Time for a Fresh Look at Equity Market Structure and Self-Regulation

Editor’s Note: Daniel M. Gallagher is a Commissioner at the U.S. Securities and Exchange Commission. This post is based on a statement from Commissioner Gallagher, available here. The views expressed in the post are those of Commissioner Gallagher and do not necessarily reflect those of the Securities and Exchange Commission, the other Commissioners, or the Staff.

In order to address the pressing market structure issues we face today, it’s important to understand not just where we are now, but also how we got here. Over the past several decades, our capital markets have undergone a series of extraordinary changes. Some of those changes have come about organically, that is, as the result of market participants innovating with new products and ideas. Other changes, however — many others — have been imposed by the SEC and Congress. Or, they were developed by market participants in order to respond to and comply with new and constantly changing laws and regulations. In short, understanding the structure of our capital markets today requires acknowledging that in recent years, changes to the structure of our equities markets have been driven as much, if not more by legislative and regulatory action than by the private sector.

As you well know, this wasn’t always the case. From the earliest days of our nation to the Great Depression, self-regulation, rather than government regulation, played the primary role in growing and shaping the markets, with little or no federal regulation and limited state regulation. Indeed, the origins of U.S. capital market self-regulation can be traced back a long time ago but not so far away — about a ten-minute walk from here to 68 Wall Street, where in 1792, 24 traders signed the famous Buttonwood Agreement. In the Agreement, those traders pledged to conduct their stock trading directly with one another, rather than through an auctioneer, and to limit their commissions to one quarter of a percent. Within three decades of those humble beginnings, the organization that grew out of the Buttonwood Agreement — then referred to as the New York Stock & Exchange Board — had in place a constitution and detailed by-laws. Our capital markets began, and then grew and flourished, on the back of self-regulation.

It wasn’t until nearly a century and a half later that Congress, through the Securities Exchange Act of 1934, took the tremendous step of codifying the self-regulatory role of exchanges, requiring all existing exchanges to register with the newly formed SEC and function as SROs. Four years later, the Maloney Act authorized, and required the registration of, national securities associations to oversee OTC market participants. The legislative history of the Maloney Act explained Congress’s desire to maintain and indeed increase its reliance on SROs, noting that relying solely on government regulation “would involve a pronounced expansion of the organization of the [SEC]; the multiplication of branch offices; a large increase in the expenditure of public funds; an increase in the problem of avoiding the evils of bureaucracy; and a minute, detailed, and rigid regulation of business conduct by law.” [1] Good thing none of that ever happened! Decades later, the 1975 amendments to the Exchange Act, which among other things authorized and directed the Commission to work with the industry to establish a national market system for securities, clarified and, in effect, endorsed the role of SROs in securities regulation.

In a speech later that year, one of my predecessors, Philip Loomis, discussed the 1975 Act amendments and their effect on what he called the “peculiar process” of self-regulation. Citing earlier Congressional studies, Commissioner Loomis noted the existence of a debate over the very nomenclature of the process. A House study concluded that “the phrase ‘self-regulation’ must be consigned to the past” in favor of a new term, “cooperative regulation.” As yet another sign that the more things change, the more they stay the same, the Senate completely rejected the House approach in its own study, concluding that the phrase “cooperative regulation” could create, as Commissioner Loomis put it, “a misleading impression as to the relative functions and authority of industry and government.” [2] Obviously, the Senate prevailed, although one could argue that the Senate study’s concerns proved all too prescient notwithstanding the retention of the term “self-regulatory organization.”

Since Commissioner Loomis’ time, the Commission’s regulatory output has grown exponentially, the nature of SROs has changed fundamentally, and the structure of our markets has changed radically. If we transported the men and women of the 73rd Congress, which passed both the 1933 and 1934 Acts, to the mid-1970s and showed them the markets of the day, the legislators would likely have marveled at the increased size and scope of those markets and the dizzying array of products offered and trades conducted. As they scanned the exchange floors, however, they would have seen much that they recognized, with a plethora of traders filling the floors of mutualized exchanges and engaging in trades with their counterparts, that is, human beings trading with other human beings. They’d even, unfortunately, have recognized the bear markets of the time.

