[Federal Register Volume 69, Number 235 (Wednesday, December 8, 2004)]
[Proposed Rules]
[Pages 71256-71282]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 04-26154]



[[Page 71255]]

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Part III





Securities and Exchange Commission





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17 CFR Part 240



Concept Release Concerning Self-Regulation; Proposed Rule

Federal Register / Vol. 69, No. 235 / Wednesday, December 8, 2004 / 
Proposed Rules

[[Page 71256]]


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SECURITIES AND EXCHANGE COMMISSION

17 CFR Part 240

[Release No. 34-50700; File No. S7-40-04]
RIN 3235-AJ36


Concept Release Concerning Self-Regulation

AGENCY: Securities and Exchange Commission.

ACTION: Concept release; request for comment.

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SUMMARY: The Securities and Exchange Commission (``Commission'' or 
``SEC'') is publishing this concept release and seeking public comment 
on a range of issues related to the self-regulatory system of the 
securities industry. This release discusses the foundations of the 
self-regulatory system and new considerations that the Commission and 
the industry are facing. In addition, this release describes certain 
enhancements that could be made to the current system that could 
improve its operation and also discusses a variety of other potential 
approaches to securities industry regulation.

DATES: Comments should be submitted on or before March 8, 2005.

ADDRESSES: Comments may be submitted by any of the following methods:

Electronic Comments

    <bullet> Use the Commission's Internet comment form (http://www.sec.gov/rules/concept.shtml); or
    <bullet> Send an e-mail to <a href="/cdn-cgi/l/email-protection#eb999e878ec6888486868e859f98ab988e88c58c849d"><span class="__cf_email__" data-cfemail="91e3e4fdf4bcf2fefcfcf4ffe5e2d1e2f4f2bff6fee7">[email protected]</span></a>. Please include 
File Number S7-40-04 on the subject line; or
    <bullet> Use the Federal eRulemaking Portal (http://www.regulations.gov). Follow the instructions for submitting comments.

Paper Comments

    <bullet> Send paper comments in triplicate to Jonathan G. Katz, 
Secretary, Securities and Exchange Commission, 450 Fifth Street, NW., 
Washington, DC 20549-0609.
    All submissions should refer to File Number S7-40-04. This file 
number should be included on the subject line if e-mail is used. To 
help us process and review your comments more efficiently, please use 
only one method. The Commission will post all comments on the 
Commission's Internet Web site (http://www.sec.gov/rules/concept.shtml). Comments are also available for public inspection and 
copying in the Commission's Public Reference Room, 450 Fifth Street, 
NW., Washington, DC 20549. All comments received will be posted without 
change; we do not edit personal identifying information from 
submissions. You should submit only information that you wish to make 
available publicly.

FOR FURTHER INFORMATION CONTACT: Christopher B. Stone, Senior Special 
Counsel to the Director, at (202) 942-7938 who is in the Division of 
Market Regulation, Securities and Exchange Commission, 450 Fifth Street 
NW., Washington DC 20549-1001.

SUPPLEMENTARY INFORMATION: 

Table of Contents

I. Introduction
II. Foundations of Self-Regulation
III. New Considerations
IV. Current SRO System Attributes
    A. Inherent Conflicts With Members, Market Operations, Issuers, 
and Shareholders
    1. Inherent Conflicts with Members
    2. Inherent Conflicts with Market Operations
    3. Inherent Conflicts with Issuers
    4. Inherent Conflicts with Shareholders
    B. Inefficiencies of Multiple SROs
    C. Intermarket Surveillance
    D. Funding
    1. Overview
    2. SRO Funding Sources
    a. Regulatory Fees
    b. Transaction Fees
    c. Listing Fees
    d. Market Data Fees
    e. Miscellaneous Fees
V. Alternative Regulatory Approaches
    A. Proposed Enhancements to the Current SRO System
    1. SRO Governance and Transparency Rulemaking
    2. Intermarket Surveillance Enhancements
    B. Independent Regulatory and Market Corporate Subsidiaries
    C. Hybrid Model
    D. Competing Hybrid Model
    E. Universal Industry Self-Regulator
    F. Universal Non-Industry Regulator
    G. SEC Regulation
    H. Other Models
VI. Solicitation of Additional Comments

I. Introduction

    Self-regulation is a key component of U.S. securities industry 
regulation. All broker-dealers are required to be members of a self-
regulatory organization (``SRO''), which sets standards, conducts 
examinations, and enforces rules regarding its members.\1\ Most, but 
not all, SROs also operate and regulate markets or clearing 
services.\2\ Inherent in self-regulation is the conflict of interest 
that exists when an organization both serves the commercial interests 
of and regulates its members or users.
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    \1\ 15 U.S.C. 78o15(b)(8).
    \2\ Analysis in this release focuses primarily on one registered 
national securities association SRO, the National Association of 
Securities Dealers (``NASD'') (including its subsidiary, the Nasdaq 
Stock Market (``Nasdaq'')), and those registered national securities 
exchange SROs that operate equity or options markets, the American 
Stock Exchange (``Amex''), the Boston Stock Exchange (``BSE''), the 
Chicago Board Options Exchange (``CBOE''), the Chicago Stock 
Exchange (``CHX''), the International Securities Exchange (``ISE''), 
the National Stock Exchange (``NSX'') the New York Stock Exchange 
(``NYSE''), the Pacific Exchange (``PCX''), and the Philadelphia 
Stock Exchange (``Phlx''). Unless otherwise specifically noted, 
discussion in this release does not necessarily relate to other 
registered SROs, including the National Futures Association 
(``NFA''), the Municipal Securities Rulemaking Board (``MSRB''), the 
registered clearing agencies, and notice registered national 
securities exchanges.
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    The Securities Exchange Act of 1934 (``Exchange Act''),\3\ the 
Maloney Act of 1938 (``Maloney Act''),\4\ and the Exchange Act 
Amendments of 1975 (``1975 Amendments''),\5\ reflect Congress' 
determination to rely on self-regulation as a fundamental component of 
U.S. market and broker-dealer regulation, despite this inherent 
conflict of interest. Congress favored self-regulation for a variety of 
reasons. A key reason was that the cost of effectively regulating the 
inner-workings of the securities industry at the federal level was 
viewed as cost prohibitive and inefficient.\6\ In addition, the 
complexity of securities trading practices made it desirable for SRO 
regulatory staff to be intimately involved with SRO rulemaking and 
enforcement.\7\ Moreover, the SROs could set standards that exceeded 
those imposed by the Commission, such as just and equitable principles 
of trade and detailed proscriptive business conduct standards.\8\ In 
short, Congress determined that the securities industry self-regulatory 
system would provide a workable balance between federal and industry 
regulation.\9\
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    \3\ 15 U.S.C. 78a et seq.
    \4\ Pub. L. 75-719, 52 Stat. 1070 (1938) (codified as amended at 
15 U.S.C. 78o, authorizing the U.S. Securities and Exchange 
Commission to register national securities associations).
    \5\ Pub. L. 29, 89 Stat. 97 (1975).
    \6\ See generally S. Rep. No. 1455, 73d Cong., 2d Sess. (1934); 
H.R. Doc. No. 1383, 73d Cong., 2d Sess. (1934); S. Rep. No. 1455, 
73d Cong., 2d Sess. (1934).
    \7\ Id.
    \8\ Id.
    \9\ Id.
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    Since the self-regulatory system was incorporated into the federal 
securities laws, the Commission has reexamined it periodically.\10\ 
While steps have been

[[Page 71257]]

taken over time to redress perceived shortcomings, the SRO structure 
has been repeatedly reaffirmed both by Congress and the Commission.\11\ 
In recent years, changes in the markets and in the ownership structure 
of SROs have generated questions about the fairness and efficiency of 
the current SRO structure.\12\ The increased dispersion of order flow 
across multiple markets has produced questions of comparable regulation 
by SROs and the effectiveness of cross-market supervision.\13\ The 
increased competition among markets for listings and trading volume has 
applied pressure on SRO regulatory efforts and sources of funding.\14\ 
Moreover, the advent of for-profit, shareholder-owned SROs has 
introduced potential new conflicts of interest and issues of regulatory 
incentives.\15\ In addition, recent failings or perceived failings with 
respect to SROs fulfilling their self-regulatory obligations have 
sparked public debate as to the efficacy of the SRO system in 
general.\16\
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    \10\ See e.g., 1961-1963 Special Study of Securities Markets. 
Securities and Exchange Commission, Report of Special Study of 
Securities Markets, (``Special Study''), H.R. Doc. No. 95, 88th 
Cong., 1st Sess. (1963) and Market 2000: An Examination of Current 
Equity Market Developments, Division of Market Regulation, U.S. 
Securities and Exchange Commission (January 1994) (``Market 2000 
Report'').
    \11\ See e.g., Id.; infra notes 30-31.
    \12\ See generally infra Section IV.
    \13\ Id.
    \14\ Id.
    \15\ Id.
    \16\ Id.
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    For these reasons, the Commission is publishing this release to 
discuss and solicit comments on the role and operation of SROs in 
today's markets. This release examines a number of issues concerning 
securities industry self-regulation, including: (1) The inherent 
conflicts of interest between an SRO's regulatory obligations and the 
interests of its members, its market operations, its listed issuers, 
and, in the case of a demutualized SRO, its shareholders; (2) the costs 
and inefficiencies of the multiple SRO model; (3) the challenges of 
surveillance across markets by multiple SROs; and (4) the manner in 
which SROs generate revenue and how SROs fund regulatory operations. 
Finally, this release examines and seeks comment on certain 
enhancements to the current system and a number of regulatory 
approaches or legislative initiatives that could be considered by the 
Commission to address concerns with the current SRO model.

II. Foundations of Self-Regulation

    Securities industry self-regulation has a long tradition in the 
U.S. securities markets. In its earliest years, the nascent U.S. 
securities industry was subject loosely to state laws and, in 1792, the 
New York broker community negotiated the historic Buttonwood Agreement 
to form the first organized stock market in New York.\17\ As the NYSE 
and other stock exchanges developed, trading conventions became 
formalized as exchange rules. In 1817, the NYSE's Constitution was 
adopted and the NYSE subsequently adopted a range of rules governing 
its members and listed companies, including member financial 
responsibility rules and listed company registration and financial 
reporting rules.\18\ In 1820, a detailed set of NYSE By-Laws was 
adopted.\19\
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    \17\ Robert Sobel, The Big Board, A History of the New York 
Stock Market 14-27 (The Free Press 1965). The agreement generally 
bound its signors to give preference to each other when buying and 
selling. Id.
    \18\ Id. at 30-31.
    \19\ Id. at 38-40.
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    Federal regulation of exchanges, and their formal recognition as 
self-regulatory organizations, followed a number of significant events, 
including the stock market crash of 1929 and the evidence of NYSE 
investigatory failures related to market manipulation highlighted at 
the 1934 Pecora Hearings.\20\ In Section 6 of the Exchange Act, 
Congress recognized the regulatory role of exchanges, and required all 
existing securities exchanges, including the NYSE, to register with the 
Commission and to function as self-regulatory organizations.\21\
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    \20\ Joel Seligman, The Transformation of Wall Street: A History 
of the Securities and Exchange Commission and Modern Corporate 
Finance at 1-38 (Aspen Pub. N.Y. 3rd ed. 2003).
    \21\ Exchange Act Section 6, 15 U.S.C. 78f.
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    The stock market crash of 1929 also severely damaged the public 
reputation of over-the-counter (``OTC'') securities dealers. In 1933, 
in an effort to improve their collective image, OTC dealers formed the 
Investment Bankers Code Committee (``IBCC''), which promulgated 
industry best practices.\22\ In 1936, the IBCC was succeeded, by the 
Investment Bankers Conference (``IBC''), a prominent group of 
investment banks formed to act as a national, voluntary industry 
organization.\23\
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    \22\ Seligman at 183-85.
    \23\ The IBC, however, proved to be imperfect, because only 
seventeen hundred of the nation's six thousand securities dealers 
ultimately joined. While the Commission realized that this voluntary 
organization was not effectively regulating the OTC market, it also 
determined that direct Commission regulation of the OTC market was 
not practicable. See Seligman at 183-85. While not speaking for the 
whole Commission, one early Commissioner compared the prospect of 
regulating the OTC market to building a structure out of sand 
because ``there is no cohesive force to hold it together, no 
organization with which [the Commission] could build, as 
authoritatively representing a substantial element in the over-the-
counter business.'' Id.
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    After experience with the IBCC and the IBC, the Commission and 
leaders of the investment banking community generally agreed that an 
industry association needed official legal status in order to 
effectively carry out the task of self-regulating the OTC market.\24\ 
Ultimately, in 1938, the Maloney Act amended the Exchange Act by adding 
a new Section 15A and establishing the concept of registered national 
securities association SROs.\25\ To date, the NASD and the NFA \26\ are 
the only registered national securities associations.
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    \24\ Id.
    \25\ Exchange Act Section 15A, 15 U.S.C. 78o-3.
    \26\ NFA is a national securities association registered for the 
limited purpose of regulating the activities of members who are 
registered as brokers or dealers in security futures products under 
Section 15(b)(11) of the Exchange Act, 15 U.S.C. 78o(b)(11).
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    In enacting these provisions, Congress concluded that self-
regulation of both the exchange markets and the OTC market was a 
mutually beneficial balance between government and securities industry 
interests.\27\ Through establishment of self-regulation, the securities 
industry was supervised by an organization familiar with the nuances of 
securities industry operations. In addition, industry participants 
preferred the less invasive regulation by their peers to direct 
government regulation and the government benefited by being able to 
leverage its resources through its oversight of self-regulatory 
organizations.\28\ Moreover, the SROs had the ability to set 
proscriptive standards relating to just and equitable principles of 
trade and detailed business conduct standards.\29\ In enacting the 
Maloney Act in 1938, Congress stated that an approach to securities 
regulation relying solely on government regulation ``would involve a 
pronounced expansion of the organization of the Securities and Exchange 
Commission; the multiplication of branch offices; a large increase in 
the expenditure of public funds; an increase in the problem of avoiding 
the evils of bureaucracy; and a minute, detailed, and rigid regulation 
of business conduct by law.'' \30\
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    \27\ See supra notes 6-9.
    \28\ Id.
    \29\ Market 2000 Report at VI-6.
    \30\ S. Rep. No. 1455, 75th Cong., 3d Sess. I.B.4. (1938); H.R. 
Rep. No. 2307, 75th Cong., 3d Sess. I.B.4. (1938) (duplicate text 
quoted in both reports).
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    The legislative history of the 1975 Amendments noted that, rather 
than adopt this purely governmental approach, Congress determined that 
it was ``distinctly preferable'' to rely on ``cooperative regulation, 
in which the task will be largely performed by representative 
organizations of investment bankers, dealers, and brokers, with the 
Government exercising appropriate supervision in the public interest, 
and exercising supplementary

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powers of direct regulation.'' \31\ Similarly, in 1975, Congress stated 
that a principal reason for retaining a self-regulatory regime was the 
``sheer ineffectiveness of attempting to assure [regulation] directly 
through the government on a wide scale,'' and that, although the SROs 
had not always performed their role up to expectations, self-regulation 
generally was considered to have worked well and ``should be preserved 
and strengthened.'' \32\
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    \31\ S. Rep. No. 94-75, 94th Cong., 1st Sess. 7, II (1975).
    \32\ Id.
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    The Commission has periodically examined the self-regulatory system 
and the extent to which SROs have successfully fulfilled their 
statutory obligations.\33\ Such analysis has sometimes resulted in SROs 
making changes to their structures or regulatory programs. For example, 
after problems surfaced regarding the floor operations of Amex 
specialists, the Commission sponsored the sweeping 1961-1963 Special 
Study.\34\ The Special Study concluded that SROs have a natural 
tendency to protect member firms and that SRO regulatory operations 
appear to falter without the ``pointed stimuli'' of vigilant Commission 
oversight.\35\ Among other conclusions, the Special Study found a need 
for a reduction in the amount of control that exchange floor members 
exercised over exchange regulatory operations and governance.\36\ 
Moreover, the study called for a general strengthening of SRO 
governance.\37\
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    \33\ See e.g., supra note 10. In addition, the Commission speaks 
implicitly and explicitly to self-regulatory concepts in virtually 
every SRO rule that is noticed for public comment and approved 
through the Commission Rule 19b-4 rule filing process. SEC Rule 19b-
4, 17 CFR 240.19b-4.
    \34\ Specialist domination of the Amex resulted in a series of 
scandals in the late 1950s involving market manipulations. In 1961, 
the Commission launched an investigation into the trading practices 
of two Amex specialists in particular. This investigation was 
ultimately broadened into the Special Study. See Seligman at 281-86.
    \35\ See generally Seligman at 299-348.
    \36\ Id.
    \37\ Id. Congress recognized that self-regulators may not always 
be as diligent as desired, and, indeed, may use self-regulation as a 
device to avoid regulation altogether. Nonetheless, Congress also 
was of the view that members of the securities industry could bring 
down to bear on the problems of regulation a degree of expertise 
and, in many circumstances, expedition not expected of a necessarily 
more remote governmental agency. Special Study at 693-697.
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    Another example of past analysis was the Commission's Division of 
Market Regulation review of the structure and costs of the SRO system 
in the Market 2000 Report, which was published by the Commission in 
1994. The Market 2000 Report noted the impact that increasing 
intermarket competition and duplicative SRO rules were having on the 
self-regulatory system.\38\ In addition, the report discussed the 
extent to which costs to support the SRO system were being fairly 
allocated across the markets.\39\ The report also examined the 
desirability of reallocating the regulatory and market functions of 
SROs and the possibility of the Commission assuming a greater role with 
respect to the functions carried out by the SROs.\40\ While the opinion 
advanced in the Market 2000 Report was that such changes were unlikely 
to improve the existing SRO system, it did not foreclose the 
possibility of reconsidering this position in the future in light of 
changed circumstances.\41\
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    \38\ See Market 2000 Report at III-1.
    \39\ Id. at III-3.
    \40\ Id. at III-5-7.
    \41\ Id. at III-10. See also infra Section IV.
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    Another example of past Commission analysis on this issue was in 
1996 when the Commission instituted administrative proceedings against 
the NASD with respect to OTC market maker pricing collusion.\42\ At the 
same time, the Commission issued the 21(a) Report regarding the NASD 
and Nasdaq. In the 21(a) Report, issued pursuant to Section 21(a) of 
the Exchange Act, the Commission discussed at length a range of issues 
concerning the efficacy of the self-regulatory system and the potential 
problems associated with inherent SRO conflicts.\43\ Of particular 
concern, in this case, was the lack of independence of the NASD 
regulatory staff from Nasdaq's market operations.\44\
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    \42\ See In the Matter of National Association of Securities 
Dealers, Inc.; SEC Release No. 34-37538, August 8, 1996; 
Administrative Proceeding File No. 3-9056 (``21(a) Administrative 
Order''). See also Report and Appendix to Report Pursuant to Section 
21(a) of the Securities Exchange Act of 1934 Regarding the NASD and 
The Nasdaq Stock Market (August 8, 1996) and Securities Exchange Act 
Release No. 37538 (August 8, 1996) (``21(a) Report''). The 
undertakings were included in the SEC Order (``21(a) Report 
Undertakings'').
    \43\ See 21(a) Administrative Order Section III; 21(a) Report at 
40-47.
    \44\ See 21(a) Administrative Order Section III; 21(a) Report at 
52-54.
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    In sum, while Congress and the Commission have criticized and 
modified the SRO system in the past, it has not been radically revised 
or dismantled since its establishment. Rather, it is generally 
considered that the SRO system has functioned effectively and has 
served government, industry, and investors well.\45\ Notwithstanding 
this positive record, because of new considerations in our markets, the 
Commission believes it is an appropriate time to reexamine and solicit 
public comment on the efficacy of the system overall.
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    \45\ See e.g., supra note 10.
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III. New Considerations

    In recent years, the U.S. markets have experienced increasingly 
vigorous competition. The effect of this development is that markets 
operated by SROs have faced increased competition from foreign trading 
markets and from electronic communications networks (``ECNs'') that 
have shifted significant amounts of market share away from the primary 
markets, especially with respect to Nasdaq securities. For example, the 
NYSE and Amex historically dominated trading in their listed 
securities, and market makers dominated trading in Nasdaq stocks. 
Today, however, in the Nasdaq market, automated market centers (such as 
Nasdaq's order collector, aggregator, and execution system, 
SuperMontage, the Archipelago exchange (``ArcaEx''), and the INET ECN) 
have captured more than 50% of share volume.\46\ For Amex-listed stocks 
(for which approximately 39% of share volume now is represented by two 
extremely active exchange-traded funds (``ETFs'')--the QQQ and SPDR), 
Amex now handles approximately 21% of the volume, with the remaining 
balance split among Arca-Ex, INET, and others.\47\ The NYSE has managed 
to retain approximately 80% of the volume in its listed stocks, but 
other market centers are raising the level of competition and reducing 
the NYSE's share of trading.\48\ Moreover, the NYSE and Amex have 
sought to add automated facilities that are integrated with and 
complement their traditional exchange floors.\49\ In the listed options 
markets, the proliferation of multiple trading of options and the entry 
of two new electronic exchanges has raised the tempo of competition 
among these markets and redistributed their market share.\50\
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    \46\ The figure is based on Nasdaq/UTP Plan market data (as of 
September 2004).
    \47\ The figure is based on Network B, CTS Activity market data 
(as of September 2004).
    \48\ The figure is based on Network A, CTS Activity market data 
(as of September 2004). See also e.g., Ivy Schmerken, Will the 
NYSE's Specialist Probe Open the Listed Market to ECNs?, Wall Street 
+ Technology, July 1, 2003, at 18; Robert Sales, The Big Picture--
ECN Evolution, Wall Street + Technology, February 1, 2003, at 6.
    \49\ See Securities Exchange Act Release Nos. 50173 (August 10, 
2004), 69 FR 50407 (August 16, 2004) (notice of proposed rule change 
proposing improvements to NYSE's existing automatic execution 
facility, NYSE Direct+[reg]); and 49921 (June 25, 2004), 69 FR 40690 
(July 6, 2004) (approval of proposed rule change by Amex to enhance 
its Auto-Ex technology for exchange-traded funds and Nasdaq stocks 
traded on the exchange).
    \50\ In August 1999, 32% of equity options were traded on more 
than one exchange. By September 2000, that number had risen to 45%. 
Over the same period, the percentage of aggregate option volume 
traded on only one exchange fell from 60% to 15%. See Exchange Act 
Release No. 43085 (July 28, 2000), 65 FR 47918 (August 4, 2000) 
(proposing to extend Exchange Act Rule 11Ac1-1 to options). 
According to the Options Clearing Corporation, by September 2003, 
98.3% of equity options classes traded on more than one exchange. As 
of December 2003, the market shares held by options exchanges were 
31.3% by the CBOE, 27.0% by the ISE, 19.8% by the Amex, 12.4% by the 
Phlx, and 9.5% by the PCX. Options Clearing Corporation, 2003 Annual 
Report 1 (2004). By June of 2004, the ISE's market share was 33.6%, 
the CBOE's was 26.0%, the Amex's was 18.6%, the Phlx's was 11.6%, 
the PCX's was 8.4% , and the BSE Boston Options Exchange (``BOX'') 
facility's was 1.8%. Will Acworth, Electronic Trading Sweeps Options 
Industry, Futures Industry Magazine, September/October 2004 (citing 
Futures Industry Association statistics).

