Everything's Coming Up Hybrid

Jan 06, 2006
URL: http://www.wallstreetandtech.com/showArticle.jhtml?articleID=175802171

Wall Street's leading regulators, NYSE Regulation and the NASD, are in talks to form a hybrid regulator that will oversee dual member firms. But skeptics question whether a joint regulator will result in the $100 million-a-year savings that the NASD is proposing.

Years of regulatory scrutiny have caused firms to increase compliance spending. Now, to reduce the burden on broker-dealers that are members of both the New York Stock Exchange and the National Association of Securities Dealers, Wall Street leaders are pushing the NYSE and the NASD - the industry's two leading self-regulatory organizations (SROs) - to combine their efforts.

The review of SROs comes at a time when the industry is undergoing dramatic changes in market structure as Regulation NMS forces market centers to automate trading. Additionally, with its merger with Archipelago, the NYSE is becoming a hybrid exchange and, at the same time, a for-profit entity - a move that has caused much debate about a for-profit company's ability to regulate its members. Meanwhile, the NYSE's rival, the Nasdaq Stock Market, is separating from its regulator. All this has prompted the Securities and Exchange Commission (SEC) to examine the inherent conflicts of interest in the industry's current self-regulatory structure.

Officials at the Securities Industry Association (SIA) - the brokerage industry's main trade group - as well as regional brokerage firms have been urging the NYSE and the NASD to reduce the redundancy in their rule books, examinations and reporting requirements. The issue affects more than 170 bulge-bracket and regional brokerage firms that are members of both the NYSE and the NASD. These firms "are subject to very duplicative rules and examination requirements," according to George Kramer, deputy general counsel at the SIA, which is pushing the concept of a single, hybrid SRO. "Rather than having two sets of regulators working hard to make sure they are coordinating, we think it would make more sense to have one regulator handling exams," Kramer says.

Under a hybrid SRO, a broad set of functions common to member firms of both the NYSE and the NASD would be moved into a centrally managed organization, but regulation of trading on the NYSE and Nasdaq stock markets would remain within each market's SRO. The hybrid SRO would deal with the day-to-day issues that affect every broker, such as sales practice and financial responsibility issues, explains Ira Hammerman, the SIA's general counsel.

The topic of combining regulatory functions surfaced in early November at the SIA's annual meeting, where NYSE CEO John Thain raised the idea of the SROs cooperating to reduce the duplication in their examinations. The NYSE, which owns its regulator, NYSE Regulation, revealed that it was exploring a joint venture with the NASD to reduce the duplication that exists in their procedures for examining broker-dealers that are members of both the NYSE and the NASD.

NYSE Regulation oversees the actions of 130 specialist firms, floor brokerages and registered traders that do not interact directly with investors, as well as some 250 member firms that do work directly with investors. Also, NYSE Regulation oversees 2,800 companies listed on the NYSE that are required to meet standards of financial and corporate accountability, and transparency. According to a spokesman for NYSE Regulation, Thain suggested there are three ways the SROs could work together: form a joint venture, alternate examinations every other year or divide up responsibility for examining firms.

At the SIA's annual meeting, Robert Glauber, CEO and chairman of the NASD, said he estimates that member firms could save $100 million with the move to a single, joint regulator. At a Nov. 17 Congressional hearing exploring SRO reform, Glauber asserted that having one regulation fee instead of two would save the industry about $50 million a year. In addition, by contending with one examination staff and one enforcement staff, Glauber testified that firms would lower their compliance costs by another $50 million a year.

According to an NASD spokesman, the estimate is based on the savings of firms that have chosen to be regulated by just the NASD. "The savings would largely come from member regulation fees that are duplicated," the spokesman explains, adding that brokers could benefit further from more uniformity across NYSE and NASD rules, and a single examiner for sales practice review examinations - an area in which dual members are examined by both SROs. Glauber was not available for an interview at press time.

Regional Firms Press Their Case

Certainly, regional firms support reform. "The cost of increased regulation presents significant challenges to regional firms," Ben Plotkin, CEO and chairman of Ryan Beck, a Florham Park, N.J.-based regional brokerage firm, testified before the Congressional hearing. Plotkin, who also chairs the SIA's Regional Firm's Committee, told Congress that 16 regional firms around the country had signed a letter urging regulatory reform.

"The big question is why we have redundant regulation when we have the SEC and 50 state regulations," Plotkin tells WS&T. Originally, multiple SROs were established because each market has specific rules and there's a belief that each market is the most qualified to regulate itself. But the SROs only can enforce the rules under SEC supervision, and the SEC must approve any changes to the SRO structure.

