UPDATE 1-Wall Street group seeks end of exchange self regulation
(Adds comments from NYSE and Direct Edge; no comments from Nasdaq and BATS; background on exchanges and SIFMA)
NEW YORK, Aug 1 (Reuters) - The largest U.S. securities trade group asked regulators on Thursday to end the self-regulatory status of stock exchanges, saying the structure is outdated, creates conflicts of interest, and should be replaced by some form of outside supervision.
U.S. securities exchanges and non-exchange trading venues operated by broker-dealers perform largely identical functions in many respects, the Securities Industry and Financial Markets Association (SIFMA) said in a letter to the U.S. Securities and Exchange Commission.
As for-profit businesses, exchanges compete with broker-dealers for the same order flow, with around 40 percent of equities trades taking place on non-exchange venues.
As self regulatory organizations (SROs), exchanges are responsible for governing their members' activities, ensuring compliance with their own rules and federal securities laws, and disciplining their members for violations.
"A result of this structure is that one group of businesses is empowered to oversee and regulate the business and activities of its competitors. Conflicts of interest in this model abound and only worsen as they are left unresolved," SIFMA said.
SIFMA represents the interests of hundreds of securities firms, banks and asset managers. The group called on the SEC to consider the regulatory status of exchange operators, which include NYSE Euronext, Nasdaq OMX Group, BATS Global Markets, and Direct Edge, as part of a broader review of equity market structure.
In its letter, SIFMA called the current self-regulatory structure "outdated and in great need of rethought and reform."
The exchanges themselves have been calling for a comprehensive review of the benefits and obligations of market participants, which NYSE said in a statement on Thursday are not accurately represented by the SIFMA letter.
"We also continue to be discouraged by the efforts by heavily conflicted brokers to reduce the influence of exchanges and interests of investors, further decrease transparency and price discovery in the equities marketplace, and generate additional profits for the broker community," NYSE said.
Direct Edge said it would welcome the themes brought up by SIFMA as part of a holistic discussion of market structure. Representatives at Nasdaq and BATS declined to comment.
Every alternative trading system (ATS) has the option to register as an exchange, but very few have, Eric Noll, who heads Nasdaq's U.S. and UK transaction services, told a U.S. Senate subcommittee in December. "One need only look at the list of SRO responsibilities and obligations that registration triggers to understand why so few ATSs voluntarily take that step."
Exchanges began as member-owned trading platforms, but have transformed over the years into for-profit businesses. At the same time, regulatory changes put in place by the SEC, along with advances in technology and the automation of the markets, have blurred the distinctions between exchanges and trading platforms owned by broker-dealers, SIFMA said.
As self-regulatory organizations, exchanges are immune from private liability for damages they cause, while broker-dealers performing similar services are subject to private liability, SIFMA said. The line between where regulatory functions at exchanges end and commercial activities begin has never been clearly drawn, it added.
Regulatory immunity at exchanges came under scrutiny last year, when market-making firms said they lost up to a combined $500 million as a result of technical errors by Nasdaq's main exchange during Facebook's market debut.
Nasdaq was fined $10 million by the SEC, and made voluntary payments totaling $62 million to trading firms. Some market participants said the exchange should have been fully liable.
NYSE, Nasdaq, and Direct Edge, currently outsource many of their regulatory duties to the Financial Industry Regulatory Authority, which will have oversight of more than 90 percent of U.S. equity markets by this fall. BATS does its own surveillance and then makes referrals to the Chicago Board Options Exchange for further investigation.
Since exchanges have largely separated the regulatory function from their market function, the distinction between the activities performed by an exchange compared to an alternative trading system lacks functional difference, SIFMA said.
"This conflict can be resolved by simply eliminating the obligation for exchanges to act as SROs. It is easy to envision what an exchange would look like without its SRO status, because it is how most exchanges look today in all practical effect," SIFMA said.
(Reporting by John McCrank; editing by Andrew Hay and Leslie Adler)