An agency can be too large to be efficient or sufficiently flexible. Or it can be too small to be efficient. Furthermore, the existence of more than one agency can lead to inconsistent or duplicative regulation and uncertainty concerning regulatory jurisdiction. On balance, it may be desirable for nations with emerging derivatives markets to consolidate regulation in one governmental agency. Certainly, if a country already has an agency which is capable of taking on the task of regulating derivatives, it would seem appropriate to give it that responsibility rather than creating a new agency. That is, the advantages of having all governmental regulatory authority over derivatives and securities exchanges in the existing agency appear to outweigh the costs of this arrangement. On the other hand, if regulatory responsibilities are already handled by more than one agency and the arrangement is working well, there may be good reason not to consolidate the agencies.

Self-Regulation

The question of the appropriate division of regulatory responsibilities between the governmental agency and SROs is easier to answer in principle than in practice. There can be substantial benefits from self-regulation. SROs have the ability to impose ethical standards which go beyond those imposed by government. They have incentives to use the most efficient methods of regulation. They have the business sensitivity to know when a regulation will be workable and beneficial to market users. They are able to identify and comprehend problems at an early stage and to respond with appropriate solutions. SROs should undertake those regulatory responsibilities which they can perform most efficiently and which they have incentives to perform efficiently. The ability of an SRO to perform well, however, depends on many factors, including the qualifications and experience of its personnel. It is likely that, as the domestic industry grows and matures, it will be desirable to have SROs play a larger regulatory role. Thus, the regulatory structure should be flexible enough to accommodate such a development.

A recent report by the Council of Securities Regulators of the Americas provides an excellent discussion of the issue of self-regulation. The discussion below borrows heavily and contains direct quotes from this report.

"The governmental authority should consider creating a regulatory system where market operators or market intermediaries exercise direct oversight responsibility over their respective areas of competence, subject to appropriate government supervision, and to the extent appropriate to the size and complexity of the markets."

As markets expand, government authorities should consider allowing market operators or market intermediaries to exercise oversight responsibility, i.e., a system of self-regulation under the oversight of a government authority. In this manner, government authorities can more efficiently use limited resources and create a network of shared responsibility throughout the industry.

There are a number of advantages to shared responsibility between market intermediaries, market operators, and the government authority. First, when market intermediaries participate in promoting markets through self-regulation, they are more likely to comply with the rules that are imposed. Second, market intermediaries offer considerable depth and expertise regarding market operations and practices, and may be able to respond more quickly and flexibly than the government authority to changing market conditions. Third market intermediaries and market operators should be highly motivated to develop cost-effective, workable regulations. Fourth, market intermediaries and market operators can establish high standards of business practice and ethics that surpass legal standards. With industry cooperation and assistance, the government authority can achieve its goals of protecting investors from fraud and manipulation. This structure also may have the benefit of encouraging innovation.

The concept of self-regulation, however, does not imply that the government authority can or should abdicate responsibility for oversight of the self-regulatory system. Indeed, all those involved in the self-regulatory system should ensure that conflicts of interest between SROs, their members and the public, as well as other potentially anti-competitive behavior, be avoided and, where they arise, be affirmatively addressed.

A system of shared oversight responsibility can be pictured as a pyramid. The bottom tier is comprised of market intermediaries, which are members of the SRO and must meet established standards to join the organization. The second tier consists of SROs, which include exchanges and other market operators. At the top of the pyramid, oversight authority converges in the government authority, which is responsible for the entire oversight system. In such a system, the first level of oversight is conducted by the market intermediaries. These entities are responsible for training and educating their employees about applicable laws, regulations, and SRO rules, and for supervising their activities. At the next level, SROs should be given the legal obligation to oversee daily trading activity, and oversee and enforce standards of conduct and financial integrity. In enforcing standards of conduct by market intermediaries, SROs may find it useful to establish a membership structure. This allows the SRO to protect the integrity of the organization by adopting standards that regulate member conduct, while at the same time permitting fair and open access to the organization. The SROs also should be legally obligated to cooperate with and assist the government authority in investigating and enforcing applicable laws and regulations. The government authority has ultimate responsibility for the fair and effective operation of this oversight system. Consequently, if the market operator is granted oversight responsibility and authority, the market operator should be responsible for the oversight and regulation of the market intermediaries within its jurisdiction. The intermediary, in turn, should be required to comply with the rules and mechanisms a market operator imposes.

The market intermediary should be held accountable for the actions of its individual employees. Imposing these responsibilities creates an incentive for market operators and intermediaries to provide adequate training and supervision of their work force. The widespread distribution of responsibility for market integrity among market intermediaries and operators increases the opportunities to detect and deter fraudulent and illegal conduct.

"The government authority should require a SRO to meet appropriate standards before allowing the organization to exercise its authority. Moreover, once the SRO is operating, the government authority should assure itself that the exercise of this power results in fair and consistent enforcement of applicable securities and futures laws, regulations and appropriate SRO rules."

As a condition to authorization, the government authority might consider requiring the SRO to:

· promote the public interest; · have the capacity to carry out the purposes of governing laws, regulations, and SRO rules, and to enforce compliance by its members and persons associated with those laws, regulations, and rules;
· treat all members of the SRO or applicants for membership in a fair and consistent manner;
· develop rules that are designed to prevent fraudulent and manipulative practices and to foster cooperation and coordination with persons engaged in regulating, clearing, settling, processing information with respect to, and facilitating transactions in financial instruments;
· submit to the government authority its rules for review and / or approval as the authority deems appropriate, and ensure that the rules of the SRO are consistent with the public policy directives established by the government authority;
· cooperate with the government authority and other SROs to investigate and enforce applicable laws and regulations;
· enforce its own rules and impose appropriate sanctions for non-compliance;
· assure a fair representation of members in selection of its directors and administration of its affairs;
· avoid rules that may impose any unnecessary burden on competitors; and
· avoid using the oversight role to allow any market participant unfairly to gain advantage in the market.

"The government authority and / or SRO should develop enforceable standards including standards of business conduct for market intermediaries, based on high standards of commercial honor, and just and equitable principles of trade, and standards of financial integrity."

Regulatory Authority

Regardless of the extent to which self-regulation is used, the governmental agency should have authority to (1) establish rules, (2) monitor compliance with the rules and (3) enforce the rules. This may take the form of direct responsibility by the agency or of requiring SROs to perform these functions. In the latter case the agency should have compliance and enforcement authority over SROs.