TCS Daily

Separate Regulator and Regulated

By James K. Glassman - June 18, 2003 12:00 AM

In the wake of a series of scandals and embarrassments, including an investigation by the Securities and Exchange Commission into abuses by the "specialist firms" that match buyers and sellers on the trading floor, the New York Stock Exchange has unveiled a set of corporate-governance reforms.

Among them: Top officials would be barred from serving as directors of NYSE-listed companies. That would mean that the exchange's chief executive officer, Richard Grasso, whose compensation package is worth $10 million a year, would have to resign from the board of Home Depot.

But what's the big deal? The NYSE's competitor, the NASDAQ Stock Market, instituted similar rules long ago. A fair question is why the larger exchange, at a time of deep concern about fairness and accountability, has been so slow to act?

The answer lies in the structure of securities exchanges and how they are regulated. The NYSE is a "self-regulatory organization," or SRO. As the name implies, it sets its own rules and requires its dues-paying members, who also dominate its board, to abide by them. Think of a club with bylaws.

And think of the conflicts of interest that this structure presents. The exchange wants to keep its members happy, but it also has to act in ways that retain and enhance the trust of investors. Typically, SROs change their rules after a scandal or crisis, or under pressure from the SEC.

Is this the best way to regulate exchanges? Absolutely not.

Instead, the regulator and the regulated should be separate. The regulator does not have to be a government agency - although it could. And the exchange would not be a completely passive party. It would choose its regulator and be responsible for that choice. Investors could judge for themselves whether this selection is merely self-serving or whether the regulator is serious about protecting them.

One likely candidate to regulate the NYSE is the National Association of Securities Dealers, a private entity with an annual budget of $400 million and a staff of 2,000, which already regulates both the NASDAQ and more than 5,000 securities firms.

The NASD used to own NASDAQ, but three years ago, as the NASD says on its website, "we decided to sell NASDAQ, in order to concentrate solely on our core mission, ensuring market integrity and investor confidence."

Unfortunately, the process of separation between NASD and NASDAQ has been stalled by the SEC, which has been distracted lately by corporate scandals and a change at the top. The new chairman, William Donaldson, should move swiftly to complete the cycle by granting NASDAQ independence through exchange registration. NASDAQ would become an independent exchange, and the NASD would be its independent regulator.

Earlier this month, the NASD announced it would sell its interest in a third market, the American Stock Exchange, to a Chicago-based private equity firm. The NASD acquired the Amex in 1998, but Robert Glauber, NASD's CEO, now says, "One of our key goals over the last few years has been to exit NASD's ownership of exchanges and focus....on NASD's core mission as a regulator."

The Amex, however, is expected to retain SRO status, rather than adopting the NASD as its independent regulator. That's a mistake.

The SEC has the opportunity to prevent this kind of nonsense by establishing a new regulatory regime for exchanges - one in keeping with principles that the Bush Administration (as well, I am sure, the majority of Americans) holds dear: choice, competition, strict compliance and investor protection.

There's a model for such a regime, and it works well: U.S. corporations choose the state in which they are chartered and that state's corporate law prevails. States compete to offer rules that are sensible both for corporations and investors. Landmark research by Roberta Romano, a Yale University law professor, has found that this competition does not result in a "race to the bottom," but just the opposite - strong, productive regulations that benefit the managers, employees, shareholders and the economy.

In a book published last year, "The Advantage of Competitive Federalism for Securities Regulation," Romano extended the model to the regulation of individual public companies. Under her proposal, they would "select their regulator from among the 50 states, the District of Columbia, the SEC or other nations."

Competition, she argues, produces the best results, not just in the commercial marketplace, but also in the regulatory marketplace.

When it comes to securities exchanges, the choose-your-regulator principle would be even easier to put into practice since there are thousands of corporations but only a handful of exchanges. One of them, NASDAQ, already has an outside regulator, and the other major market, the NYSE, could readily pick one.

Currently, the NYSE has an insurmountable conflict of interest and - because of rules that make it nearly impossible for listed companies to move elsewhere and limits on NASDAQ as a "non-exchange" - a position that's largely protected from competition.

The result is hardly surprising: an anachronistic system that has long outlived its usefulness in a high-tech age. And worse: "The NYSE looks like the poster child for all the abuses we are supposed to be reforming," says Barbara Roper, director of investor protection for the Consumer Federation of America, quoted in a recent, scathing piece about the exchange in U.S. News & World Report. That article also reminded readers of the "firestorm of protest" after the NYSE nominated Citicorp chairman Sanford Weill as a public representative on its board

"The nicest thing you can say about the NYSE and their performance is that they are set up in such a way that you can't expect them to do a good job," says Sarah Teslik, executive director of the Council of Institutional Investors. "And they have not disappointed us."

The answer is not merely for the NYSE's own cozy board to issue minor reforms or for it fire its current management. Instead, the entire structure to get an overhaul that's long overdue. The big change is simple: Put distance between the regulator and the regulated. Until that happens, there's little doubt that the scandals and the embarrassments will continue.

TCS Daily Archives