@sunandoroy September 2002

In financial markets worldwide, market discipline and systemic stability has assumed paramount importance both to the regulator and the market participants. The costs of market failures and instability have become alarmingly high in integrated markets. As money on  constantly on the move, financial market investors have become extremely sensitive not only to rate of return but also to the embedded risk profile of those markets. At the same time, rapid technological developments have made the markets highly sophisticated and dynamic, where the regulator has to constantly hone his skills to be able to provide effective regulation. There is hardly any doubt, that if some of the best talents of the markets join hands with the regulator within a cooperative framework, this will remove information asymmetries in the regulation process.  Self-Regulation is fast emerging as a viable co-operative framework for both the regulator and market participants to come together towards the fulfillment of common goals and objectives. By creating an unique combination of private interests and government oversight, SROs have emerged as an effective and efficient form of regulation for the complex and dynamic financial services industry. The broad objectives of the SROs are preserving market integrity through fair, efficient and transparent markets, to preserve financial integrity and reduce systemic risk and finally to protect investors in financial markets. These areas of responsibility may be performed by  either a single or multiple SROs depending on the nature and size of the market.  International experience with self-regulation suggests that the power of self-regulatory organizations vary significantly.    In its most complete form, self-regulation encompasses the authority to create, amend, implement and enforce rules of conduct with respect to the entities subject to the SRO’s jurisdiction and to resolve disputes through arbitration or other means. Typically, this authority is derived from a statutory delegation of power to a non-governmental entity. In some countries, SROs do not have formal regulatory status but nevertheless  provide  codes of good conduct and master agreements and perform important roles in the standardization of common practices without any formal regulatory status.

 SROs have contributed significantly to advanced economies like US,UK,Canada, Australia and several European economies. Since the introduction of the Securities and Exchange Act in the US in 1934, where the existing stock exchanges were labeled as self-regulatory organisations (SROs), the role of SROs have expanded throughout the world significantly over the past few decades. Major SROs in the US are  the National Association of Securities Dealers Regulation Inc. (NASDR) , the New York Stock Exchange and National Futures Association . Self-regulatory organisations  have made important contributions in advanced and in emerging economies. In order to maintain a balance of power, the Securities and Exchange Commission has over time widened its regulatory powers and greater scope of regulatory intervention in the activities of the SROs.  

The UK experience with  self regulation provides interesting insights into the contribution that the SROs can make to the financial services industry. The Financial Services Authority (FSA) is an independent non-governmental body with statutory powers . It is a company limited by guarantee, financed by levies on the industry and regulates a wide range of financial services. It receives no funds from the public purse. It is accountable to Treasury Ministers and, through them, to Parliament. The Financial Services and Markets Act 2000 (FSMA) requires the FSA to pursue four objectives:

• to maintain confidence in the UK financial system.
• to promote public understanding of the financial system.
• to secure an appropriate degree of protection for consumers whilst recognising their own responsibilities; and
• to reduce the scope for financial crime. The FSA has been entrusted with the broad objectives of making rules, preparing and issuing codes, giving advice and guidance to the market.

The FSA works in close coordination with the Treasury and the Bank of England.

The Major activity of FSA includes, authorizing the entry of firms into financial system of U.K., setting the code of conduct for financial institution, supervising the adherence of the code of conduct by market participants, initiating action against firms who are not  coomplying with the rules of the game and providing acting as a financial ombudsman.  IT is instructive to find that the FSA has recently taken initiatives to enlarge its scope and has taken new responsibilities which include, a transparent new framework for identifying and addressing the most important issues facing firms, markets and consumers, switching  resources from reactive post-event action towards front-end intervention; and creation of incentives for firms to manage their own risks better and thereby reduce the burden of regulation.

Certain financial activities are regulated by organisations other than the FSA. For example, the sale of general insurance products is regulated by the General Insurance Standards Council (GISC), which is a self-regulatory organisation. Consumer credit and competition issues are covered by the Office of Fair Trading. The Occupational Pensions Regulatory Authority regulates the operation of occupational pension schemes.

The contribution of SROs in emerging markets has been no less significant. The Stock exchanges of Hong Kong,  Indonesia(Jakarta and Surabaya Stock exchange), Philippines ( Kualalampur  Stock exchange), the Stock Exchange of Thailand are examples of SROs who have contributed to the development of financial markets.

The scheme of regulation in the futures industry in Malaysia is one of co-regulation between the Commission (as the public authority) and the exchanges and clearing house, the self-regulatory organisations (as front-line regulators). Kuala Lumpur Stock Exchange (KLSE), a self-regulatory organisation with its own Memorandum and Articles of Association, governs the conduct of its members in securities dealings. It is also responsible for the surveillance of the market place and for the enforcement of its Listing Requirements which spell out the criteria for listing, disclosure requirements and standards to be maintained by listed companies

This apart, SROs play an important role in futures markets in Malaysia, with the MME , a self-regulatory organization, performing its regulatory functions by establishing and enforcing a body of policies and rules known as the Business Rules. The Business Rules are the basis of the contractual relationships between MME and its members. The Business Rules may also be amended by MME from time to time, subject to the approval of the Securities Commission.