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[[Page 71259]]

    This heightened competition has benefited trading markets by 
spurring innovation in trading systems and responsiveness to 
customers.\51\ It has also driven down costs, including fees charged by 
the trading markets.\52\ At the same time, this competition places 
greater strains on the self-regulatory system.\53\ Some industry 
observers have posited that trading previously covered by one market's 
rules may move to another market in search of lower regulatory 
standards.\54\ Others have argued that trading across markets may be 
subject to inconsistent rules across several markets.\55\ Some have 
voiced concerns about falling market share inducing SROs to reduce the 
rigor of their member and market supervision programs.\56\ Also, 
concerns have been raised about SROs favoring key participants in their 
markets to encourage those key participants to remain active in their 
markets or to attract other users.\57\ Shifts in market share can 
undermine revenues supporting an SRO's regulatory functions, without 
reducing the SRO's responsibility for supervision of its members 
trading across markets.\58\ Shifts in trading to multiple markets also 
increase concerns about potential gaps in the surveillance of 
intermarket trading.\59\
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    \51\ See generally infra Section IV.
    \52\ Id.
    \53\ Id.
    \54\ Id.
    \55\ Id.
    \56\ Id.
    \57\ Id.
    \58\ Id.
    \59\ Id.
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    Other considerations also may alter the delicate balance of the SRO 
system. The conversion of some SROs to publicly traded, for profit 
status may increase the actual or perceived conflicts inherent in the 
SRO model.\60\ Likewise, numerous recent SRO failings related to 
governance, member oversight and trading supervision raise significant 
concerns about the efficacy of the self-regulatory model.\61\ Finally, 
in response to the recently proposed Regulation NMS (``Reg NMS''),\62\ 
commenters raised serious questions about the level of market data 
fees, which are an important component of SRO revenues and the funding 
of self-regulation.\63\ The Commission believes that it is an 
appropriate time to issue a concept release to examine and solicit 
public comment on the extent to which recent developments in our 
markets warrant changes to the current system.
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    \60\ Id.
    \61\ See In the Matter of Chicago Stock Exchange, Securities 
Exchange Act Release No. 48566 (September 30, 2003). See also In the 
Matter of Bear Wagner Specialists LLC, Securities Exchange Act 
Release No. 49498 (March 30, 2004); In the Matter of Fleet 
Specialist, Inc., Securities Exchange Act Release No. 49499 (March 
30, 2004); In the Matter of LaBranche & Co. LLC, Securities Exchange 
Act Release No. 49500 (March 30, 2004); In the Matter of Spear, 
Leeds & Kellogg Specialists LLC, Securities Exchange Act Release No. 
49501 (March 30, 2004); In the Matter of Van der Moolen Specialists 
USA, LLC, Securities Exchange Act Release No. 49502 (March 30, 
2004). See In the Matter of SIG Specialists, Inc., Securities 
Exchange Act Release No. 50076 (July 26, 2004) and In the Matter of 
Performance Specialist Group LLC, Securities Exchange Act Release 
No. 50075 (July 26, 2004). See also Securities Exchange Act Release 
No. 48946 (December 17, 2003), 68 FR 74678 (December 24, 2003) 
(approving NYSE proposal to restructure NYSE corporate governance 
structure).
    \62\ See Exchange Act Release No. 49325 (February 26, 2004), 69 
FR 11126 (March 9, 2004) (noticing proposed rulemaking for comment); 
Exchange Act Release No. 49749 (May 20, 2003), 69 FR 30142 (May 26, 
2004) (extending comment period and seeking additional comments).
    \63\ See infra Section IV.
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IV. Current SRO System Attributes

    This discussion focuses on the following distinctive attributes of 
the existing SRO system and explores how recent market changes have 
impacted them: (1) The inherent conflicts of interest between SRO 
regulatory operations and members, market operations, issuers, and 
shareholders; (2) the costs and inefficiencies of multiple SROs, 
arising from multiple SRO rulebooks, inspection regimes, and staff; (3) 
the challenges of surveillance of cross market trading by multiple 
SROs; and (4) the funding SROs have available for regulatory operations 
and the manner in which SROs allocate revenue to regulatory operations.

A. Inherent Conflicts With Members, Market Operations, Issuers, and 
Shareholders

    Among the most controversial features of the existing SRO system is 
the inherent conflict that exists within every SRO between its 
regulatory functions and its members, market operations, listed 
issuers, and shareholders. The following discussion considers these 
conflicts.
1. Inherent Conflicts With Members
    The SROs are responsible for promulgating and enforcing rules that 
govern all aspects of their members' securities business, including 
their financial condition, operational capabilities, sales practices, 
and the qualifications of their personnel.\64\ In fulfilling these 
functions, the SROs conduct examinations on the premises of their 
members, monitor financial and other operational reports, investigate 
potential violations of rules, and bring disciplinary proceedings when 
appropriate. In addition, SROs must surveil trading on any markets they 
operate to detect rule violations and other improper practices, such as 
insider trading and market manipulation. Unchecked conflicts in the 
dual role of regulating and serving can result in poorly targeted SRO 
rulemaking, less extensive SRO rulemaking, and under zealous 
enforcement of SRO rules against members. It is also important to note 
that, even where an SRO structure may appear sound, successful self-
regulation relies on sufficiently vigorous rule enforcement against 
members on the part of the SRO. If regulatory staff is disinclined to 
regulate members, self-regulation will fail. Thus, to be effective, an 
SRO must be structured in such a way that regulatory staff is 
unencumbered by inappropriate business pressure.
---------------------------------------------------------------------------

    \64\ See e.g., Exchange Act Sections 6(b) and 15A(b), 15 U.S.C. 
78f(b) and 78o-3(b).
---------------------------------------------------------------------------

    Pressures that inhibit effective regulation and discourage vigorous 
enforcement against members can arise for a variety of reasons, 
including member domination of SRO funding, member control of SRO 
governance, and member influence over regulatory and enforcement staff. 
In addition, the economic importance of certain SRO members may create 
particularly acute conflicts, especially in light of the consolidation 
of some of the largest securities firms. For example, the number of 
NYSE specialist firms, which are central to the NYSE's auction trading 
model, has dropped from 27 in 1999 to 7 in 2002.\65\ One NYSE 
specialist firm in 2003 accounted for over 28% of total NYSE trading 
volume.\66\ The number of specialist firms at the CHX has dropped from 
15 in 2002 to 8 in 2004.\67\ Approximately 47% and 29% of the NSX's 
total

[[Page 71260]]

transaction charges were derived from one member for the years 2003 and 
2002, respectively.\68\ In addition, this single NSX member was 
responsible for generating 93% and 10% of Tape B market data revenues 
for the years 2003 and 2002, respectively.\69\ This single NSX member 
was also responsible for generating 100% of NSX's Tape C market data 
revenues in both 2003 and 2002.\70\ In the options market, there are 
just over 40 specialists and market makers on the nation's options 
exchanges, whereas just three years ago there were over 70.\71\
---------------------------------------------------------------------------

    \65\ LaBranche & Co. Inc., 2002 Annual Report 6 (2002).
    \66\ LaBranche & Co. Inc., 2002 Annual Report 14 (2003).
    \67\ Peter Chapman, Windy City Loses Another Specialist, Traders 
Magazine, July 1, 2004.
    \68\ NSX, 2003 Annual Report Exhibit I-12 (2004).
    \69\ Id.
    \70\ Id.
    \71\ Eric Noll, Shifting Models of Option Market Participants, 
Futures Industry Magazine, September/October 2004.
---------------------------------------------------------------------------

    Thus, the current situation appears to be one in which a declining 
number of member firms are increasingly important to the business 
interests of their regulator SROs. The anecdotal evidence cited above 
could indicate that SROs have become more dependent on large members 
for their funding, potentially enabling those members to wield 
significant influence with respect to their regulator SROs. This 
creates the potential for failures by SROs to enforce rules against 
these members, especially when compared to enforcement against other 
smaller or less economically influential members, and SRO failures to 
develop rules that would disrupt the business practices of important 
members.
    The PCX's proposal in 2001 to enter into an arrangement in which 
ArcaEx would become the PCX's equity trading facility presented a 
particularly complicated situation in which an SRO would be affiliated 
with a member. \72\ In the ArcaEx Approval Order, the Commission 
examined a variety of issues related to self-regulation, including the 
regulatory responsibilities of the PCX under the new structure and the 
potential for inherent conflicts to be exacerbated when an SRO is 
affiliated with a member. In addition, the Commission imposed certain 
requirements with respect to PCX and ArcaEx that were designed to 
ensure that the various functions of the affiliated broker-dealer were 
properly regulated.\73\
---------------------------------------------------------------------------

    \72\ See Exchange Act Release No. 44983 (October 25, 2001), 66 
FR 55225, 55229-30 (November 1, 2001) (approving SR-PCX-00-25) 
(``ArcaEx Approval Order''). ArcaEx is operated by Archipelago 
Exchange LLC. At the time of this approval, PCX's ownership interest 
in Arca LLC consisted solely of a 10% interest in Archipelago 
Holdings LLC, the parent company of Arca LLC. See 66 FR at 55225.
    \73\ Id.
---------------------------------------------------------------------------

    In the ArcaEx Approval Order, the Commission discussed the PCX's 
proposal that Wave Securities LLC (``Wave''), a wholly owned subsidiary 
of ArcaEx, would be a registered broker-dealer and a member of both the 
PCX and the NASD. Wave would have two primary functions with respect to 
ArcaEx. Specifically, Wave would act as an introducing broker for 
customers that were not PCX members and would provide sponsored access 
to ArcaEx. Wave would also provide an optional routing service for 
ArcaEx, and, as necessary, would route orders to other market centers 
from ArcaEx.\74\
---------------------------------------------------------------------------

    \74\ Id.
---------------------------------------------------------------------------

    Under Section 6(b)(5) of the Exchange Act, the rules of a national 
securities exchange must not be designed to permit unfair 
discrimination between customers, issuers, brokers, or dealers.\75\ The 
Commission noted in the ArcaEx Approval Order that the potential for 
unfair discrimination may be heightened if a national securities 
exchange or its affiliate owns or operates a broker-dealer. This is 
because, the Commission stated, the financial interests of the exchange 
may conflict with its responsibilities as an SRO regarding the 
affiliated broker-dealer. Moreover, the Commission described the 
conflict of interest that may arise if a national securities exchange 
(or an affiliate) provides advantages to its broker-dealer that are not 
available to other members, or provides a feature to all members that 
was designed to give its broker-dealer a special advantage. These 
advantages, such as greater access to information, improved speed of 
execution, or enhanced operational capabilities in dealing with the 
exchange, might constitute unfair discrimination under the Exchange 
Act, the Commission concluded. Thus, the Commission required that the 
PCX not serve as the self-regulatory organization primarily responsible 
for examining the Wave broker dealer.\76\
---------------------------------------------------------------------------

    \75\ See Section 6(b)(5) of the Act, 15 U.S.C. 78f(b)(5).
    \76\ See ArcaEx Approval Order at 55233.
---------------------------------------------------------------------------

    The Commission ultimately determined that, although Wave's routing 
services would be optional, Wave's order-routing function occupied a 
special position with respect to ArcaEx. In the Commission's view, Wave 
was uniquely linked to and endorsed by ArcaEx to provide its outbound 
routing functionality. Therefore, the Commission concluded that the PCX 
application of the Wave order-routing function fell within the 
definition of a facility under Section 3(a)(2) of the Exchange Act \77\ 
and, as such, would be subject to the Commission's continuing 
oversight. In particular, under the Exchange Act, the PCX would be 
required to file rule changes and fees relating to the Wave order-
routing function, and Wave would be subject to exchange non-
discrimination requirements. Thus, the Commission imposed these 
requirements to address the potential misuse of advantages that might 
arise from an SRO member carrying out an order-routing function on 
behalf of an SRO.\78\
---------------------------------------------------------------------------

    \77\ The term ``facility'' when used with respect to an exchange 
includes its premises, tangible or intangible property whether on 
the premises or not, any right to use of such premises or property 
or any service thereof for the purpose of effecting or reporting a 
transaction on the exchange (including, among other things, any 
system of communication to or from the exchange, by ticket or 
otherwise maintained by or with the consent of the exchange), and 
any right of the exchange to the use of any property or service. 
(Emphasis added.) Exchange Act Section 3(a)(2), 15 U.S.C. 78c(a)(2).
    \78\ See ArcaEx Approval Order at 55233-55234.
---------------------------------------------------------------------------

    In the past, members also have historically controlled the boards 
and the key committees of SROs. For example, in the 21(a) Report 
concerning the NASD, the Commission discussed the extent to which large 
members had made up a majority or substantial proportion of the NASD's 
Board of Governors.\79\ Moreover, the Commission discussed the 
extensive influence wielded by market maker members over the SRO's 
disciplinary process due to their strong representation on the NASD's 
District Business Conduct Committees (``DBCCs''), which served a 
``grand jury'' function with respect to the initiation of disciplinary 
proceedings.\80\ Ultimately, the Commission's settlement with the NASD 
resulted in significant corporate structure changes designed to prevent 
these conflicts from occurring in the future.\81\
---------------------------------------------------------------------------

    \79\ See 21(a) Report at 41.
    \80\ See 21(a) Report at 40-44.
    \81\ See supra note 42. See also infra Section V.B.
---------------------------------------------------------------------------

    Recently, the NYSE changed its governance structure to reduce 
conflicts of interest with respect to members.\82\ Specifically, the 
NYSE created a wholly independent board and regulatory staff that 
report to an independent board committee.\83\ In addition, amendments 
to the NYSE's charter mandated increased transparency of the NYSE's 
operations and corporate governance.\84\ The governance changes 
included the

[[Page 71261]]

establishment of a fully independent board of directors composed of 6 
to 12 fully independent directors, the NYSE Chief Executive Officer 
(``CEO''), and the NYSE Chairman.\85\ The concept of ``independence'' 
under the NYSE rules was redefined with respect to directors to exclude 
essentially all persons with any relationship or association to the 
exchange, an exchange member, or an exchange listed issuer.\86\ A fully 
independent board committee, the Regulatory Oversight & Regulatory 
Budget Committee, was established and tasked with overseeing the NYSE's 
regulatory plans, programs, budget and staffing proposals on an annual 
basis.\87\
---------------------------------------------------------------------------

    \82\ See generally Exchange Act Release Nos. 48764 (November 7, 
2003), 68 FR 64380 (November 13, 2003), and 48946 (December 17, 
2003), 68 FR 74678 (December 24, 2003) (``NYSE Governance Changes 
Approval'').
    \83\ Id.
    \84\ Id.
    \85\ Id. at 74679.
    \86\ Id.
    \87\ Id. at 74681.
---------------------------------------------------------------------------

    In an effort to ensure that the NYSE's regulatory function was 
sufficiently independent, a new Chief Regulatory Officer position was 
created that reports directly to the Regulatory Oversight & Regulatory 
Budget Committee \88\ An additional fully independent committee, the 
Human Resources & Compensation Committee, was created to set staff 
compensation.\89\ Other fully independent committees included the Audit 
Committee and the Nominating & Governance Committee, which was designed 
to ensure that governance procedures are appropriate and to administer 
the board's annual self-review process.\90\
---------------------------------------------------------------------------

    \88\ Id. at 74682.
    \89\ Id. at 74681.
    \90\ Id. at 74680-74681.
---------------------------------------------------------------------------

    Because the new definition of independent director excluded most 
users of the NYSE's services, an advisory Board of Executives was also 
created to ensure that NYSE constituents continued to have a meaningful 
voice in the affairs of the exchange.\91\ This advisory group was to be 
composed of 22 individuals representing key NYSE constituencies and 
tasked primarily with advising the board on operational issues.\92\ The 
Board of Directors is required to meet on at least a quarterly basis 
both with and without the Board of Executives present.\93\ In approving 
these amendments, the Commission noted the importance of independence 
of regulatory staff from business pressures.\94\
---------------------------------------------------------------------------

    \91\ Id. at 74679-74680.
    \92\ Id.
    \93\ Id. at 74679.
    \94\ Id. at 74687.
---------------------------------------------------------------------------

    As discussed further below,\95\ another recent concern is the 
extent to which the profit motive of a demutualized SRO could detract 
from proper self-regulation. In that regard, the Commission recently 
approved SRO rule changes that permitted several SROs to convert to 
for-profit entities.\96\ To avoid the potential for member shareholders 
to wield an in appropriate amount of influence over the regulatory 
function of the SROs, limits were imposed on the percentage that could 
be controlled by any one member.\97\ SROs have put forth various 
reasons for demutualizing, but a common theme is an increased ability 
to more quickly respond to competitive pressures.\98\
---------------------------------------------------------------------------

    \95\ See infra Section IV.A.4.
    \96\ See e.g., Securities Exchange Act Release Nos. 45803 (April 
23, 2003), 67 FR 21306 (April 30, 2003) (order approving the 
restructuring of the ISE from a limited liability company to a 
corporation); 49718 (May 17, 2004), 69 FR 29611 (May 24, 2004) 
(order approving the demutualization of the PCX); and 49098 (January 
16, 2004), 69 FR 3974 (January 27, 2004) (order approving the 
demutualization of the Phlx).
    \97\ Id.
    \98\ See Securities Exchange Act Release Nos. 49451 (March 19, 
2004), 69 FR 16305 (March 29, 2004) (PCX stating that by 
``restructuring its business as a stock corporation with business 
control and management vested in a Board of Directors, the entity 
will have greater flexibility to develop and execute strategies 
designed to improve its competitive position than it has under the 
current membership-cooperative structure'' and that it anticipates 
that ``by restructuring as a stock corporation, PCX management will 
be better able to respond quickly to competitive pressures and to 
make changes to its operations as market conditions warrant, without 
diminishing the integrity of its regulatory programs.'') and 49098, 
supra note (Phlx stating that it proposed to effect a 
demutualization for a number of reasons, including to ``expand its 
sources of capital and revenue; to facilitate its ability to enter 
into relationships with strategic for financial partners who may be 
crucial for the Exchange's future development, capital formation and 
viability; to facilitate the introduction for new products and thus 
potentially increase transaction volume and Exchange revenues; and 
to better position itself to react to new opportunities and 
challenges'').
---------------------------------------------------------------------------

    In a companion release, the Commission is proposing SRO governance 
and transparency measures (the ``SRO Governance and Transparency 
Proposal'') to address a range of concerns, including member ownership 
controls for demutualized exchanges.\99\ If adopted, the SRO Governance 
and Transparency Proposal, which will be discussed in greater detail 
below,\100\ would impose a variety of restrictions on shareholder owned 
SROs, including effectively restricting revenue from regulatory 
operations being used to pay dividends to shareholders.
---------------------------------------------------------------------------

    \99\ See Exchange Act Release No. 34-50699, (November 18, 2004).
    \100\ For a more detailed description of the SRO Governance and 
Transparency Proposal see infraSection V.A.1.
---------------------------------------------------------------------------

    The Commission seeks public comment on the following specific 
questions related to conflicts in member regulation:
    Question 1: To what extent are the conflicts caused by member 
funding of SRO operations a concern? Has consolidation within the 
securities industry, and the dependence of SROs on a relatively small 
number of firms for the bulk of their funding, or other developments 
exacerbated this conflict? If other developments have done so, identify 
them. Is it possible to minimize these conflicts through SRO governance 
initiatives that are designed to ensure greater independence of the 
board and key committees from the regulated members?
    Question 2: To what extent are member governance conflicts a 
concern? Have the governance changes recently made by the NYSE and 
other SROs to enhance their independence been effective in reducing 
these conflicts? Are there other governance changes that could be made 
by the SROs that would further reduce these conflicts?
    Question 3: Can potential conflicts between the regulatory function 
and SRO members be effectively managed through the recent enhancements 
made to SRO governance and the changes proposed by the SRO Governance 
and Transparency Proposal? Are there other measures the Commission 
should consider?
2. Inherent Conflicts with Market Operations
    In addition to conflicts with members, an SRO's regulatory 
obligations may conflict with the interests of its own or its 
affiliate's market operations. The SROs that operate markets 
(currently, all except the MSRB, the NFA, and the clearing agencies) 
are responsible for promulgating rules that govern trading in their 
markets; establishing the necessary systems and procedures to monitor 
such trading; identifying instances of suspicious trading, such as 
potential insider trading and market manipulation; and enforcing the 
Exchange Act, the rules thereunder, and their own rules.\101\ If an SRO 
identifies potential misconduct involving persons or entities within 
its jurisdiction, the SRO is responsible for conducting a further 
investigation and bringing a disciplinary action when appropriate. For 
potential misconduct outside its jurisdiction, an SRO is responsible 
for making referrals to the Commission or other appropriate agencies 
and assisting these agencies in their investigations.
---------------------------------------------------------------------------

    \101\ See e.g., Exchange Act Sections 6(b) and 15A(b), 15 U.S.C. 
78f(b) and 78o-3(b).
---------------------------------------------------------------------------

    As competition among markets grows, the markets that SROs operate 
will continue to come under increased pressure to attract order flow. 
This

[[Page 71262]]

business pressure can create a strong conflict between the SRO 
regulatory and market operations functions. Because increasing inter-
market competition has provided members (and those that represent their 
orders through members) with increasing flexibility as to where to 
direct order flow, SRO staff may be less inclined to enforce vigorously 
SRO rules that would cause large liquidity providers to redirect order 
flow.
    For example, one hedge fund typically may account for between 1% 
and 2% of total daily dollar volume traded on the NYSE.\102\ One mutual 
fund complex may account for as much as 5% of the NYSE's daily trading 
volume.\103\ Approximately half of the 80 million exchange-listed 
shares executed per day on the CHX is directed to eight specialist 
firms.\104\ Moreover, as of July 2004, the NSX's market share grew to 
26.2 percent of the Nasdaq market with the majority of that trading 
activity being generated by one member, the INET ECN.\105\ As of May 
2004, the Brut ECN's matched shares reported to the BSE represented 
8.7% of overall Nasdaq trading volume.\106\
---------------------------------------------------------------------------

    \102\ See Citadel Investment Group LLC Web site (https://www.citadelgroup.com/).
    \103\ Charles Forelle, Fidelity Opposes NYSE Proposal Over 
Limits on ``Sweeps'' of Trades, The Wall Street Journal, August 17, 
2004, at C3.
    \104\ Traders Magazine, The Windy City's Auto-Ex Democracy 
(March 1, 2004).
    \105\ Isabelle Clary, Markets Editor, Securities Industry News, 
Brut Buy May Boost Nasdaq, (September 6, 2004).
    \106\ Isabelle Clary, Markets Editor, Securities Industry News, 
Nasdaq Strikes Back with Brut Deal (May 31, 2004). The Brut ECN has 
subsequently shifted the reporting of all of its Tape C trading 
activity to Nasdaq. See Nasdaq Head Trader Alert <greek-i>2004-115, 
Nasdaq Completes Acquisition of Brut LLC (September 7, 2004).
---------------------------------------------------------------------------

    While regulatory staff is responsible for carrying out self-
regulatory obligations, they are also a component of a competitive 
business organization. As intermarket competition increases, regulatory 
staff may come under pressure to permit market activity that attracts 
order flow to their market. Market operations staff may also be less 
likely to cooperate and communicate with regulatory staff if they think 
such cooperation or communication will hinder their effort to attract 
order flow.
    In addition, SROs face conflicts in regulating members that are 
influential in the their markets. For example, in the 21(a) Report 
concerning the NASD, the Commission found that Nasdaq market makers had 
exerted substantial influence over the affairs of the NASD through 
their dominant role in its governance, the administration of the NASD's 
disciplinary process, and the operation of Nasdaq.\107\ Other less 
favored constituencies, such as retail and institutional investors and 
other broker-dealers, particularly those day trading firms that heavily 
used Nasdaq's Small Order Execution System (``SOES Firms''), did not 
have comparable representation on the key NASD boards and 
committees.\108\
---------------------------------------------------------------------------

    \107\ See 21(a) Report at 40-44.
    \108\ Id.
---------------------------------------------------------------------------

    The Commission found that market maker influence led to a concerted 
effort by the NASD staff to bring disciplinary actions against SOES 
firms.\109\ Indeed, the 21(a) Report concluded that the NASD made a 
high priority of enforcement related to violations of its SOES rules by 
subjecting firms to special ``sweep'' examinations, and devoting 
substantial resources to monitoring, examining, and bringing 
disciplinary actions for potential violations of the day trading 
rules.\110\ In contrast, the Commission found that the NASD was far 
less aggressive with respect to its enforcement of rule violations by 
market makers.\111\
---------------------------------------------------------------------------

    \109\ Id.
    \110\ Id.
    \111\ For example, complaints related to market makers failing 
to abide by the firm quote rule were effectively discouraged both by 
an ineffective procedure for enforcing the rule and by the absence 
of adequate sanctions for demonstrated misconduct. The Commission 
found that the small number of NASD formal disciplinary actions for 
market related rule violations brought against joint NYSE/NASD 
member firms, which would encompass the larger firms in the 
securities industry, was cause for serious concern over the NASD's 
enforcement priorities. See 21(a) Report at 40-44.
---------------------------------------------------------------------------

