Poonam Mehra
National Institute of Securities Markets
Self Regulation in 10th Century A.D.

The Maghribi were Jewish traders (centered in Baghdad) until the
first half of the 10th century

Uncertainty and complexity of trade
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Operated through business associates for business dealings
abroad
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Agency relations at the time were characterized by asymmetric
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Verification and tracing difficult
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Solution: Formation of coalition
 Coalition members were governed by an implicit contract which
stated that members would employ only member agents.
 Any agent who treated a member unfairly could never hope to do
business again with other members.
 Potential Loss in business prevented cheating or double crossing on
part of agents
Self Regulation

Looking after own affairs: the system by which an
organization or institution deals with its own disciplinary
and legal problems, often in private, rather than being
publicly regulated by somebody else
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Self Regulatory Organization
Private Arrangement: trade associations

Some examples of SROs include
 stock exchanges,
 the Investment Dealers Association of Canada, and
 the National Association of Securities Dealers in the United
States.
Rational for self regulation
Securities markets cannot operate without trust.
 The question is whether more government intervention
will restore confidence in the securities market.
 Financial policymakers recognize that sound and
stable long-term economic growth can best be
supported by regulatory policies that minimize
interference with the functioning of the market
 Financial sector reforms in developing economies are
thus increasingly oriented

 toward mechanisms to induce effective market discipline,
 toward regulatory/supervisory regimes that are market-
friendly
 or that mimic the market in driving agent decisions
through incentives to honest and prudent behavior.
How is Self-Regulation Possible?
Honest and prudent behavior by a financial market institution is
integral to its reputational capital, which in turn increases
its franchise value
 Private sector agreement on principles and rules for selfregulation can provide incentives for that honest and prudent
behavior.
 Self-regulation, in turn, tends to emerge and to be effective
when the franchise values of individual businesses in a
community stand to receive a considerable boost from
cooperation to reduce the costs to deal with limited trust and
asymmetric information.
 Self-policing can either result
 When agents having incentives to undertake behavior that
conforms to the collective interest
 of the outcome of agents having an incentive to mutually
monitor behavior.
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Basic Features of Self-Regulation
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Regulation of market transactions
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Regulation of market participants
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Disputes resolution and enforcement
actions
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Pre-commitment of resources
Regulation of Market
Transactions
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Self-regulation of market transactions ensures that
they are executed and completed by each
member according to pre-agreed rules and
modalities.

To achieve this the following needs to be ensured
 exercise effective market and system
surveillance
 identify rules of information disclosure and
sharing

Information is crucial for effective self-regulation
Regulation of Market Participants


Regulation of market participants ensures that
members have an adequate level of reputational
capital and that they maintain it over time
To achieve this:
 Admission criteria (e.g. capital requirement, credit
worthiness, organizational requisites)
 Rules of conduct (e.g. Ethical behavior, compliance,
performance, maintenance of financial strength)
 Sanctioning criteria for non-compliance (e.g. punishment,
suspension, exclusion)
Dispute Resolution and Enforcement
Action

The efficiency of dispute resolution and adjudication processes is
crucial for the success of self-regulation

The government should not preclude (indeed, it should encourage)
private mechanisms and institutions that serve to enforce good
conduct, so long as they are consistent with national law.

self-policing groups have successfully governed themselves even in the
absence of coercive power of government.

Members formed their own courts to adjudicate disputes, and courts’
decisions were accepted by members under the threat of reputational
capital losses.

Private adjudication schemes guaranteed speed, informality, and
technical competence. The adjudicative procedures and the rules
adopted by the courts were designed to facilitate commercial
interactions.
Pre-Commitment of Resources

Incentives in financial self-regulation can be strengthened by
members agreeing to individually pre-commit resources

This would be mobilized in the event of one or more
members running into illiquidity or insolvency problems

Pre-commitments generate incentives for each member
 to monitor the behavior of the others
 to agree on and to enforce information disclosure rules
 to take action in case of misbehavior

Example: mutual lending obligations or collateral pooling
Self-regulation in Payment and Settlement
Systems

Euro Clearing and Settlement System

Solves the information and trust problems in a
cross-border payment system
Owned and Operated by an association of
commercial banks
established in 1985 and headquartered in Paris
the clearing and settlement of payments
denominated in a currency (then the ECU) for
which no central bank of issue and lender of last
resort existed
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Admission & Exclusion

Banks can be admitted as clearers by a Euro
Banking Association committee, subject to
compliance with requirements based on credit
standing, technical and operational capacity, and
willingness to participate (within approved limits)
in risk-sharing schemes that ensure daily
completion of settlement.