Value of  Self Regulation in Debt Markets

 The international experience shows that the value of regulation lies in the ability of the regulator and the market players to work together towards the broad objectives of competition, stability, investor protection and the development of markets. In the presence of self regulatory organisations, both institution based or market based, the ability to enforce the rules of the game set by the regulators due to the symbiotic association of regulators and SROs.  In the context of financial markets, the role of SROs lie in establishment of suitable code of conduct for market players, ensuring high quality surbveillance, dissemination of information to the market and in establishing bechmarks to enable market participants to price their securities effectively.

                        One can discern five broad elements of effective self regulation.

Firstly, Self-regulatory bodies have the expertise and direct market contact needed to stay abreast of rapid changes in a complex industry. An SRO typically adopts, updates and enforces its own procedural rules and rules of conduct, using large networks of market professionals  which contributes towards effective regulation. Indeed, SROs may offer considerable depth and expertise regarding market operations and practices, and may be able to respond more quickly and flexibly than the government authority to changing market conditions.

Second, the  self-policing  method of SROs  increase motivation of market participants , who contribute to the development of industry best practices and standards. SROs  help to develop a strong compliance culture within the firms within their ambit.

Third,  inclusion of industry professionals on an SRO’s governing body and public participation in deliberations pertaining to regulatory policy and rulemaking, provide the foundation for an open transparent regulatory framework. organization.

                    Fourth, historical experience shows that self-regulation allows for greater flexibility and diversity in methods of compliance with rules and regulations than may be possible for a statutory regulator to provide. Self-regulatory bodies have the  ability to modify their rules in response to changes taking place in the industry more readily than government agencies .

Fifthly, SROS ensure better information sharing among participants, which is of immense value as it contributes to coordination of market oversight and reduces systemic risks. This apart, the SROs provide  an excellent platform  to discuss emerging regulatory issues benefitting both the regulator and the SROs.

Relationship between Regulator and SRO

The regulatory body and SROs enjoy a special relationship in financial markets that requires a closer look. Regulatory oversight is an essential element in the self-regulatory structure as it provides a system of checks and balances and provide guidance to SROs to attain their objectives. Government oversight of SRO activities ensures that, among other things, all interests are given the proper consideration and voice in all regulatory activities. The relationship requires a delicate balance where the SROS should be under the regulator who will keep a close watch on the activities of the SRO and yet shall not become too intrusive which may lead to overlaps in the functions of these bodies. As William Douglas, ex-chairman of the Securities and Exchange Commission of United States has observed that the SROs should take the leadership while the Government  “would keep the shotgun ready behind the door, loaded, well oiled , cleaned and ready for use but with the hope that it would never be used.” [i]  In other words, the statutory regulator should be able to rely on the work performed by the SRO  and believe in the natural checks and balances of market forces. The regulator’s job is then mostly supervisory, to verify the efficacy of programs executed by the SROs  either through inspection of SROs or SROs may be required to report regularly on compliance with the statutory requirements. The relation between the government regulators and SROs will be  determined by the willingness of  statutory regulators to delegate powers to SROs. Stable market condition and the track record of SROs are important determinants of the extent of  delegation of power to SROs. Ideally, The statutory regulator should step in only if a self-regulatory organization shirks its responsibilities and puts the system to greater risks. This would allow the statutory regulator to focus its limited resources where there is the most risk, rather than creating an unnecessary layer of review and regulation. International experience, however shows that in many countries, the regulators have  taken a cautious stand by retaining excessive power in their hands and  as a result, denying the SROs an environment to blossom.

                    To ensure effective co-ordination among SROS and statutory regulators, it is essential that there is an open platform of communication between SROs and their government oversight bodies . This enhances the  confidence of regulators and prevents the  broadening of the government regulator’s role from oversight to supervision, direction and policy making.

At the same time, an effective regulatory framework should ensure that there is little to no duplication of the regulatory work performed by SROs and the statutory regulators. There is a need to clearly delineate the responsibilities between the front-line regulator and the oversight body.

                    Giving freedom to SROs in the day-to-day regulation of their respective jurisdiction enables the Government regulator to ensure that the regulatory functions are being properly performed by the SROs and are consistent with the broad objectives of regulation  and to focus on the  promotion of  a level playing field across all markets, help prevent fragmentation and promote consistent regulation.

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[i]  W.O.Douglas, Democracy and Finance, New Haven, Conn: Yale University Press, 1940, page 82.