    Another concern is the potential for SRO regulatory staff, in the 
course of developing rules and examining members, to become overly 
dependent on members for their understanding of market practices and to 
lose their independent perspective concerning these practices. A 
potential loss of objectivity could accompany the greater knowledge and 
expertise that result from having SRO regulatory staff interwoven with 
SRO market operations.
    Also, SROs may have a tendency to abuse their SRO status by over-
regulating members that operate markets that compete with the SRO's own 
market for order flow.\112\ Indeed, among other reasons, these concerns 
led the Commission to require the NASD to establish the Alternative 
Display Facility (``ADF'').\113\ Exchange Act rule 11Ac1-1 \114\ 
requires that SRO members communicate their best bids and offers to an 
SRO and in the late 1990s broker-dealer choice as to where to post 
quotes in Nasdaq securities was effectively limited to Nasdaq.\115\ 
Thus, certain users of Nasdaq were concerned that they would be put at 
a distinct competitive disadvantage if they were compelled to provide 
their best bids and offers to the exclusive securities information 
processor (``SIP'') for Nasdaq securities through the new SuperMontage 
system.\116\ These users argued that, not only would their quotes be 
subject to a competing market's trading rules, but that the situation 
would be rife for abuse because of Nasdaq functioning both as a 
regulator and competitor of the ECNs.\117\ Thus, before permitting the 
launch of Nasdaq's SuperMontage, the Commission required that the NASD 
provide an alternative, the ADF, to Nasdaq's SuperMontage on which to 
quote Nasdaq securities.\118\
---------------------------------------------------------------------------

    \112\ Securities and Exchange Commission Concept Release, 
Regulation of Exchanges, S7-16-97, Exchange Act Release No. 38672 
(May 23, 1997), 62 FR 30485 (June 4, 1997) (``ATS Concept 
Release''). The Commission acknowledged that conflicts could become 
particularly acute when an ATS member is regulated by an SRO that 
operates a competing market. Id. at 30486-30487.
    \113\ See Exchange Act Release No. 43863 (January 19, 2001), 66 
FR 8020 (January 26, 2001); Exchange Act Release No. 42166 (November 
22, 1999), 64 FR 68125 (December 6, 1999); Exchange Act Release No. 
42573 (March 23, 2000), 65 FR 16981 (March 30, 2000); Exchange Act 
Release No. 43133 (August 10, 2000), 65 FR 49842 (August 15, 2000); 
and Exchange Act Release No. 43514 (November 3, 2000), 65 FR 69084 
(November 15, 2000). The Commission received 104 comments regarding 
Nasdaq's order collector, aggregator, and execution facility 
(``SuperMontage'') proposal.
    \114\ 17 CFR 240.11Ac1-1.
    \115\ 66 FR 8020, 8052-8055.
    \116\ Id.
    \117\ Id.
    \118\ Id.
---------------------------------------------------------------------------

    The Commission specifically seeks public comment on the following 
questions related to conflicts with market operations:
    Question 4: To what extent do conflicts exist between SRO 
regulatory and market operations functions? Has increased intermarket 
competition exacerbated this potential conflict? Are markets today 
attempting to use ``lax regulation'' as a means to attract business? 
Are they attempting to use ``aggressive regulation'' as a weapon 
against competitors? Is it unrealistic to expect a ``cost center,'' 
such as regulation, to resist pressure from a function that generates 
business revenue in a modern business enterprise?
    Question 5: To what extent has internal SRO separation of these 
functions addressed these concerns? Has the restructuring of the NASD, 
and the recent governance changes of the NYSE and other SROs to enhance 
their independence, been effective in better insulating the regulatory 
function from the market function?
    Question 6: Can potential conflicts between the regulatory function 
and

[[Page 71263]]

SRO market operations be effectively managed through the recent 
enhancements made to SRO governance and the changes proposed by the SRO 
Governance and Transparency Proposal? Are there other measures the 
Commission should consider?
3. Inherent Conflicts With Issuers
    Another potential SRO conflict is with listed issuers. The SROs 
promulgate and administer listing standards that govern the securities 
that may be traded in their markets. For corporate securities, these 
rules include minimum financial qualifications and reporting 
requirements for their issuers. Obtaining a listing on a prominent SRO 
market provides corporate issuers with enhanced visibility and prestige 
in the eyes of investors, as well as the appearance of a well-operated 
and well-regulated trading market for their securities. An active 
market for secondary trading in a corporation's securities benefits not 
only its shareholders, but also the corporation itself through enhanced 
capital-raising capacities.
    SRO listing standards also have a major role in corporate 
governance, particularly since the passage of the Sarbanes-Oxley 
Act.\119\ Specifically, under recently adopted rules, SROs are 
prohibited from listing any security of an issuer that is not in 
compliance with certain standards.\120\ Each member of the audit 
committee of the issuer must be independent according to specified 
criteria.\121\ In addition, the audit committee of each issuer must be 
directly responsible for the appointment, compensation, retention and 
oversight of the work of any registered public accounting firm engaged 
for the purpose of preparing or issuing an audit report or performing 
other audit, review or attest services for the issuer, and each such 
registered public accounting firm must report directly to the audit 
committee.\122\ Moreover, each audit committee must establish 
procedures for the receipt, retention and treatment of complaints 
regarding accounting, internal accounting controls or auditing matters, 
including procedures for the confidential, anonymous submission by 
employees of the issuer of concerns regarding questionable accounting 
or auditing matters.\123\ Each audit committee must also have the 
authority to engage independent counsel and other advisors, as it 
determines necessary, to carry out its duties and each issuer must 
provide appropriate funding for the audit committee.\124\
---------------------------------------------------------------------------

    \119\ Pub. L. 107-204, 116 Stat. 745 (2002).
    \120\ See generally Exchange Act Release No. 47654 (April 9, 
2003), 68 FR 18788 (April 16, 2003).
    \121\ Id. at 18790.
    \122\ Id.
    \123\ Id.
    \124\ Id.
---------------------------------------------------------------------------

    The SROs are responsible for monitoring issuers and delisting the 
securities of those that fail to meet SRO minimum requirements, but 
also compete vigorously to attract and retain listings, as illustrated 
recently by the high profile competition to list the Google Initial 
Public Offering.\125\ This competition has been heightened by new 
listing venues. For instance, the equity trading facility of the PCX, 
ArcaEx, has been actively courting issuers to list \126\ and in the 
Spring of 2004, Nasdaq launched a high profile dual listing program for 
NYSE stocks.\127\ Moreover, there are indications that international 
stock exchanges are becoming more competitive with respect to 
attracting foreign companies to list on their markets (rather than on 
U.S. markets).\128\
---------------------------------------------------------------------------

    \125\ Andrei Postelnicu, Listing Chief Sets Sights Abroad, 
Financial Times, August 23, 2004, at 25.
    \126\ Andrei Postelnicu, ArcaEx launches listings drive, 
Financial Times, September 16, 2004, at 22.
    \127\ Nasdaq CEO: Competitive Practices Could Have Helped NYSE, 
Dow Jones News Service, August 25, 2004.
    \128\ Yuka Hayashi, Foreign Firms Consider Listing Shares in 
Tokyo, Wall Street Journal, October 18, 2004, at C16.
---------------------------------------------------------------------------

    As issuers are offered new alternatives as to markets on which to 
list their securities, SROs face increasing competitive pressure to 
gain and retain listings. As with SRO competition for members and order 
flow, competition for issuers may cause an SRO to fail to discharge its 
self-regulatory responsibilities properly. This can take the form of 
admitting to trading issuers that fail to satisfy initial listing 
standards; delaying the delisting of issuers that no longer satisfy 
maintenance standards; failing to enforce listing standards (including 
the new issuer corporate governance standards); and reducing (or even 
eliminating) listing fees. This competition also can reveal itself in 
an unwillingness to restrict issuer activities or impose requirements 
that may be more stringent than similar rules of competitor SROs.
    Another issue with respect to listings relates to conflicts 
associated with listings of members' proprietary products such as 
Exchange Traded Funds (``ETFs''). In some instances, the creator of a 
proprietary product may be an SRO member that becomes the specialist or 
primary market maker of the product. In the equity markets, the issuer 
typically has authority with respect to where the stock is to be 
listed. With respect to such proprietary products, the product creator 
(and potentially the product's sole specialist or primary market maker) 
may have significant authority as to where the product is listed. When 
an SRO member is a combined member/issuer of a popular product and that 
member wields authority with respect to transferring the listing of the 
product to another SRO, the SRO may be disinclined to regulate that 
member vigorously.
    The Commission specifically seeks public comment on the following 
questions related to conflicts with issuers:
    Question 7: To what extent have conflicts arisen between SRO 
regulatory and issuer listing functions? Has the recent increase in 
competition among SRO markets for listings created incentives to admit 
issuers that fail to satisfy initial listing standards or delay the 
delisting of issuers that no longer satisfy maintenance standards? To 
the extent increased competition for listings has caused SROs to waive 
or lower listing fees, has this negatively impacted regulatory funding 
and further inhibited enforcement of listing standards?
    Question 8: Has the sponsorship of popular proprietary products by 
member firms compounded the inherent conflicts discussed above with 
both members and issuers? Specifically, are SROs disinclined to 
regulate vigorously either the trading activity of popular proprietary 
products or the activity of members firms that are the sponsors of such 
products?
4. Inherent Conflicts With Shareholders
    Another significant conflict of interest for SRO responsibilities 
is with SRO shareholders. SRO demutualization raises the concern that 
the profit motive of a shareholder-owned SRO could detract from proper 
self-regulation. For instance, shareholder owned SROs may commit 
insufficient funds to regulatory operations or use their disciplinary 
function as a revenue generator with respect to member firms that 
operate competing trading systems or whose trading activity is 
otherwise perceived as undesirable. Moreover, as with the inherent 
conflicts discussed above, this conflict can be exacerbated by 
increased intermarket competition.\129\
---------------------------------------------------------------------------

    \129\ It is also possible for demutualization of SROs to cause 
complicated transactional issues to arise. For instance, 
complications could surface if a demutualized SRO bid to purchase a 
listed company. Another problematic situation could be one in which 
a demutualized SRO competes with a listed company for the purchase 
of a third entity. Conflicts would clearly present themselves in 
these situations.

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[[Page 71264]]

    A variety of ownership controls for demutualized SROs can 
potentially prevent some of these conflicts.\130\ Indeed, as previously 
noted, this concept release is being published in conjunction with the 
SRO Governance and Transparency Proposal, which would, if adopted, 
impose a variety of restrictions, including an effective restriction on 
revenue from regulatory operations being used to pay dividends to 
shareholders.
---------------------------------------------------------------------------

    \130\ For instance, several exchanges that have converted to 
shareholder-owned structures have limited the ability of any person, 
including their members, to directly or indirectly own and vote more 
than a certain percentage of the interest in the exchange. See e.g., 
Securities Exchange Act Release Nos. 49718 and 49098. Exchanges also 
have similar limits on concentration of ownership of facilities that 
are separate corporate entities from the exchange. See e.g., 
Securities Exchange Act Release Nos. 50170 and 49067. The Commission 
approved these limitations on a case-by-case basis pursuant to the 
rule filing process of Section 19(b) of the Exchange Act and Rule 
19b-4 thereunder. 15 U.S.C. 78s(b) and 17 CFR 240.19b-4.
---------------------------------------------------------------------------

    The Commission specifically seeks public comment on the following 
questions related to conflicts with shareholders:
    Question 9: What are the conflicts between a demutualized SRO's 
regulatory responsibilities and the profit-making orientation of its 
shareholders? To what extent do they heighten the inherent SRO 
conflicts with members, market operations, and listed issuers discussed 
above?
    Question 10: Can potential conflicts between the regulatory 
function and SRO shareholders be effectively managed through the recent 
enhancements to SRO governance and the changes proposed by the SRO 
Governance and Transparency Proposal? Or are there other measures the 
Commission should take to help ensure that the effectiveness of the 
regulatory function is not diminished?

B. Inefficiencies of Multiple SROs

    Securities industry self-regulation carries with it an inherent 
inefficiency in that it can cause duplicative and potentially 
conflicting regulation. Specifically, the existence of multiple SROs 
can result in duplicative and conflicting SRO rules, rule 
interpretations, and inspection regimes. The system can also result in 
redundant SRO regulatory staff and infrastructure across SROs.
    Congress and the Commission have put in place methods for reducing 
a certain amount of regulatory duplication. Pursuant to Exchange Act 
Section 17(d) and Rule 17d-1,\131\ when a member belongs to more than 
one SRO, the SEC shall designate the responsibility to one SRO for 
examining the member for compliance with applicable financial 
responsibility rules.\132\ The undesignated SRO is relieved of 
responsibility for examining the member for compliance with financial 
responsibility rules.\133\ In addition, Rule 17d-2 under the Exchange 
Act permits SROs to establish Commission approved joint plans for 
allocating regulatory responsibilities with respect to common 
members.\134\ An SRO participating in such a regulatory plan approved 
by the Commission is relieved of regulatory responsibilities with 
respect to a broker-dealer member, if those regulatory responsibilities 
have been allocated to another SRO under the regulatory plan.\135\
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    \131\ 15 U.S.C. 78q and 17 CFR 240.17d-1.
    \132\ 17 CFR 240.17d-1.
    \133\ Id.
    \134\ 17 CFR 240.17d-2.
    \135\ Id.
---------------------------------------------------------------------------

    The options SROs, for example, have utilized a 17d-2 agreement to 
reduce regulatory redundancies.\136\ The options markets' 17d-2 Plan 
reduces regulatory duplication for a large number of firms currently 
members of two or more of the SRO participants by equitably allocating 
regulatory responsibility for a set of options sales practice rules 
that are substantially identical for each of the SRO participants.\137\
---------------------------------------------------------------------------

    \136\ See generally Exchange Act Release No. 49197 (February 5, 
2004), 69 FR 7046 (February 12, 2004).
    \137\ Under the plan, the SRO participant responsible for 
conducting options-related sales practice examinations of a firm, 
and investigating options-related customer complaints and 
terminations for cause of associated persons of that firm, is known 
as the firm's Designated Options Examining Authority (``DOEA''). 
Pursuant to the plan, any other SRO of which the firm is a member is 
relieved of these responsibilities during the period the firm is 
assigned to a DOEA. The options 17d-2 Plan is administered by a 
committee, the Options Self-Regulatory Council, which is composed of 
one representative from each SRO signatory to the plan. Under the 
Options 17d-2 plan, common options rules across the different 
options SROs have been designated and are enforced by the DOEA. The 
DOEAs for common members are assigned based on a variety of factors, 
including the most equitable allocation of the regulatory burden of 
carrying out the duties of the DOEA. In addition, all DOEA 
assignments are made by a majority vote of all SRO participants of 
the plan. Common rules covered by the plan include those related to 
the opening of options accounts, the supervision of options trading, 
and customer suitability for trading options. See e.g., Exchange Act 
Release No. 49197 (February 5, 2004), 69 FR 7046 (February 12, 
2004).
---------------------------------------------------------------------------

    While the potential for the SRO system to cause regulatory 
redundancies is not a novel issue for the Commission,\138\ it appears 
that the inefficiencies caused by the SRO system are being aggravated 
by greater market fragmentation of order flow among SROs. Thus, a 
recent U.S. General Accounting Office (``GAO'') analysis is worth 
discussing. In May of 2002, the GAO issued a report, which specifically 
focused on the implications of market fragmentation with respect to 
securities industry regulatory redundancies.\139\ It ultimately 
discussed a broad range of issues related to the relationship between 
self-regulation and intermarket competition for order flow. The GAO 
Report recommended that the Commission work with the SROs and broker-
dealers to implement a formal process for systematically identifying 
and addressing material regulatory inefficiencies caused by differences 
in rules and rule interpretations among SROs and by multiple 
examinations of broker-dealers.\140\ In the wake of the GAO Report, the 
Commission supported the formation of a joint NASD and NYSE task force 
with the mission of examining their conflicting rules and determining 
how those conflicts could be resolved. The Commission has been working 
with the SROs in this respect and facilitating SRO rule amendments when 
appropriate.\141\
---------------------------------------------------------------------------

    \138\ See supra Section II.
    \139\ U.S. General Accounting Office Report to Congressional 
Committees, ``Securities Markets Competition and Multiple Regulators 
Heighten Concern about Self-Regulation'' (May 2004) (``GAO 
Report'').
    \140\ GAO Report at 30.
    \141\ See e.g., notice and comment process for the adoption of a 
uniform NASD and NYSE ``branch office'' definition. Exchange Act 
Release Nos. 48897 (December 9, 2003), 68 FR 70059 (December 16, 
2003); 46888 (November 22, 2002), 67 FR 72257 (December 4, 2002).
---------------------------------------------------------------------------

    More recently, in light of issues raised in a petition for 
rulemaking filed by Nasdaq, the Commission published a concept release 
covering the regulation of intermarket trading of Nasdaq 
securities.\142\ The Intermarket Trading Concept Release discussed 
Nasdaq's concern about the potential development of ``regulatory 
arbitrage'' when SRO rules are inconsistent across markets.\143\ 
Specifically, according to Nasdaq, this type of arbitrage could result 
in the attraction of order flow and members to certain SROs over others 
because of the prospect of lax regulation.\144\ The Intermarket Trading 
Concept Release sought public comment on the importance of uniformity 
with respect to a variety of rules related to intermarket trading of 
Nasdaq-listed securities, including rules related to market 
manipulation, illegal short

[[Page 71265]]

selling, insider trading, fraud, front running, marking the open or 
close, non-compliance with the limit order display rule, and non-
compliance with the firm quote rule.\145\ The Intermarket Trading 
Concept Release solicited comment on whether uniform rules are 
necessary to prevent regulatory arbitrage.\146\ It also noted Nasdaq's 
contention that the disparities in rules between SROs pose a serious 
threat to investor protection and discussed Nasdaq's request that the 
Commission exercise its authority under Sections 12(f)(2) and (3) of 
the Act \147\ to prohibit the launch or continuation of Nasdaq trading 
by any market that failed to adopt adequate regulatory protections, 
including rules related to inter-market trading issues.\148\
---------------------------------------------------------------------------

    \142\ Concept Release: Request for Comment on Nasdaq Petition 
Relating to the Regulation of Nasdaq-Listed Securities, Exchange Act 
Release No. 47849 (May 14, 2003), 68 FR 27722 (May 20, 2003) 
(``Intermarket Trading Concept Release'').
    \143\ Intermarket Trading Concept Release at 27724.
    \144\ Id.
    \145\ Id.
    \146\ Id.
    \147\ Exchange Act Sections 12(f)(2) and (3), 15 U.S.C. 
78l(f)(2) and (3). Intermarket Trading Concept Release at 27725.
    \148\ See Intermarket Trading Concept Release at 27724-27725.
---------------------------------------------------------------------------

    The Commission received a variety of comments in response to the 
Intermarket Trading Concept Release. Commenters, including certain SROs 
and ECNs that compete with Nasdaq for order flow, argued that there is, 
in fact, no unequal regulation across markets and that trading that 
falls within each SRO's purview is effectively regulated.\149\ Some 
commenters voiced a qualified endorsement of uniform rules in certain 
areas, but were careful to note that uniform rules should in no way 
restrict each SRO's ability to craft rules that reinforce its own 
unique intra-market structures or competitive business models.\150\ At 
least one commenter even supported the creation of a single independent 
regulator that would be responsible for regulating all broker-dealers 
in all markets.\151\
---------------------------------------------------------------------------

    \149\ See letter from John S. Markle, Associate General Counsel, 
Ameritrade Holding Company, to Jonathan G. Katz, Secretary, 
Commission, pp. 2-3 (July 10, 2003) (``Ameritrade Letter''); letter 
from William O'Brien, Chief Operating Officer, Brut, LLC, to 
Jonathan G. Katz, Secretary, the Commission, p. 2 (June 19, 2003) 
(``Brut Letter''); letter from Jeffrey T. Brown, Cincinnati Stock 
Exchange, to Jonathan G. Katz, Secretary, Commission, pp. 5-6 (June 
19, 2003) (``CSE Letter''); letter from Michael J. Simon, Senior 
Vice President and Secretary, ISE, to Jonathan G. Katz, Secretary, 
Commission, p. 2 (June 19, 2003) (``ISE Letter''); letter from Brian 
F. Colby, Chairman, Intermarket Surveillance Group, to Jonathan G. 
Katz, Secretary, Commission, pp. 1-2 (June 18, 2003) (``ISG 
Letter''); letter from Darla C. Stuckey, Corporate Secretary, NYSE, 
to Jonathan G. Katz, Secretary, Commission, pp. 4-5 (June 19, 2003) 
(``NYSE letter''); letter from Meyer S. Frucher, Phlx, to Jonathan 
G. Katz, Secretary, Commission, pp. 2-6 (June 17, 2003) (``Phlx 
Letter'').
    \150\ See Ameritrade Letter pp. 2-3; letter from Kim Bang, 
Bloomberg Tradebook LLC, to Jonathan G. Katz, Secretary, Commission, 
p. 2 (June 20, 2003) (Bloomberg letter); Brut letter pp. 3-4, letter 
from Richard Ketchum, General Counsel, Global Corporate & Investment 
Bank, Citigroup Global Capital Markets, to Jonathan G. Katz, 
Secretary, Commission, pp. 7-9 (July 8, 2003) (``Citigroup 
letter''); letter from Edward J. Joyce, President and Chief 
Operating Officer, Chicago Board Options Exchange, Incorporated, to 
Jonathan G. Katz, Secretary, Commission, p. 2 (June 30, 2003) 
(``CBOE letter''); letter from Eric Schwartz, Managing Director, 
Goldman Sachs & Co., and Duncan Niederauer, Co-Chief Executive 
Officer, Spear, Leeds & Kellogg, L.P., to Jonathan G. Katz, 
Secretary , Commission, p. 2 (July 25, 2003) (``GS/SLK letter''); 
letter from Craig S. Tyle, General Counsel, Investment Company 
Institute , to Jonathan G. Katz, Secretary, Commission, p. 1 (June 
19, 2003) (``ICI letter''); letter from Barbara Z. Sweeney, Senior 
Vice President and Corporate Secretary, NASD, to Jonathan G. Katz, 
Secretary, Commission, p. 12 (June 20, 2003) (``NASD letter''); 
letter from Donald D. Kittell, Executive Vice President, Securities 
Industry Association, to Jonathan G. Katz, Secretary, Commission, 
pp. 3-5 (June 27, 2003) (``SIA letter''); and Mary McDermott 
Holland, Mark Madoff, and John C. Giesea, Securities Traders 
Association, to Jonathan G. Katz, Secretary, Commission, p. 3 (June 
19, 2003) (``STA letter'').
    \151\ See letter from W. Hardy Callcott, SVP & General Counsel, 
Charles Schwab & Co., Inc., to Jonathan G. Katz, Secretary, 
Commission (July 7, 2003) (``Schwab letter'').
---------------------------------------------------------------------------

    Thus, while the Intermarket Trading Concept Release drew out 
thoughtful public commentary on discrete issues related to the SRO 
system's regulatory inefficiencies and redundancies, this concept 
release seeks public commentary on these issues in the broader context 
of the efficacy of the SRO system overall. Specifically, the Commission 
specifically seeks public comment on the following questions:
    Question 11: Is the lack of intermarket rules across markets 
trading the same type of securities causing regulatory arbitrage and, 
if so, what is the impact of this on the SRO system? Should this issue 
be addressed through changes at the SRO system level, rather than at 
the individual SRO level?
    Question 12: How significant are the inefficiencies resulting from 
multiple SROs overseeing the activities of the same members? In what 
areas do these issues primarily arise?

