approach and the current system of numerous redundant SRO member
regulators. Moreover, this approach would not require the potential
elimination of one of the existing primary member regulators in favor
of another. Depending on the extent to which the Competing Member SROs
are delegated responsibility for inter-market surveillance (and if
ultimately a limited number of these Competing Member SROs are
registered), cross-market surveillance could be simplified and
enhanced. Finally, this model might succeed in centralizing member
regulation to a much greater extent than under the current system, but
at the same time foster competitive discipline by allowing Competing
Member SROs to compete with each other.
As with the approaches already discussed, this model has
significant drawbacks. For instance, and as discussed above, it would
require the same difficult ``boundary issue'' determinations between
``market'' and ``member'' rules to be made as would be made under the
Hybrid approach. As with the pure Hybrid approach, this model could
reduce self-regulatory experience by separating self-regulatory member
staff from market operations. Moreover, conflicts with members, market
operations, issuers, and shareholders would remain unabated in the
Market SROs.
Competition could result in an effort by the Competing Member SROs
to reduce their fees to attract and keep members and the Commission
would ultimately continue to be responsible for determining whether
funding remained adequate. This model could reduce conflicting member
rules, but would only eliminate these conflicting rules if the
Competing Member SROs adopted a uniform set of member rules. In
addition, conflicting market rules across Market SROs would still
exist. Ideally, under this approach, competitive forces would
discipline the Competing Member SROs and discourage them from becoming
unresponsive.
As noted above, a significant issue with the Competing Member SRO
model would be the ability of an SRO to discipline members if the
members could then choose another regulator. This could be addressed by
limitations on the ability of members to make changes or a charge for
switching from one regulator to another, but such barriers might tend
to diminish the benefits of competition.
Finally, if the NASD should be one of the Competing Member SROs,
its specific role in overseeing the OTC market and its operation of the
ADF, in particular, would also require further analysis under this
model. While the NASD, as a registered national securities association
under Exchange Act Section 15A,\277\ is responsible for overseeing OTC
broker-dealer activity, many of its rules related to member use of the
ADF could be characterized as market rules (e.g., NASD Rule 4300A
regarding direct and indirect electronic access to best bids and offers
posted in the ADF).
---------------------------------------------------------------------------
\277\ 15 U.S.C. 78k-1.
---------------------------------------------------------------------------
The Commission specifically seeks public comment on the following
questions related to the Competing Hybrid SRO structure model:
Question 56: To what extent would the implementation of the
Competing Hybrid SRO structure model effectively manage inherent SRO
limitations related to conflicts, funding, redundancies, and
intermarket surveillance?
Question 57: To what extent would the Competing Hybrid SRO
structure model continue to provide the benefits of the current SRO
system (e.g., largely self-funded system with market specific expertise
of SRO regulatory staff enhancing rule promulgation and enforcement)?
Question 58: What should the criteria be upon which Competing
Member SROs would be registered under the Competing Hybrid approach?
Question 59: What would be the ideal number of Competing Member
SROs under the Competing Hybrid approach?
Question 60: What limitations, if any, should be placed on members'
ability to change Competing Member SROs?
[[Page 71280]]
Question 61: Should the Competing Member SROs be required to adopt
a uniform set of member rules?
E. Universal Industry Self-Regulator
Another model, which would require significant restructuring, would
be 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. This
approach likely would require legislation or significant restructuring
of the current SROs.\278\ Under this approach, all member firms would
be registered directly with the Universal Industry Self-Regulator and
all markets would be non-SROs registered with the Universal Industry
Self-Regulator similar to how ATSs are currently registered with SROs.
Under this approach, the markets' self-regulatory authority would be
eliminated.
---------------------------------------------------------------------------
\278\ See Exchange Act Sections 6 and 15A, 15 U.S.C. 78f and
78k-1. It is conceivable that this approach could be achieved by the
SROs engaging in an omnibus market and member regulatory agreement
pursuant to Exchange Act Rule 17d-2, 17 CFR 240,17d-2. However, this
approach would require significant restructuring of the existing
SROs.
