Financial Regulatory Forum

Brokers face a fight asking the SEC to end exchanges’ SRO structure

By Guest Contributor
August 14, 2013

By Nick Paraskeva, Compliance Complete contributing author

NEW YORK, Aug. 14 (Thomson Reuters Accelus) - Wall Street has asked regulators to consider ending the special supervisory status given to exchanges, saying that new technology such as dark pools and algorithmic trading has led to broker-dealers directly competing with exchanges for market share.

The exchanges have countered that market dispersion hurts investors, and are seeking regulatory protection from high frequency trading, and the Securities and Exchange Commission, which oversees both brokers and exchanges, is in the middle.

The request to end the exchanges’ status came in a letter from the Securities Industry and Financial Markets Association, a trade group whose executive vice president, Randy Snook, in a statement said “the current structure of the self-regulatory model is widely viewed to be outdated and in need of reform.”

“We hope the issue gets traction, and want to add our voice to the dialogue and hope it accelerates,” T.R. Lazo, SIFMA managing director and associate general counsel, told Compliance Complete in a telephone interview. Lazo, who signed the letter, said the issue is of great interest to SIFMA members, who have been discussing it for at least the last 12 months.

Lazo said there was no specific reason the matter was being brought up now, adding, “We hope it leads to dialog and constructive engagement with the exchanges and legislators.”

“We continue to be discouraged by the efforts by heavily conflicted brokers to reduce the influence of exchanges and interests of investors, further decrease transparency and price discovery in the equities marketplace, and generate additional profits for the broker community,” NYSE Euronext said in a statement.

NYSE said it supports a comprehensive review of the benefits and obligations of exchanges and non-exchange trading venues that “we do not believe is accurately represented in the SIFMA letter.” Other issues the exchange wants explored include levels of dark trading leading to market fragmentation, use of algorithms, smaller trades, more order types, and higher cancellation rates.

In a briefing to the U.S. Treasury late in 2012, NYSE cited a “complex web of 63 execution venues and 200 internalization desks” that causes markets to be “more error prone and difficult to regulate.”

NYSE also noted that markets were becoming costlier to link, with client segmentation creating two-tiered markets that raise concerns over best execution, fair and orderly markets, competition and access to liquid public prices.

One recent issue of concern to SIFMA, Lazo said, is the direction taken on the Consolidated Audit Trail (CAT), the cross-market system the SEC delegated to the market to develop a proposal. The plan creates structural concerns for industry, given its significance and that it is being designed by a group of markets, said Lazo. The industry is participating in the CAT discussions but only has an advisory role.

“We are reviewing the [SIFMA] letter but note that the SEC initiated a comprehensive review of market structure beginning with a concept release in January 2010,” John Nester of the SEC said, adding that “this review, which already has led to reform measures, is continuing.”

The SEC claimed the review enabled it to respond rapidly to the flash crash, which occurred soon after the release, and highlighted actions taken to strengthen circuit breakers and to reduce excess volatility such as the rules to clarify erroneous trades and control market access. The agency is also implementing Regulation SCI, which requires a review of market systems, and moving forward on the CAT.

SIFMA in its letter asked the SEC to review of the regulation of brokers, exchanges and self-regulators within the U.S. equity market structure, saying the review should focus on the structure of exchanges as self-regulatory organizations, or SROs. Eliminating the SRO status could also centralize regulatory processes, given that many exchanges already agree to delegate their regulatory functions to FINRA.

Exchanges get competitive benefits from their SRO status, including limitations on liability, SIFMA said. After facing technology problems on the Facebook initial public offering, NASDAQ benefitted from its rules limiting liability to the dealers that had lost money. In May the SEC fined NASDAQ $10 million, the largest-ever penalty against an exchange, for poor systems during the offering and secondary trading.

The costs of regulation and funding to pay for it

SIFMA’s letter claims that funding of self-regulation is largely paid by brokers that are subject to SRO regulatory fees. The exchanges use these fees to offset costs of outsourcing their own regulatory responsibility to other SROs such as FINRA. Dealers claim they pay twice for regulation, as they also pay direct fees to FINRA. SIFMA declined to provide specific estimates of what levels of saving they expect.

Exchanges are also subject to unique requirements such as filing of proposed rule changes with the SEC prior to approval, but they are not subject to major regulations that apply to brokers such as best execution, supervisory controls, and on financial responsibility. SIFMA claims there is no way to assess the reasonableness of exchange costs, without more public transparency of the fees that they charge.

In the event all SROs were required to outsource their regulatory functions, FINRA would be a candidate to perform these, as one of the only independent SROs that are not an exchange. FINRA was formed as a combination of the regulatory units of NYSE and NASDAQ. A FINRA spokesperson stated by telephone that they did not have a comment on the letter, given it is an issue for the SEC, exchanges and the industry.

The SEC is already weighing in

“We need to ask whether allowing exchanges to outsource the bulk of their regulatory responsibilities to FINRA through regulatory services agreements risks implicitly transforming the meaning of SROs to selectively regulatory organizations,” SEC Commissioner Daniel Gallagher said last October at a SIFMA event.

Moreover, given their private sector status, Gallagher asked whether exchanges should continue to enjoy immunity from liability.

More recently, in a late June interview with the Wall Street Journal, SEC Chairman Mary Jo White said, “one set of issues that clearly got my attention before I arrived is market-structure issues” and that dealing with it is a matter of urgency.

But given the many other SEC priorities, such as rules to implement the JOBS Act and the remainder of Dodd Frank, and the agency’s stretched resources, it would appear likely that such structural review will be a long-term process.

Reference documents

July 31, 2013 comment letter to the SEC requesting a review of the self-regulatory structure of securities markets

(Nick Paraskeva is principal of Reg-Room LLC (www.reg-room.com), which provides regulatory information and consultancy. He covers various facets of the banking and securities industry and delivers exclusive analysis through Thomson Reuters. He can be contacted at (212) 217-0403 and nparaskeva@nyc.rr.com. Follow Nick on Twitter@regroom.)

 (This article was produced by the Compliance Complete service of Thomson Reuters Accelus. Compliance Complete provides a single source for regulatory news, analysis, rules and developments, with global coverage of more than 400 regulators and exchanges. Follow Accelus compliance news on Twitter: @GRC_Accelus)

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