The federal regulatory structure of the U.S. securities markets was established by the Securities Exchange Act of 1934 (the Exchange Act). Congress also created SEC as an independent agency to oversee the securities markets and their participants. Under the Exchange Act, the U.S. securities markets are subject to a combination of industry self- regulation (with SEC oversight) and direct SEC regulation. This regulatory scheme was intended to give SROs responsibility for administering their ordinary affairs, including most of the daily oversight of the securities markets and broker-dealers. The Exchange Act provides for different types of SROs, including national securities exchanges and national securities associations. Entities operating as national securities exchanges or associations are required to register as such with SEC. As of March 31, 2002, nine securities exchanges were registered with SEC as national securities exchanges. As of the same date, NASD was the only registered national securities association; NASD Regulation (NASDR) is its regulatory arm. Although it is the SRO, NASD delegates to NASDR, its wholly owned subsidiary, SRO responsibilities for surveilling trading on Nasdaq and the over-the-counter market and for enforcing compliance by its members (and persons associated with its members) with applicable laws and rules. Nasdaq also surveils trading on its market and refers potential violations to NASDR and SEC for investigation. While NASD is currently the parent company of Nasdaq, NASD is in the process of selling Nasdaq. Recognizing the inherent conflicts of interest that exist when SROs are both market operators and regulators, the Exchange Act states that to be registered as a national securities exchange or association, SEC must determine that the exchange’s or association’s rules do not impose any burden on competition and do not permit any unfair discrimination. SROs are also responsible for enforcing members’ compliance with their rules and with federal securities laws by conducting surveillance of trading in their markets and examining the operations of member broker-dealers. The Exchange Act also mandates that securities SROs operate under direct SEC oversight and authorizes SEC to ensure that SROs do not abuse their regulatory powers. SEC inspects SROs to ensure that they are fulfilling their SRO duties, focusing on, among other things, the quality of SRO financial operations examination programs; market surveillance, investigations, and disciplinary programs; and customer complaint review programs. SEC also reviews rule changes proposed by SROs for consistency with the Exchange Act and SEC rules. Finally, SEC provides direct regulation of the markets and their participants in a number of ways, including direct examinations of broker-dealers, investigations into markets and their participants, disciplinary actions for violations of the Exchange Act, and promulgation of rules and regulations. Nasdaq increasingly has been in competition with NASD members that operate as ECNs, while NYSE has competed for many years with members that trade its listed securities off of the exchange. This competition has heightened some SRO members’ concerns that an SRO could abuse its regulatory authority through rule-making processes, disciplinary actions, or use of proprietary information. Market participants expect that demutualization will increase the ability of exchanges and other markets to compete both domestically and internationally, however, their views differ on how it might affect potential abuses of regulatory authority related to conflicts of interest. SEC generally concluded that it is too soon to predict the effects of demutualization. Concerns about conflicts of interest persist despite measures by SEC and the SROs that are intended to address them. NASD’s dual roles as the owner-operator of Nasdaq and as the primary SRO for the 11 ECNs that compete with Nasdaq have created conflicts of interest between NASD’s economic interests and regulatory responsibilities, which NASD’s pending spin off of Nasdaq is intended to mitigate (discussed further below). SEC regulations require ECNs, as registered broker-dealers, to be members of at least one SRO. According to an ECN official, the ECNs chose NASD as their primary SRO because the unique trading rules as well as other features of the Nasdaq market were conducive to the growth of the ECNs’ business. ECNs are an alternative to the Nasdaq market for trading in Nasdaq stocks. They differ from Nasdaq and registered exchanges principally in that they do not require an intermediary to execute orders. ECNs match orders electronically and anonymously, while Nasdaq broker-dealers, in their roles as market makers, act as intermediaries for all customer orders. In deciding whether to use an ECN or a Nasdaq market maker, customers consider such factors as execution quality, transaction costs, and anonymity. The number of ECNs and their share of total Nasdaq volume have grown significantly since 1993. According to SEC, in 1993 all alternative trading systems (including one ECN) accounted for