C. Intermarket Surveillance

    Another area in which the SRO system has recently come under 
increasing strain because of market fragmentation is with respect to 
SRO and Commission supervision of intermarket trading. When order flow 
was largely concentrated in the primary markets, traders had limited 
ability to cloak illicit activity by spreading trades across markets. 
When trading takes place in multiple active markets, however, it is 
possible for traders to veil illegal trading activity by dispersing 
trades across markets.
    The Intermarket Trading Concept Release specifically sought public 
comment on this topic. \152\ The release focused public attention on 
Nasdaq's contention that its extensive audit trail data was of limited 
use for cross-market surveillance, because it cannot capture relevant 
data for executions that take place on other markets trading Nasdaq 
securities, and other markets do not have comparable systems that can 
interact with NASD's Order Audit Trail System (``OATS''), which 
captures regulatory data concerning the important stages in the life of 
a trade. \153\
---------------------------------------------------------------------------

    \152\ Intermarket Trading Concept Release at 27724.
    \153\ Intermarket Trading Concept Release at 27724. OATS is part 
of an integrated audit trail system, developed by NASD. It provides 
a source of timed, sequenced order events, which, when combined with 
existing quotation and trading information, assists in the 
surveillance of the Nasdaq market. See OATS Subscriber Manual 
2004.3, 1-1 (October 4, 2004). The general objective of OATS is to 
recreate daily market activity by capturing and maintaining order 
data reported by member firms. OATS Subscriber Manual at 2-1.
---------------------------------------------------------------------------

    The Intermarket Trading Concept Release also focused comment on the 
role of the Intermarket Surveillance Group (``ISG''), which is an 
industry organization created in 1983 to coordinate intermarket 
surveillance among the self-regulatory organizations by cooperatively 
sharing regulatory information pursuant to a written agreement between 
the parties. \154\ The goal of the ISG's information sharing is to 
coordinate regulatory efforts to address potential intermarket trading 
abuses and manipulations. \155\ Although the ISG Agreement was not 
established under Section 11A or 17(d) of the Securities Exchange Act 
of 1934, \156\ ISG asserts that the Commission has required new markets 
to become ISG members as a condition of registration, thus recognizing 
its importance. \157\ ISG's full members are the Amex, BSE, CBOE, CHX, 
NSX, ISE, NASD, NYSE, PCX, and the Phlx (collectively ``Full 
Members''). \158\ Each of the Full Members is an SRO for which the 
Commission has direct oversight. \159\ As

[[Page 71266]]

a result, the regulatory procedures that these SROs have developed, 
individually and jointly, including those developed for insider trading 
and certain types of market manipulation, are subject to Commission 
jurisdiction and are regularly examined for sufficiency. \160\
---------------------------------------------------------------------------

    \154\ Intermarket Trading Concept Release at 27723.
    \155\ Id.
    \156\ 15 U.S.C. 78k-1 or 78q(d).
    \157\ See ISG letter at 1.
    \158\ In its comment letter, ISG states that it has also 
established an affiliate category of membership to all futures 
exchanges and non-U.S. organizations to join. Moroever, ISG notes 
that certain ISG affiliate members (One Chicago LLC, Nasdaq LIFFE 
Markets LLC, CME Inc. and Island Futures Exchange LLC) by virtue of 
their status as ``notice registered National Securities Exchanges'' 
and as signatories to the Addendum for Securities Futures products, 
have already submitted themselves to elements of the ISG Agreement, 
as amended in 1994. As such, ISG maintains they have accepted ISG as 
the appropriate forum for resolving inter-market issues. See ISG 
Letter p. 1-2.
    \159\ Id.
    \160\ Id.
---------------------------------------------------------------------------

    In its petition, Nasdaq asserted that, for a variety of reasons, 
the data, received through ISG regarding other markets, is insufficient 
to enable Nasdaq to properly surveil intermarket trading activity. 
\161\ Nasdaq also posited that consolidated regulation of Nasdaq 
trading across all markets for intermarket surveillance purposes would 
be fundamentally more effective because of the flaws of ISG data and 
because the ISG is composed of some members that do not necessarily 
trade Nasdaq securities (including certain non-Full Members that are 
not regulated as SROs by the Commission). \162\
---------------------------------------------------------------------------

    \161\ For instance, ISG audit trail information is clearing 
level data, rather than executing firm level data. According to 
Nasdaq, the ISG data time fields are not generated by clocks subject 
to uniform synchronization protocols, as is the case with OATS data. 
Moreover, Nasdaq states that ISG data is transmitted two days after 
the trade takes place and in a format that cannot be readily 
integrated into the NASD's automated surveillance systems. Nasdaq 
argued that the two day delay significantly hinders NASD's ability 
to investigate unlawful trading activity on a real-time basis and 
can prevent NASD from obtaining non-stale regulatory information in 
an ongoing investigation. Inter-Market Trading Concept Release at 
27723.
    \162\ Id.
---------------------------------------------------------------------------

    In response to the Intermarket Trading Concept Release, the 
Commission received a variety of comments on intermarket surveillance 
and order audit trail issues. \163\ Some commenters argued that 
existing audit trail systems were well designed, even though they did 
not interact with Nasdaq's. \164\ In addition, many commenters were 
concerned that complying with multiple SROs' different order audit 
trail systems would be burdensome and expensive to implement and 
administer. \165\ Other commenters argued that Nasdaq had understated 
the effectiveness of ISG and that the organization should be allowed to 
continue in its role as the facilitator of regulatory data sharing 
among markets. \166\
---------------------------------------------------------------------------

    \163\ See infra notes 164-176.
    \164\ CSE letter at 3-7 and ISG letter at 2.
    \165\ Ameritrade letter at 3; CSE letter at 17-18; ISE letter at 
3-4; GS/SLK letter at 3-4; Phlx letter at 6-7; SIA letter at 4; STA 
letter at 3.
    \166\ Ameritrade letter at 2; Brut letter at 6; CBOE letter at 
2; CSE letter at 10-13; ISE letter at 3-4; ISG letter at 2; NYSE 
letter at 3-5; Phlx letter at 6-7; and SIA letter at 7.
---------------------------------------------------------------------------

    In its comment letter, the ISG described its consolidated audit 
trail system, which supplements individual markets' surveillance 
systems by facilitating the analysis and review of information 
concerning potential trading violations. \167\ By allowing the SROs to 
share their regulatory information, ISG asserts, the SROs are able to 
view trading activity in the context of all markets' clearing level 
quote and trade data. \168\ The ISG argued that its Equity Audit Trail 
system provides a consolidated view across all markets of quotes and 
trades, including clearing information. \169\ Moreover, ISG stated that 
its systems serve their purpose well and that no other market had 
raised the issues that Nasdaq raised in its petition. \170\ 
Specifically, the ISG claimed that neither the time delays in receiving 
information through ISG nor the lack of a uniform synchronization 
protocol had proven to be problematic. \171\
---------------------------------------------------------------------------

    \167\ ISG letter at 2.
    \168\ Id.
    \169\ Id.
    \170\ ISG letter at 2-3.
    \171\ ISG letter at 2-3.
---------------------------------------------------------------------------

    In the NYSE's comment letter, it generally supported the 
traditional role of the ISG. \172\ Moreover, the NYSE described its own 
order audit trail, the Order Tracking System (``OTS''), and how its 
rules are comparable to those of the NASD's OATS. \173\ The NYSE raised 
the possibility of the Commission requiring that each individual market 
establish an order audit trail system similar to the NYSE's and the 
NASD's and mandating that the data from these separate order audit 
trails be integrated into the ISG's consolidated order audit trail. 
\174\
---------------------------------------------------------------------------

    \172\ See generally NYSE letter.
    \173\ NYSE letter at 4-5.
    \174\ NYSE letter at 4-5.
---------------------------------------------------------------------------

    In its comment letter in response to the Intermarket Trading 
Concept Release, the NASD echoed many of the concerns raised by Nasdaq 
in its petition. Specifically, the NASD argued that the current model 
of coordinated regulation results in regulatory gaps and that potential 
misconduct can occur across markets undetected by regulators. \175\ It 
also argued that the less detailed regulatory information collected by 
the ISG lacks certain critical pieces of information to effectively 
assist SROs in regulating intermarket trading activity. \176\
---------------------------------------------------------------------------

    \175\ NASD letter at 9.
    \176\ NASD letter at 8.
---------------------------------------------------------------------------

    With respect to the options markets, in September of 2000, the 
Commission accepted settlement agreements from the Amex, CBOE, Phlx, 
and PCX in connection with administrative proceedings, alleging, among 
other things, that these options exchanges had inadequately discharged 
their obligations as SROs by failing to enforce compliance with certain 
rules, including order handling rules, reporting rules, and rules 
prohibiting anticompetitive conduct. \177\ As a result, in settling the 
Commission's enforcement action, the options exchanges undertook a 
variety of steps to prevent future self-regulatory lapses, including 
the design and implementation of a consolidated options audit trail 
system (``COATS''). \178\ COATS would enable the options exchanges to 
reconstruct markets promptly, effectively surveil them and enforce 
order handling, firm quote, trade reporting and other rules. \179\ The 
full extent to which COATS effectively enhances intermarket options 
surveillance is not known as of yet because the system is in the final 
stage of its implementation. COATS, however, suggests the potential for 
a consolidated audit trail for the equity markets.
---------------------------------------------------------------------------

    \177\ See Exchange Act Release No. 43268 (September 11, 2000), 
File No. 3-10282, (``Options Settlement'').
    \178\ See Id. at Section IV.B.e.
    \179\ Id.
---------------------------------------------------------------------------

    While the full implementation of robust intermarket order audit 
trails would be a significant step forward, an order audit trail is 
simply a tool that can be used by regulators to better surveil for 
illicit trading activity. In the 2000 Options Settlement, the options 
exchanges undertook to design and implement, concurrent with the design 
and implementation of COATS, effective surveillance systems to use the 
newly available COATS data to enforce the federal securities laws and 
SRO rules. \180\ Thus, even when COATS is fully implemented and even if 
a similar intermarket audit trail were developed for the equity 
markets, the SRO regulatory function would still play a critical role 
in the regulation of intermarket trading.
---------------------------------------------------------------------------

    \180\ Id.
---------------------------------------------------------------------------

    The Commission specifically seeks public comment on the following 
questions related to intermarket surveillance and regulation:
    Question 13: To what extent does our market model of multiple 
competing SROs create gaps in intermarket trading surveillance? What 
types of illicit trading activity in particular can be hidden from 
regulators by dispersing trading across multiple markets?
    Question 14: How effectively does the ISG serve as a facilitator of 
regulatory data sharing and surveillance coordination among SROs? Is 
the ISG's order audit trail effective as a regulatory

[[Page 71267]]

tool? How feasible would it be to require all markets to adopt order 
audit trails similar to those of the NYSE and the NASD and ultimately 
to integrate all markets' order audit trails into the ISG's 
consolidated order audit trail?
    Question 15: How similar are the order audit trail systems of the 
NYSE and the NASD? Could they be merged into one consolidated system 
and what would be the benefits of such a consolidated system? Should 
NASD's OATS or NYSE's OTS requirements be extended to all equity 
markets to enhance the ability of SROs to surveill intermarket 
activity? If so, could all markets' individual order audit trails be 
successfully integrated into the ISG's consolidated order audit trail 
or another consolidated system? How useful a regulatory tool would the 
ISG's consolidated order audit trail system be if all markets were 
required to adopt their own order audit trail systems and their data 
was required to be integrated into the ISG's?
    Question 16: To what extent is there a need for an order audit 
trail to provide crossover surveillance between the equities and 
options markets? To what extent would such crossover surveillance 
detect specific types of illicit trading activity?

D. Funding

    Another feature of the SRO system to be discussed relates to the 
funding of SRO regulatory operations. One of the key historical 
benefits of the SRO system is its self-funding structure, which 
leverages the limited resources of the Commission. Experience appears 
to indicate that the Commission, in its current form, does not have the 
resources to effectively carry out on its own the full panoply of 
duties for which the SROs are currently responsible. In 1983, after 18 
years of experience with directly regulating over-the-counter broker-
dealer activity through the SEC Only (``SECO'') program,\181\ the 
regime was repealed.\182\ Congress amended the Exchange Act provisions 
covering direct regulation of broker dealers by the SEC and imposed 
compulsory SRO membership.\183\
---------------------------------------------------------------------------

    \181\ The SECO program was implemented because neither the 
Exchange Act nor the Maloney Act compelled broker-dealers to become 
SRO members. In 1964, the Commission was in favor of compulsory 
membership in the NASD. Congress, however, opted for Commission 
regulation of broker-dealers who were not members of an association. 
Congress intended the SECO regulations to mirror the substantive and 
most of the procedural requirements of the NASD so that SECO firms 
would not enjoy a competitive advantage over NASD members or escape 
the regulation of ethical standards. Consequently, the Commission 
was tasked with designing rules to promote just and equitable 
principles of trade; to regulate the training and competency of 
securities industry professionals; to adopt regulations regarding 
broker-dealers and associated persons qualifications and training; 
and to adopt standards to cooperate with associations on 
qualification exams and exam fees. See Market 2000 Report VI-6.
    \182\ See Pub L. 98-38; Exchange Act Release No. 20409 (November 
22, 1983), 48 FR 53688(November 29, 1983).
    \183\ Id. See also Exchange Act Section 15, 15 U.S.C. 78o.
---------------------------------------------------------------------------

    At the time of the repeal of the SECO program, the House Committee 
on Energy and Commerce reported to the Committee of the Whole House 
that the SECO program was unnecessarily costly and diverted the SEC's 
limited resources away from areas of major concern, merely to duplicate 
the functions of the NASD.\184\ The House Committee stated ``that any 
attempt to put SECO regulation on a par with that provided by the NASD 
would require significant expenditures by the Commission for additional 
staff and administrative costs.'' \185\ The committee also noted that 
SROs were better able to maintain ethical standards for the industry 
and to perform certain detailed oversight functions.\186\ The House 
also cited the limitations of enforcement and compliance remedies 
available to the Commission in comparison to the remedies available to 
the NASD.\187\
---------------------------------------------------------------------------

    \184\ H.R. Rep. No. 98-106 (1983).
    \185\ H.R. Rep. No. 98-106, at 7 (1983).
    \186\ Id.
    \187\ Id. at 6.
---------------------------------------------------------------------------

    In the Market 2000 Report, the Commission's staff provided its 
retrospective impression of the SECO program's performance. The staff 
noted its belief that the SECO experience illustrated ``that the 
resources necessary for the Commission to assume SRO regulatory 
functions directly and effectively are not realistically attainable.'' 
\188\ The SECO experience demonstrated the important role that SROs 
play in maximizing the Commission's limited resources. It also 
illustrated that regulation must be properly funded and have sufficient 
resources to be effective. In that regard, the most finely-balanced SRO 
structure will not ensure that SRO statutory obligations are met, if 
regulatory operations are insufficiently funded. Thus, SRO funding 
arrangements are critical to the SRO system.\189\
---------------------------------------------------------------------------

    \188\ See Market 2000 Report at VI-6.
    \189\ As noted above, two ongoing Commission rulemakings have a 
bearing on SRO funding. First, proposed Reg NMS contains a provision 
that would reallocate market data revenues to encourage price 
formation. The Commission is also proposing the SRO Governance and 
Transparency Proposal, a rulemaking that would greatly increase SRO 
transparency with respect to funding (including regulatory funding) 
and funding allocations.
---------------------------------------------------------------------------

1. Overview
    While Congress was fairly prescriptive in its initial enactment of 
the Exchange Act and in subsequent amendments as to the standing 
responsibilities of SROs, it has not provided explicit guidance as to 
the proper levels or methods of funding for self-regulatory 
operations.\190\ Section 6 of the Exchange Act, which addresses the 
registration of national securities exchanges, requires that ``the 
rules of the exchange provide for the equitable allocation of 
reasonable dues, fees, and other charges among its members and issuers 
and other persons using its facilities.'' \191\ Section 15A contains a 
similar provision in connection with the registration of national 
securities associations.\192\ These provisions also require that an SRO 
be ``so organized and [have] the capacity to be able to carry out the 
purposes'' of the Exchange Act and ``to comply, and * * * to enforce 
compliance by its members, and persons associated with its members, 
with the provisions' of the Exchange Act.\193\ Accordingly, while 
Congress provided only general guidance with respect to SRO funding, a 
reasonable reading of the Exchange Act indicates that it intended that 
regulatory funding be sufficient to permit SROs to fulfill their 
statutory responsibilities under the Exchange Act, and contemplated 
that such funding would be achieved through equitable assessments on 
the members, issuers, and other users of an SRO's facilities.
---------------------------------------------------------------------------

    \190\ See generally Exchange Act Sections 6 and 15A, 15 U.S.C. 
78f and 78o-3.
    \191\ Exchange Act Section 6(b)(4), 15 U.S.C. 78f(b)(4).
    \192\ See Exchange Act Section 15A(b)(5), 15 U.S.C. 78o-3(b)(5).
    \193\ See Exchange Act Section 15A(b)(2) and 6(b)(1) 15 U.S.C. 
78o-3(b)(2) and 78f(b)(1).
---------------------------------------------------------------------------

    The Commission to date has not issued detailed rules specifying 
proper funding levels of SRO regulatory programs, or how costs should 
be allocated among the various SRO constituencies. Rather, the 
Commission has examined the SROs to determine whether they are 
complying with their statutory responsibilities. This approach was 
developed in response to the diverse characteristics and roles of the 
various SROs and the markets they operate. The mechanics of SRO 
funding, including the amount of revenue that is spent on regulation 
and how that amount is allocated among various regulatory operations, 
is related to the type of market that an SRO is operating. Prior to the 
SRO Governance and Transparency Proposal, the Commission had not 
proposed requiring a single

[[Page 71268]]

regulatory structure for all SROs, and the financial structure of each 
individual SRO is a result of a variety of factors, including the SRO's 
particular history and competitive position. Thus, each SRO and its 
financial structure is, to a certain extent, unique. While this 
uniqueness can result in different levels of SRO funding across 
markets, it also is a reflection of one of the primary underpinnings of 
the National Market System. Specifically, by fostering an environment 
in which diverse markets with diverse business models compete within a 
unified National Market System, investors and market participants 
benefit.\194\
---------------------------------------------------------------------------

    \194\ See generally Exchange Act Section 11A, 15 U.S.C. 78k-1.
---------------------------------------------------------------------------

    The ``appropriate'' amount of funding to be spent by SROs on 
regulatory operations is governed by a variety of factors, including 
the SRO's business model, trading systems, regulatory responsibilities, 
and types of members. For instance, electronic marketplaces may be able 
to supervise trading occurring in their markets at lower cost than 
floor-based markets because their trading systems may capture 
comparatively more information associated with any given trade. 
Likewise, the characteristics of an SRO's membership base may affect 
the appropriate level of regulatory funding and how the funding is 
allocated.
    Potential varying levels of regulatory funding notwithstanding, all 
SROs must meet their statutory obligations. The Exchange Act itself, as 
well as the Commission's rules and automation review policies 
thereunder, impose on the SROs important regulatory and operational 
responsibilities, including most of the day-to-day responsibilities for 
market and broker-dealer oversight.\195\ Satisfying these self-
regulatory responsibilities requires a substantial expenditure of 
expertise and funds. The SROs' combined total operating expenses in 
1998 were $1.68 billion \196\ and total combined SRO operating expenses 
in 2003 were $2.4 billion.\197\ As stated above, a significant benefit 
of self-regulation in the securities industry is that this significant 
cost is largely self-funded.
---------------------------------------------------------------------------

    \195\ See generally Policy Statement: Automated Systems of Self-
Regulatory Organizations, Exchange Act Release No. 27445 (November 
16, 1989), 54 FR 48703 (November 24, 1989); Policy Statement: 
Automated Systems of Self-Regulatory Organizations (II), Exchange 
Act Release No. 29185 (May 9, 1991), 56 FR 22490 (May 15, 1991).
    \196\ See Concept Release, Regulation of Market information Fees 
and Revenues (``Market Data Concept Release''), Exchange Act Release 
No. 42208 (File No. S7-28-99) (December 9, 1999), 64 FR 70613, 70615 
(December 17, 1999).
    \197\ Data compiled from SRO 2003 Annual Reports.
---------------------------------------------------------------------------

    The Commission's supervision of the adequacy of SRO regulatory 
funding presents considerable challenges. Given the inherent tension 
between an SRO's role as a business and as a regulator, there 
undoubtedly is a temptation for an SRO to fund the business side of its 
operations at the expense of regulation. For example, if the 
``appropriate'' amount of regulatory spending would seriously impair 
the financial stability of an SRO, that SRO would likely reduce 
regulatory spending rather than jeopardize its financial viability. 
When the Commission examines the underlying reasons for regulatory 
failings, it is often clear that an SRO has not allocated sufficient 
resources to its regulatory function. Without such failings, however, 
it can be difficult for the Commission to determine whether an SRO is 
insufficiently funding its regulatory function or simply administering 
an efficient regulatory program.\198\
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    \198\ Even if the Commission were to determine that an SRO was 
insufficiently funding regulation, it would then have the difficult 
task of deciding whether to take extreme action (such as 
deregistration of an SRO) or more measured action (such as the 
NASD's 21(a) Undertaking requiring that it commit $100 million on 
self-regulatory enhancements). See e.g., 21(a) Report requiring that 
the NASD expend $100 million over a five year period, to enhance its 
systems for market surveillance, including the development and 
implementation of an enhanced audit trail, and to increase its 
staffing in the areas of examination, surveillance, enforcement, and 
internal audit; see also NYSE settlement in connection with Exchange 
Act section 11(a), 15 U.S.C. 78k(a), violations requiring 
establishment of OTS, Exchange Act Release No. 41574 (June 29, 
1999), Administrative Proceeding File No. 3-9925; see also Options 
Settlement requiring establishment of COATS.
---------------------------------------------------------------------------

    If the Commission's SRO Governance and Transparency Proposal is 
adopted, however, it could illuminate more clearly SRO practices with 
respect to regulatory spending levels and allocations. Specifically, 
the detailed accounting of SRO revenues and expenses proposed could 
enable the Commission to more accurately and efficiently compare these 
items. Under the current reporting regime, SROs update their Form 1 
annually, including an updated financial statement, but their financial 
information is not necessarily submitted in a comparable format.\199\ 
Thus, the Commission could use this new information to assist in its 
effort to detect when an SRO is becoming an industry outlier in terms 
of relative regulatory spending levels. If the Commission made such a 
determination, it has the ability to pursue a range of regulatory 
responses, including designating that SRO for heightened Commission 
oversight or stronger action, such as SRO deregistration.
---------------------------------------------------------------------------

    \199\ See Exchange Act Rule 6a-2, 17 CFR 240.6a-2, and 15Aj-1, 
17 CFR 240.15Aj-1.
---------------------------------------------------------------------------

    Although not proposed in the SRO Governance and Transparency 
Proposal, the Commission could also consider developing formal or 
informal regulatory spending guidelines for SROs. Establishing uniform 
guidelines for SROs generally would be a very complex task, however, 
given the diversity of their marketplaces and memberships and the 
evolving nature of regulatory oversight. While the SRO Governance and 
Transparency Proposal would likely result in a heightened Commission 
ability to detect low regulatory spending levels, it is important to 
note that gauging the effectiveness of an SRO's self-regulation cannot 
necessarily be accurately judged by considering capital expenditures in 
isolation.
    The Commission specifically seeks public comment on the following 
questions related to SRO funding generally:
    Question 17: Should the Commission prescribe specific regulatory 
funding and allocation levels for SROs and, if so, how? Also, how would 
these levels be determined?
    Question 18: Could enhanced transparency of SRO funding be used 
effectively to promote adequate SRO regulatory funding levels or would 
other steps be more effective in that regard? What measures could be 
used to promote adequate SRO regulatory funding levels?
2. SRO Funding Sources
    To provide commenters a basis for considering SRO funding, this 
section discusses the five primary sources of SRO funding: (a) 
Regulatory fees; (b) transaction fees; (c) listing fees; (d) market 
data fees; and (e) other miscellaneous fees. While each source of SRO 
revenue is important, this discussion will provide an extensive 
discussion of market data and specifically the level of fees charged 
for market data.
a. Regulatory Fees
    SROs charge members fees for joining and maintaining membership. In 
addition, SROs charge regulatory fees to members that typically take 
the form of per member or per transaction fees and are generally 
allocated to funding self-regulatory operations. SROs also contract 
with other SROs to provide regulatory services. In 1998, regulatory 
fees accounted for approximately 19%

[[Page 71269]]

of SRO revenue,\200\ while, in 2003, approximately 23% of SRO revenue 
was derived from such fees.\201\
---------------------------------------------------------------------------

    \200\ Market Data Concept Release at 70625.
    \201\ Data compiled from SRO 2003 Annual Reports. Note that the 
NYSE 1998 Consolidated Statement of Revenue did not account for 
``Data Processing Fee'' revenue. Due to an intervening change in 
accounting procedures, the NYSE 2003 Consolidated Statement of 
Revenue includes this item. To provide a more accurate comparison 
between the 1998 and 2003 percentages, ``Data Fee Processing'' 
revenue was not included in total SRO revenue for the purpose of 
calculating the percentage of total SRO revenue represented by 
regulatory fee revenue. Based on SRO 2003 Annual Report Consolidated 
Statements of Income certain items were allocated to regulatory fees 
with respect to the NYSE (``Regulatory Fees'' and ``Annual 
Membership Fees''), the BSE (``Members'' Dues and Fees''), the Phlx 
(``Regulatory Fees''), the NASD (including Amex and Nasdaq 
consolidated statements of income) (``Regulatory Fees,'' 
``Registration Fees,'' ``Qualification Fees,'' ``Corporate Financing 
Fees,'' and ``Fines''), the PCX (``Regulatory and Registration 
Fees,'' ``Archipelago Revenue: Regulatory Oversight,'' and ``Member 
and Participant Dues''), the CHX (``Member Services and Fees'' and 
``Member Dues''), the CBOE (``Regulatory Fees'' and ``Other Member 
Fees''), and the NSX (``Regulatory Fees'').
---------------------------------------------------------------------------