Still, if the burden of redundant regulation is not addressed, Plotkin warns, it could lead to further consolidation among the regional firms. He notes that Advest recently was acquired by Merrill Lynch, and Legg Mason sold its broker-dealer unit to Citigroup.

Plotkin says overlapping regulations from multiple SROs are draining resources from his firm's compliance staff, which is struggling to meet compliance demands even though it's grown from five people to 25 people over the last few years. He would prefer that his staff were doing surprise internal audits in Ryan Beck's branches or drilling down in areas to uncover the potential one bad apple in the firm, rather than continually responding to multiple SROs. "If they are spending most of their time on regulatory sweeps, exams and comments to [rule proposals], those resources are really drawn away from protecting the customer," says Plotkin.

NYSE officials point out, however, that Ryan Beck has not been a member of the NYSE for at least a decade. "We are an exception," notes Plotkin, who explains that the regional firm made a decision to access the NYSE through other brokers to avoid the burden of regulatory duplicity. After weighing "the benefits of the NYSE versus accessing it in other ways," Plotkin says, Ryan Beck decided, "The burdens of another regulator weren't worth it." The SEC and the NASD each typically examine Ryan Beck every two years, according to Plotkin.

NYSE members also are examined by NYSE Regulation. Historically, firms that joined the NYSE had their primary business in listed stocks, so the SEC appointed the NYSE as the designated examining authority for financial operational reviews, according to NYSE officials. So, if a firm is a member of both NASD and the NYSE, with one or two exceptions, NYSE Regulation conducts Fin/Op reviews every year. In the case of sales practice reviews, both the NASD and the NYSE conduct their own exams. The NYSE says the largest firms are examined annually, while medium-size firms are examined every other year and small firms are looked at every four years.

Until recently, contends Plotkin, there has been very little coordination between NYSE and NASD regulators. If there is more coordination today, "industry frustration" is the reason it's happening, he says. "Frankly, it is physically impossible for one compliance department to prepare for more than one exam at one time," he adds.

In response, Grace Vogel, EVP of Member Firm Regulation at NYSE Regulation, maintains that the NYSE has made substantial progress toward reducing duplicated efforts over the past year, particularly since Richard Ketchum, the NYSE's chief regulatory officer, came on board in June 2004. That summer, NYSE Regulation met with the SIA and member firms that were feeling pressure from the increased regulatory scrutiny after the research and mutual fund market timing scandals, according to Vogel. The firms felt they had to increase their compliance staffs to deal with multiple requests from regulators, she relates. That led the NYSE to approach the NASD about a plan to divide responsibility, Vogel says. "So, if the NASD was going in to look at anti-money laundering, we would not touch anti-money laundering," she notes.

Vogel adds that the NYSE has identified 15 areas for which it has identical or similar rules to the NASD as well as to the SEC rules that both SROs enforce. In addition, the NASD developed an internal Web site, which is made available to both the NYSE and the SEC, that identifies which branches the SROs are scheduled to visit. "We all have so much work to do, it's not efficient or effective for us to visit the same locations that the SEC or the NASD just visited," says Vogel. "It truly is a win-win all around when we can divide responsibility."

Charles Roney, chief compliance officer at Rosenblatt Securities, an institutional agency broker that is a member of both the NYSE and the NASD, asserts that the SROs already try to avoid duplication. The SROs are mandated by a memorandum of understanding that they signed with the SEC to conduct nonduplicative exams, he contends. "If a regulator wants to look at business continuity or anti-money laundering or soft dollars, both regulators are not going to be looking at the same thing," Roney says. "This has been in place more than two years."

While SIA and NASD officials agree the two SROs already are coordinating their exams and harmonizing their rules, they believe that this isn't enough. "Even when they talk to each other, it's a big distraction to senior management to constantly have to keep focusing on trying to harmonize what each regulator requires," says the SIA's Kramer.

But, NYSE rules are more stringent than NASD's rules, the NYSE's Vogel points out, noting that the 400 broker-dealers the NYSE regulates are the largest and operate the most-sophisticated businesses. The NASD oversees 5,200 brokerage firms; many are small and midsize firms.

One Regulator, One Rule Book

Still, the SIA's Hammerman explains, "Ideally, we want to have one regulator, with one rule book, one examination staff, one enforcement department, as the one SRO looking at member-firm regulation." The time is right, SIA officials say, to examine duplication among the SROs because the NYSE is going public. After the exchange's merger with Archipelago is completed, NYSE Regulation is to become a separate subsidiary of NYSE Group and will report to an independent board.

