From markets to venues: securities regulation in an evolving world.

• Author: Macey, Jonathan R.

INTRODUCTION I. THE ORGANIZATION OF FIRMS AND THE ORGANIZATION OF MARKETS II. SECURITIES TRADING--MARKET STRUCTURE AND REGULATION A. The Old Environment: Tradition Versus Transition B. The Modern Exchange: Demutualized and Publicly Traded III. WHO SHOULD REGULATE WHAT? COMPETITION, COLLUSION, AND CAPTURE IN REGULATORY STRUCTURES A. Listing and Delisting Decisions B. Oversight of Exchange Trading Practices C. Insider Trading and Share-Price Manipulation D. Oversight of Exchange Trading Capacity IV. ALTERNATIVE REGULATORY MODELS--GLOBAL EVIDENCE CONCLUSION INTRODUCTION

The world of securities trading is changing. Advances in technology, combined with the dramatic decrease in the cost of information processing, have conspired to change the way that securities transactions occur. While broker-dealers, specialists, and market makers still ply their trades, they are now joined by a host of new market participants such as robot traders and electronic limit order providers. And while exchanges and the Nasdaq continue to operate, they are confronted by a wide range of competitors including the trading desks of the large broker-dealer firms as well as Alternative Trading Systems (ATSs), the best known of which are Electronic Communications Networks (ECNs) such as Brut ECN, Instinet, and Inet ATS. (1) Trades in equities also are executed on the "third market," which simply refers to firms like Madoff Investment Securities, Knight Trading Group, Jefferies Group, and ITG, all of which arrange trades in exchange-listed stocks on venues other than an exchange. Trading has become a commodity, a standard process whose measure of success is increasingly captured by the simple metric of cost of transacting.

Against this backdrop, stock exchanges are also changing both in function and in governance. Forced to compete after enjoying decades of essentially monopoly franchises, exchanges and markets have had to embrace new technologies or face extinction. Traditionally owned by their members, exchanges worldwide are now converting to become publicly traded corporations. Since 1998, more than a dozen exchanges have publicly listed their shares, leaving only two of the world's ten largest exchanges (New York and Tokyo) as member-owned entities. (2) Soon there will be only one, as the New York Stock Exchange and the Archipelago Exchange announced on April 20, 2005, that the two firms had entered into a definitive merger agreement that will produce a new, combined entity to be called NYSE Group, Inc. (3)

In this new world of trading, market forces are requiring dramatic change in market structure and in the way in which competing firms are organized and operated; yet the regulatory structure of securities trading in the United States has remained the same. Can such immutability be optimal in the face of this economic upheaval in the markets in which the exchanges operate? (4)

This Article considers the role of self-regulation of the trading markets in the changing world in which exchanges and other trading venues conduct their business. Our particular focus is on the role of self-regulation in a world that has come to be dominated (indeed almost exclusively inhabited) by profit-seeking firms rather than member-owned associations. Our analysis draws on insights from the Coasean view of markets and firms to investigate how economic functions are evolving to meet the new trading environment. A particular thesis we develop is that shifts in transaction costs and agency costs have dictated changes in the optimal economic organization of trading. These changes have forced economic activity to migrate from a centralized market to multiple competing venues. We argue that these shifts, in turn, have changed the optimal ownership structure of exchanges, pushing exchanges away from a cooperative structure to a corporate structure. These new governance arrangements reflect the different incentives that exchange members face in a competitive environment and produce the need for a thorough reexamination of the principles of self-regulation in light of this new environment.

We then argue that while, in an ideal world, regulatory form should reflect economic function, the "market forces" that have changed the organizational structure and corporate governance of stock exchanges have not operated to change the regulatory structure of the exchanges. Consequently, the regulatory structure is asynchronous with the new economic realities of trading.

The traditional regulatory structure relied on self-regulation by members, combined with general oversight by the Securities and Exchange Commission (SEC). (5) As we argue in this Article, however, this allocation of regulatory responsibilities is now suboptimal. With the incentives of exchanges and other market participants altered, the regulatory framework is ill-structured to provide either oversight or control of trading activity.

A particular problem is self-regulation by profit-seeking firms. We demonstrate that self-regulation by profit-seeking entities may actually be more effective in handling particular regulatory functions than was the case in the past. These functions include activities such as monitoring to prevent manipulation, as well as general oversight of exchange order capacity and reliability. But other aspects of self-regulation are now fatally flawed because the incentives of those charged with regulating are diametrically at odds with their corporate mandates to maximize profits. We demonstrate how issues such as access to trading, listing and delisting requirements, and supervision of exchange members, employees, and trading practices fall into this category. We also identify dysfunctional aspects of the role played by the SEC, particularly with respect to the Commission's current inability to propose rule changes.

Finally, we consider the broader question of how securities regulation should be handled in this new trading environment. Our analysis provides a number of specific recommendations and is bolstered by our review of evidence from other countries, where global economic forces have forced markets to change sooner, and in some cases more drastically, than has been the case in the United States, at least to date. We investigate several regulatory approaches currently being used in other countries and discuss their applicability to the U.S. market.

This Article is organized as follows: Part I sets out the basic Coasean economic arguments (6) involving the allocation of economic activity between firms and markets. Our particular focus here is on the impact of transaction costs and agency costs on economic organization. Part II then applies this paradigm to securities trading, providing an analysis of how changes in the economic environment have changed the functions of stock exchanges and markets. This Part also demonstrates how these changes, in turn, have altered the optimal corporate governance structure of markets. Part III then turns to the issue of regulation, considering in more detail the impact of these changes in firms and markets on the self-regulatory process. In that Part, we also analyze how regulatory functions should be allocated across firms and the SEC. Part IV then reviews alternative models for securities regulation currently in use in several other countries.

1. THE ORGANIZATION OF FIRMS AND THE ORGANIZATION OF MARKETS

   The issue of how economic activity should be organized has long been a focus of economic interest. The economic differences between organizing production within a firm or within a market were first addressed in Ronald Coase's seminal paper, (7) and these ideas have been expanded upon by a wide range of scholars. (8) Central to these analyses is the role played by the costs of organizing economic activity both within firms and across markets.

   Coase's thesis was that the optimal allocation of economic activity involved a tradeoff between the transaction costs and agency costs associated with the activity. (9) In particular, Coase argued that firms arose because there were costs of using the price system. That is, companies and individuals who demand a product or service can always buy the good from a supplier in the market by paying the prevailing market price. But that market price inevitably will include transaction costs, which often are substantial. Alternatively, those demanding such goods can decide to produce the goods themselves, setting up a firm within which to organize the necessary productive capacity.

   In contrast with market transactions, there are no transaction costs when economic activity is organized within a firm, but the firm will incur another distinctive set of costs in the form of agency costs arising out of the interactions between the owners of the firm and the producers of the product. Coase's important observation was that a balance is struck when the firm has expanded to the point where "the costs of organising an extra transaction within the firm become equal to the costs of carrying out the same transaction by means of an exchange on the open market or the costs of organising in another firm." (10)

   Coase's analysis provides a simple, but profound, diagnosis of the causes and consequences of economic organization. When transaction costs are high, firms prevail as economic activity is organized within firms. When transaction costs are low, markets prevail as economic activity is organized across markets. Oliver Williamson expands on this concept, noting that "[i]t will be convenient to assume that transactions will be organized by markets unless market exchange gives rise to serious transaction costs. In the beginning, so to speak, there were markets." (11)

   Focusing on transaction costs seems particularly relevant when addressing the question of how best to organize securities trading. Trading securities--at least to the extent that such trading involves the trading of equities, options, and futures--has...