    A recent development with respect to SRO regulatory fees was the 
NASD's establishment of a Trading Activity Fee (``TAF''), to supplement 
the regulatory fees it historically charged its members.\202\ The TAF 
assessed a transaction-based fee that was not linked to trading 
activity reported through Nasdaq systems.\203\ In approving the TAF, 
the Commission found that it was reasonably designed to recover the 
NASD's costs related to regulation and oversight of its members.\204\ A 
principal factor in the Commission's approval was its explicit 
recognition of the NASD's broad responsibilities with respect to its 
members' activities, irrespective of where securities transactions take 
place.\205\ Specifically, the Commission noted that, as a national 
securities association, the NASD has the responsibility to oversee its 
members' finances and conduct toward their customers, except in limited 
circumstances where this responsibility is allocated to another 
SRO.\206\ The Commission further stated that the NASD's responsibility 
exists even if the conduct involves a transaction executed on a market 
not directly regulated by the NASD because it has direct responsibility 
to oversee the firm's dealing with the public in effecting the 
transactions and may also have responsibility to oversee the impact of 
the trading on the firm's financial condition.\207\
---------------------------------------------------------------------------

    \202\ See Exchange Act Release Nos. 46817 (November 12, 2002), 
67 FR 69784 (November 19, 2002) (``TAF Proposing Release''); 47946 
(May 30, 2003), 68 FR 34021 (June 6, 2003) (``TAF Approval Order''). 
See also Exchange Act Release Nos. 49114 (January 22, 2004), 69 FR 
4194 (January 28, 2004) (proposing to amend the TAF and extend it to 
Trade Reporting and Compliance Engine (``TRACE'')-eligible and 
municipal securities); 50485 (October 1, 2004), 69 FR 60445 (October 
8, 2004)(approving proposal to amend the TAF and extend it to TRACE-
eligible and municipal securities).
    \203\ In its filing, the NASD noted its belief that assessing 
the regulatory fees only for Nasdaq transactions was no longer 
appropriate for three reasons. First, on a corporate entity level, 
Nasdaq was separating itself from the NASD and attempting to 
register as a national securities exchange. Second, the NASD 
believed that the historic regulatory fee structure was out of step 
with recent changes in the markets, such as the drastic growth in 
trading volumes, reductions in average trade size, decimalization, 
and trading no longer remaining exclusive to the listing market. 
Finally, the regulatory fee was only assessed against Nasdaq-listed 
and other transactions that are reported through Nasdaq's trade 
reporting system, although these fees were used to support member 
regulatory activities across all markets. See TAF Proposing Release 
at 69785.
    The Commission received a total of 23 comment letters on the 
proposal, all of which objected to the proposal, either for 
substantive or procedural reasons. Commenters of the TAF proposal 
argued that the NASD should not charge members for services related 
to transactions on other markets, where the NASD does not provide 
the relevant service. In addition, commenters argued that the TAF 
proposal was anti-competitive in that it indirectly subsidized 
Nasdaq by effectively reducing the cost of regulatory services the 
NASD provides to Nasdaq. They also posited that the TAF could 
establish a dangerous precedent under which fees could be charged by 
SROs for trading activity that had little or no nexus to that SRO's 
market. See TAF Approval Order at 34022-34023.
    In response, the NASD clarified that the TAF was to be used only 
to fund its member regulatory activities in a variety of areas such 
as sales practices, examinations, financial and operational reviews, 
new member applications, and enforcement wherever such member 
activity occurs. In addition, the NASD argued that it regulates the 
activities of its members in all securities, not simply Nasdaq 
securities. The specific revenues from the TAF, the NASD stated, 
would not fund regulatory activities of the Nasdaq stock Market and, 
thus, not create an inappropriate regulatory subsidy. Finally, with 
regard to comments that no clear nexus existed between the TAF and 
the corresponding NASD regulatory responsibilities, the NASD 
maintained that its mandate is broad, and that its regulatory 
obligations ``exist separate and apart from any market-specific 
rules and obligations.'' See TAF Approval Order at 34023.
    \204\ TAF Approval Order at 34023-34024.
    \205\ Id.
    \206\ Id.
    \207\ The Commission also stated its belief that the TAF 
approval was not a harbinger for the imposition of fees on 
transactions executed on markets for which an SRO either has little 
or no nexus to regulatory tasks performed by the SRO or for which 
the SRO has no business interest. Most SROs, the Commission 
concluded, do not have the broad aegis of the NASD regarding 
members' customer business, and so will not have a regulatory nexus 
to support a transaction fee applicable to other markets. See TAF 
Approval Order at 34023-34024.
---------------------------------------------------------------------------

    The Commission specifically seeks public comment on the following 
question related to SRO regulatory fees:
    Question 19: Under current SRO cost structures, SRO funding for 
regulatory operations is not derived strictly from revenue associated 
with regulatory fees and operations. Instead, SROs cross subsidize the 
cost of regulatory operations with revenue that is not strictly derived 
from regulatory fees and operations. Should the Commission require that 
SRO funding for regulatory operations be derived only from regulatory 
fees, rather than allowing the cost of regulatory operations to be 
subsidized by other revenue sources? If regulatory funding should be 
limited strictly to revenue generated by regulatory fees, how should 
the Commission address a situation in which an SRO does not generate 
sufficient regulatory revenue to fully fund regulatory operations?
b. Transaction Fees
    Another important source of revenue for SROs that operate markets 
is derived from fees that are associated with members' or others' use 
of the SRO's systems, such as order routing systems, trade execution 
systems, and electronic connectivity services. These fees are paid by 
any user of an SRO's market facilities for services, including 
executing, reporting, and clearing transactions. In 1998, transaction 
fees accounted for approximately 30% of SRO revenue,\208\ while, in 
2003, approximately 27% of SRO revenue was associated with transaction 
fees.\209\
---------------------------------------------------------------------------

    \208\ Market Data Concept Release at 70625.
    \209\ Data compiled from SRO 2003 Annual Reports. Note that the 
NYSE 1998 Consolidated Statement of Revenue did not account for 
``Data Processing Fee'' revenue. Due to an intervening change in 
accounting procedures, the NYSE 2003 Consolidated Statement of 
Revenue includes this item. To provide a more accurate comparison 
between the 1998 and 2003 percentages, ``Data Fee Processing'' 
revenue was not included in total SRO revenue for the purpose of 
calculating the percentage of total SRO revenue represented by 
transaction fee revenue. Based on SRO 2003 Annual Report 
Consolidated Statements of Income certain items were allocated to 
transaction fees with respect to the NYSE (``Transaction Fees''), 
the BSE (``Transaction Fees''), the Phlx (``Transaction Fees''), the 
NASD (including Amex and Nasdaq consolidated statements of income) 
(``Transaction Fees''), the PCX (``Transaction Fees and Data Service 
Charges''), the CHX (``Transaction Fees''), the CBOE (``Transaction 
Fees''), and the NSX (``Transaction Fees'').
---------------------------------------------------------------------------

    The intense intermarket competition for order flow has put 
substantial pressure on these fees. For example, greater competition 
among options markets has caused transaction fees to all but disappear 
in the options markets.\210\ The equity markets have also come under 
intense competitive pressure to lower transaction fees. As discussed in 
the Reg NMS proposal, transaction fees have decreased steadily

[[Page 71270]]

in recent years.\211\ In addition, most ECNs and Nasdaq are paying a 
per-share rebate for limit orders that become executed against incoming 
orders, thereby further reducing net transaction fees.\212\ Thus, not 
only are SRO transaction fees being driven lower, but competition is 
compelling certain SROs to rebate a significant percentage of 
transaction fees collected to market participants.
---------------------------------------------------------------------------

    \210\ See generally Concept Release: Competitive Developments in 
the Options Markets. Exchange Act Release No. 49175 (February 3, 
2004), 69 FR 6124, 6125 (February 9, 2004) (``Options Concept 
Release'').
    \211\ See supra note 62.
    \212\ Most ECNs and Nasdaq pay a per-share rebate for limit 
orders that become executed against incoming orders. This rebate 
rewards market participants for submitting ``resting'' limit orders 
that give depth to the trading book. The ECNs and Nasdaq also impose 
a per-share access fee on the incoming marketable orders that 
execute against the resting limit orders and thereby ``remove 
liquidity'' from the book. In this way, the ECNs and Nasdaq use 
access fee rebates as payment to attract liquidity to their limit 
order books. Because non-subscribers cannot place limit orders on an 
ECN's book and therefore cannot receive the rebates, the fees that 
they pay act as a subsidy to the subscribers that place standing 
limit orders on the ECN's book. See Reg NMS at 11157.
---------------------------------------------------------------------------

    The Commission specifically seeks public comment on the following 
questions related to SRO transaction fees:
    Question 20: SRO transaction fees have been driven sharply lower in 
recent years by competition. In light of that, why has the overall 
percentage of SRO revenue associated with transaction fees not dropped 
as dramatically since 1998 (approximately 27% in 2003 compared to 
approximately 30% in 1998)?
    Question 21: How has the trend of decreasing transaction fees 
impacted the SROs' ability to fulfill their statutory obligations?
c. Listing Fees
    Another important source of revenue for some SROs is listing fees, 
which are paid by issuers that list their securities on an SRO's 
market. Initial listing fees are paid at the time of listing and are 
typically related to the amount of shares being offered. Listing 
maintenance fees are paid annually and are generally related to the 
issuers' total shares outstanding in the listed security. In 1998, 
listing fees accounted for approximately 23% of SRO revenue,\213\ 
while, in 2003, these fees represented approximately 20% of SRO 
revenue.\214\ These revenues have been highly concentrated in the 
primary listing markets, with secondary markets charging little or no 
listing fee.\215\ This concentration is exemplified by the fact that of 
the $9,182 billion worth of stocks listed on exchanges in 2002, $9,119 
billion was listed on the New York Stock Exchange.\216\
---------------------------------------------------------------------------

    \213\ Market Data Concept Release at 70625.
    \214\ Data compiled from SRO 2003 Annual Reports. Note that the 
NYSE 1998 Consolidated Statement of Revenue did not account for 
``Data Processing Fee'' revenue. Due to an intervening change in 
accounting procedures, the NYSE 2003 Consolidated Statement of 
Revenue includes this item. To provide a more accurate comparison 
between the 1998 and 2003 percentages, ``Data Fee Processing'' 
revenue was not included in total SRO revenue for the purpose of 
calculating the percentage of total SRO revenue represented by 
listing fee revenue. Based on SRO 2003 Annual Report Consolidated 
Statements of Income certain items were allocated to listing fees 
with respect to the NYSE (``Listing Fees''), the BSE (``Listing 
Fees''), the NASD (including Amex and Nasdaq consolidated statements 
of income) (``Issuer Services''), and the CHX (``Listing Fees'').
    \215\ The recent increase in intermarket competition for equity 
listings has raised issues related to listing fees and SRO funding. 
In early 2004, for example, the Nasdaq Stock Market launched a dual 
listing program to attract NYSE-listed issuers and offered a one 
year waiver of all entry fees and annual fees for NYSE-listed 
companies that became dually listed. Craig Karmin, Nasdaq Recruits 
Six NYSE Firms to Dual Listings, Wall Street Journal, January 13, 
2004, at C1.
    \216\ See Commission, 2003 Annual Report, 140 (2004).
---------------------------------------------------------------------------

    The Commission specifically seeks public comment on the following 
question related to SRO listing fees:
    Question 22: To what extent has increased inter-market competition 
impacted SRO listing fee revenue? To what extent has this impacted the 
SROs' ability to fulfill their regulatory obligations?
d. Market Data Fees
    Market data revenue has traditionally been a very important 
component of SRO funding.\217\ In 1998, market data revenue represented 
approximately 21% of SROs' total revenues,\218\ while, in 2003, 
approximately 18% of SRO revenue flowed from market data.\219\ Market 
data revenues represented 16% of NYSE revenues and 24% of Nasdaq 
revenues in 2003.\220\ For one SRO, market data fees accounted for more 
than 80% of its total 2003 revenue.\221\
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    \217\ As noted above, while the level of fees charged by the 
SROs for market data was not directly addressed in Reg NMS, broad 
industry interest in the issue was apparent from the comments 
received by the Commission in response to Reg NMS. Thus, while each 
source of SRO revenue is important, this discussion examines market 
data extensively and specifically examines the level of fees charged 
for market data. Various commenters in response to Reg NMS stated 
that market data revenues are an important source of funding for 
SROs and should therefore not be capped or reduced. See letter from 
William J. Brodsky, Chairman and Chief Executive Officer, The 
Chicago Board Options Exchange, Inc., to Jonathan G. Katz, 
Secretary, Commission, p. 9 (July 1, 2004) (``Reg NMS CBOE 
letter''); letter from David A. Herron, Chief Executive Officer, 
Chicago Stock Exchange, to Jonathan G. Katz, Secretary, Commission, 
pp.18-19 (June 30, 2004); and letter from David Humphreville, 
President, The Specialist Association, to Jonathan G. Katz, 
Secretary, Commission, p. 17 (June 30, 2004). One Reg NMS commenter 
believed that, in absence of market discipline, the Commission and 
SROs must ensure that the collection and allocation of revenues to 
different regulatory functions maximize investor protections at a 
reasonable cost. See letter from Huw Jenkins on behalf of UBS 
Securities LLC, Managing Director, Head of Equities for the 
Americas, to Jonathan G. Katz, Secretary, Commission, p. 10 (June 
30, 2004) (``Reg NMS UBS letter''). An SRO commenter stated that it 
is consistent with the purpose and intent of Section 11A of the 
Exchange Act for a significant portion of the market data revenue to 
be used by SROs for operations and regulation because such costs are 
directly related to the quality of the market data disseminated. See 
Reg NMS CBOE letter, p. 9.
    \218\ Market Data Concept Release at 70625.
    \219\ Data compiled from SRO 2003 Annual Reports. Note that the 
NYSE 1998 Consolidated Statement of Revenue did not account for 
``Data Processing Fee'' revenue. Due to an intervening change in 
accounting procedures, the NYSE 2003 Consolidated Statement of 
Revenue includes this item. To provide a more accurate comparison 
between the 1998 and 2003 percentages, ``Data Fee Processing'' 
revenue was not included in total SRO revenue for the purpose of 
calculating the percentage of total SRO revenue represented by 
market data fee revenue. Based on SRO 2003 Annual Report 
Consolidated Statements of Income certain items were allocated to 
market data fees with respect to the NYSE (``Market Data Fees''), 
the BSE (``Communications, Net Note B''), the Phlx (``Security Price 
Data and Floor Charges''), the NASD (including Amex and Nasdaq 
consolidated statements of income) (``Market Data Fees''), the PCX 
(``Peripheral Equipment and Market Data Fees''), the CHX (``Market 
Data Fees''), the CBOE (``OPRA Income''), and the NSX (``Market Data 
Fees'').
    \220\ Data compiled from NYSE and NASD 2003 Annual Reports.
    \221\ See NSX, 2003 Annual Report Exhibit I-12 (2004).
---------------------------------------------------------------------------

    In contrast to the importance of market data revenue to overall SRO 
funding, it is worth noting that it represents a relatively small 
portion of the securities industry's total expenses. For example, in 
1998, the total SRO market data revenue of $410.6 million represented a 
very small portion of the securities industry's total expenses for the 
year--less than 1/4th of one percent.\222\ In spite of revenue derived 
from market data playing an important role in SRO funding, some SROs 
rebate substantial market data revenues to the market participants that 
contribute to creating the market data.\223\
---------------------------------------------------------------------------

    \222\ See Market Data Concept Release Appendix.
    \223\ See Reg NMS at 11179.
---------------------------------------------------------------------------

    The U.S. equity markets are not alone in their reliance on market 
data revenues as a source of funding. All of the other major world 
equity markets currently derive large amounts of revenues from selling 
market information, despite having significantly less trading volume 
and less market capitalization than the NYSE and Nasdaq. To illustrate, 
the following table sets forth the respective market information 
revenues, dollar value of trading, and market

[[Page 71271]]

capitalization for the largest world equity markets in 2003: \224\
---------------------------------------------------------------------------

    \224\ Table data is derived from the 2003 annual reports of the 
various markets and from statistics compiled by the World Federation 
of Exchanges.

----------------------------------------------------------------------------------------------------------------
                                                                                                     Market
                                                           Data revenues      Trading volume     capitalization
                                                             (millions)        (trillions)        (trillions)
----------------------------------------------------------------------------------------------------------------
London.................................................               $180               $3.6               $2.5
NYSE...................................................                172                9.7               11.3
Nasdaq.................................................                147                7.1                2.8
Deutsche Bourse........................................                146                1.3                1.1
Euronext...............................................                109                1.9                2.1
Tokyo..................................................                 60                2.1                3.0
----------------------------------------------------------------------------------------------------------------

    Understanding market data pricing and the role that market data 
plays with respect to SRO funding is an important part of this 
discussion. Congress recognized that SROs would charge for market data 
when it gave the Commission authority in the 1975 Amendments to 
determine the extent to which SRO fees charged for market data are 
``fair and reasonable,'' are ``not unreasonably discriminatory,'' and 
achieve ``equitable allocation'' of reasonable fees among persons who 
use an SRO's facilities.\225\ Market information revenues serve an 
important and unique role in that they provide a broad source of SRO 
funding. The fees are paid by all users of market information, 
including, for example options and futures markets participants that 
otherwise would not contribute (through transactions services fees or 
listing fees) to the funding of the particular markets on whose 
information they rely. \226\
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    \225\ See Exchange Act Sections 6(b), 11A(c), and 15A(b), 15 
U.S.C. 78f(b), 78k-1(c), and 78o-3. Two provisions of the Exchange 
Act directly address market data fees. Section 11A(c)(1)(C) grants 
rulemaking authority to the Commission to assure that all securities 
information processors may obtain market information from an 
exclusive processor of that information (i.e., the processors for 
the three Networks) on terms that are fair and reasonable. Section 
11A(c)(1)(D) also grants rulemaking authority to the Commission to 
assure that all persons may obtain market information on terms that 
are not unreasonably discriminatory. The Commission applies these 
standards in reviewing fee filings submitted by exclusive processors 
for the three consolidated networks that disseminate market data in 
NMS stocks. The three Networks are (1) Network A, which disseminates 
data in stocks listed on the NYSE; (2) Network B, which disseminates 
data in stocks listed on Amex and the regional exchanges; and (3) 
Network C, which disseminates data in stocks listed on Nasdaq. The 
Commission also applies these standards in reviewing market data 
filings submitted by individual SROs.
    \226\ See Market Data Concept Release at 70628.
---------------------------------------------------------------------------

    In addition to being important to SROs, market data is also 
critical to market participants and investors. Market data is essential 
to investors and other market participants not physically present in a 
trading market, enabling them to make informed decisions when to buy 
and sell. It provides the basis for investment and portfolio decisions. 
And it creates confidence in the fairness and reliability of the 
markets. The current market data systems for equities and options 
collect quotes and trades from many different market centers and 
disseminate them to the public in a single stream of information for 
each security. This market information has been an essential element in 
the success of the U.S. securities markets. In addition to providing 
transparency of buying and selling interest, consolidated data is the 
principal tool for addressing fragmentation of trading among many 
different market centers, and for facilitating the best execution of 
investor orders by their brokers.\227\ Market data fees can have a 
major impact on the effectiveness of the market data system. The level 
of these fees and their structure determines the extent that market 
data is available to different types of market participants and 
investors. And market data can have anticompetitive effects if it is 
sold on discriminatory terms or in an unfair fashion.\228\
---------------------------------------------------------------------------

    \227\ Reg NMS at p.11176.
    \228\ In the past, SROs have attempted to distribute market data 
in ways that could potentially harm competitors. For example, in 
proposing a new ``depth of book'' market data product, Liquidity 
Quote, the NYSE asserted that it would incorporate a downstream data 
consolidation restriction clause into its agreements with market 
data vendors for the product that would prohibit its being 
integrated with any other market data product. A variety of anti-
competition arguments were raised in connection with this proposal 
and, ultimately, the Commission approved the proposal, but made the 
approval expressly contingent upon the NYSE not applying the 
downstream restrictions that were in its vendor agreements at the 
time of the approval. See generally Exchange Act Release Nos. 47091 
(December 23, 2002), 68 FR 133 (January 1, 2003); 47614 (April 2, 
2003), 68 FR 17140 (April 8, 2003).
---------------------------------------------------------------------------

    Market data fees also support the timeliness, accuracy, and 
reliability of the market data being disseminated. Market data, whether 
consolidated or not, that is untimely or untrustworthy could harm 
investors and reduce confidence in the fairness of the U.S. securities 
markets. One of the Commission's most important market structure 
responsibilities is to assure the integrity of market data.\229\ Today, 
market data from all equity and options markets is highly reliable and 
widely used. In order to promote the wide public availability of this 
information, market data fees must be fair and reasonable.\230\ 
Consistent with this is the notion that such fees should at least 
generate sufficient revenue to provide adequate funding for the 
dissemination of market data.
---------------------------------------------------------------------------

    \229\ When Congress mandated the creation of a national market 
system, it stated that ``communication systems, particularly those 
designed to provide automated dissemination of last sale and 
quotation information with respect to securities, will form the 
heart of the national market system.'' H.R. Rep. No. 94-229, 94th 
Cong., 1st Sess. 93 (1975). While Congress did not specifically 
mandate the creation of a consolidated market data processor system, 
the Commission has recently emphasized the benefits of consolidated 
market data, particularly for retail investors. See Reg NMS at 
11177.
    \230\ See Exchange Act Section 11A(c)(1)(C). 15 U.S.C. 78k-
1(c)(1)(C).
---------------------------------------------------------------------------

    Currently, the Commission typically reviews market data fees in the 
context of proposed fee changes filed by the three networks that 
disseminate market data in NMS stocks. These fee filings are published 
for notice and comment before Commission action.\231\ After

[[Page 71272]]

these filings are published, the Commission determines whether the fees 
are fair and reasonable, not unreasonably discriminatory, and otherwise 
consistent with the requirements of the Exchange Act.\232\ Although 
most market data fee filings currently involve Network fees, the same 
standard applies and the same questions arise with regard to the market 
data fees of an individual SRO.
---------------------------------------------------------------------------

    \231\ Several Reg NMS commenters believed that the existing 
notice and comment process for effecting market data fee changes 
does not facilitate informed and meaningful public and industry 
participation and comment. See letter from Gary Cohn, Managing 
Director, Goldman, Sachs & Co., to Jonathan G. Katz, Secretary, 
Commission, p. 12 (July 19, 2004) (``Reg NMS Goldman letter''); 
letter from Carrie E. Dwyer, Charles Schwab & Co., Inc., to Jonathan 
G. Katz, Secretary, Commission, p. 9 (June 30, 2004) (``Reg NMS 
Schwab letter''); letter from Marc Lackritz, President, Securities 
Industry Association, to Jonathan G. Katz, Secretary, Commission, 
pp. 24 and 26 (June 30, 2004) (``Reg NMS SIA letter''); and letter 
from Mary McDermott-Holland, Chairman, John C. Giesea, President/
CEO, The Security Traders Association, to Jonathan G. Katz, 
Secretary, Commission, p. 15 (June 30, 2004) (``Reg NMS STANY 
letter''). A few of these commenters also believed that these 
procedures, which provide that market data fee changes are effective 
upon filing, gives excessive power to self-interested parties. See 
Reg NMS Schwab letter, p. 9; Reg NMS SIA letter, p. 26; and Reg NMS 
STANY letter, p. 15. The SIA also stated that ``[t]he fact that the 
Commission may abrogate the proposal and require refiling does not 
equate to a substantive review or challenge to the fees charged, and 
has not proved such in the past.'' See Reg NMS SIA letter, p. 26. 
The SIA and STANY also suggested that this is responsible, in part, 
for excessive market data fees. See Reg NMS SIA letter, pp. 3 and 
26-27; STANY letter, p. 15. Schwab recommended amending Commission 
rules and the joint-SRO plans to eliminate the ``effective upon 
filing'' process for market data fee changes, including changes that 
would impact the treatment of market data users and market data 
distribution policies. See Reg NMS Schwab letter, p. 9. Schwab also 
recommended that the Commission require the joint-SRO plans to file 
material policy changes as rule changes that require public notice 
and comment prior to adoption. See Reg NMS Schwab letter, p. 9. 
Although fees charged by SROs to members generally are effective on 
filing, market data fees charged to the public are published for 
notice and comment before approval. See Exchange Act Rule 19b-4, 17 
CFR 240.19b-4.
    \232\ See Exchange Act Section 11A, 15 U.S.C. 78k-1; Exchange 
Act Rule 11Aa3-2, 17 CFR 240.11Aa3-2.
---------------------------------------------------------------------------