about 13 percent of the total volume in Nasdaq securities. By October 2001, ECNs alone accounted for over 30 percent of the total volume in Nasdaq securities. SEC and certain ECNs have attributed a significant part of the growth in the volume of Nasdaq securities traded on ECNs to the SEC order- handling rules that SEC promulgated to enhance competition and pricing efficiency in the securities markets. Before the rules became effective in 1997, only ECN subscribers had access to the orders and, thus, to the prices that ECNs displayed for Nasdaq securities. Implementation of the rules resulted in ECNs’ orders for Nasdaq securities being displayed and accessible to the public on Nasdaq, thereby providing the public an opportunity to obtain any better prices that might be available on ECNs.According to one ECN, both Nasdaq’s access to ECNs and the efficiencies that ECNs brought to the Nasdaq market through the electronic matching of orders have contributed to the overall growth of trading in Nasdaq securities. NYSE, as an SRO that operates a market, has also confronted conflicts of interest between its economic interests and its regulatory responsibilities. Specifically, for many years the exchange has regulated competing member broker-dealers that trade its listed stocks off of the exchange. Customer orders for NYSE stocks that are not sent to the floor of the exchange to be executed are executed internally by a broker-dealer or in an alternative market. A broker-dealer internalizes an order when it executes a customer order for a security in house or directs the order to an affiliated dealer, instead of sending the order to an exchange or another market. Numerous large broker-dealers that are NYSE members have also established relationships with regional exchange specialists and sometimes route their orders to them instead of to NYSE. In addition, member broker-dealers direct orders to alternative markets, such as ECNs or third-market broker-dealers. Competition with member broker-dealers may increase with the May 2000 rescission of NYSE Rule 390, which had restricted off-exchange trading by NYSE members in NYSE-listed securities. Some SRO members expressed concern that increased competition between SROs and their members had given SROs a greater incentive to abuse their regulatory authority. These members were concerned that SROs could adopt rules that unfairly impede the ability of members to compete against the SROs—for example, by adopting rules that give preference to noncompetitors’ orders. An official from one broker-dealer also noted that an SRO might sanction a competing member more severely than other members by, for instance, inappropriately concluding that the member had failed to satisfy its best-execution obligation when it routed an order to a competing market for execution rather than to the SRO. ECNs have also expressed concern that an SRO, in its regulatory capacity, could obtain proprietary information from a member and, in its capacity as a market operator, inappropriately use the information. For example, an SRO might obtain proprietary information about its members’ customers and then use that information to market its services to the customers. Some institutional market users that were not SRO members were more broadly concerned about how conflicts of interest in the self-regulatory structure affected the fairness and efficiency of the securities markets. These market users asserted that the self-regulatory structure was inherently biased in favor of broker-dealers that were SRO members and owners and that SROs interpreted their rules to favor these broker-dealers. These market users, as well as some broker-dealers, told us that they did not believe that their concerns were addressed when these concerns diverged from the interests of the most powerful broker-dealers at the exchange. Market users also said that the current self-regulatory structure ultimately impeded market-driven innovations that could improve competition and benefit the investing public. One investment company official cited NYSE Rule 390, which had been in place for 20 years, as a classic example of the difficulty of repealing an anticompetitive SRO rule. Demutualization has heightened the concerns of some SRO members about the potential for abuses of regulatory authority. They expressed concern that a demutualized, for-profit market operator might be more likely to misuse its regulatory authority or be less diligent in fulfilling its regulatory responsibilities in a desire to increase profits. For example, demutualized SROs might have a greater incentive to propose rules that unfairly disadvantage members or other markets or inappropriately sanction or otherwise discipline members against which the SROs compete. Other SRO members expressed concern that demutualized market operators might have a greater incentive to either insufficiently fund or otherwise inadequately fulfill their self-regulatory responsibilities. However, other market participants believed demutualization could reduce at least some conflicts and lead to needed changes in market structure.