This has sparked industry debate over the structure of SROs and potential conflicts that exist within a for-profit exchange that owns its regulator. "It's a catalyst because now, for the first time, the exchange will be a for-profit, public company. And even though [the NYSE] is taking steps to wall off regulation - by setting up a nonprofit company and by having a board of directors that is independent from the holding company - we think that is not really going far enough," says Hammerman. "We think the way the NASD distanced itself from Nasdaq was more appropriate." While NASD already is a separate company from the Nasdaq Stock Market, it plans to sell off its minority stake in Nasdaq after the SEC grants Nasdaq exchange status, which was expected at the end of 2005.

"Today, the New York Stock Exchange finds itself in a similar position as it merges with Archipelago and moves toward going public," the NASD's Glauber testified at the Congressional hearing on SROs. "The concern is that for-profit, publicly traded exchanges will be faced with the conflicting goal of having to maximize profits while not compromising regulation," he continued. Under the current multiple SRO system, Glauber said, there are inherent conflicts and inefficiencies, such as frequently redundant examinations. To address these shortcomings, Glauber advocated adopting one of the hybrid models described in an SEC concept release on SRO reform.

But some sources closer to the NYSE position contend that in advocating the hybrid model, the NASD is using the situation to grow its fiefdom at the expense of the NYSE. "A lot of it is a turf battle," says Joe Gawronski, COO at Rosenblatt Securities, who calls the debate "a rehash of old arguments about whose regulatory model is superior from a corporate governance standpoint." He adds, "The NASD is trying to point out and embarrass the NYSE by saying its structure with Nasdaq ensures more independence for its regulator while, 'You guys are riddled with conflicts, ... especially as you become a for-profit corporation.'"

Controversy Continues

Further, Gawronski questions whether the hybrid SRO plan will save as much money as the NASD claims it will. "I don't believe the cost savings numbers in the hybrid regulator model that Glauber is proposing can be achieved - whether you have one super regulator as opposed to a few different ones, each firm still has to have a compliance officer(s) and do the work," he says. "Anything that reduces the burden and duplicate regulation is a good thing for our firm," Gawronski adds. "But I'm skeptical about $100 million figures being thrown around. It seems to be more of a turf battle and PR, and a grab for greater share of the regulatory marketplace - not substance."

In addition, not everyone is convinced that a single regulator actually would reduce the burden. According to Rosenblatt Securities' Roney, the size and scope of the exam will be the same even if there is one merged regulator. "The burden is the same," he says. "I don't see it being lessened because the size of the scope" - the material covered by the exam - is not being reduced, Roney asserts.

Furthermore, Roney contends, the NYSE model is correct for Rosenblatt's business model - since about two-thirds of its business still is done on or through the floor. "I'm dealing with regulators that are close and more familiar with our model - I get less uneducated questions," he says. "If I get a super regulator, I'll have to educate them."

Meanwhile, NYSE Regulation's Vogel also says she doesn't see where the $100 million savings is going to come from. "We have two major expenses - people and technology," she notes. "I don't see how we could reduce people costs - there's no duplication now, so where are the people costs coming from?" she asks. "We have plenty of work for all of us to do."

Officials at the NYSE say they are open to a dialogue on reducing regulatory duplication, but they are against anything that could reduce regulatory oversight or dilute their rules at a time when the securities industry still is restoring investor confidence. Alluding to recent scandals on Wall Street, Vogel cautions that the industry has a "short memory," adding, "I don't think that a reduction in regulatory resources makes sense."

But, "This is not about less regulation; this is not about getting a free ride," the SIA's Hammerman insists. "This is about being smarter with how we regulate an intensely regulated industry," he continues. "The industry should be dealing with representatives from one [SRO]."

According to Patrick Gordon, principal at Medfield, Mass.-based Compliant Systems Consulting, if the two SROs join forces, it will be doing away with duplications. "It will actually reduce the number of inspections from the broker-dealer standpoint," he asserts. Both SROs have their eyes on enforcing 17a-4 e-mail compliance, for example, so both could be doing a sweep on the same topic, he suggests. "Inspections and audits are very time-consuming and very expensive for the member firms, the exchange and the broker-dealers," says Gordon. "This is going to take costs out of it," he insists.

While there has been a lot of buzz surrounding the idea of a partnership or an all-out merger between the competing regulators, the talks are preliminary. "All of this is an SEC decision," points out Ryan Beck's Plotkin. SEC Chairman Christopher Cox must weigh in, and the SEC needs to approve any change to the SRO structure, he notes. "This is not about one regulator disappearing and one surviving - this is about consolidating two very good regulatory bodies so they are more effective and efficient," Plotkin continues. "I don't believe, net-net, there will be fewer regulators in this process - they'll just be better regulators."

Three Ways for the NYSE and The NASD to Work Together

1. Form a joint venture for examinations/rule making.

2. Alternate exams ( e.g., sales practice, anti-money laundering, soft dollars) every other year.

3. Divide up responsibility for examining member firms.

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