Bring them forward twenty-five years or so, however, and our time-traveling legislators would be confronted with markets altered beyond recognition, with computers tied into demutualized, for-profit exchanges, some now global in nature, and using algorithms to trade decimalized securities at speeds measured in microseconds. I believe that they would be intrigued by the existence of a national market system, but bewildered by the multitude of exemptions riddling that system. They would likely be utterly befuddled by concepts like dark pools and ATSs, although, to be fair, judging from the Study Regarding Financial Literacy Among Investors the Commission released last month, they’d be in good company on that front. It’s difficult to imagine what they’d make of the wildly fluctuating markets of the past several years, but they’d certainly be staggered by the numbers involved.

I can’t speculate as to what their overall normative judgments on today’s markets would be, but I’m fairly confident that they’d reach one crucial conclusion: the basic premises on which the self-regulatory framework they put into place almost eighty years ago — private, mutualized, self-regulating exchanges and a simple association of dealers — were no longer true.

Why does any of this matter? Earlier this year, at the Commission’s SRO Outreach Conference, I stated that we are at a crossroads with respect to the status of self-regulation. For decades now, we’ve been building upon a self-regulatory framework premised on circumstances that no longer exist, a framework that permeates every aspect of market structure. Even as the Commission’s resources are stretched thin responding to entirely new fields of mandated responsibilities such as regulating OTC derivatives, we should take the time to pause and take a close and critical look at the fundamental framework of self-regulation that defines so much of today’s market structure.

Doing so entails being willing to acknowledge and address the role that regulation has played in developing the structure of today’s markets. As I’ve noted recently in a different context, the Commission must resist the urge to regulate on the basis of incomplete data and analysis, including a less than up-to-date understanding of the efficacy of the Commission’s prior regulatory actions.

Now let me emphasize that this doesn’t necessarily imply that the Commission should simply defer undertaking thorough reviews of critical market structure issues such as high-frequency trading and dark pools until we’ve reached some higher plane of understanding about self-regulation and its impact on market structure in general. It does mean, however, that as we look at those issues, we should be mindful of the state of the markets as a whole and how they’ve come to be the way they are today. We should focus on working with the industry to better understand market structure issues and find ways to encourage the development of best practices. Smart regulation involves taking the time to understand how things became the way they are, and, critically, better defining and articulating the goals of regulations. It entails carefully reviewing the results, intended and otherwise, of recently promulgated regulations before rushing into a new round of regulations. As noted securities law expert Lawrence Peter Berra once said, “You’ve got to be very careful if you don’t know where you are going because you might not get there.” Too often in the past regulators have seemingly been guided by a better known quote of Yogi’s: “When you come to a fork in the road, take it.”

In addition to analyzing data, the Commission must be willing to analyze and challenge the relevancy of the statutory provisions underlying our current market structure regulatory paradigm. How relevant is the 1934 view of exchanges in a world of demutualized, public company exchange operators? Does the intent of Congress in 1938 regarding oversight of the OTC markets bear any relevance to today’s markets? What problems do the 1975 Act amendments solve in today’s markets, when there is no longer an exchange monopoly or fixed commissions? Do the 19(b) SRO rule filing requirements, a legacy of the 1975 Act amendments, still make sense after almost four decades of fundamental changes to the SROs and the markets within which they operate?

The last time the Commission undertook a formal, thorough evaluation of the equity markets, the result was the January 1994 Market 2000 Report. [3] That report was largely an evaluation of the principles underlying the 1975 Act amendments as they applied to the markets at the time, resulting in the conclusion, “The principles which Congress enacted into law in the Securities Acts Amendments of 1975 have served our markets and our country, enhancing a system that by any measure is the cleanest, fairest and most efficient in the world.” [4]

Even while extolling the benefits of the 1975 Act amendments, however, the Market 2000 Report noted that the equity markets had changed “dramatically” since the adoption of those amendments, citing, as examples of such changes, growth in trading volume, the increasing prominence of institutional investors, the introduction of derivative products, the globalization of securities markets, and advances in trading technology. [5] To put those “advances in trading technology” between 1975 and 1994 in perspective, however, let me share a few words and phrases that do not appear anywhere in the 450-page report:

  • “Internet”
  • “Web-site”
  • “.com”
  • “High frequency trading”
  • “Dark pools”

I would argue that the markets have evolved even more over the past two decades than the two decades that passed between the passage of the 1975 Act amendments and the release of the Market 2000 Report — indeed, the structure of our equities markets may have changed more since the issuance of the Market 2000 Report than they have over any other two-decade period. Many of the issues that were discussed at the Commission’s Market Technology Roundtable earlier this week, for example — complex issues at the very core of equities trading today — are based on technologies and processes that did not exist, and indeed would have been unforeseeable, in 1994.

