With exchanges and operators of alternative trading systems each trooping to Washington this year to complain about the unfair competitive advantages held by the other, Securities and Exchange Commissioner Daniel Gallagher weighed in on the issue recently.
Speaking at an industry conference last month, Gallagher said the time may have come to put brokers and exchanges on equal regulatory footing. Rather than take one side over the other, the commissioner contends that both exchanges and the brokers that compete with them may be at a disadvantage due to the exchanges’ special regulatory status.
“Each market participant has its own set of costs and benefits,” Gallagher said during an online market structure conference sponsored by the Investment Company Institute last month. “The SEC needs to step back and take a look at them all and decide if we should be leveling the playing field.”
In June, two prominent industry leaders—one from an exchange and the other from a large brokerage—testified at a congressional hearing in Washington that legislators and regulators needed to do just that: “level the playing field.” That way they could more effectively compete with one another.
Duncan Niederauer, chief executive of NYSE Euronext, told the House Committee on Financial Services that policymakers should either lighten exchanges’ regulatory burden or increase that of their competitors, the brokers’ alternative trading systems. Specifically, he wants quicker approval of rule filings, a loosening of exchange fair access rules and for ATSs to be regulated like exchanges.
Brokers, at this point, have no similar self-regulatory requirement to police the members of their alternative trading systems.
Dan Mathisson, head of U.S. equity trading at Credit Suisse, operator of the largest ATS, told congressional leaders at the hearing that Washington should either strip the exchanges of their self-regulatory status or scrap the policy that bars broker-dealers from owning more than 20 percent of an exchange. That way brokers would have an incentive to convert their ATSs into exchanges and compete on equal terms with the existing exchanges.
For his part, Gallagher agreed that something needs to be done. Gallagher wants the SEC to determine whether certain aspects of the Securities Exchange Act of 1934 should be amended or scrapped. The act gave exchanges regulatory powers over their broker-dealer members and is also the basis for their regulation by the SEC.
In particular, Gallagher questioned Section 19-b of the act, which requires exchanges to file rule changes with the SEC, and Section 6, which requires them to police their members.
Gallagher suggested that some parts of the Exchange Act, such as Section 6, make no sense in today’s world, where trading is done not by members on a single trading floor, but electronically across several marketplaces in multiple locations.
The Republican commissioner pointed out that the nature of exchanges has changed significantly since 1975, when the Exchange Act was last amended. Exchanges have transformed themselves over the past 37 years from nonprofit, mutual organizations into profit-seeking, public companies. Yet they are still treated as quasi-governmental entities.
That’s despite the fact, he noted, that exchanges have already shed many of their regulatory duties by outsourcing them to the Financial Industry Regulatory Authority. “Should exchanges bear the expense of being (a self-regulatory organization) when, in fact, they are pretty far removed from that status?” Gallagher asked. “Does this make sense?”
Despite Gallagher’s concerns, the SEC has no power to scrap any or all of the Exchange Act. That rests with Congress, said Steve Nelson, principal at Nelson Law Firm, a boutique firm that has represented the Security Traders Association.
Nelson agrees with Gallagher that the Exchange Act is outdated, as there is no longer much of a floor crowd to police. But the attorney is not optimistic that Congress will act anytime soon. “It would require Congress to rejigger things,” Nelson told Traders Magazine, “and that would be extremely hard to do. It probably would only happen if there is enough of a crisis that people decide that something has to get done. I don’t think we’ll have something like that anytime soon.”
None of the exchange operators contacted by Traders Magazine would discuss Gallagher’s comments. But it is no secret they would like to see their regulatory obligations reduced. Both Nasdaq OMX Group and NYSE Euronext, for example, have contracted out nearly all of their regulatory duties to FINRA.
And NYSE Euronext, at least, would like to see even more of the burden streamlined or eliminated. At the hearing in June, Niederauer told Congress that SEC approval of exchange rule changes should be effective on filing. The often lengthy filing process puts exchanges at a competitive disadvantage to ATSs, Niederauer said.
The exec also indicated that exchanges shouldn’t be constrained by the fair access requirements of the Exchange Act. Unlike ATSs, exchanges are forced to accept anyone who wants to trade in their market. That’s a problem, Niederauer told Congress.
Despite Niederauer’s complaints, it is an open question whether their special regulatory status hinders or hurts the exchanges. Mathisson told Congress that due to their status as self-regulatory organizations, exchanges have four primary economic advantages over broker-dealers:
They are immune from liability for technical disruptions. They generate revenue from sales of market data. They do not having to pay clearing fees, as do broker-dealers. And they are not required to hold costly capital against any positions they take on.
“Within the past five years, two major ATSs, BATS and Direct Edge, both voluntarily chose to become exchanges, spending millions of dollars and devoting years of effort to make the switch,” Mathisson wrote in his testimony. “They became exchanges because they wanted to benefit from the four big advantages that exchanges have.”
In his quest to alter the balance of power between exchanges and alternative trading systems, Mathisson petitioned Congress on two fronts. First, he asked Congress to strip exchanges of their self-regulatory status. Second, he asked them to scrap the policy that prohibits a broker-dealer from owning more than 20 percent of an exchange.
Mathisson is seeking to register the Credit Suisse ATSs—Crossfinder and Lightpool—as exchanges, wholly owned by the big broker. But because of SEC policy, he faces a tough slog.
Ever since the middle of the last decade, when exchanges began demutualizing and coming under ownership by shareholders, the SEC has not permitted a single broker-dealer to own more than 20 percent of an exchange.
In 2004, the SEC tried to codify that policy, but it never approved its own rule proposal. The 20 percent cap has remained a policy however. The SEC’s concern, according to the proposal, is that a broker-dealer that controlled more than 20 percent of the voting rights of a self-regulatory organization could “use its controlling interest in its regulator to influence the regulatory process to its benefit.” It might also shirk its regulatory duties, the SEC argued.
Mathisson argued this summer that times have changed and that the 20 percent cap is irrelevant. Exchanges are SROs in name only. They have no regulatory authority that could be abused by their owners, he contends. “Now that most exchanges outsource most of their regulatory functions to FINRA, we believe that this restriction is obsolete,” the executive testified.
