Self-Regulation in the Financial Markets

In the aftermath of the global financial crisis, many finance industry commentators have scrutinized the role of regulators in contributing to the crisis. Particular scrutiny has fallen on self-regulatory organizations (SROs). To help shape a better future for the financial industry, CFA Institute published a report last year entitled Self-Regulation in the Securities Markets: Transitions and New Possibilities. The report, which builds on earlier CFA Institute research on self-regulation, concluded:

“We believe… that despite differences in the securities regulatory landscape that existed when they were first created, SROs and the market expertise they offer are now more important than ever. In fact, the ever-evolving complexities of the securities markets argue for more, rather than fewer, uses of SROs, if only to take advantage of their understanding of market practices.”

In support of this conclusion, and in the interest of moving the SRO reform agenda forward, CFA Institute recently hosted an event in Washington DC under the auspices of our Future of Finance initiative, entitled “Self-Regulation in the Financial Markets: Exchange Issues, Market Structure, and Investor Protections.” A panel of current and former senior regulators, practitioners, and law professors — including the previous US Securities and Exchange Commission chairman, Mary Schapiro, pictured above — discussed a range of topics, from security exchange issues and market structure to investor protections, global financial market interconnections, and both the strengths of SROs and areas of needed reform.

All panelists, including those from traditional regulators and the legal profession, felt that SROs are an important part of the global regulatory framework. Still, the panelists identified many ongoing challenges. In opening remarks, for example, Schapiro contended that SROs can be a highly effective enforcer and complement the role of governments, especially in an environment where traditional regulators are underfunded. However, she argued, this is only true if the following conditions are met:

• SROs are well-funded;
• They are technologically advanced;
• There is government oversight;
• They are held accountable;
• They act within their authority; and
• They are structured to avoid conflicts of interest.

Highlights from each of the three panel sessions follow below:

1.  Global Overview: Role of Self-Regulation in Increasingly Interconnected and Complex Markets

Chris Brummer, professor of law at Georgetown University Law Center, argued that SROs face several challenges going forward, prompted by two key drivers of change:

• Globalization: Interconnectivity changes the way financial markets must be regulated and the ways traditional regulators must coordinate with SROs. Globalization presents a number of challenges for the US, in particular, since the country is no longer a regulatory hegemon and must now engage in more coordination with European counterparts. Brummer pointed out that the tools being used today to coordinate global financial markets regulation are very different than what lawyers learned about in law school. Ad hoc, informal agreements; rulemaking; and codes of ethics are more commonly being relied upon as opposed to arduously negotiated international treaties.

• Disintermediation: Disintermediation of financial markets spread via technology or new regulatory proposals is a root cause of many of the challenges that SROs must confront.

Brummer also highlighted the challenge to SROs posed by “regulatory arbitrage” when market participants shop for the most favorable jurisdictions. He specifically pointed to a white paper published by the Atlantic Council, entitled “The Dangers of Divergence,” which highlights the perils that regulatory divergence poses to financial stability, as an important resource.

Susan Wolburgh Jenah, president and CEO of the Investment Industry Regulatory Organization of Canada, Canada’s primary self-regulator, emphasized the need for SROs and formal regulators to have carefully delineated roles. “No one can know everything,” she cautioned. Wolburgh Jenah also emphasized that for SROs to be effective, they must manage inherent conflicts of interest; in other words, the trade association aspects of SROs must be separated from regulatory functions. She argued that such separation is especially important for establishing and maintaining public trust. Consistently good SRO governance is also key, she added, including independent board members and nominations that are handled by an independent board committee.

2. Exchange SROs: Meeting the Needs of Investors and the Financial Marketplace

Brooklyn Law School Professor Roberta Karmel, a former commissioner of the US Securities and Exchange Commission, argued that self-regulation at the stock exchange level only ever worked when fixed commissions served as the glue that held that regulatory framework together. In the 1970s, when price competition for commissions was permitted, the self-regulators were simply left in place and thus exchange SROs “have very little to do with self-regulation, and more to do with ‘more accessible’ regulation.”

A lack of “tire kicking” of SROs is what worries Richard G. Ketchum, chairman and CEO of the Financial Industry Regulatory Authority. Ketchum pointed out that private lawsuits seem to be the only form of checks and balances on securities exchange SROs.

“Even if we said exchanges are no longer SROs they will always have a responsibility to the public,” Mary Schapiro contended, “because the way orders interact is a matter of public interest.” She believes that communication between exchanges has gotten worse since they became public companies, however.

3. US System of Self-Regulation through SROs: Strengths and Areas for Reform

Daniel J. Roth, president and CEO of the National Futures Association (NFA) said that all of its rules are written with enforcement and consequences in mind. He stressed that this is critical to a proper regulatory framework, because if a regulation cannot be enforced, or if there are no consequences for violating rules, then there is no reason for the regulation. Roth thought that requiring futures market participants to be mandatory members of NFA was key to enforcement because membership revocation creates legitimate pain for wrongdoing.

Panelists at the event included:

• David Blass: Chief Counsel, Division of Trading and Markets, US Securities and Exchange Commission
• Chris Brummer: Professor of Law, Georgetown University Law Center
• Daniel J. Roth: President and CEO, National Futures Association
• Amarilis Sardenberg: Chair of the Board, BM&FBOVESPA Market Supervision
• Mary Schapiro: Vice Chairman of the Advisory Board, Promontory Financial Group; Former Chairman of the US Securities and Exchange Commission; Former CEO of the Financial Industry Regulatory Authority; Former Chairman of the Commodity Futures Trading Commission
• Susan Wolburgh Jenah: President and CEO, Investment Industry Regulatory Organization of Canada
• Roberta Karmel: Centennial Professor of Law, Brooklyn Law School; Former Commissioner of the US Securities and Exchange Commission
• Lynnette Kelly: Executive Director, Municipal Securities Rulemaking Board
• Richard G. Ketchum: Chairman and CEO, Financial Industry Regulatory Authority

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Photo credit: LK Photos