Capturing the Benefits of Market Discipline

Over the past decade, oversight of the SROs has become tighter. For example, oversight of Canadian exchanges formerly consisted of approvals for changes to rules and bylaws, but over the last decade the commissions have moved towards a much more micro-approach that now includes comprehensive examinations of an exchange’s operations. These examinations extend beyond the exchanges’ self-regulatory activities to cover operational and financial integrity as well.

Is this the right direction for the commissions to be moving in – or is there a better approach, one that would tap the benefits of regulatory competition?

A paper by the International Organization of Securities Commissions’ (IOSCO) Consultative Committee on Self-Regulatory Organizations recently noted “the powerful motivating forces of reputation and competition” in ensuring quality self-regulation. Unfortunately, the SROs in Canada are essentially monopolists.

In the case of securities exchanges, because of recent consolidation the TSX now occupies a monopolist position within Canada for trading equities although it is increasingly facing competition from exchanges outside the country. Facilitating more direct competition within Canada for the TSX from new entrants such as foreign exchanges would unquestionably be healthy for Canadian capital markets.

But Canada’s rigorous regulatory oversight regime for exchanges is a huge barrier for new entrants. The barrier is becoming larger through not only more aggressive oversight, but new regulation such as the adoption by the commissions of new rules that were supposedly introduced to facilitate alternative trading systems, but which effectively expanded the regulation of any trading platform that operates in Canada.

A far superior approach would be to replace the exchange oversight regime with some basic transparency requirements that would consist of (1) a requirement by an exchange to publicly disclose all its rules and (2) a periodic performance review by an external party, that would also have to be disclosed, of how well the exchange is enforcing its rules.

This approach would lead to better quality self-regulation by stock exchanges through increasing regulatory competition. Competition creates an incentive for exchanges to promote themselves through the quality of their self-regulation.

Logically, investors would be willing to pay a premium for shares that trade on exchanges with self-regulation amenable to their interests.Public companies would respond by listing on exchanges that investors prefer. Only if investors desire faulty regulation that facilitates manipulative and deceitful trading practices harmful to their own interests, will a poorly regulated exchange survive.

Historical evidence shows that rigorous oversight regimes by public regulators really are not necessary to ensure that exchanges engage in self-regulation that is in the interest of investors. A study of stock exchange rules in the US prior to governmental regulation by Paul Mahoney concluded that many stock exchange rules were established on the premise that to attract investors, an exchange had to provide elementary protections against defaults, forgeries, fraud, manipulation and other avoidable risks. For example, the New York Stock Exchange’s 1817 constitution contained a provision prohibiting fictitious transactions.

Another benefit of this approach is it would reduce some of the complexity and overlap within the Canadian securities regulatory framework. Under the existing regime, five provincial commissions have chosen to exercise oversight authority over the TSX’s self-regulatory subsidiary. While these commissions will coordinate their oversight activity, it still means the TSX needs approvals from five commissions every time it wants to amend a rule or bylaw.

This can hardly be described as the ideal regulatory framework for an exchange to differentiate itself through the quality of its regulation in increasingly competitive global capital markets. To be successful, exchanges will need the flexibility to adapt their self-regulation quickly in response to market innovations.

For other SROs, such as the IDA, a combination of transparency and a relaxation of the rules that prevent Canadian residents from doing business with foreign dealers and advisers would also result in better self-regulation than the current system of oversight.

One possible criticism of relying on transparency is that if SRO’s are responsible for commissioning external performance reviews of themselves, this would raise the same conflict issues associated with audits of public companies or solicited credit ratings. But under the current regulatory oversight regime, investors receive no information at all on how well self-regulatory functions are being performed. The securities commissions prefer to keep the results of their examinations confidential. Disclosure of an external performance review would unquestionably be superior to the status quo, which is keeping investors in the dark.