Similarly, banks can be excluded in cases of
serious deterioration in credit standing, or
persistent non-compliance with the system’s
rules.
Structure
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The institutional and organizational structure of the
Association ensures participation of all members in decision
making.
Risks connected to the highly interrelated nature of the
payment and clearing business,
lack of a lender of last resort,
 provided the members with strong incentives for their own
prudent behavior,
 careful monitoring of counterparty behavior, and
 improvement of the system’s robustness.
Operation
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The system operates as a closed circuit
Each participant with a provisional net debit position can
only square it by borrowing excess funds from participants
with a provisional net credit balance.
Successful daily clearing relies on the willingness of banks to
re-flow their surpluses into the system to finance banks in
deficit.
The system also provides for facilities that commit banks
with surpluses to channel liquidity (up to a limit) to a deficit
(solvent) bank if one participant opposes lending to that
bank.
Clearing banks have access to real-time information that
enables them to monitor the clearing.
The system establishes multilateral and bilateral mandatory
limits on each bank’s net debit and credit position, and
breaches are subject to sanctions.
Compliance is enforced through automated procedures.
SRO Structures of the World
Model
Description
Example
Government Model
Public body performs most or all
regulatory functions. Exchanges
perform very limited supervision of
their markets
UK (FSA),
France (AMF)
Limited Exchange
SRO Model
Exchange performs front-line
regulation functions for its market
US(NYSE),
Hongkong
(HKEX)
Strong Exchange
SRO Model
Exchange performs extensive
market and member regulation
function
US(CME),
Japan (TSE),
Australia (ASX)
Independent
Member SRO
Model
SRO that is a pure regulator , not a
market operator, performs
extensive regulatory functions
US (FINRA),
Canada (IIROC),
Japan (JSDA),
Columbia (AMV)
Industry
Association SRO
Model
Industry Body performs some
regulation functions plus other
industry association functions
ICMA
Study of Self Regulation in Stock
Exchanges
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

A stock exchange is an organized market where
securities are traded
Stock market provides the securities
 Price discovery
 Liquidity
Historically stock exchanges started as
 Mutually governed
 Self-regulated structures
 Profit was not a very strong motive
 Authorized to promulgate by laws to govern
their functioning
Evolution of Stock Exchange
Stock markets began as mutual firms
 They were physical locations: trading floors
 As members of stock exchanges, brokers had
superior knowledge culminating market power:
broking commission
 Common responsibility, same structure, self
responsibility: mutual co-operative structure
 Non-profit organization
 Homogeneity of skill and jobs
 Self-regulation was sustainable
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Change in Market Structure and Demutualization
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Advent of Electronic Trading system
Concept of floor trading no longer holds ground
Reduction in trading cost
Additional member does not impose additional cost,
membership fee no longer important
Members like customers, hence priority on service
Physical presence of trader no longer required
Mutual dependence has become extinct
Outcome: demutualization
Ownership separated from trading activity
Profit seeking organization
Is self-regulation still valid?
Conflict of Interest
Conflict of interest is an important characteristic of
self regulation
 Rules set in public interest may adversely affect
commercial interest
 In demutualized stock exchange, a trade off works
 Investment in reputational capital makes sense
 Cost benefit analysis may shift the balance in
favour of profit at the cost of regulation
 Conflict of interest arises

 Regulatory activity hinders source of revenue
 Regulatory activity compels expenditures which cannot be
recouped easily
Conflict of Interest in Listing Activity
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Traditionally, listing has been viewed as a “signaling” function
endorsing quality
If exchange set the listing criterion to be too high
 Many firms may not be able to list their securities in the
trading platform
 Exchange will lose revenue from listing fees
If the eligibility criterion is set too low
 Poor quality securities will get listed
 Deterioration of investor’s profitability
 Adversely affect reputation
Thus this trade off would lead to an equilibrium set of
criterion
Conflict of Interest in Listing Activity
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
Equilibrium holds true so long as listing and
trading takes place in one exchange
With multiple exchanges
 Listing and trading have been separated i.e. it is
not necessary that a security trades only in the
exchange where it is listed
 Hence the listing exchange may not necessarily
face reduced order flows
 Revenue becomes important for owners
 Loss of order flow faced by members
Conflict of Interest in Regulating Market Operations
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Exchanges as SRO are responsible for regulating
trading activities
At the same time they are supposed to promulgate
rules that govern trading activities
Regulation includes: overseeing trading activities,
identification suspicious activities, their detection and
taking appropriate action in case of misconduct
Conflict of interest in regulatory and business function
Due to competition with other exchanges the exchange
will be under pressure to attract orderflow
Conflict of Interesting in Regulating


