Turning Seats Into Shares: Implications of Demutualization for the Regulation of Stock Exchanges

A dramatic shift in the economic and power structure of the securities industry is currently in progress. Although competition to traditional markets from electronic trading markets may be the precipitating cause of this upheaval, more than technology is driving these changes. The worldwide rise in stock exchange trading volume, global integration of the capital markets and competition for trading profits are leading to disintermediation at a rate that the securities markets have not experienced since the unfixing of commission rates. Looming on the horizon is decimalization which will further cut the conventional trading increment to a penny or less. Another important development is the ongoing demutualization of the National Association of Securities Dealers Inc. (NASD) and the future demutualization of the New York Stock Exchange, Inc. (NYSE). Traditionally, stock exchanges have operated in the form of non-profit mutual or membership organizations. To the extent market power was not curtailed by competition or regulation, mutual governance gave specialist or market maker members of an exchange control of the price, quality and range of services produced by the exchange. Exchange profits were returned to broker and dealer members in the form of lower access fees or trading profits. Further, exchanges have long operated as self-regulatory organizations (SROs) with members contributing their time to governance and self-regulation to make exchanges more effective and more profitable. Self-regulation was enshrined in the federal securities laws with oversight by the Securities and Exchange Commission (SEC). In addition, in 1975 the Securities Exchange Act of 1934 (Exchange Act) was amended to impose certain corporate governance structures on exchanges. The pressure to reduce trading execution costs, the demands for technological innovation and demutualization are raising many market structure issues. These include regulation of electronic communication networks; market fragmentation; linkages; market information fees and other exchange revenues; the fair treatment of customer orders; and perhaps most importantly, the future of self-regulation. New competitive strategies by exchanges and their members, including demutualization, are raising conflicts of interest questions about self-regulation that the SEC has only begun to address. This article will argue that the SEC is attempting to re-regulate market structure under a command and control model pursuant to the national market system provisions injected into the Exchange Act in 1975 at a time when the monopoly trading regime which led to the national market system mandate is breaking down. Further, this model is probably doomed to fail unless the securities industry endorses the SEC's market structure initiatives. An interesting and relevant question this article will pose is whether current trading technologies and the competition these technologies have engendered should lead to a reduction of SEC market regulation, rather than the increase in regulation envisioned by current SEC concept and rulemaking releases, so that competition rather than regulation can determine outcomes. This article will also inquire about the future of self-regulation and stock exchange governance in a world where stock exchanges are not mutual organizations. As a general matter, judging from developments in other countries, demutualization may lead to a transfer of regulation from exchanges to government regulators. A countervailing trend could be that national regulators will be unable to engage in as effective regulation of trading markets in a trading environment that moves across boundaries with the click of a mouse. Therefore, self-regulation will be required to assure that global markets are fair and honest.