---------------------------------------------------------------------------
This model could resolve weaknesses of prior alternatives in a
variety of ways. For instance, and as discussed above, it would erase
the ``boundary'' issues between market and member rules associated with
the Hybrid and Competing Hybrid Models because one entity would be
responsible for all ``market'' and ``member'' rules. This model would
establish a level playing field among competing markets in that they
would all be subject to the same uniform standards of a single SRO. The
Universal Industry Self-Regulator would benefit from a broader
knowledge of regulated entities and markets because it would be
responsible for all member and market regulation. Because one SRO would
exist that would not be subject to inter-market competition, conflicts
with market operations, issuers, and shareholders would be almost
entirely eliminated as would regulatory redundancies.
Moreover, this approach would address the arguments that unequal
funding of regulatory operations and unequal allocation of costs for
regulation across the markets cause market distortions. Specifically,
the existence of one SRO would prevent unequal regulation in the sense
that only one entity would be responsible for the regulation across all
markets. Because one SRO would be in possession of all regulatory data
(rather than it being held by disparate SROs), this model would also
facilitate the development of a consolidated order audit trail for
intermarket trading and better enable the regulation of intermarket
trading. Because of the central role the Universal Industry Self-
Regulator would play in the U.S. securities markets, demutualization of
the entity would likely be prohibited. Thus, the primary concern of the
profit motive of a shareholder owned market detracting from proper
self-regulation could be eliminated under this approach as well.
As with other models discussed, this approach has limitations. The
Universal Industry Self-Regulator would be precluded from being a
market specific regulator and as such would likely lack market specific
expertise. In addition, member conflicts would still remain under this
approach in that the Universal Industry Self-Regulator would still rely
on members for funding. As discussed above, this conflict would be
further complicated if the Universal Industry Self-Regulator became
particularly dependent on certain large members for the
disproportionately large amount of funding that they provide the SRO in
regulatory fees. This universal approach would still require separate
market rules to account for different market structures and types of
securities traded. For instance, the market operation of an options
exchange has markedly different trading rules than an equity exchange.
There would also be the potential under this model for the functions of
the Universal Industry Self-Regulator and the SEC to overlap with one
another. Moreover, the potential for the Universal Industry Self-
Regulator to become unresponsive to industry developments would greatly
increase because of its size, scope, and lack of competition. Finally,
implementing this model would effectively result in the elimination of
the existing SROs' role and, thus, could be met with significant
resistance.
The Commission specifically seeks public comment on the following
questions related to the universal industry self-regulator SRO
structure model:
Question 62: To what extent would the implementation of the
Universal Industry Self-Regulator model effectively manage inherent SRO
limitations related to conflicts, funding, redundancies, and
intermarket surveillance?
Question 63: To what extent would the Universal Industry Self-
Regulator model continue to provide the benefits of the current SRO
system (e.g., largely self-funded system with market specific expertise
of SRO regulatory staff enhancing rule promulgation and enforcement)?
Question 64: Would the NASD's role as the regulator of the OTC
market be completely occupied by the Universal Industry Self-Regulator
or would there be a continuing need for the NASD's existence?
Question 65: To what extent would the Universal Industry Self-
Regulator compete or conflict with the Commission?
F. Universal Non-Industry Regulator
Another approach, which would also require significant industry
reshaping, 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. All markets would be registered with the Universal Non-
Industry Regulator similar to how ATSs are currently registered with
SROs and would not have any self-regulatory authority. The Universal
Non-Industry Regulator would be solely responsible for promulgating
member and market rules, inspecting for compliance with member and
market rules, and taking enforcement action with respect to member and
market rules.
While not exactly analogous, this model could resemble the
regulatory regime recently adopted for audits of public companies.
