Transparent exchanges; As stock exchanges merge, regulators should remove the barriers to entry that stifle competition - Appeared in the Financial Post

The proposed TMX-London Stock Exchange merger and the more recently announced acquisition of NYSE Euronext by Deutche Boerse AG follow a trend of cross-border mergers of exchanges as capital markets become more integrated globally. The benefits of this trend are clear: Companies have access to more investors, investors have easier access to foreign stocks, and larger exchanges may be able to achieve economies of scale, with the cost savings passed on to both companies and investors. To fully capture these benefits, securities regulators in Canada and elsewhere need to fundamentally rethink exchange regulation and oversight to create a model that functions seamlessly across borders without the costs of current differences in regulatory regimes.

The regulatory structures for the activities undertaken by exchanges differ significantly from jurisdiction to jurisdiction in two core areas: market integrity rules and listing standards. Here in Canada, regulation of our stock exchanges is multi-layered and multi-jurisdictional. It begins with a self-regulatory organization, the Investment Industry Regulatory Organization of Canada (IIROC), which is responsible for setting and enforcing market integrity rules regarding trading activity for Canadian equity marketplaces, including the TMX. These rules are intended to ensure trading occurs in an orderly manner and to prevent market manipulation and fraud. IIROC operates under the oversight of Canadian provincial securities regulators, including approval of the rules that IIROC sets. In addition, Canadian provincial securities regulators exercise direct oversight of both the TMX and TMX Venture Exchange to ensure compliance with their recognition orders.

In contrast to the Canadian approach, the London Stock Exchange sets and enforces rules on trading activity. The rules must be consistent with European Union legislation. In Australia, a jurisdiction also dealing with a cross-border merger proposal, the Australian Securities Exchange had been responsible for the oversight of trading activity, but the function was recently transferred to its regulator, the Australian Securities and Investment Commission. In the U. S, the New York Stock Exchange has a not-for-profit subsidiary responsible for market integrity; NASDAQ has a surveillance department that monitors for suspicious activity, which it reports to a self-regulatory organization called the Financial Industry Regulatory Authority; and the U.S. Securities and Exchange Commission exercises oversight of all U.S. exchanges.

The other core regulatory difference across jurisdictions is in listing standards. In Canada, the TMX is responsible for setting listing standards and approving companies for listing. However, listing standards and approvals for the London Stock Exchange are the responsibility of the U.K. Listing Authority, which is currently part of the U.K. Financial Services Authority, but will be transferred to a new consumer protection regulator. In other jurisdictions, including the U.S., an operationally independent committee or subsidiary is responsible for listing standards.

The differences in regulatory regimes will create problems and costs for the emerging global exchanges, detracting from the benefits described above. There are the compliance costs from having to deal with multiple regulatory regimes. The differences in regimes may impede exchanges from capturing the savings from operating under a single set of rules and a single supervision regime. Another major issue is that exchanges may not be able to offer companies and their investors consistency in the quality of the services they provide across the markets in which they operate.

Securities regulators should reconsider their approach to the oversight of exchanges using three basic concepts. First, investors are risk adverse. They desire minimum risk for the returns they can get. Hence, they will prefer exchanges where the risk of fraud and market manipulation is lower. Next, companies will list on the exchanges that are most attractive to investors in order to minimize their cost of capital. Finally, exchanges need to differentiate themselves from their competitors. They need to set listing standards that fit with the business segments they are pursuing. For example, the TSX Venture Exchange has listing standards that accommodate sectors such as junior mining explorers.

What follows from these three concepts is that regulatory objectives can be achieved seamlessly for global exchanges by shifting to a new model based on transparency and competition. Under this model, regulators would withdraw from their current activities in exchange regulation in favour of basic standards for exchanges to follow regarding transparency about their policies and practices for market integrity and listing standards.

A combination of transparency and competition provides the mechanisms that will ensure investors are well served. If regulators continue with all their various regimes for regulating exchanges, they will run counter to their own objectives by creating regulatory barriers to entry, such as different trading rules, and by stifling competition among the global exchanges that will emerge through transactions such as the proposed TMX-London Stock Exchange merger.