TCS Daily

Regulate Thyself?

By Kevin Hassett - October 29, 2003 12:00 AM

When former Chairman and Chief Executive Officer Richard Grasso was pushed from the halls of the New York Stock Exchange with his pockets full of cash, he left the equities exchange giant reeling and beset with calls for outside regulation. Many critics, including state governments, have pressed the Securities and Exchange Commission to conduct an independent review of the NYSE's governance in the wake of Grasso's ouster. Alan Hevesi, New York State Comptroller, threatened to press the SEC to invoke a third-party review of the NYSE if it did not promptly address the exchange's governance problems.


At the heart of the matter is the NYSE's unique structure. Unlike the NASDAQ, which is regulated by an outside party, the NYSE sets its own rules. This structure lead to a world where the regulator can design rules that are highly profitable to the specialists who run the trading floor, and then receive -- in exchange -- healthy executive compensation. Given the right rules, there is money to go around for everyone.


Walking, or perhaps running, into this debate is new interim New York Stock Exchange Chairman John Reed. The former chairman of Citicorp agreed to head the exchange on September 21st until a permanent replacement is found. Mindful of appearances, he has also agreed to be paid a total of one dollar for his services. SEC chairman William Donaldson praised Reed upon hearing of his acceptance of NYSE's top spot, "I am gratified that he is willing to take on this critical post," going on to note that, "He is independent, experienced and has impeccable credentials, all of which will be crucial as he works with the NYSE board to ensure the highest standards of governance." As a further nod to Reed, officials for the SEC have said they want to give Reed time to review the NYSE's governance before they conduct an independent review, according to the Wall Street Journal.


In his first month, however, time has not been an issue for Reed. Indeed, his strategy is already quite evident. He hopes to modify the practices of the NYSE enough to mollify critics but to hold on to the basic organizational structure that has been so controversial.


As one of his first major acts as chairman and CEO of the NYSE, Reed rejected a special board committee's report on the exchange's governance, and launched a new review, aimed at making "more dramatic" changes than the original report was suggesting. H. Carl McCall, who was co-chairman of the special committee on corporate governance and who lead the scrapped report, resigned in the wake of Reed's action. Responding to the Grasso scandal, Reed promised to reveal the salaries of top NYSE directors, which he did on October 13th.


The rest of his evolving strategy was discussed in his recent testimony to the Subcommittee on Capital Markets, Insurance, and Government Sponsored Enterprises of the House Financial Services Committee on October 16th.


He began his testimony by acknowledging the failings of the NYSE board of directors, calling recent NYSE failings a, "governance debacle," and conceding that self-regulated bodies suffer inherent conflicts of interest.


Mr. Reed, however, reiterated his defense of self-regulation, arguing that remediation of the exchange's governance would not require splitting off the Regulatory Group. He further defended self-regulation citing the practice places those with the most, "knowledge and expertise," at the regulatory helm, and creates minimal interference with market mechanisms. He also noted that internal NYSE is but one component of a regulatory regime that includes the SEC and Congress and proposed that the NYSE's ills might be improved through modifications of the exchange's methods rather than through a wholesale change in the regulatory structure.


And what might those changes be? Structurally, Reed proposes to shrink the existing board of directors, which an NYSE panel recommended just days before Reed's testimony. Moreover, Reed argued for, "a board of directors that consists of a substantial majority of directors who are independent, not just of the exchange's management, but also of both the broker-dealer industry and the companies listed on the exchange." This proposed change mirrors standards set by the NYSE for its own listed companies.


But aside from this, and some increased transparency, the NYSE would escape unscathed. Most notable is the debate over the exchange's agency-auction market structure. In response to critics, who argue that the exchange should go to an all-electronic structure such as the type used by networks like Instinet, Reed defended the "physically convened" structure and urged critics not use the governance crisis as a means to affect market structure changes.


So what should one make of these efforts? There is no question that the unique structure of the NYSE has great potential to create conflicts of interest. Even if Mr. Reed is as saintly as Mother Theresa and chooses a new Board that is as independent as possible, there is the risk that the next Board will be not quite as independent, and the one after that as bad as the most recent one. Under such a scenario, historians would doubtless look back at the Reed effort as purely cosmetic, and designed to rescue a questionable structure at a key moment of crisis.


That view may be inaccurate, however. There are reasonable arguments for self regulation. A free-market advocate like myself might argue, for example, that competition among exchanges is the best form of regulation possible. Government empowered regulatory bodies, on the other hand, tend to be inefficient and to grow over time. According to this view, it might be fine to let the NYSE regulate itself provided that there is ample competition among exchanges. If the NYSE, as it has been, is opaque and a cash cow for its managers, then investors and firms will take their listings elsewhere, and discipline the market far more than a regulator ever would.


Why didn't this mechanism work yet? As I have argued elsewhere, NYSE and SEC regulations have hamstrung the ability of NASDAQ to effectively compete for listed stocks with the NYSE. Firms and investors who felt cheated had basically no recourse. While there are signs that this may be changing, the basic idea of competition as a regulator is a powerful one, and it puts a great deal of pressure on Washington policymakers. If the NYSE is going to be allowed to continue to self regulate, it must do so in an environment that is alive with competition. It must be trivial and common for firms to switch among exchanges. If such a world is beyond our capabilities, then self regulation will continue to be a recipe for corruption.


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