We are discussing a recent article by the WSJ noting that regulators have targeted exchanges "amid concerns over their ability to police the markets they operate". As the article noted:
- Some financial regulators have lost patience with what they see as exchanges' failure to manage ever-more-complex technology, reflected in a stream of market-jarring software errors, according to people familiar with the regulators' thinking. Many of the errors have been driven by exchanges' efforts to boost profits by rolling out complicated new products sought by the speediest customers.
As we noted in the prior post, concern over the ability or willingness of self regulatory organizations to "police" the markets has been around at least since the 1930s. Thus, in some ways, the concerns expressed by regulators are nothing new.
What is new, however, is that the NYSE and Nasdaq have become "for profit" companies. The boards of for profit companies have a fiduciary obligation to profit maximize. This also can potentially impact the regulatory function of the exchanges. Exchanges may, for example, compete for listings, something that can generate a race to the bottom.
In obtaining SEC approval of its for profit status, the NYSE agreed to localize its regulatory functions in a separate entity (NYSE Regulation, a non-profit) with an independent board. Other policies were put in place in an effort to ensure that NYSE Regulation remained independent of the "for profit" holding company.
Whether it is possible to have a separate entity to handle regulatory matters that is unaffected by the "for profit" goals of the holding companies remains unresolved. Directors from the NYSE holding company, for example, can sit on the NYSE Regulation board (although they must be independent and must be a minority of the directors). One currently does. Moreover, the funding for NYSE Regulation is determined by an agreement that is not public. The amount of funding and the degree of influence by the holding company is, therefore, not public.
Although retaining its regulatory role when transforming into a for profit company, the NYSE has gradually been shearing off its regulatory functions. Oversight of brokers was transferred to the NASD in the merger that created FINRA. Similarly, the market surveillance function was mostly transferred to FINRA in 2010. The NYSE retains some oversight of intermediaries in the market but its main regulatory function is probably the adoption and enforcement of listing standards. The functions of NYSE Regulation are listed here.
Yet retaining a regulatory function, as Nasdaq is apparently about the demonstrate, can be expensive. Moreover, the exchanges have a mountain of regulatory requirements that can interefere with a basic business model. The benefits may also be declining. To the extent that the exchanges view their regulatory role as a protection against private law suits, this may be changing. Non-regulatory functions are not protected by immunity and, as for profit activities expand, more private law suits may be coming.
The problems encountered by exchanges operating as self regulatory organizations and the increased interest by regulators will likely continue to grow. Nasdaq and any settlement with the SEC over Facebook indicates the consequences of oversight. As more fines are imposed, the exchanges may need to rethink their regulatory role. Ultimately, they may decide that efforts to profit maximize are incompatible with significant regulatory oversight.