When regulating a competitor a different kind of
conflict arises
Suppose a member of an exchange provides an
alternative trading pool, the exchange might
indulge in discriminatory action like
 Sanction imposed in disciplinary proceedings
 Charging discriminatory fees
 Creating entry barriers
 unfairness
Conflict of Interest in Business Continuity Planning
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Security and Capacity are of paramount
importance to an Exchange
It is argued that such concerns are congruent to
business interest
This argument may be flawed because
 No direct return
 Agency issue
Public good versus Private benefit
Factors Facilitating Self-Regulation
a strong tradition
of self regulation in the securities market;
 a legal framework that clearly defines the
functions, activities and responsibilities of selfregulatory organizations;
 self-regulatory organizations' legal obligation to
develop corporate governance policies with
specific instructions on members, general
assemblies and board of directors' functions; and
 the independence of the self-regulatory
organization i.e. act purely as a regulator and not
as a market operator.
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Limitations and Benefits of Self-Regulation
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SROs might transform themselves into cartels and
jeopardize competition
Short-term tensions between the managers and the
authorities responsible for SROs—such as, for example,
on the looseness of listing requirements—might either
discourage participation or diminish long-term confidence
in the market
Scarcity of institutional and human resources may
constrain the quality of oversight
Lack of reasonably homogenous institutions could impede
the formation of balanced structures within SROs
With limited competition in securities markets, selfregulation may not be enough to ensure safe and efficient
markets
Benefits of Self-Regulation
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Even so, financial self-regulation in developing economies could
help improve the efficiency-stability tradeoff.
Because of their knowledge and experience, and commercial
interest, SRO members are better placed than government
bureaucrats
 to design rules consistent with the operational features of their
business,
 to keep their operational processes and infrastructures apace
with technological progress
Since information is vital to each SRO member, an SRO setting is
better positioned than government regulatory agencies to achieve
enforcement of disclosure rules through peer monitoring.
appropriate institutional setting to develop market microstructures
that facilitate securities trading and market liquidity.
Incentives to induce private-sector self-policing would mobilize
resources that would complement the public sector’s scarce
resources used to enforce rules and best practice standards.
Self Regulation in Securities Market in
India
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Through the SEBI Act of 1992, SROs were
introduced in the Indian capital market
This was notified by a notification in 2004
They are not yet operational
A clear regulatory framework has yet to be set up
Relevant market participants are not ready to
regulate themselves for professional purposes
Recognized Stock Exchanges are the only
securities-related SROs in India
 whose regulatory frameworks have been well
established and
 which are actually functioning
Self Regulatory Organization

A non-governmental organization that has the power to
create and enforce regulations and standards
 with internal statutory rules
 dedicated financial resources
 formal structures involving shareholders, managers, and
employees; codes of conduct
 oversight procedures
 SROs could involve payments and securities settlement
systems, interbank deposit markets,
 securities trading and stock exchanges, securities lending
and clearinghouse services, deposit insurance, or credit
information-sharing systems.
Reputational Capital

The reputational capital of a financial institution is the value of the
institution’s commitment not to breach (implicit or explicit) contracts and
take risks that might endanger its compliance with contractual
obligations.

If the institution breaks the promise underlying the contracts, its
reputational capital may be damaged or destroyed.

Reputational capital is a complex set of variables that signal at any
point in time the institution’s ability and willingness to fulfill its
obligations.

To induce investment in reputational capital
 Honesty and prudence should be awarded
 An appropriate rewards structure links the institution’s
franchise value to its past record of business conduct and
practice
Constituents of Reputational
Capital
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Constituents of Reputational Capital
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the institution’s long-term mission and strategy
market presence and established name
market knowledge and information
financial strength and profitability
organizational and governance structure
risk management capacity
record of compliance with legal and financial obligations
quality of service and advice delivered
quality of projects financed
quality and ethics of management and personnel, and
transparency