Using the U.S. stock exchanges as an example, the following post explains why a Self Regulatory Organization (SRO) may or may not work better than traditional government regulation.
History provides the best argument for the effectiveness of SROs as it relates to our financial exchanges. Despite the “hit and miss” effectiveness of government intervention in previous financial crises/bubbles (See Tulip Mania, The South Sea Bubble, Japan ’89, Alexander Hamilton 1792), historical effectiveness in non-government market-specific self-regulation is likely the reason that the modified SRO model exists today. The SRO concept arose as market participants (specifically, the exchanges) realized that they needed some form of regulation to protect the market’s integrity. Knowing full well that a far-removed, bureaucratic organization would likely poison the well more than protect it, the market participants did not seek assistance from Mother government. Instead they recognized that those who understood the intricacies of the market would be best suited to create, enforce and direct the regulatory rules they needed. With great foresight, they also recognized that self-regulation would result in faster dispute resolution – as those resolving the disputes would already be familiar with the culture of the market and be able to recognize the importance of speedy resolution in a market-based environment. This would also prevent any possible “lag time” in the evolution of regulatory measures in a fast-paced and ever-evolving industry. The SRO model is also more efficient in terms of cost – both to the market participants and the government. Creating a new government entity to regulate the exchanges would have imposed costs on the taxpayer, the market participants and, possibly the consumer (if regulatory fees were to be passed on to listed companies). Despite the argument for an efficient and effective SRO system, the SEC still maintains a background regulatory presence.
It is important to note that other incarnations of self-regulation have been less successful. In 2004, the SEC implemented an alternative rule allowing the use of internal market models. Broker dealers with a maintained tentative net capital of at least $1 billion were allowed to use this method and would only be regulated by the SEC on a consolidated basis (known as Consolidated Supervised Entities or CSE’s). This rule allowed the CSE’s to increase risk levels significantly and ultimately ended in disaster. Three of the five CSE’s no longer exist, and the remaining two are now federally chartered as bank holding companies. While these CSE’s are not true SRO’s, their failure is illustrative by analogy. We have also seen troubles in the self-regulated exchanges (see Dick Grasso), and the SRO model has created some internal competition complexities, but overall the SRO model in the US exchanges has been a success.
While the success of SRO exchanges in the U.S. are clear, these successes were for mutual company exchanges. In recent years, many exchanges have demutualized and become publicly-traded companies. There are many reasons why exchanges might demutualize. Moving to outside ownership is more efficient and flexible than membership cooperatives and going public raises more capital for the exchanges. However, demutualization is obviously a trigger for the restructuring of the exchanges – opening membership to new investors and changing the focus of exchange(s). They can freely pursue business opportunities without being restricted to the vested interests of members. This, however, can create a problem for the SRO model, because the interests of management are potentially more aligned with increasing revenue for their shareholders, which can pervert the integrity of the SRO model. That is, if a profit-driven exchange is self-regulating they might be more apt to lessen their own regulatory restrictions in order to drive up shareholder revenues. Despite this potential conflict, we will not likely see a major disruption to the SRO model without first experiencing a serious scandal at a publicly-traded exchange. As we’ve seen throughout the past ten years, its difficult to pass regulation on a hypothetical problem. Financial reform legislation is born only from crisis, not the potential thereof.