Specifically, the Public Company Accounting Oversight Board (``PCAOB'')
was established, pursuant to the Sarbanes-Oxley Act,\279\ as an
independent, non-profit corporation, to oversee the audits of public
companies that are subject to the securities laws, and related matters,
in light of significant failings in self-regulatory oversight of the
accounting profession.\280\ If this approach were to
[[Page 71281]]
be adopted in the securities industry, an independent, non-profit, non-
governmental body could be established to be the Universal Non-Industry
Regulator. The board of the Universal Non-Industry Regulator would
consist of full-time members appointed by the Commission, and would be
tasked with overseeing all member and market rules for all members and
all markets. The SEC would have ongoing oversight responsibility for
supervising the universal regulator, including appointing and removing
members, approving its budget, and approving its rules. The Universal
Non-Industry Regulator approach would reduce substantially, if not
eliminate, the industry's self-regulatory role in that the universal
regulator's board would be entirely selected by the Commission and its
staff would be entirely appointed by the board.
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\279\ Pub. L. 107-204, 116 Stat. 745 (2002).
\280\ Prior to the establishment of the PCAOB, the American
Institute of Certified Public Accountants (``AICPA'') established
and interpreted Generally Accepted Auditing Standards (``GAAS'').
The AICPA is a private, professional organization composed of
certified public accountants (``CPAs''). The Public Oversight Board
(``POB''), created by the AICPA, administered peer reviews of CPAs
to assess whether CPAs' auditing practices were in conformity with
GAAS. Jerry W. Markham, Accountants Make Miserable Policemen:
Rethinking the Federal Securities Laws, 28 N.C.J. Int'l L. & Com.
Reg. 725, 764-80 (2003). In addition, the Financial Accounting
Standards Board (``FASB'') promulgated Generally Accepted Accounting
Principles (``GAAP'').
The PCAOB was given broad authority, including the power: (1) to
register public accounting firms; (2) to set rules covering
auditing, ethics, quality control and independence standards; (3) to
inspect the auditing operations of registered public accounting
firms; (4) to investigate and discipline registered public
accounting firms and associated persons of such firms; and (5) to
enforce compliance with the new legislation, the PCAOB's own rules
and certain securities laws. The standards for audits of public
companies are now set by the PCAOB, not the accounting profession.
While the AICPA still has a role in setting the standards for audits
of non-public companies, the POB has been terminated. There has been
no change in the setting of accounting standards, where the FASB, as
the standards-setting body designated by the Commission, retains
primary responsibility for the promulgation of GAAP, subject to the
Commission's oversight. Markham at 790-92.
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The sources of funding for this model would have to be established.
The PCAOB is primarily funded through accounting support fees, as
provided in the Sarbanes-Oxley Act, paid by issuers.\281\ The goal of
this funding structure is to ensure that the PCAOB's funding is
independent of both the accounting profession and the federal
government.\282\ A determination by Congress would have to be made as
to whether shifting the significant cost of regulation of the
securities industry to issuers would be appropriate or if some other
funding structure would be more appropriate (such as a fee on trades or
on markets and broker-dealer revenues).\283\
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\281\ Section 109 of the Sarbanes-Oxley Act.
\282\ The Sarbanes-Oxley Act provides that the PCAOB be funded
by accounting support fees assessed on issuers as defined therein.
Each year the PCAOB develops an operating budget that must be
approved by the Commission. The 2003 PCAOB budget, as approved by
the Commission, was $68 million. The accounting support fees are
equal to the PCAOB's total budgeted outlays for the fiscal year in
which they are set, less the amount of fees received from public
accounting firms to cover the cost of processing and reviewing
registration applications. The accounting support fees are based on
the average monthly U.S. equity market capitalization of publicly
traded companies, investment companies, and other equity issuers.
Issuers with average market capitalizations below $25 million and
investment companies with net assets of less than $250 million are
exempt from the fees. PCAOB, 2003 Annual Report 15 (2004). The 2004
PCAOB accounting support fee, as approved by the Commission, was
$101 million.
\283\ Total combined SRO operating expenses in 2003 were over
$2.4 billion. See supra note 197.