In recognition of the fact that the markets of 1994 are light years away from where are today, I believe it is time to undertake a comprehensive market and regulatory structure review, including a review of the self-regulation paradigm as a whole. I say this not despite the Commission’s unprecedented current workload, but in fact because of it. To say that the Commission’s resources are stretched thin by the workload imposed by Dodd-Frank is an understatement. All that rulemaking, however, only exacerbates the risk that we are missing the forest for the trees. As I noted recently, it’s no exaggeration to say that the Commission is handling ten times the normal rulemaking volume, with “normal” being the post Sarbanes-Oxley normal, itself was a marked increase from the pace of rulemaking before that law’s enactment. It’s troubling to me that we have been creating and amending so many rules, and in many cases such fundamentally important rules, while operating within a framework that we have not analyzed in depth for almost 20 years and that no longer accurately reflects the state of today’s markets. I realize that the Commission has taken several looks at some of these issues over the years, most notably through the issuance of the “Reg SRO” proposals [6] and the concept release on SROs [7] in 2004 and the adoption of Reg NMS in 2005. [8] These and other projects, releases, studies, and rulemakings in recent years undoubtedly enhanced our understanding of market structure issues at the time, but as in the case of Reg NMS, they have sometimes been part of undertakings that themselves further altered market structure.

It further troubles me that many recent attempts to “fix” market structure issues, for example the Dodd-Frank amendments to the 19(b) SRO rule filing requirements, have essentially been grafted onto the existing framework without a re-examination of the validity of that framework. In that particular case, I fear that by tweaking the 1975 Act-based requirements without studying whether those requirements make sense at all given the changed market structure, we’ve merely replaced one problematic regime with another. If an issue is serious enough to merit legislative action, I believe, it is serious enough to deserve a re-examination from first principles.

It is my hope, therefore, that the Commission not only pursue a new comprehensive study that addresses both market structure and self-regulation, but does so under the stipulation that there are no sacred cows. This means revisiting the 1975 Act amendments, and will most likely result in recommendations to Congress to amend existing legislation to reflect the realities of today’s markets. The Market 2000 Report’s “basic finding” was that the equity markets “are operating efficiently within the existing regulatory structure. In January 1994, however, the “basic finding” on what was then known as Apple Computer was that it was a struggling has-been left behind by the personal computing industry.

So, in addition to the questions about legislation I just raised, what are some of the fundamental market structure and self-regulation questions we should be asking? I’ll start with a big one: should exchanges still be SROs? In developing an answer to that question, we should keep two key facts in mind. First, as I discussed earlier, the SRO framework was developed in the context of private, mutualized exchanges — a context that no longer exists. Second, at the risk of stating the obvious, the “S” in SRO is for “self.” 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 SRO to “selectively regulatory organizations.”

As with most difficult questions, examining whether exchanges should still be SROs raises additional questions. For example, given the historical role of market data fees in funding exchanges, what would we do with the market data fees in a world in which exchanges aren’t SROs? Should we continue to impose ownership restrictions, which are based on neither statutory nor regulatory authority, on exchanges as they exist today? On a particularly timely note, would non-SRO exchanges continue to enjoy immunity based on their historical quasi-governmental status?

In connection with answering these questions, we need to ask questions about the role of FINRA as well. Is FINRA becoming a “deputy SEC”? With all of the issues facing the broker-dealer industry it was created to oversee, should FINRA be seeking to branch out into entirely new fields of responsibility, such as regulating investment advisors? Is “mission creep” affecting FINRA’s ability to perform its core duties?

