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Why not central regulation?
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September 21, 1999: 8:59 p.m. ET
Streamlined oversight of stock markets may well be on its way, and needed
By Staff Writer Alex Frew McMillan
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NEW YORK (CNNfn) - Would a centralized regulatory body make sense for U.S. markets? Many securities-industry executives think a streamlining of the way stock and options trading is monitored is inevitable. And Securities and Exchange Commission Chairman Arthur Levitt is likely to express his desire to see more-consolidated oversight when he gives a much-heralded speech at Columbia University in New York City on Thursday.
The idea of merging the enforcement and rule-making sections of the various stock markets isn't revolutionary - discussion to that effect has percolated for two to three years. But working out how that could happen, whether it would lead to one regulator or more, and putting that plan into effect would be revolutionary indeed.
Though Levitt's talk may well raise more ideas to hash out with stock-market executives than provide answers, those executives will be disappointed if he doesn't clue them in to the direction he and the SEC is looking to take.
"This is being billed as a seminal speech," said Kevin O'Hara, general counsel with Archipelago, a Chicago-based electronic communications network that wants to become an exchange, and looks to the SEC for guidance on how to go about it. "I think this will be a big thing."
Up to now, stock markets have set up their own self-regulatory organizations or units. The SEC has been content to work with primarily the regulatory arms of the New York Stock Exchange and Nasdaq, as well as similar arms at regional exchanges, to enforce securities rules and regulations.
But stock markets are undergoing major upheavals in the way they operate. They're looking to adapt to competitive pressures by extending their hours and switching from member organizations to for-profit companies. Those pressures gathered steam when the SEC approved new order-execution rules at the start of 1997 that allowed the formation of Electronic Communications Networks such as Archipelago, Instinet and Island.
The ECNs are computerized, highly automated quasi-exchanges that let buyers and sellers of stock meet cheaply and without the middlemen of Nasdaq and the NYSE. They are technically broker-dealer companies for now, meaning they operate within Nasdaq, as member firms. But two have filed for exchange status, and one is in the process of doing so. Nearly all have extended their hours.
The traditional markets have to move fast to keep up with these upstarts. That's why they want to demutualize, switch to for-profit status. Observers expect the roles of the market-maker companies that make up Nasdaq's membership and the specialist companies that operate trading on the NYSE to diminish substantially. Those companies have traditionally made money as intermediaries for trades. But as ECNs demonstrate, it's getting easier to trade without human interaction via computer.
Not surprisingly some of those companies resist changes in the markets that cut into their profits. Without the bureaucracy of having to answering to those members, the stock markets would have greater latitude, speed and efficiency.
But for-profit companies can't be relied on to govern themselves disinterestedly, the theory goes. So if they want to convert, they need new regulatory policies. "All this is in the context of demutualization," Chris Ullman, an SEC spokesman said. "This is a very complicated issue that is untrodden ground."
Frank Zarb, chairman and CEO of Nasdaq's parent, the National Association of Securities Dealers Inc., first mentioned that "we are weighing the option of separating our self-regulatory arm into a well-funded, stronger independent entity" in June.
The NYSE has been slower about spinning its regulatory unit off and is said to be dragging its feet, particularly when it comes to discussing merging its regulatory arm with NASD's. But its chairman and CEO, Richard Grasso, continues to talk with the SEC about how best to demutualize.
It hasn't ruled out spinning the unit off, a spokesman said. Many outsiders hope it will do so. Grasso will likely address the self-regulation issue when he talks about demutualization before a congressional committee next Tuesday.
The NYSE has a stronger brand than Nasdaq and may be hesitant to give that up. As both the most-entrenched name and market, it has the most to lose. But it could potentially maintain its more-stringent listing standards, say, while answering to a merged regulatory arm. And a combined regulator for the NYSE, Nasdaq, the regional exchanges and options exchanges makes sense to a lot of people.
"If you consolidate everything there are certainly efficiencies to be gained," said Dale Carlson, a spokesman with the Pacific Exchange. "You may end up with a more-effective self regulatory body." The same standards would apply to everybody. That's not true now. For instance, what one exchange considers "best execution," or what getting the best price for a trade means, can differ from another exchange, he explained.
That's particularly true when it comes to options trading, where the markets don't even link to make sure an options trader on one exchange gets the same price he could get at another. Levitt has been very interested in a linked options market for several months, since the main options markets, the Pacific, Philadelphia, American and Chicago Board of Options exchanges, started trading each other's options.
Another diverse area of trading that could gain from centralized regulation are the ECNs. Those that want to become exchanges aren't sure how best to regulate themselves, though they have to form a plan.
They have at least five or six options, such as creating their own individual regulatory companies or cooperating with each other to create an ECN regulator. They've even considered turning to accounting firms. They could also look to a regulatory arm of an exchange, or push for an overarching ruling body.
But since, as exchanges, they would compete with Nasdaq and the NYSE, they want to make sure the regulatory body doesn't have any conflicts of interest. That suggests a separate regulatory company, perhaps a nonprofit, would fit the bill, a sort of superregulator.
At Archipelago, Kevin O'Hara said the superregulator "would be the best of all worlds," because it would be the most efficient solution. But he stressed that one of the reasons the United States has "the best markets in the world" is because it has private, self-regulation that looks to the SEC but isn't governmental. "The last thing we want to do is take on 100 million guys who are paper pushers."
Matt Andresen, CEO of the Island ECN, agreed. "The superregulator holds many advantages," he said. "It could certainly work very well." Costs should be lower for companies to deal with one centralized regulator. Overhead should also be lower at the regulator itself than having many regulators.
And having a superregulator would preclude "pathological competition," he said, where different parties compete to provide cheaper but worse regulation. But the devil is in the details, he said, which is where the different parties look to the SEC for guidance. Monopolies can be dangerous, too, he said.
Andresen, of course, favors Nasdaq and NYSE demutualization and the competition between stock markets, all of which leads to cheaper execution and better prices for investors. Like online brokers forcing positive changes in the offline brokerage industry, he said new markets are forcing operational changes and modernization in the traditional markets.
"What you see now is even the threat of competition, not even competition, is spurring New York and Nasdaq to demutualize and innovate. This really is in the end a benefit to individual investors." They'll benefit from cheaper transaction costs, sprightly markets, better treatment.
And, surely, a modernized, more-efficient way of regulating the markets. He expects to get more clues from the SEC about how that will happen on Thursday. "We'll just have to look toward the chairman's office," Andresen said.
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