    In reviewing a market data fee filing, the Commission has relied to 
a great extent on the ability of the Networks to negotiate fees that 
are acceptable to SRO members, information vendors, investors, and 
other interested parties. The negotiation process is buttressed by the 
public notice and comment procedures that accompany the Commission's 
consideration of proposed rule changes.
    As equities and options markets have evolved in recent years, 
strains began to develop in the arrangements for market data, 
particularly with respect to setting fees. In evaluating the issues 
raised, an extensive public record has been developed on the subject of 
market data fees in the last five years. In 1999, the Commission 
initiated a full-scale review of market data fees and revenues in the 
Market Data Concept Release. The review was prompted, in part, by the 
Commission's concern that retail investors might be paying too much for 
market data.\233\ The Market Data Concept Release included the role of 
revenues derived from such fees in funding the operation and regulation 
of markets.\234\ The Market Data Concept Release presented for public 
review a great deal of factual information on market data fees and 
revenues.\235\ In the course of that effort, the Commission emphasized 
that market data must be affordable for retail investors.\236\ At about 
the same time, the Networks filed proposed rule changes that reduced 
retail investor fees generally by 75% to 80%. The following table sets 
forth retail investor fees for NYSE and Nasdaq stocks in 2003 and in 
1998:
---------------------------------------------------------------------------

    \233\ The Internet had greatly expanded the opportunity for 
retail investors to obtain access to real-time market data through 
on-line accounts with their broker-dealers, and investor demand for 
this data had grown exponentially. For example, the Market Data 
Concept Release noted that the revenues derived from fees applicable 
to retail investors had grown from $3.7 million in 1994 to $38.9 
million in 1998, and represented approximately 9% of total market 
data revenues. Market Data Concept Release at 70614 and 70631.
    \234\ See generally Id. at Section IV.
    \235\ The Appendix, for example, included 16 tables setting 
forth all of the different subscriber fees of the Networks, the 
revenues, expenses, and distributions of the Networks, and the 
revenues and expenses of each of the individual SROs that are 
participants in the Networks. In addition, the Market Data Concept 
Release included information to help the public assess whether the 
level of market data fees remained fair and reasonable. For example, 
the release noted that even prior to creation of the national market 
system and the Networks, market data revenues were an important 
source of SRO funding--market data revenues represented 14.7% of the 
NYSE's total revenues in 1975, compared to 15.3% in 1998. Market 
Data Concept Release at 70621. As noted above, market data revenues 
represented 16.0% of NYSE revenues in 2003. In addition, although 
the total amount of market data revenues had grown substantially in 
recent years, the increase was proportional to the increase in other 
SRO revenues. In 1994, market information revenues amounted to 
$246.1 million and represented 20% of SRO funding. In 1998, such 
revenues amounted to $410.6 million and represented 21% of SRO 
funding. The Commission noted that ``the growth in market 
information revenues has simply kept pace with the growth of other 
SRO revenues during the prolonged expansion in trading volume of the 
last five years. The SROs are no more, but also no less, dependent 
on market information revenues today than they were in 1994.'' 
Market Data Concept Release at 70615. Moreover, the percentage 
growth in market data revenues from 1994 to 1998 was 67%, but had 
not kept pace with the percentage growth in the securities 
industry's total revenues during this major expansion of trading, 
which was 139%. Id. at 70626.
    \236\ The Commission noted that one of the most important 
functions of the Commission is to assist retail investors in 
accessing the information they need to protect and further their own 
interests. Moreover, the Commission stated that communications 
technology had progressed so that broad access to real-time market 
information should be an affordable option for most retail 
investors. This information, the Commission believed, could greatly 
expand the ability of retail investors to trade securities. The 
Commission stated its intention that to assure that market 
information fees applicable to retail investors do not restrict 
their access to market information and that such fees must be non-
discriminatory when compared with the fees charged to professional 
users of market information. Market Data Concept Release at 70614.

----------------------------------------------------------------------------------------------------------------
                                                             NYSE                                       Nasdaq
                                       -------------------------------------------------------------------------
                                                       2003                    1998         2003         1998
----------------------------------------------------------------------------------------------------------------
Per Query.............................  \1/4\[cent] to \3/4\[cent].......      1[cent]  \1/2\[cent]      1[cent]
Monthly...............................  $0.50 to $1.00...................        $5.25        $1.00        $4.00
----------------------------------------------------------------------------------------------------------------

    The per-query fees are charged each time that a retail investor 
requests quote and trade information in a particular stock. The monthly 
fees represent limits on the total amount that a retail investor can be 
charged for market data in any month. Thus, for example, all retail 
investors currently have access to an unlimited quantity of the 
millions of best quotes and trades in Network A stocks during each 
trading day for no more than $1 per month, compared to the $5.25 that 
was charged before the Commission's review of market data fees.\237\
---------------------------------------------------------------------------

    \237\ See Network C / NASD-2003-132, Securities Exchange Act 
Release No. 48386 (August 21, 2003), 68 FR 51618 (August 27, 2003) 
(extending pilot program for reduced non-professional NQDS user 
fee); Network C / NASD-2002-117, Securities Exchange Act Release No. 
46446 (August 30, 2002), 67 FR 57260 (September 9, 2002) (extending 
pilot program for reduced non-professional NQDS user fee); Network C 
/ NASD-2001-56, Securities Exchange Act Release No. 44788 (September 
13, 2001), 66 FR 48303 (September 19, 2001) (extending pilot program 
allowing for reduced non-professional NQDS user fee); Network C / 
NASD-2001-32, Securities Exchange Act Release No. 44363 (May 29, 
2001), 66 FR 30254 (June 5, 2001) (permanently approving reduced 
Level 1 Service fees for non-professional users on a monthly and per 
query basis); Network B / CTA-01-01, Securities Exchange Act Release 
No. 44047 (March 7, 2001), 66 FR 15151 (March 15, 2001) (reducing 
the initial ticker charge at each customer location from $21.50 to 
$13.50 and thereby creating a uniform charge for each location); 
Network C / NASD-00-47, Securities Exchange Act Release No. 43190 
(August 22, 2000), 65 FR 52460 (August 29, 2000) (establishing pilot 
program for reduced non-professional NQDS user fee); Network C / 
NASD-00-19, Securities Exchange Act Release No. 42715 (April 24, 
2000), 65 FR 25411 (May 1, 2000) (extending pilot program for 
reduced Level 1 Service fees for non-professional users on a monthly 
and per query basis and further reducing the Level 1 Service monthly 
fee for non-professionals); Network B / CTA/CQ-99-02, Securities 
Exchange Act Release No. 42138 (November 15, 1999), 64 FR 63350 
(November 19, 1999) (reducing the Network B non-professional 
subscriber flat service rate, permanently approving and reducing 
tiered pay-for-use rates for non-professional subscribers, and 
allowing non-professional subscribers to pay the lower of the pay-
for-use or flat rates); Network A / CTA/CQ-99-01, Securities 
Exchange Act Release No. 41977 (October 5, 1999), 64 FR 55503 
(October 13, 1999) (reducing, inter alia, the Network A non-
professional subscriber flat service rate, permanently approving and 
reducing tiered pay-for-use rates for non-professional subscribers, 
and allowing non-professional subscribers to pay the lower of the 
pay-for-use or flat rates); Network C / NASD-99-25, Securities 
Exchange Act Release No. 41499 (June 9, 1999), 64 FR 32910 (June 18, 
1999) (establishing pilot program for reduced Level 1 fees for non-
professional users on a monthly and per query basis); Network C / 
NASD-99-17, Securities Exchange Act Release No. 38608 (May 12, 
1997), 62 FR 27095 (May 16, 1997) (increasing monthly subscriber fee 
for Level 1 Service); Network B / Securities Exchange Act Release 
No. 29879 (October 29, 1991), 56 FR 56430 (November 4, 1991) 
(increasing Network B professional and non-professional subscriber 
fees); and Network A / Securities Exchange Act Release No. 29863 
(October 25, 1991), 56 FR 56429 (November 4, 1991) (increasing 
Network A professional and non-professional subscriber fees).

---------------------------------------------------------------------------

[[Page 71273]]

    In reviewing the basis for evaluating market data fees, the Market 
Data Concept Release laid out in detail a ``flexible cost-based 
approach'' to market data fees.\238\ The Commission noted that terms 
such as ``fair'' and ``reasonable'' generally need standards to guide 
their application in practice, and that one such standard often used to 
evaluate fees is the amount of costs incurred to provide a 
service.\239\ The Commission stated that an inflexible cost-based 
standard, although unavoidable in some contexts, can entail severe 
practical difficulties.\240\ Instead, Congress, consistent with its 
approach to the National Market System in general, granted the 
Commission some flexibility in evaluating the fairness and 
reasonableness of market information fees.\241\ Specifically, Congress 
articulated general findings and objectives for the National Market 
System in section 11A and directed the Commission to act accordingly in 
overseeing its development.\242\ Congress thereby allowed the 
Commission to adopt a more flexible approach than ratemaking.\243\
---------------------------------------------------------------------------

    \238\ Market Data Concept Release at 70629-70632.
    \239\ Id. at 70619.
    \240\ Id.
    \241\ Id.
    \242\ Id.
    \243\ Id.
---------------------------------------------------------------------------

    To illustrate the practical difficulties of a strict, cost-of-
service ratemaking approach, the Market Data Concept Release described 
one prior instance in which the Commission had sought to implement such 
an approach in 1984.\244\ In that instance, Instinet had brought a 
proceeding before the Commission asserting that the NASD's fee for full 
quotation information from all Nasdaq market participants was an 
unwarranted denial of access to the information.\245\ The Commission 
found in favor of Instinet, primarily because the NASD had failed to 
submit an adequate cost-based justification for the fee.\246\ The 
Instinet Order emphasized, however, that the scope of its decision was 
limited to the particular competitive context presented in the 
proceedings and did not apply to all market data fees.\247\
---------------------------------------------------------------------------

    \244\ See generally Securities Exchange Act Release No. 20874 
(April 17, 1984), 49 FR 17640 (April 24, 1984) (``Instinet Order'').
    \245\ Id.
    \246\ Id.
    \247\ Id. The Market Data Concept Release then related the long 
process that ensued to arrive at a cost-based fee:
    The practical difficulties of implementing this strict, cost-of-
service approach are demonstrated by the subsequent history of the 
fee involved in the Instinet Order (later named the ``NQDS'' fee). 
In August 1985, the NASD proposed a revised fee of $79 per month. 
The Commission did not approve this proposal, but instead instituted 
proceedings to determine whether it should be disapproved, based 
primarily on the question whether the fee included some costs that 
were inconsistent with the Instinet Order. In September 1986, the 
NASD proposed another NQDS fee of $50.75 per month. This proposal 
was supported by an extensive and complex ratemaking analysis. It 
included a comprehensive allocation of costs to pools consisting of 
six resources and eleven services. The major categories of costs 
were summarized as (1) operational costs, which were allocated to 
the six resource pools based on identifiable personnel, equipment, 
and physical facilities dedicated to those operations, (2) systems 
and product/service development costs, which were allocated to the 
six resource cost pools based on the historical or anticipated level 
of effort to be devoted to the respective resources, (3) overhead 
and general and administrative costs, which were allocated directly 
to resource and service cost pools to the extent that a causal 
relationship existed between those resources or services and the 
incurrence of the affected costs, and (4) residual overhead and 
general and administrative costs, which were allocated to resource 
and service cost pools based on the total cost input base.
    The Commission had not acted on this proposal when the NASD, in 
July 1990, proposed yet another NQDS fee of $50 per month. This fee, 
however, included last sale information in addition to quotation 
information. The Commission approved the fee in October 1990. 
Notably, the Commission did not undertake any cost-based explanation 
of the $50 fee, nor did it express any opinion on the extensive 
cost-of-service analysis that had been included in the NASD's 
September 1986 proposal. Instead, it noted that, ``in reviewing the 
fairness and reasonableness of the proposal, the Commission finds it 
significant that the proposed fee of $50 is the result of 
negotiations among the concerned parties after protracted 
proceedings.'' The $50 fee approved for NQDS information in 1990 has 
remained unchanged up to the present.
    Market Data Concept Release at 70623 (footnotes omitted).
---------------------------------------------------------------------------

    While recognizing the practical difficulties of a detailed cost-of-
service approach, the Commission nevertheless concluded in the Market 
Data Concept Release that ``the total amount of market information 
revenues should remain reasonably related to the cost of market 
information.'' \248\ In this regard, one of the issues on which comment 
particularly was requested was whether the Commission should adopt ``a 
conceptual approach to evaluating the fairness and reasonableness of 
fees that, among other things, could establish a link between the cost 
of market information and the total amount of market information 
revenues.'' \249\ Critical to this concept was the determination of 
what SRO costs should be included in the cost of market data.
---------------------------------------------------------------------------

    \248\ Id. at 70627.
    \249\ Id. 70615.
---------------------------------------------------------------------------

    The Market Data Concept Release's flexible, cost-based approach was 
intended to arrive at an approach to market data fees that could be 
implemented in a reasonably efficient manner, as opposed to a full-
fledged ratemaking approach. The first step in fashioning the approach 
was to identify the categories of SRO costs incurred to generate and 
disseminate market data. All direct market data costs, such as market 
data recordation, communication, consolidation, and dissemination, 
would be included. The flexible cost-based approach would also have 
included in market data costs some portion of ``common costs''--those 
costs that support multiple SRO functions, in addition to market data, 
and therefore must be allocated among these services.\250\ These common 
costs comprised the costs of operating the market that produced the 
market data and the costs of regulating that market so that the data 
was not inaccurate and not derived from fraudulent or abusive conduct. 
\251\ The Market Data Concept

[[Page 71274]]

Release noted that there is little value to market information that is 
tainted by fraud, deception, or manipulation.\252\ Moreover, the goal 
of producing high quality market data cannot be achieved by a poorly 
operated market that is prone to systems outages and delays.\253\
---------------------------------------------------------------------------

    \250\ As the Commission described in the Market Data Concept 
Release, under the flexible, cost-based approach, the information 
that the SROs provide to the Networks would not be considered cost-
free. Before quotations and transaction reports can be consolidated 
and made available to the public, an organized market must provide a 
mechanism for facilitating the buying and selling of securities in a 
fair and orderly manner. In addition, the SROs must establish, 
monitor, and enforce trading rules, as well as otherwise regulate 
their markets to prevent fraudulent and manipulative acts or 
practices. The SROs incur substantial costs in performing these 
functions, and they contribute substantially to the value of the 
information. Id. at 70627.
    \251\ In contrast to costs incurred to operate and regulate 
markets, the flexible, cost-based approach set forth in the Market 
Data Concept Release excluded those SRO costs that did not directly 
contribute to the quality of market data. These included the costs 
of member regulation (e.g., sales practice and net capital 
requirements) and those costs directly associated with other SRO 
services. Advertising and marketing expenditures were specifically 
excluded from market data costs.
    \252\ Market Data Concept Release at 70627.
    \253\ For example, in times of significant price volatility and 
spikes in trading volume, it is critically important that the 
markets remain fair and orderly and that investors continue to have 
access to a timely stream of market information.
---------------------------------------------------------------------------

    The Market Data Concept Release recognized that not all common 
costs should be funded by market data, and that any resulting 
allocation decision would be conceptually difficult.\254\ While the 
Market Data Concept Release's approach to evaluating the fees of the 
Networks would require aggregating the allocated costs of the 
contributing SROs, the Market Data Concept Release specifically stated 
that a distribution of the revenues need not follow the costs of each 
SRO, but could be based on the quality of the data contributed by the 
SRO and its contribution to the market data stream.\255\ The Market 
Data Concept Release also questioned whether the rebate of market data 
revenues demonstrated that the existing fees were too high.\256\
---------------------------------------------------------------------------

    \254\ Market Data Concept Release at 70628-70629.
    \255\ Market Data Concept Release at 70628.
    \256\ Market Data Concept Release at 70630-70632.
---------------------------------------------------------------------------

    In reflecting on the Market Data Concept Release and the industry's 
reaction to it, the Commission gained an understanding of the serious 
divisions in the securities industry over how best to regulate market 
data. Specifically, there was a sharp division on the fairness and 
reasonableness of the existing fee levels of market data. In addition, 
there was a split of opinion as to whether market information fees 
should provide funding for other SRO functions such as market 
regulation or should be more closely related to the direct cost of 
producing the data. Also significant in the comments to the Market Data 
Concept Release were proposals that more competition be introduced to 
the compilation and dissemination of market data.\257\
---------------------------------------------------------------------------

    \257\ See generally Report of the Advisory Committee on Market 
Information: A Blueprint for Responsible Change (September 14, 
2001), Section V (available at http://www.sec.gov) (``Advisory 
Committee Report''). The Advisory Committee Report includes a 
comprehensive description of the arrangements for disseminating 
market data to the public, including the terms, fees, and revenues 
of the Plans.
---------------------------------------------------------------------------

    To help resolve these divisions, the Commission established its 
Advisory Committee on Market Information in the summer of 2000. In its 
2001 report, however, the Advisory Committee specifically rejected the 
flexible cost-based approach.\258\ The Advisory Committee report noted 
the consensus view that it was essentially a ``ratemaking'' approach 
that was unwise and, ultimately, unworkable.\259\ The Advisory 
Committee recommended retaining price transparency and consolidated 
market information as core elements of the U.S. securities markets, 
while adopting a ``competing consolidators'' model of data 
dissemination.\260\ Under this model, vendors and market data users 
would themselves consolidate the data from the various markets, with 
each SRO separately providing and setting fees for its own data, rather 
than consolidating this data through the Networks.
---------------------------------------------------------------------------

    \258\ See Advisory Committee Report.
    \259\ In the view of a majority of the Advisory Committee, ``the 
`public utility' cost-based ratemaking approach is generally 
disfavored today. It is resource-intensive, involves arbitrary 
judgments on appropriate costs, and creates distortive economic 
incentives. Accordingly, the Advisory Committee recommends that the 
Commission not adopt a cost-based approach for determining whether 
market information fees are consistent with the Exchange Act * * * 
Furthermore, the Advisory Committee does not recommend any specific 
changes to the standard under which the Commission reviews market 
data fees and revenues, or to the manner in which it conducts this 
review.'' Advisory Committee Report at Section VII.D.3.
    \260\ Advisory Committee Report at Section V.
---------------------------------------------------------------------------

    In commenting on proposed Regulation NMS, a number of SROs said the 
current market data Networks and their fees were reasonable, while 
several larger markets and their adherents advocated the competing 
consolidator model. Many other commenters said that the fees they pay 
to obtain basic market data--NBBO and trades--are excessive, and are 
not reasonably related to the cost of producing such data.\261\ As in 
earlier debates, some commenters said that market data fees should be 
limited to covering solely the costs incurred to disseminate 
consolidated market data, not the costs incurred by the individual SROs 
to produce the data and provide it to the Networks.\262\ Other 
commenters said that a prerequisite for evaluating the appropriateness 
of funding SRO operations and regulatory costs from market data 
revenues was a transparent accounting of the revenues received for 
market data and the expenses incurred in operating and regulating the 
SRO's market.\263\
---------------------------------------------------------------------------

    \261\ Many commenters, mostly securities firms and associations, 
believed that the Commission failed to address the main underlying 
problem, which they believe to be the root of the economic and 
regulatory distortions that the Commission is trying to address--
whether the current fees for market data are excessive in relation 
to the actual cost of collecting and disseminating market data. See 
letter from Daniel M. Clifton, Executive Director, American 
Shareholders Association, to Jonathan G. Katz, Secretary, 
Commission, ASA Letter, p. 2 (June 10, 2004) (``Reg NMS ASA 
letter''); letter from Kim Bang, President and Chief Executive 
Officer, Bloomberg Tradebook, LLC, to Jonathan G. Katz, Secretary, 
Commission, pp. 2 and 8-9 (June 30, 2004) (``Reg NMS Bloomberg 
letter''); letter from C. Thomas Richardson, Citigroup Global 
Markets, Inc., to Jonathan G. Katz, Secretary, Commission, pp. 4 and 
15 (July 20, 2004) (``Reg NMS Citigroup letter''); Reg NMS Goldman 
Sachs Letter, pp. 2 and 10; letter from Samuel F. Lek, Chief 
Executive Officer, Lek Securities Corporation, to Jonathan G. Katz, 
Secretary, Commission, (no page numbers) (May 24, 2004) (``Reg NMS 
Lek letter''); letter from Thomas N. McManus, Managing Director and 
Counsel, Morgan Stanley, to Jonathan G. Katz, Secretary, Commission, 
pp. 3 and 21 (August 19, 2004) (``Reg NMS Morgan Stanley letter''); 
letter from David Colker, Chief Executive Officer and President, 
NSX, to Jonathan G. Katz, Secretary, Commission, pp. 6-7 (June 29, 
2004) (``Reg NMS NSX letter''); Reg NMS Schwab letter, p. 2; Reg NMS 
SIA letter, pp. 3 and 22; and Reg NMS STANY letter, p. 14.
    A range of commenters believed that the current level of market 
data fees warranted review. See letter from Ellen L. S. Koplow, 
Executive Vice President and General Counsel, Ameritrade, Inc., to 
Jonathan G. Katz, Secretary, Commission, Letter, pp. 3 and 10 (June 
30, 2004) (``Reg NMS Ameritrade letter''); letter from James J. 
Angel, Ph.D., CFA, Associate Professor of Finance, McDonough School 
of Business, to Jonathan G. Katz, Secretary, Commission, Letter I, 
p. 5 (June 30, 2004)(``Reg NMS Angel letter''); Reg NMS ASA Letter, 
p. 2; Reg NMS Bloomberg Letter, pp. 2 and 8-9; letter from William 
O'Brien, Chief Operating Officer, Brut, LLC, to Jonathan G. Katz, 
Secretary, Commission, pp. 21-23 (July 29, 2004) (``Reg NMS Brut 
letter''); Reg NMS Citigroup Letter, p. 15; letter from W. Leo 
McBlain, Chairman, Financial Information Forum, and Thomas J. 
Jordan, Executive Director, Financial Information Forum, to Jonathan 
G. Katz, Secretary, Commission, p. 3 (July 9, 2004)(``Reg NMS FIF 
letter''); letter from Richard M. Whiting, Executive Director and 
General Counsel, Financial Services Roundtable, to Jonathan G. Katz, 
Secretary, Commission, pp. 6-7 (June 30, 2004) (``Reg NMS FSR 
letter''); Reg NMS Goldman Sachs letter, pp. 2 and 10; letter from 
Ari Burstein, Associate Counsel, Investment Company Institute, to 
Jonathan G. Katz, Secretary, Commission, pp. 21-22 (June 30, 2004) 
(``Reg NMS ICI letter''); Reg NMS Lek letter (no page numbers); Reg 
NMS Morgan Stanley letter, pp. 3 and 21-22; Reg NMS Nasdaq letter, 
pp. 4 and 24-26; Reg NMS NSX letter, pp. 6-7; Reg NMS Schwab letter, 
p. 2; Reg NMS SIA letter, pp. 3 and 22; Reg NMS STANY letter, p. 14; 
and Reg NMS UBS letter, p. 10.
    \262\ Many commenters believed that market data revenues should 
not be used to fund regulatory costs of the SROs. See Reg NMS 
Citigroup letter, pp. 15-16; Reg NMS FIF letter, p. 3; Reg NMS 
Goldman Sachs letter, p. 11; Reg NMS Schwab letter, p. 3; and Reg 
NMS SIA letter, pp. 3 and 23.
    \263\ Some Reg NMS commenters believed that market data fees are 
not transparent enough to allow a proper assessment of the 
appropriateness of fees charged because SROs' operating costs and 
use of revenues are not revealed. See Reg NMS Ameritrade Letter, pp. 
10-11; letter from W. Hardy Callcott, to Jonathan G. Katz, 
Secretary, Commission, pp. 2-3 (May 6, 2004) (``Callcott letter''); 
Reg NMS Goldman Sachs letter, p. 11; Reg NMS Schwab letter, p. 7; 
Reg NMS SIA letter, pp. 22-23 and 25; and Reg NMS STANY letter, pp. 
14-15.
---------------------------------------------------------------------------

