Self-Regulation in Securities Markets
This paper canvasses the trends in self-regulation and the role of self-regulation in securities markets in different parts of the world. It describes the conditions in which self-regulation might be an effective element of securities markets regulation, particularly in emerging markets. The paper also discusses important issues for the effective operation of SROs, including corporate governance, managing conflicts of interest, and regulatory oversight by government authorities.
The World Bank sponsored this work because the use of self-regulation and self-regulatory organizations (SROs) is often recommended in emerging markets as part of a broader strategy aimed at improving the effectiveness of securities regulation and market integrity. An SRO may be generally defined as a private institution that establishes, monitors compliance with, and enforces rules applicable to securities markets and the conduct of the SRO’s members. SROs may support better-regulated and more efficient capital markets, but the value of self-regulation is again being questioned in many countries. Forces such as commercialization of exchanges, development of stronger statutory regulatory authorities, consolidation of financial services industry regulatory bodies, and globalization of capital markets are affecting the scope and effectiveness of self-regulation – and in particular the traditional role of securities exchanges as SROs.
Self-regulation in securities markets takes a wide variety of forms around the world. The paper reviews different models of self-regulation, including Exchange SROs, member (or independent) SROs, and industry (or dealers’) associations. It draws on examples from many markets to illustrate the degree of reliance on self-regulation, as well as the range of functions for which SROs are responsible, in markets around the world.
Four basic regulatory structures, or models, are observed globally. The models are really points on a continuum, ranging from no formal reliance on self-regulation to significant reliance on SROs to regulate securities business. In each model, the public or governmental authority is the primary regulator.
- Government (Statutory) Model – Exchanges are usually responsible for very limited supervision of their markets but are not considered to be SROs. Examples: UK, France and most European Union countries.
2. Limited Exchange SRO Model – The regulator relies on Exchanges to perform certain regulatory functions tied to operation of the market (for example, market surveillance and listing). Examples: Hong Kong, Singapore, Sweden (Nasdaq OMX Stockholm), US.
3. Strong Exchange SRO Model – The regulator relies on Exchanges to perform extensive regulatory functions that extend beyond their market operations, including regulating members’ business conduct. Examples: Japan (TSE, and Osaka Securities Exchange, or OSE); Malaysia (Bursa Malaysia); US (CME).
4. Independent Member SRO Model – The regulator relies extensively on an independent SRO (a member organization that is not a market operator) to perform extensive regulatory functions. Examples: Canada (IIROC and the Mutual Fund Dealers Association, or MFDA), Japan (JSDA), South Korea (KOFIA), US (FINRA and the National Futures Association, or NFA), Colombia (AMV).
In addition, the Industry Association SRO Model is a less developed version of model 4. These associations function primarily as voices of the industry and are mainly member-driven, but they also set standards or rules for specific securities market activities.
Securities exchanges remain the most common form of SRO in the securities markets arena, although the role of exchanges as regulators is being reduced around the world. Exchanges in developed markets, and in many emerging markets, are now mostly commercial enterprises that must compete for business. This has diminished the role of regulatory functions at most exchanges. Only a handful of “pure SROs” exist, such as FINRA in the US, whose primary function is regulation. Furthermore, when member dealers do not own an Exchange, strictly speaking it is neither a self-regulatory body nor a membership organization. Nevertheless, most Exchanges retain jurisdiction over at least some of their participants’ market and business conduct.
Conflicts of Interest
The biggest risk of self-regulation has always been conflicts of interest. While conflicts always existed, recent changes in financial markets have heightened concerns about conflicts, especially at Exchange SROs, because corporate business models arguably create greater conflicts of interest between an Exchange’s self-regulatory responsibilities and its business activities. Independent member SROs face fewer conflicts, but the inherent conflict in members regulating themselves remains. Those SROs’ conflicts are greater if the organization doubles as a trade association, which creates conflicts between regulating members and advocacy on their behalf.
Demutualization of exchanges is now widely viewed as increasing the conflicts of interest that have always been present in self-regulation. Managing conflicts between the business and regulatory functions is the most significant regulatory and governance issue to arise with the advent of for-profit exchanges. SROs and supervising regulators use a wide range of approaches in managing conflicts of interest. The issue has been addressed mainly through a combination of corporate governance requirements, reducing the regulatory responsibilities of exchanges, creating independent SRO units to handle regulation functions, and introducing procedural changes designed to manage the conflicts.
Self-Regulation in Emerging Markets
Developing countries, in particular those aiming to develop capital markets that are competitive regionally or globally, are being pressed to improve standards of conduct in securities markets and to build more effective capacity to regulate and supervise their markets. To this end, some are evaluating whether self-regulation can play a greater role in raising standards of conduct and supervision.
The main reason to consider using self-regulation is that it enables additional resources and expertise to be applied to regulation. In large and complex securities markets, even well resourced regulatory authorities find it a challenge to set all the rules and standards, and to deploy thorough supervision programs, to ensure compliance across all areas of the markets. This challenge applies to both developed and emerging markets.
Although reliance on Exchange SROs is declining in the world, the local Exchange remains a viable option to carry out SRO responsibilities in many emerging markets. Exchanges often have existing regulatory capacity, as well as the resources, knowledge, and incentive to improve regulation and market conduct. To minimize conflicts of interest, an Exchange might concentrate on trading rules and market surveillance, leaving supervision of securities dealers’ business conduct and affairs to the government regulator.
Where a valuable role for a formal SRO is not realistically achievable, or when the size of the market does not justify the cost of a two-tier regulatory system, the European model of creating a government regulator with independent operational authority is preferred. It is more efficient than a two-tier system. The resources required to develop a formal SRO are worth investing only if the SRO would have sufficient responsibilities and authority to contribute significantly to raising standards of conduct and supervision.
International experience teaches that different approaches to self-regulation are workable, as well as that a formal SRO is not a necessary feature of a regulatory system. Based on experience in many jurisdictions, a set of conditions that would support successful reliance on self-regulation in a capital market are identified and discussed in the paper.
*This article is excerpted from a paper published as World Bank Policy Research Working Paper No. 5542. Download the complete report at:
About John W. Carson
John Carson is a capital markets expert with extensive international experience in the operation and regulation of financial markets and capital markets development. A securities lawyer and regulator by background, Mr. Carson has worked at the strategic, management and operational levels of exchanges and SROs. Recently Mr. Carson’s work has focused on development of regulatory organizations and programs, development of securities exchanges and investment dealer compliance. His projects have covered the development, governance and operations of SROs, as well as international trends in regulatory structure.
Before launching his consulting practice in 2001, Mr. Carson was well known in the Canadian securities industry as the TSX’s Senior Vice-President of Listings and Market Regulation, responsible for all of the Exchange’s Listings, regulatory and policy operations when it was Canada’s foremost SRO. He was centrally involved in the TSX's demutualization in 1999-2000.