Another key question is whether the SROs have the resources — and, just as importantly, the willingness — to perform sufficiently rigorous analyses to support their rulemaking. The Commission’s 19(b) review process for SRO rule filings is not meant to be a rubber stamp for proposed new SRO rules, and the Commission’s delegation of authority to staff to review those filings cannot be an abdication of its responsibility to ensure that SRO rule proposals are fully vetted and pass legal muster. As my good friend and colleague Troy Paredes and I noted earlier this year in registering our objection to the Commission’s approval of an interpretive notice issued by the MSRB concerning the application of its Rule G-17 to underwriters of municipal securities, any rulemaking, whether by an SRO or by the Commission itself, should be the product of a careful and balanced assessment of the potential consequences that could arise. This entails a thorough analysis of both the intended benefits and the possible costs of a proposed rulemaking. Specifically, it requires identifying the scope and nature of the problem to be addressed, determining the likelihood that the proposed rulemaking will mitigate or remedy the problem, evaluating how the rule change could impact affected parties for better and for worse, and justifying the recommended course of action as compared to the primary alternatives. [9] I’m under no illusion as to the onus this places on SROs — cost-benefit analysis isn’t easy, it isn’t quick, and it isn’t cheap. If self-regulation is to remain viable, however, it is necessary. Chairman Schapiro has reiterated the Commission’s commitment to performing meaningful economic analyses in its rulemaking on multiple occasions. [10] If self-regulation is to continue to play a central role in securities regulation, SROs must be committed to ensuring that the rules they send to the Commission for approval are the result of the same degree of rigorous analysis as the Commission applies to its own rules. There has been significant progress on this issue lately, but there is still a long way to go.

These are not easy questions, and I doubt any of them will lead to simple answers. It’s my hope, however, that in our conversations about market structure issues, we take the time to consider fundamental questions such as the ones I’ve put forth this morning.

As a complete non-sequitur, I would like to end with a plea to retail investors. Given the impending fiscal cliff — a potentially fundamental change to our economy — I hope that individual investors are re-examining their own fundamental assumptions by seeking out guidance as to how that change could impact their own investments. They should be talking to their financial advisors and using resources such as the IRS, the SEC, and FINRA for guidance.


[1] S. Rep. No. 1455, 75th Cong., 3d Sess. I.B.4. (1938); H.R. Rep. No. 2307, 75th Cong., 3d Sess. I.B.4. (1938) (duplicate text quoted in both reports).
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[2] Commissioner Philip. A. Loomis, Jr., The Securities Acts Amendments of 1975, Self-Regulation and the National Market System, address before the Joint Securities Conference, 1975 (November 18, 1975), available at http://www.sec.gov/news/speech/1975/111875loomis.pdf.
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[3] U.S. Securities and Exchange Commission, Division of Market Regulation, Market 2000: An Examination of Current Equity Market Developments (1994), available at http://www.sec.gov/divisions/marketreg/market2000.pdf.
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[4] Id. at iv (Statement by the Securities and Exchange Commission, Upon Release of the Market 200 Report – January 27, 1994).
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[5] Id. at 5.
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[6] Fair Administration and Governance of Self-Regulatory Organizations; Disclosure and Regulatory Reporting by Self-Regulatory Organizations; Recordkeeping Requirements for Self-Regulatory Organizations; Ownership and Voting Limitations for Members of Self-Regulatory Organizations; Ownership Reporting Requirements for Members of Self-Regulatory Organizations; Listing and Trading of Affiliated Securities by a Self-Regulatory Organization, Securities Exchange Act Release No. 50699 (November 18, 2004), 69 FR 71126 (December 8, 2004).
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[7] Concept Release Concerning Self-Regulation, Securities Exchange Act Release No. 50700 (November 18, 2004), 69 FR 71256 (December 8, 2004).
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[8] Regulation NMS: Final Rules and Amendments to Joint Industry Plans, Securities Exchange Act Release No. 34-51808 (June 9, 2005), 70 FR 37496 (June 29, 2005).
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[9] Commissioners Daniel M. Gallagher and Troy A, Paredes, Statement Regarding Commission Approval of MSRB Rule G-17 Interpretive Notice (May 14, 2012), available at http://www.sec.gov/news/speech/2012/spch051412dmgtap.htm.
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[10] Mary L. Schapiro, Chairman, Securities & Exchange Commission, Testimony Concerning Economic Analysis in SEC Rulemaking Before the Subcommittee on TARP, Financial Services and Bailouts of Public and Private Programs of the Committee on Oversight and Government Reform, U.S. House of Representatives (April 17, 2012), available at http://sec.gov/news/testimony/2012/ts041712mls.htm; Mary L. Schapiro, Chairman, Securities & Exchange Commission, Testimony Concerning the “JOBS Act in Action Part II: Overseeing Effective Implementation of the JOBS Act at the SEC” Before the Subcommittee on TARP, Financial Services and Bailouts of Public and Private Programs of the Committee on Oversight and Government Reform, U.S. House of Representatives (June 28, 2012), available at http://www.sec.gov/news/testimony/2012/ts062812mls.htm.
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