    As noted above, to provide greater transparency of SRO revenues and

[[Page 71275]]

expenses, the Commission is proposing in the SRO Governance and 
Transparency Proposal to require SROs to file with the Commission 
public reports detailing their sources of revenues and their uses of 
these revenues, specifically including their costs of regulation.\264\ 
These reports could provide observers greater ability to evaluate the 
role of market data revenues in financing an SRO, and to compare these 
revenues to the expenses of operating and regulating their market. This 
information also could empower users to respond to market data fee 
changes on a more informed basis.
---------------------------------------------------------------------------

    \264\ See supra note 99.
---------------------------------------------------------------------------

    Thus, given the concerns raised in response to proposed Reg NMS 
regarding market data fees and because these issues are related to 
considerations of overall SRO funding and regulatory operations, the 
Commission is seeking comment on a number of issues.
    Question 23: Should market data revenue be used to cross subsidize 
SRO regulatory operations?
    Question 24: Are current market data fees significantly limiting 
access of market participants, investors, or other users to data? Why 
are certain market data fees more problematic than others, such as 
those associated with SRO data products that are not part of the 
consolidated quote stream? If so, which fees and why?
    Question 25: Should the Commission reconsider the flexible, cost-
based approach?
    Question 26: Should the Commission consider a narrow cost-based 
approach that takes into account only limited costs, such as 
consolidation costs?
    Question 27: On a conceptual basis, what should be included in the 
cost of generating market data?
    Question 28: Are there other, better cost-based approaches? What 
are their potential benefits and drawbacks?
    Question 29: Should the Commission require a more detailed 
explanation of how SROs spend the revenue generated from market data 
fees? Would the requirements proposed in the SRO Governance and 
Transparency Proposal that SROs detail their sources and uses of 
revenues add sufficient transparency in this area, or should more 
detailed reporting be mandated?
    Question 30: If the Commission were to implement a revised approach 
to market data fees that substantially reduced this element of SRO 
funding, would SROs be able to raise the level of other revenue sources 
to remain adequately funded to comply with their statutory obligations?
    Question 31: What SRO fees or other charges presently are under 
priced? What SRO fees or charges are over priced? On balance, are SROs 
over funded or under funded? What would be the impact on smaller SRO 
members of funding regulatory costs exclusively through regulatory 
fees?
    Question 32: If market data fees were substantially reduced and 
SROs were unable to replace these revenues from other sources, would 
SROs be able to adequately fund their regulatory operations? If an 
SRO's funding were to become insufficient because of such a decline in 
revenue, should that SRO lose its status as a registered SRO?
    Question 33: If market data fees were substantially reduced, would 
this exacerbate the conflicts inherent in the SRO system--in 
particular, the incentive to fund business functions at the expense of 
regulation?
    Question 34: To what extent would the enhancements proposed in the 
SRO Governance and Transparency Proposal mitigate these concerns about 
inherent conflicts? Are there other measures that could mitigate these 
conflicts?
    Question 35: Should the Commission require that all SRO fees and 
charges be closely related to the cost of the SRO providing the service 
in question? What would be the benefits and risks of doing so?
e. Miscellaneous Fees
    In addition to regulatory fees, transaction fees, listing fees, and 
market data fees, SROs receive revenue from a variety of miscellaneous 
sources as well. For instance, SROs charge fees for administering joint 
industry plans and market systems.\265\ SROs also derive funding from 
product licensing,\266\ investment gains, and fines. In 1998, these 
types of miscellaneous SRO fees accounted for 8% of SRO revenue,\267\ 
while, in 2003, 12% of SRO revenue was associated with these 
miscellaneous fees.\268\ This relatively significant increase (a 50% 
increase compared with the 1998 percentage for miscellaneous fees) may 
have been caused by an increase in certain SRO sources of revenue, such 
as derivative product licensing fees, and by the intervening 
establishment of SRO relationships with other markets.\269\
---------------------------------------------------------------------------

    \265\ For example, the NASD operates both the Central 
Registration Depository (``CRD'') System for registered 
representative registration and the Investment Advisor Registration 
Depository (``IARD'') system. In addition, certain SROs earn fees 
from the administration of the consolidated data networks.
    \266\ For example, Nasdaq receives licensing fees from regional 
exchanges that report trades in Nasdaq-100 Index Tracking Stock. 
Nasdaq, 2003 Annual Report 43 (2004).
    \267\ Market Data Concept Release at 70625.
    \268\ Data compiled from SRO 2003 Annual Reports. Note that the 
NYSE 1998 Consolidated Statement of Revenue did not account for 
``Data Processing Fee'' revenue. Due to an intervening change in 
accounting procedures, the NYSE 2003 Consolidated Statement of 
Revenue includes this item. To provide a more accurate comparison 
between the 1998 and 2003 percentages, ``Data Fee Processing'' 
revenue was not included in total SRO revenue for the purpose of 
calculating the percentage of total SRO revenue represented by 
miscellaneous fee revenue. Based on SRO 2003 Annual Report 
Consolidated Statements of Income certain items were allocated to 
miscellaneous fees with respect to the NYSE (``Facility and 
Equipment'' and ``Investment Income''), the BSE (``Interest'' and 
``Other''), the Phlx (``Clearing and settlement,'' ``Dividend and 
Interest,'' and ``Other''), the NASD (including Amex and Nasdaq 
consolidated statements of income) (``Dispute Resolution Fees'' and 
``Other Revenue''), the PCX (``Archipelago Revenue: Original 
Consideration Amortization,'' ``Communications,'' and ``Other''), 
the CHX (``Interest'' and ``Other''), and the CBOE (``Interest'' and 
``Other'').
    \269\ E.g., the Amex's affiliation with the NASD and Arca's 
affiliation with the PCX.
---------------------------------------------------------------------------

    The Commission specifically seeks public comment on the following 
question related to SRO miscellaneous fees:
    Question 36: In light of the recent growth in SRO revenue that is 
derived from miscellaneous fees, how important are these fees to SRO 
funding generally and will this growth trend continue? If so, how does 
this revenue pose conflicts with respect to the SRO regulatory 
function? How should these conflicts be addressed? How does it relate, 
if at all, to the SROs' fulfilling their statutory obligations?

V. Alternative Regulatory Approaches

    In order to focus consideration of the strengths and weaknesses of 
the SRO system, the following section discusses a variety of 
enhancements and alternative approaches, which would require either 
Commission or Congressional action to achieve. Specifically, this 
section will examine: (1) Proposed enhancements to the current SRO 
system; (2) implementing an independent regulatory and market corporate 
subsidiary model; (3) implementing a hybrid model; (4) implementing a 
competing hybrid model; (5) implementing a universal industry self-
regulator model; (6) implementing a universal non-industry regulator 
model; and (7) establishing direct Commission regulation of the 
securities industry. The discussion of each alternative examines how 
effectively it would manage the current SRO system's inherent 
limitations.
    It is important to note that this discussion does not attempt to 
provide an exhaustive list of every potential option and alternative 
approach that

[[Page 71276]]

could be considered. The purpose of this section is to provide a 
discussion of what appear to be some of the more promising 
alternatives. Public comment sought, however, is not limited to the 
options and alternative approaches described herein. In addition, while 
this section attempts to detail the strengths and weaknesses of the 
various options and alternative approaches, it should be noted that 
such a discussion is inherently speculative. The full range of 
strengths and weaknesses of any given option or alternative approach 
would likely not be known until that approach were fully implemented.

A. Proposed Enhancements to the Current SRO System

    The current SRO system has provided essential regulation of markets 
and members for over seven decades. Nonetheless, this system has 
inherent limitations that should be considered. This section discusses 
possible enhancements to the status quo that could be implemented to 
address these SRO limitations.
1. SRO Governance and Transparency Rulemaking
    The Commission today is proposing an SRO Governance and 
Transparency Proposal.\270\ If adopted, the proposed rulemaking would 
strengthen SRO governance, enhance SRO disclosure and reporting 
requirements, and address various issues that have arisen with respect 
to shareholder-owned SROs.\271\ The proposed governance standards would 
require SROs that are national securities exchanges and registered 
securities associations to have a majority independent board and fully 
independent Nominations, Governance, Audit, Compensation, and 
Regulatory Oversight Committees (or their equivalent).\272\ SROs also 
would be required to effectively separate their regulatory function 
from their market operations and other commercial interests.\273\
---------------------------------------------------------------------------

    \270\ See supra note 99.
    \271\ Id.
    \272\ Id.
    \273\ Id.
---------------------------------------------------------------------------

    With respect to the regulatory function, each SRO would be required 
to establish standards to assure the independence of its regulatory 
program. At a minimum, the regulatory function of an SRO would be 
required to be overseen by a Chief Regulatory Officer who reports to, 
and is evaluated by, an independent Regulatory Oversight Committee. 
Moreover, SROs would be required to provide the Commission with 
specified information concerning their regulatory programs on a regular 
basis. As part of this proposal, each SRO would be required to prepare 
for the Commission annual and quarterly regulatory reports that would 
give details regarding key aspects of the SRO's regulatory program. As 
part of the annual report, each SRO also would be required to disclose 
employment arrangements with its Chief Regulatory Officer and other key 
regulatory personnel. The filing of this regulatory program information 
is intended to bolster the Commission's SRO inspections program and 
thus would be kept confidential to the extent permitted by law.
    In addition to filing quarterly and annual reports about their 
regulatory programs, each SRO would be required to disclose publicly 
information about its regulatory program and provide greater disclosure 
regarding revenues and expenses and staffing of its regulatory program. 
Finally, the SRO Governance and Transparency Proposal proposes 
ownership and voting concentration limits on members that are broker-
dealers to mitigate the conflict of interest that would arise if a 
broker-dealer were to control a significant interest in its regulator 
or if a member could exercise too much control over the operations of 
the SRO.
    If the proposed SRO Governance and Transparency Proposal is 
adopted, a number of benefits could be gained. Regulatory conflicts 
with members, market operations, issuers, and shareholders could be 
reduced. The strict reporting lines of the Chief Regulatory Officer 
reporting to an independent board committee could reduce the SRO 
regulation conflicts. In addition, the wholly independent Regulatory 
Oversight Committee's sole responsibility for budgeting decisions with 
respect to regulatory operations could help insulate the budgeting 
process from business pressures.
    While the Governance and Transparency Proposal could help manage a 
variety of the traditional SRO limitations, it would not eliminate 
them. For instance, conflicts could persist in spite of the majority 
independent board because of the influence of representatives of large 
members serving on the board, particularly if intermarket competition 
pressures continue to increase. In addition, the fact that the 
independent directors would necessarily rely on the expertise of the 
industry directors to some degree could undermine some of the 
structural protections put in place. Moreover, the independent 
directors' own imperceptible institutional biases could compromise some 
of the structural protections.
    Concerns regarding unequal regulation and unequal regulatory 
funding across markets would persist under the SRO Governance and 
Transparency Proposal. This would be true even if each SRO's Regulatory 
Oversight Committee were to make regulatory budgeting decisions 
irrespective of business or other pressures. These committees would not 
all necessarily allocate regulatory funding in the same fashion in the 
different SROs; thus, regulatory inequalities could still exist. The 
concerns regarding conflicting SRO rules, conflicting SRO rule 
interpretations, conflicting SRO inspection regimes, and redundant 
regulatory staff and infrastructure across markets would remain under 
this proposal. Finally, the proposal also does not address potential 
intermarket trading surveillance issues.
    The Commission specifically seeks public comment on the following 
questions related to the SRO Governance and Transparency Proposal:
    Question 37: To what extent would the changes proposed in the SRO 
Governance and Transparency Proposal effectively manage inherent SRO 
limitations related to conflicts, funding, redundancies, and 
intermarket surveillance?
    Question 38: To what extent would the changes proposed in the SRO 
Governance and Transparency Proposal continue to provide the benefits 
of the current SRO system (e.g., largely self-funded system with market 
specific expertise of SRO regulatory staff enhancing rule promulgation 
and enforcement)?
    Question 39: If adopted, would the SRO Governance and Transparency 
Proposal enable the Commission, investors, and market participants to 
perceive when a particular SRO was insufficiently funding its 
regulatory function? If so, could this lead the SROs to develop and 
follow voluntary guidelines or standards with respect to regulatory 
spending levels?
    Question 40: Would the changes proposed in the SRO Governance and 
Transparency Proposal more effectively manage inherent SRO limitations 
compared to the NYSE's recent corporate and regulatory function 
restructuring? \274\
---------------------------------------------------------------------------

    \274\ See Exchange Act Release Nos. 48946 (December 17, 2003), 
68 FR 74678; 48764 (November 7, 2003), 68 FR 64380 (November 13, 
2003) (regarding NYSE governance and regulatory function 
amendments).

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[[Page 71277]]

2. Intermarket Surveillance Enhancements
    Another incremental improvement to the current system could be the 
enhancement of the Commission's and the SROs' ability to regulate 
intermarket trading activity. As discussed at length above, several 
equity markets have developed individual order audit trails, the 
options markets have developed COATS to assist in the surveillance of 
order flow in the options markets, and the ISG has developed a clearing 
level order audit trail. Full implementation of a more robust 
intermarket order audit trail for both the options and equity markets 
could enhance the surveillance of intermarket order flow. It would not 
by itself, however, manage any of the other inherent SRO limitations, 
including conflicts, regulatory redundancies, and funding problems. In 
addition, even with a consolidated order audit trail, the Commission 
would have to be vigilant in determining whether the SROs used it to 
enhance surveillance and regulation of intermarket trading.
    The Commission specifically seeks public comment on the following 
questions related to intermarket surveillance enhancements:
    Question 41: To what extent would the establishment of a more 
robust intermarket surveillance regime more effectively manage inherent 
SRO limitations related to conflicts, funding, redundancies, and 
intermarket surveillance?
    Question 42: To what extent would enhancing intermarket 
surveillance continue to provide the benefits of the current SRO system 
(e.g., largely self-funded system with market specific expertise of SRO 
regulatory staff enhancing rule promulgation and enforcement)?
    Question 43: To what extent is COATS serving as an effective tool 
for enhancing intermarket surveillance?
    Question 44: To what extent should COATS be used as a template for 
the establishment of a consolidated order audit trail for the equity 
markets?
    Question 45: To what extent are SROs effectively using intermarket 
order audit trail data to enhance surveillance?
    Question 46: What are examples of illicit intermarket trading 
activity that can be engaged in undetected by regulators?

B. Independent Regulatory and Market Corporate Subsidiaries

    Another approach would be to increase SRO regulatory independence 
through mandated SRO internal restructuring. One option would be to 
require that all SROs create independent subsidiaries for regulatory 
and market operations. This model could resemble the NASD corporate 
structure that was devised in the wake of the joint Department of 
Justice and SEC investigation into OTC market maker pricing collusion 
that resulted in a Commission enforcement action.\275\ Among the most 
important NASD Undertaking resulting from the settlement was a 
corporate restructuring of the NASD and the establishment of an 
independent regulatory corporate subsidiary, NASD Regulation, Inc. 
(``NASDR'').\276\
---------------------------------------------------------------------------

    \275\ See 21(a) Administrative Order and 21(a) Report.
    \276\ See 21(a) Report at 50-55.
---------------------------------------------------------------------------

    Under this model, regulatory staff of each SRO would be placed 
within an independent regulatory subsidiary, which would report 
directly to the corporate parent's board. Substantially all regulatory 
operations would be housed in the regulatory subsidiary, including 
examination, rulemaking, and enforcement responsibilities. All market 
operations responsibilities would be placed within an independent 
market subsidiary.
    This model would provide a more clear organizational separation 
than most SROs currently exhibit. It would help strengthen an 
independent attitude in the regulatory subsidiary, which could address 
conflicts with members, market operations, issuers, and shareholders. 
This approach might establish even more clearly defined divisions 
between the regulator and the market functions than the proposed SRO 
Governance and Transparency Proposal. While the SRO Governance and 
Transparency Proposal relies on corporate reporting lines to insulate 
the regulator function, this model would house the regulator and market 
in distinct corporate subsidiaries that would be governed by separate 
boards.
    As with making incremental changes to the current system, however, 
this model would not alleviate all SRO limitations. A primary purpose 
of the regulatory subsidiary would be supervising the competitive 
market subsidiary. Thus, the independent regulatory subsidiary would 
still be a component of a larger competitive enterprise and subject to 
business pressure on some level. With respect to regulatory funding, 
the influence of major members, issuers, and shareholders, and 
increased intermarket competitive pressure could still have a 
detrimental impact on the regulatory budgeting process. Even though an 
independent board committee would be responsible for budgeting 
decisions, there would still be reliance on major members and the 
market operation for funding. As with the approaches already described, 
the self-funding of regulatory operations by each SRO would cause a 
continued degree of unequal funding and unequal regulation across 
markets. Moreover, conflicting SRO rules, conflicting SRO rule 
interpretations, conflicting SRO inspection regimes, redundant SRO 
regulatory staff and redundant regulatory infrastructures across 
markets would remain. This approach also could reduce market specific 
knowledge on the part of regulatory staff by removing it on a corporate 
level from market operations. In addition, the intermarket trading 
surveillance issues in the system would persist.
    The Commission specifically seeks public comment on the following 
questions related to the separate market and regulatory subsidiary SRO 
structure model:
    Question 47: To what extent would the implementation of the 
separate market and regulatory subsidiary SRO structure model 
effectively manage inherent SRO limitations related to conflicts, 
funding, redundancies, and intermarket surveillance?
    Question 48: To what extent would the separate market and 
regulatory subsidiary SRO structure model continue to provide the 
benefits of the current SRO system (e.g., largely self-funded system 
with market specific expertise of SRO regulatory staff enhancing rule 
promulgation and enforcement)?
    Question 49: To what extent is the separate market and regulatory 
subsidiary SRO structure model effective in managing inherent SRO 
limitations specifically with respect to the NASD?

C. Hybrid Model

    Another option, which would require significant system 
restructuring, would be the Commission's designation of a market 
neutral single self-regulatory organization (``Single Member SRO'') to 
regulate all SRO members with respect to membership rules, including 
rules governing members' financial condition, margin practice, handling 
of customer accounts, registered representative registration, branch 
office supervision, and sale practices. The Single Member SRO would be 
solely responsible for promulgating membership rules, inspecting 
members for compliance with ``member'' rules, and taking enforcement 
action against those members that fail to comply. Each SRO that 
operates a market (``Market SRO'')

[[Page 71278]]

would be solely responsible for its own market operations and market 
regulation.
    This approach would have a variety of sub-options with respect to 
the Market SROs' role in surveillance of the market and enforcement of 
``market'' rules. For instance, the Market SROs could maintain all of 
the functions that SROs currently carry out with respect to their 
market operations, including promulgating market rules, conducting 
market surveillance, and taking enforcement action with respect to 
violations of market rules. Alternatively, the Market SROs could be 
responsible for promulgating rules and conducting surveillance, but 
enforcement actions could be referred to the Single Member SRO. Another 
option would limit the Market SROs' responsibility to market rule 
promulgation and the Single Member SRO would be responsible for all 
other market surveillance and enforcement functions.
    As with the approaches already discussed, this Hybrid model could 
improve upon the current system in a variety of respects. For instance, 
because the Single Member SRO would not be affiliated with a particular 
market, inherent conflicts that exist between the regulatory function 
and market operation of an SRO would be reduced. It would also 
eliminate duplicative regulation with respect to membership rules. This 
approach could result in beneficial synergies by the centralization of 
membership regulation, while maintaining the value of having market 
regulatory staff embedded within the Market SROs. The Single Member SRO 
would also potentially serve as a more effective liaison with the SEC, 
Congress, and international entities on behalf of the industry because 
it would be a single, market neutral voice. Depending on the extent to 
which the Single Member SRO was delegated responsibility under this 
approach for intermarket surveillance, cross-market surveillance could 
be simplified and enhanced.
    As with other models, this approach has limitations. For example, 
this approach could reduce self-regulatory knowledge of business 
practices by removing the Single Member SRO from market operations. In 
addition, this model would raise a ``boundary issue'' between member 
and market rules, in that every SRO rule would have to be characterized 
as either a ``member'' or ``market'' rule. Some rules, such as those 
related to member capital requirements, would likely be categorized as 
member rules, because they are unrelated to direct trading activity and 
deal with requirements imposed on members in support of trading 
operations. In contrast, certain rules, such as those related to the 
priority of orders on a market's trading floor or system, would clearly 
be characterized as trading rules. A variety of other rules, however, 
such as those related to front running or margin requirements, could be 
categorized as either ``market'' or ``member'' rules because they 
embody elements of both types of rules.
    While this Single Member SRO approach could reduce certain 
conflicts, it would not resolve the conflicts arising from member 
funding, and control, and from reliance on industry members for 
business experience. Also, conflicts would persist unabated in the 
Market SROs. As noted above, sub-issues with respect to the duties of 
the Market SROs would have to be determined and the extent of this 
conflict would depend on the extent of the Market SRO's regulatory 
responsibility. For instance, the Market SRO's role in market rule 
promulgation, market surveillance, and market rule enforcement would 
have to be determined.
    The concerns about unequal funding and unequal regulation of 
members would be substantially reduced. Specifically, unequal funding 
and unequal regulation with respect to member regulation would be 
eliminated because only one Single Member SRO would exist. However, 
other funding issues could arise. Either the Single Member SRO would be 
required to depend solely on regulatory fees for funding or the Market 
SROs would have to contribute to the Single Member SRO from listing, 
market data, and market operation revenues. Determining the absolute 
and relative amounts of these contributions would raise difficult 
issues. Specifically, an allocation formula would have to be devised 
for determining the relative amount that each Market SRO owed annually 
for funding the Single Member SRO. The formula could be weighted based 
on a host of complex and potentially subjective factors, including 
trading volume, average member size, number of members, type of 
security traded on the market, and type of business (e.g., agency or 
proprietary) engaged in by the SROs' members. The concern about unequal 
funding and unequal regulation would also persist with respect to the 
Market SROs. Although, inconsistent member rules, staff, and 
infrastructure would be eliminated, inconsistent market rules, staff, 
and infrastructure would remain.
    The Commission specifically seeks public comment on the following 
questions related to the Hybrid SRO structure model:
    Question 50: To what extent would the implementation of the Hybrid 
model more effectively manage inherent SRO limitations related to 
conflicts, funding, redundancies, and intermarket surveillance?
    Question 51: To what extent would the Hybrid model continue to 
provide the benefits of the current SRO system (e.g., largely self-
funded system with market specific expertise of SRO regulatory staff 
enhancing rule promulgation and enforcement)?
    Question 52: How would the Single Member SRO be funded under the 
Hybrid approach?
    Question 53: To what extent would the boundary issue with respect 
to ``member'' and ``market'' rules be a concern in implementing the 
Hybrid approach? Which types of rules would be subject to the 
``boundary'' problem (i.e., which types of rules could be categorized 
either as ``market'' or ``member'' rules)? How should these 
``boundary'' issue rules be categorized and why?
    Question 54: In establishing itself, should the Single Member SRO 
draw personnel, facilities, or other assets from the existing SROs? If 
so, would the Market SROs from which personnel, facilities, or assets 
were drawn be able to replace those resources? Would there be any 
conflicts of interest with respect to Single Member SRO personnel 
allegiance to their former Market SROs?
    Question 55: To what extent should the Market SROs or the Single 
Member SRO under the Hybrid approach be responsible for market rule 
promulgation, market surveillance, and enforcement of market rules?