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This model would have several advantages over other approaches. For
instance, this approach would likely eliminate the member rule and
market rule boundary concerns that exist under the Hybrid and Competing
Hybrid approaches. Even more than the Hybrid and Competing Hybrid
approaches, this model would result in broad interaction between the
regulator, members, and markets. Conflicts with members, market
operations, issuers, and shareholders would be substantially eliminated
under this model because the entity would have no direct affiliation
with any of those constituencies. Regulatory redundancies would also be
effectively diminished because the Universal Non-Industry Regulator
would be responsible for all ``member'' and ``market'' rules for all
members and markets. This would be particularly true if the NASD's role
were completely subsumed by the new Universal Non-Industry Regulator.
As with the Hybrid and Competing Hybrid models, this approach would
address the concern of unequal funding and unequal allocation of
regulatory costs across markets. Moreover, cross market surveillance
would likely be facilitated by this approach because the Universal Non-
Industry Regulator would be responsible for all regulatory data from
all markets. Because of the critical role the Universal Non-Industry
Regulator would play in the U.S. securities markets, demutualization of
the entity would likely be prohibited. Thus, the primary concern of the
profit motive of a shareholder owned market detracting from proper
self-regulation could be eliminated under this approach as well.
This model also has serious drawbacks. For example, it could result
in a lower degree of market specific expertise in the regulator. In
addition, the degree of direct industry involvement with respect to
rulemaking and enforcement would be significantly reduced, which could
reduce the Universal Non-Industry Regulator's ability to refine and
target its regulation. Market rules would still differ to account for
different market structures and types of securities traded. As with the
Universal Industry Self-Regulator, there would be the potential under
this model for the regulatory entity and the SEC to overlap or even
compete with one another. In addition, there is also the risk that this
model would become inefficient, inflexible, and unresponsive to
evolutionary market practices. Also similar to the Universal Industry
Self-Regulator, this model would likely require legislation and could
be met with resistance from the existing SROs, whose SRO role would be
largely eliminated.
The Commission specifically seeks public comment on the following
questions related to the Universal Non-Industry Regulator model:
Question 66: To what extent would the implementation of the
Universal Non-Industry Regulator model effectively manage inherent SRO
limitations related to conflicts, funding, redundancies, and
intermarket surveillance?
Question 67: To what extent would the Universal Non-Industry
Regulator model continue to provide the benefits of the current SRO
system (e.g., largely self-funded system with market specific expertise
of SRO regulatory staff enhancing rule promulgation and enforcement)?
Question 68: How would the Universal Non-Industry Regulator model
be funded?
Question 69: What would be the relationship between the Universal
Non-Industry Regulator, the Commission, and the NASD under this model?
G. SEC Regulation
Another alternative that will be discussed in this section 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 market and member regulation of all
members and all markets. All member firms and markets would be required
to register directly with the Commission under this model. Markets
would be non-SROs registered with the Commission similar to how ATSs
are currently registered with SROs. The markets' registered status,
however, would carry with it no self-regulatory authority. 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
[[Page 71282]]
rules. With respect to funding, this model would require dramatic
change in that the public would be directly responsible for
substantially all of the costs of regulating the industry, albeit
perhaps, through a range of fees imposed on the industry for the
Commission's increased services. The Commission, however, is not self-
funded under its enabling statute and, thus, Congress would need to
appropriate funds for this approach.\284\
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\284\ Although the Commission currently deposits the variety of
fees that it collects in the U.S. Treasury, where its deposits are
treated as offsetting collections and not general funds of the
Treasury, it cannot deposit its fees in a depository institution,
and its monies are annually appropriated and apportioned. U.S.
General Accounting Office Report to Congressional Committees, ``SEC
Operations `` Implications of Alternative Funding Structures,'' 1
(July 2002).
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Benefits could be gained from this approach. For instance, because
only one centralized regulator would exist, SEC direct regulation would
eliminate substantially all of the conflicts that exist between SRO
regulation and members, market operations, issuers, and shareholders.