D. Competing Hybrid Model

    Another approach involving a significant departure from the current 
system would be a derivative of the Hybrid approach. Under this 
approach, Market SROs would exist as in the pure Hybrid approach and 
market regulation would be conducted separately from member regulation. 
Rather than one Single Member SRO, however, this approach would permit 
the existence of multiple competing member SROs (``Competing Member 
SROs''), which would be required to be registered with the Commission 
and, thereby, authorized to provide member regulatory services. Under 
this approach, each Market SRO member would also have to be a member of 
one of the Competing Member SROs. A Competing Member SRO would charge 
its members a regulatory fee. Because of the potential disparity in 
bargaining

[[Page 71279]]

power between the Competing Member SROs and individual brokerage firms, 
this regulatory fee would likely need to be subject to appropriate 
oversight, including Commission approval. The Competing Member SROs 
would be responsible for promulgating the range of member rules 
described in the Hybrid discussion, inspecting members for compliance 
with member rules, and taking enforcement action against those members 
that fail to comply. Under this approach, as with the pure Hybrid 
approach, Market SROs would retain their market regulatory 
responsibilities.
    Under this approach, members of Competing Member SROs would have 
the right to periodically switch Competing Member SROs. A limit on the 
frequency with which members could switch between Competing Member SROs 
would likely need to be imposed for a variety of reasons. For instance, 
members could conceivably avoid being effectively regulated by 
switching between Competing Member SROs whenever regulatory action 
loomed. Further, Competing Member SROs may not vigorously regulate 
important members that are able to switch to another Competing Member 
SRO, if the members believe they can receive more lenient regulation 
from a different Competing Member SRO. In addition, longer Competing 
Member SRO experience with a particular member would likely result in 
increased institutional knowledge and potentially more effective 
regulation.
    As with the pure Hybrid model, this approach would have a variety 
of sub-issues to be resolved with respect to the Market SROs' role in 
promulgating market rules, conducting surveillance of the market, and 
enforcement of market rules. For instance, the Market SROs could 
maintain all of the functions that SROs currently carry out with 
respect to their market operations. Alternatively, the Market SROs 
could be responsible for promulgating market rules and conducting 
market surveillance, but enforcement actions could be referred to the 
Competing Member SRO of the offending Market SRO member. Another option 
would be the Market SROs being responsible solely for market rule 
promulgation and the Competing Member SROs being responsible for all 
other market surveillance and enforcement functions. This approach 
would also require considering whether Competing Member SROs should be 
required to have uniform membership rules to ensure uniformity of rules 
governing the membership of each market and to limit the potential for 
regulatory arbitrage. In addition, difficult issues would have to be 
addressed with respect to the criteria for a Commission determination 
as to whether a Competing Member SRO was ``authorized'' to provide 
member regulation.
    This model carries with it a variety of benefits. For example, as 
with the pure Hybrid model, if uniform membership rules were required, 
this approach could significantly reduce conflicts and inconsistent 
application and enforcement with respect to membership rules. In 
addition, it would concentrate membership regulatory expertise in a 
small number of entities, while continuing to foster market specific 
expertise in the regulatory staff embedded in Market SROs. As with the 
Hybrid model, the Competing Member SROs could be more effective 
liaisons with the SEC, Congress, and international entities on behalf 
of the industry.
    This approach would be a compromise between the Single Member SRO 
approach and the current system of numerous redundant SRO member 
regulators. Moreover, this approach would not require the potential 
elimination of one of the existing primary member regulators in favor 
of another. Depending on the extent to which the Competing Member SROs 
are delegated responsibility for inter-market surveillance (and if 
ultimately a limited number of these Competing Member SROs are 
registered), cross-market surveillance could be simplified and 
enhanced. Finally, this model might succeed in centralizing member 
regulation to a much greater extent than under the current system, but 
at the same time foster competitive discipline by allowing Competing 
Member SROs to compete with each other.
    As with the approaches already discussed, this model has 
significant drawbacks. For instance, and as discussed above, it would 
require the same difficult ``boundary issue'' determinations between 
``market'' and ``member'' rules to be made as would be made under the 
Hybrid approach. As with the pure Hybrid approach, this model could 
reduce self-regulatory experience by separating self-regulatory member 
staff from market operations. Moreover, conflicts with members, market 
operations, issuers, and shareholders would remain unabated in the 
Market SROs.
    Competition could result in an effort by the Competing Member SROs 
to reduce their fees to attract and keep members and the Commission 
would ultimately continue to be responsible for determining whether 
funding remained adequate. This model could reduce conflicting member 
rules, but would only eliminate these conflicting rules if the 
Competing Member SROs adopted a uniform set of member rules. In 
addition, conflicting market rules across Market SROs would still 
exist. Ideally, under this approach, competitive forces would 
discipline the Competing Member SROs and discourage them from becoming 
unresponsive.
    As noted above, a significant issue with the Competing Member SRO 
model would be the ability of an SRO to discipline members if the 
members could then choose another regulator. This could be addressed by 
limitations on the ability of members to make changes or a charge for 
switching from one regulator to another, but such barriers might tend 
to diminish the benefits of competition.
    Finally, if the NASD should be one of the Competing Member SROs, 
its specific role in overseeing the OTC market and its operation of the 
ADF, in particular, would also require further analysis under this 
model. While the NASD, as a registered national securities association 
under Exchange Act Section 15A,\277\ is responsible for overseeing OTC 
broker-dealer activity, many of its rules related to member use of the 
ADF could be characterized as market rules (e.g., NASD Rule 4300A 
regarding direct and indirect electronic access to best bids and offers 
posted in the ADF).
---------------------------------------------------------------------------

    \277\ 15 U.S.C. 78k-1.
---------------------------------------------------------------------------

    The Commission specifically seeks public comment on the following 
questions related to the Competing Hybrid SRO structure model:
    Question 56: To what extent would the implementation of the 
Competing Hybrid SRO structure model effectively manage inherent SRO 
limitations related to conflicts, funding, redundancies, and 
intermarket surveillance?
    Question 57: To what extent would the Competing Hybrid SRO 
structure model continue to provide the benefits of the current SRO 
system (e.g., largely self-funded system with market specific expertise 
of SRO regulatory staff enhancing rule promulgation and enforcement)?
    Question 58: What should the criteria be upon which Competing 
Member SROs would be registered under the Competing Hybrid approach?
    Question 59: What would be the ideal number of Competing Member 
SROs under the Competing Hybrid approach?
    Question 60: What limitations, if any, should be placed on members' 
ability to change Competing Member SROs?

[[Page 71280]]

    Question 61: Should the Competing Member SROs be required to adopt 
a uniform set of member rules?

E. Universal Industry Self-Regulator

    Another model, which would require significant restructuring, would 
be the establishment of a universal industry self-regulator 
(``Universal Industry Self-Regulator''). Under this model, one industry 
self-regulatory organization would be responsible for all market and 
member rules for all members and all markets. The current SROs' self-
regulatory authority would be transferred to the Universal Industry 
Self-Regulator, including member and market rulemaking, member and 
market surveillance, and member and market rule enforcement. This 
approach likely would require legislation or significant restructuring 
of the current SROs.\278\ Under this approach, all member firms would 
be registered directly with the Universal Industry Self-Regulator and 
all markets would be non-SROs registered with the Universal Industry 
Self-Regulator similar to how ATSs are currently registered with SROs. 
Under this approach, the markets' self-regulatory authority would be 
eliminated.
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    \278\ See Exchange Act Sections 6 and 15A, 15 U.S.C. 78f and 
78k-1. It is conceivable that this approach could be achieved by the 
SROs engaging in an omnibus market and member regulatory agreement 
pursuant to Exchange Act Rule 17d-2, 17 CFR 240,17d-2. However, this 
approach would require significant restructuring of the existing 
SROs.
---------------------------------------------------------------------------

    This model could resolve weaknesses of prior alternatives in a 
variety of ways. For instance, and as discussed above, it would erase 
the ``boundary'' issues between market and member rules associated with 
the Hybrid and Competing Hybrid Models because one entity would be 
responsible for all ``market'' and ``member'' rules. This model would 
establish a level playing field among competing markets in that they 
would all be subject to the same uniform standards of a single SRO. The 
Universal Industry Self-Regulator would benefit from a broader 
knowledge of regulated entities and markets because it would be 
responsible for all member and market regulation. Because one SRO would 
exist that would not be subject to inter-market competition, conflicts 
with market operations, issuers, and shareholders would be almost 
entirely eliminated as would regulatory redundancies.
    Moreover, this approach would address the arguments that unequal 
funding of regulatory operations and unequal allocation of costs for 
regulation across the markets cause market distortions. Specifically, 
the existence of one SRO would prevent unequal regulation in the sense 
that only one entity would be responsible for the regulation across all 
markets. Because one SRO would be in possession of all regulatory data 
(rather than it being held by disparate SROs), this model would also 
facilitate the development of a consolidated order audit trail for 
intermarket trading and better enable the regulation of intermarket 
trading. Because of the central role the Universal Industry Self-
Regulator would play in the U.S. securities markets, demutualization of 
the entity would likely be prohibited. Thus, the primary concern of the 
profit motive of a shareholder owned market detracting from proper 
self-regulation could be eliminated under this approach as well.
    As with other models discussed, this approach has limitations. The 
Universal Industry Self-Regulator would be precluded from being a 
market specific regulator and as such would likely lack market specific 
expertise. In addition, member conflicts would still remain under this 
approach in that the Universal Industry Self-Regulator would still rely 
on members for funding. As discussed above, this conflict would be 
further complicated if the Universal Industry Self-Regulator became 
particularly dependent on certain large members for the 
disproportionately large amount of funding that they provide the SRO in 
regulatory fees. This universal approach would still require separate 
market rules to account for different market structures and types of 
securities traded. For instance, the market operation of an options 
exchange has markedly different trading rules than an equity exchange. 
There would also be the potential under this model for the functions of 
the Universal Industry Self-Regulator and the SEC to overlap with one 
another. Moreover, the potential for the Universal Industry Self-
Regulator to become unresponsive to industry developments would greatly 
increase because of its size, scope, and lack of competition. Finally, 
implementing this model would effectively result in the elimination of 
the existing SROs' role and, thus, could be met with significant 
resistance.
    The Commission specifically seeks public comment on the following 
questions related to the universal industry self-regulator SRO 
structure model:
    Question 62: To what extent would the implementation of the 
Universal Industry Self-Regulator model effectively manage inherent SRO 
limitations related to conflicts, funding, redundancies, and 
intermarket surveillance?
    Question 63: To what extent would the Universal Industry Self-
Regulator model continue to provide the benefits of the current SRO 
system (e.g., largely self-funded system with market specific expertise 
of SRO regulatory staff enhancing rule promulgation and enforcement)?
    Question 64: Would the NASD's role as the regulator of the OTC 
market be completely occupied by the Universal Industry Self-Regulator 
or would there be a continuing need for the NASD's existence?
    Question 65: To what extent would the Universal Industry Self-
Regulator compete or conflict with the Commission?

F. Universal Non-Industry Regulator

    Another approach, which would also require significant industry 
reshaping, would be the establishment of a universal non-industry 
regulator (``Universal Non-Industry Regulator''). Under this approach, 
one non-industry entity would be designated to be responsible for all 
markets and member regulation for all members and all markets. As with 
the Universal Industry Self-Regulator, this model would require all 
member firms to be registered with the Universal Non-Industry 
Regulator. All markets would be registered with the Universal Non-
Industry Regulator similar to how ATSs are currently registered with 
SROs and would not have any self-regulatory authority. The Universal 
Non-Industry Regulator would be solely responsible for promulgating 
member and market rules, inspecting for compliance with member and 
market rules, and taking enforcement action with respect to member and 
market rules.
    While not exactly analogous, this model could resemble the 
regulatory regime recently adopted for audits of public companies. 
Specifically, the Public Company Accounting Oversight Board (``PCAOB'') 
was established, pursuant to the Sarbanes-Oxley Act,\279\ as an 
independent, non-profit corporation, to oversee the audits of public 
companies that are subject to the securities laws, and related matters, 
in light of significant failings in self-regulatory oversight of the 
accounting profession.\280\ If this approach were to

[[Page 71281]]

be adopted in the securities industry, an independent, non-profit, non-
governmental body could be established to be the Universal Non-Industry 
Regulator. The board of the Universal Non-Industry Regulator would 
consist of full-time members appointed by the Commission, and would be 
tasked with overseeing all member and market rules for all members and 
all markets. The SEC would have ongoing oversight responsibility for 
supervising the universal regulator, including appointing and removing 
members, approving its budget, and approving its rules. The Universal 
Non-Industry Regulator approach would reduce substantially, if not 
eliminate, the industry's self-regulatory role in that the universal 
regulator's board would be entirely selected by the Commission and its 
staff would be entirely appointed by the board.
---------------------------------------------------------------------------

    \279\ Pub. L. 107-204, 116 Stat. 745 (2002).
    \280\ Prior to the establishment of the PCAOB, the American 
Institute of Certified Public Accountants (``AICPA'') established 
and interpreted Generally Accepted Auditing Standards (``GAAS''). 
The AICPA is a private, professional organization composed of 
certified public accountants (``CPAs''). The Public Oversight Board 
(``POB''), created by the AICPA, administered peer reviews of CPAs 
to assess whether CPAs' auditing practices were in conformity with 
GAAS. Jerry W. Markham, Accountants Make Miserable Policemen: 
Rethinking the Federal Securities Laws, 28 N.C.J. Int'l L. & Com. 
Reg. 725, 764-80 (2003). In addition, the Financial Accounting 
Standards Board (``FASB'') promulgated Generally Accepted Accounting 
Principles (``GAAP'').
    The PCAOB was given broad authority, including the power: (1) to 
register public accounting firms; (2) to set rules covering 
auditing, ethics, quality control and independence standards; (3) to 
inspect the auditing operations of registered public accounting 
firms; (4) to investigate and discipline registered public 
accounting firms and associated persons of such firms; and (5) to 
enforce compliance with the new legislation, the PCAOB's own rules 
and certain securities laws. The standards for audits of public 
companies are now set by the PCAOB, not the accounting profession. 
While the AICPA still has a role in setting the standards for audits 
of non-public companies, the POB has been terminated. There has been 
no change in the setting of accounting standards, where the FASB, as 
the standards-setting body designated by the Commission, retains 
primary responsibility for the promulgation of GAAP, subject to the 
Commission's oversight. Markham at 790-92.
---------------------------------------------------------------------------

    The sources of funding for this model would have to be established. 
The PCAOB is primarily funded through accounting support fees, as 
provided in the Sarbanes-Oxley Act, paid by issuers.\281\ The goal of 
this funding structure is to ensure that the PCAOB's funding is 
independent of both the accounting profession and the federal 
government.\282\ A determination by Congress would have to be made as 
to whether shifting the significant cost of regulation of the 
securities industry to issuers would be appropriate or if some other 
funding structure would be more appropriate (such as a fee on trades or 
on markets and broker-dealer revenues).\283\
---------------------------------------------------------------------------

    \281\ Section 109 of the Sarbanes-Oxley Act.
    \282\ The Sarbanes-Oxley Act provides that the PCAOB be funded 
by accounting support fees assessed on issuers as defined therein. 
Each year the PCAOB develops an operating budget that must be 
approved by the Commission. The 2003 PCAOB budget, as approved by 
the Commission, was $68 million. The accounting support fees are 
equal to the PCAOB's total budgeted outlays for the fiscal year in 
which they are set, less the amount of fees received from public 
accounting firms to cover the cost of processing and reviewing 
registration applications. The accounting support fees are based on 
the average monthly U.S. equity market capitalization of publicly 
traded companies, investment companies, and other equity issuers. 
Issuers with average market capitalizations below $25 million and 
investment companies with net assets of less than $250 million are 
exempt from the fees. PCAOB, 2003 Annual Report 15 (2004). The 2004 
PCAOB accounting support fee, as approved by the Commission, was 
$101 million.
    \283\ Total combined SRO operating expenses in 2003 were over 
$2.4 billion. See supra note 197.
---------------------------------------------------------------------------

    This model would have several advantages over other approaches. For 
instance, this approach would likely eliminate the member rule and 
market rule boundary concerns that exist under the Hybrid and Competing 
Hybrid approaches. Even more than the Hybrid and Competing Hybrid 
approaches, this model would result in broad interaction between the 
regulator, members, and markets. Conflicts with members, market 
operations, issuers, and shareholders would be substantially eliminated 
under this model because the entity would have no direct affiliation 
with any of those constituencies. Regulatory redundancies would also be 
effectively diminished because the Universal Non-Industry Regulator 
would be responsible for all ``member'' and ``market'' rules for all 
members and markets. This would be particularly true if the NASD's role 
were completely subsumed by the new Universal Non-Industry Regulator. 
As with the Hybrid and Competing Hybrid models, this approach would 
address the concern of unequal funding and unequal allocation of 
regulatory costs across markets. Moreover, cross market surveillance 
would likely be facilitated by this approach because the Universal Non-
Industry Regulator would be responsible for all regulatory data from 
all markets. Because of the critical role the Universal Non-Industry 
Regulator would play in the U.S. securities markets, demutualization of 
the entity would likely be prohibited. Thus, the primary concern of the 
profit motive of a shareholder owned market detracting from proper 
self-regulation could be eliminated under this approach as well.
    This model also has serious drawbacks. For example, it could result 
in a lower degree of market specific expertise in the regulator. In 
addition, the degree of direct industry involvement with respect to 
rulemaking and enforcement would be significantly reduced, which could 
reduce the Universal Non-Industry Regulator's ability to refine and 
target its regulation. Market rules would still differ to account for 
different market structures and types of securities traded. As with the 
Universal Industry Self-Regulator, there would be the potential under 
this model for the regulatory entity and the SEC to overlap or even 
compete with one another. In addition, there is also the risk that this 
model would become inefficient, inflexible, and unresponsive to 
evolutionary market practices. Also similar to the Universal Industry 
Self-Regulator, this model would likely require legislation and could 
be met with resistance from the existing SROs, whose SRO role would be 
largely eliminated.
    The Commission specifically seeks public comment on the following 
questions related to the Universal Non-Industry Regulator model:
    Question 66: To what extent would the implementation of the 
Universal Non-Industry Regulator model effectively manage inherent SRO 
limitations related to conflicts, funding, redundancies, and 
intermarket surveillance?
    Question 67: To what extent would the Universal Non-Industry 
Regulator model continue to provide the benefits of the current SRO 
system (e.g., largely self-funded system with market specific expertise 
of SRO regulatory staff enhancing rule promulgation and enforcement)?
    Question 68: How would the Universal Non-Industry Regulator model 
be funded?
    Question 69: What would be the relationship between the Universal 
Non-Industry Regulator, the Commission, and the NASD under this model?

G. SEC Regulation

    Another alternative that will be discussed in this section would be 
the termination of the SRO system in favor of direct Commission 
regulation of the industry. Under this approach, the Commission would 
be solely responsible for the market and member regulation of all 
members and all markets. All member firms and markets would be required 
to register directly with the Commission under this model. Markets 
would be non-SROs registered with the Commission similar to how ATSs 
are currently registered with SROs. The markets' registered status, 
however, would carry with it no self-regulatory authority. The 
Commission would be responsible for the promulgation of detailed member 
and market rules, the surveillance of members and markets, and the 
enforcement of member and market

[[Page 71282]]

rules. With respect to funding, this model would require dramatic 
change in that the public would be directly responsible for 
substantially all of the costs of regulating the industry, albeit 
perhaps, through a range of fees imposed on the industry for the 
Commission's increased services. The Commission, however, is not self-
funded under its enabling statute and, thus, Congress would need to 
appropriate funds for this approach.\284\
---------------------------------------------------------------------------

    \284\ Although the Commission currently deposits the variety of 
fees that it collects in the U.S. Treasury, where its deposits are 
treated as offsetting collections and not general funds of the 
Treasury, it cannot deposit its fees in a depository institution, 
and its monies are annually appropriated and apportioned. U.S. 
General Accounting Office Report to Congressional Committees, ``SEC 
Operations `` Implications of Alternative Funding Structures,'' 1 
(July 2002).
---------------------------------------------------------------------------

    Benefits could be gained from this approach. For instance, because 
only one centralized regulator would exist, SEC direct regulation would 
eliminate substantially all of the conflicts that exist between SRO 
regulation and members, market operations, issuers, and shareholders. 
As with the Hybrid, Competing Hybrid, Universal Industry Self-
Regulator, and Universal Non-Industry Regulator approaches, direct SEC 
regulation would provide the Commission with a broader understanding of 
the members and markets. Conflicting member rules, interpretations, and 
inspection regimes, and regulatory redundancies would be eliminated 
under this model because the Commission would be able to adopt uniform 
member rules. The Commission would need to adopt numerous detailed 
operations and conduct rules for members to replace existing SRO rules 
related to business practices and just and equitable principles of 
trade. Cross market surveillance would likely be facilitated by this 
approach because the relevant regulatory data would be collected and 
examined by the Commission, rather than by disparate SROs. In addition, 
this model could potentially align the U.S. regulatory scheme more 
closely with those of a variety of other countries.\285\
---------------------------------------------------------------------------

    \285\ For instance, the Financial Services Authority (``FSA'') 
was created in the United Kingdom in 1997 and is an ``independent 
non-governmental body which exercises statutory powers.'' Through 
the creation of the FSA, the duties of nine regulatory entities were 
consolidated and the use of the British equivalent of U.S. SROs was 
abandoned. The FSA was given extensive financial regulation 
responsibility, assuming the same roles played in the U.S. by the 
SEC, the Commodity Futures Trading Commission, federal and state 
banking regulators, state insurance and state securities 
commissions, as well as the SROs. Among other initiatives, the FSA 
has assigned one office to develop policy on prudential issues 
across all financial sectors, so as to develop a common approach to 
risk and capital requirements. The agency also announced that it was 
streamlining the existing financial services rules and has been 
focusing its regulatory attention on high-risk firms. See Jerry W. 
Markham, A Comparative Analysis of Consolidated and Functional 
Regulation: Super Regulator: A Comparative Analysis of Securities 
and Derivatives Regulation in the United States, United Kingdom, and 
Japan, 28 Brooklyn J. Int'l L. 319, 374-82 (2003).
---------------------------------------------------------------------------

    An SEC-only approach would also have numerous problems. The SEC 
would be responsible for detailed regulation and interpretation of 
complex areas previously the province of SROs, without the aid of 
direct industry involvement and with a significant lessening of 
industry input in rulemaking. Market specific rules, under this model, 
would still conflict because of the markets' different market 
structures and types of securities traded. Direct Commission regulation 
would be governed by the limitations and rules addressing federal 
rulemaking and would be undertaken in a political environment and the 
cost of carrying out all of the duties of the SROs would be extensive. 
It is important to note that the Commission has attempted to undertake 
direct SRO level regulatory duties in the past. As discussed above, the 
Commission ultimately requested that Congress terminate the SECO 
program because the Commission could not effectively carry out the 
detailed responsibilities required.\286\
---------------------------------------------------------------------------

    \286\ See supra note 181.
---------------------------------------------------------------------------

    The Commission specifically seeks public comment on the following 
questions related to the direct SEC regulation model:
    Question 70: To what extent would the implementation of the direct 
SEC regulation model effectively manage inherent SRO limitations 
related to conflicts, funding, redundancies, and intermarket 
surveillance?
    Question 71: To what extent would direct SEC regulation continue to 
provide the benefits of the current SRO system (e.g., largely self-
funded system with market specific expertise of SRO regulatory staff 
enhancing rule promulgation and enforcement)?
    Question 72: Could current SRO staff be effectively drawn upon by 
the Commission under the direct SEC regulation model, or would this 
staff be inappropriately influenced by their prior affiliations with 
specific SROs?

H. Other Models

    Alternative models of regulation exist that were not specifically 
explored in this release. Such approaches may be variations of the 
above alternatives or completely different models. The Commission 
specifically seeks public comment on the following question:
    Question 73: Are there any other approaches to regulation of the 
securities industry that are worthy of consideration whether discussed 
herein or not? Should the current model remain unaltered?

VI. Solicitation of Additional Comments

    In addition to the areas for comment identified above, we are 
interested in any other issues that commenters may wish to address 
relating to the current structure of the SRO system, potential 
enhancements that could be made to the current system, or potential 
models that could be implemented that would restructure the SRO system. 
Please be as specific as possible in your discussion and analysis of 
any additional issues. Where possible, please provide empirical data or 
observations to support or illustrate your comments.

    By the Commission.

    Dated: November 18, 2004.
Margaret H. McFarland,
Deputy Secretary.
[FR Doc. 04-26154 Filed 12-7-04; 8:45 am]
BILLING CODE 8010-01-P


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