As with the Hybrid, Competing Hybrid, Universal Industry Self-
Regulator, and Universal Non-Industry Regulator approaches, direct SEC
regulation would provide the Commission with a broader understanding of
the members and markets. Conflicting member rules, interpretations, and
inspection regimes, and regulatory redundancies would be eliminated
under this model because the Commission would be able to adopt uniform
member rules. The Commission would need to adopt numerous detailed
operations and conduct rules for members to replace existing SRO rules
related to business practices and just and equitable principles of
trade. Cross market surveillance would likely be facilitated by this
approach because the relevant regulatory data would be collected and
examined by the Commission, rather than by disparate SROs. In addition,
this model could potentially align the U.S. regulatory scheme more
closely with those of a variety of other countries.\285\
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\285\ For instance, the Financial Services Authority (``FSA'')
was created in the United Kingdom in 1997 and is an ``independent
non-governmental body which exercises statutory powers.'' Through
the creation of the FSA, the duties of nine regulatory entities were
consolidated and the use of the British equivalent of U.S. SROs was
abandoned. The FSA was given extensive financial regulation
responsibility, assuming the same roles played in the U.S. by the
SEC, the Commodity Futures Trading Commission, federal and state
banking regulators, state insurance and state securities
commissions, as well as the SROs. Among other initiatives, the FSA
has assigned one office to develop policy on prudential issues
across all financial sectors, so as to develop a common approach to
risk and capital requirements. The agency also announced that it was
streamlining the existing financial services rules and has been
focusing its regulatory attention on high-risk firms. See Jerry W.
Markham, A Comparative Analysis of Consolidated and Functional
Regulation: Super Regulator: A Comparative Analysis of Securities
and Derivatives Regulation in the United States, United Kingdom, and
Japan, 28 Brooklyn J. Int'l L. 319, 374-82 (2003).
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An SEC-only approach would also have numerous problems. The SEC
would be responsible for detailed regulation and interpretation of
complex areas previously the province of SROs, without the aid of
direct industry involvement and with a significant lessening of
industry input in rulemaking. Market specific rules, under this model,
would still conflict because of the markets' different market
structures and types of securities traded. Direct Commission regulation
would be governed by the limitations and rules addressing federal
rulemaking and would be undertaken in a political environment and the
cost of carrying out all of the duties of the SROs would be extensive.
It is important to note that the Commission has attempted to undertake
direct SRO level regulatory duties in the past. As discussed above, the
Commission ultimately requested that Congress terminate the SECO
program because the Commission could not effectively carry out the
detailed responsibilities required.\286\
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\286\ See supra note 181.
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The Commission specifically seeks public comment on the following
questions related to the direct SEC regulation model:
Question 70: To what extent would the implementation of the direct
SEC regulation model effectively manage inherent SRO limitations
related to conflicts, funding, redundancies, and intermarket
surveillance?
Question 71: To what extent would direct SEC regulation continue to
provide the benefits of the current SRO system (e.g., largely self-
funded system with market specific expertise of SRO regulatory staff
enhancing rule promulgation and enforcement)?
Question 72: Could current SRO staff be effectively drawn upon by
the Commission under the direct SEC regulation model, or would this
staff be inappropriately influenced by their prior affiliations with
specific SROs?
H. Other Models
Alternative models of regulation exist that were not specifically
explored in this release. Such approaches may be variations of the
above alternatives or completely different models. The Commission
specifically seeks public comment on the following question:
Question 73: Are there any other approaches to regulation of the
securities industry that are worthy of consideration whether discussed
herein or not? Should the current model remain unaltered?
VI. Solicitation of Additional Comments
In addition to the areas for comment identified above, we are
interested in any other issues that commenters may wish to address
relating to the current structure of the SRO system, potential
enhancements that could be made to the current system, or potential
models that could be implemented that would restructure the SRO system.
Please be as specific as possible in your discussion and analysis of
any additional issues. Where possible, please provide empirical data or
observations to support or illustrate your comments.
By the Commission.
Dated: November 18, 2004.
Margaret H. McFarland,
Deputy Secretary.
[FR Doc. 04-26154 Filed 12-7-04; 8:45 am]
BILLING CODE 8010-01-P