Independent Self-Regulatory Organization Models in the United

Independent Self-Regulatory Organization Models in the United States:States:

Financial Industry Regulatory Authority (FINRA)Options Regulatory Surveillance Authority (ORSA)

National Futures Association (NFA)

Presentation by Michael J. Kulczak, Senior Director, FINRAI MEETING of AMERICA’s SROs

Organized by theColombian Securities Self-Regulatory Organization—

A t l d d l M d d V l d C l bi (AMV)Autorregulador del Mercade de Valores de Colombia (AMV)November 13-14, 2008

Bogota, Colombia

Document Title Confidential Copyright 2007 FINRA 0

The Role of SROs in the United States

• SEC delegates significant authority to securities industry member organizations, called SROs, which must register with the SECorganizations, called SROs, which must register with the SEC− SROs oversee the securities markets and the member firms participating

in those markets

• An SRO must:• An SRO must:− Maintain the organization and capacity to monitor compliance − Enact rules that prohibit fraudulent and manipulative practices

Have a disciplinary mechanism to enforce rules− Have a disciplinary mechanism to enforce rules − Assure fair representation of members in governance and rule making− An SRO can be a national securities exchange, securities association, or

a registered clearing housea registered clearing house.


Financial Industry Regulatory Authorityy g y y

(FINRA)

2

Introduction to FINRA

FINRA is the frontline self-regulatory organization in the US securities marketsecurities market

• Self-regulatory organization for US securities industry; 5,000 member firms and 600 000 registered personsfirms, and 600,000 registered persons. • Membership is mandatory for all broker/dealers doing securities

business with the publicR lt f lid ti f NASD d NYSE b l ti• Result of consolidation of NASD and NYSE member regulation

• Annual budget of roughly $700 million funded by the industry• More than 3,000 employees• Overseen by the US Securities and Exchange Commission


NASD/NYSE Consolidation

July 30, 2007

NASD + NYSE


Goals of the Consolidation of NASD and NYSE

Consolidation is intended to improve both the effectiveness and theefficiency of regulationefficiency of regulation

• Reduce complexity and eliminate potential conflictsH l k U S k t titi b t li i l ti• Help make U.S. markets more competitive by streamlining regulation

• Ensure greater small-firm industry participation in SRO process• Eliminate dueling rulebooksg• Create cost savings for every firm in securities industry


FINRA Corporate Governance: Board Structure

23 persons on Board of Governors

T G f iti i d t• Ten Governors from securities industry:–Small firms (1-150 registered representatives) elect three seats–Medium-sized firms (151-499 registered representatives) elect

tone seat –Large firms (500+ registered representatives) elect three seats –Three appointed industry seats: one each to NYSE floor

members; independent dealers/insurance affiliated brokers; and investment companies

• Eleven Governors from outside securities industryEleven Governors from outside securities industry

• FINRA CEO and Non-Executive Chairman serve on Board


Primary Objectives

Investor protection Market integrity


Overview of U.S. Regulatory Jurisdiction

US SECSt t

National Securities Association.

States

National Securities Exchange

Publicly-Traded CompaniesMutual FundsInvestors

National Securities Association.(FINRA)

Broker/Dealers

National Securities Exchange(e.g., NYSE, NASDAQ)

Companies

Listed UnlistedB/D Subsidiary ATS

Jurisdiction to conduct inspectionsJurisdiction to request information and to enforce listing requirementsAll entities within red box are subject to SEC jurisdiction; the SEC examines SROs, mutual funds, and

Legend


broker/dealers

What FINRA Does

FINRA’s activities include both traditional regulatory, as well other activities designed to improve the functioning of regulation andactivities, designed to improve the functioning of regulation and the markets

M it /Rule-writing

Monitor /Detect

EnforceInvestigate

Transparency and Regulatory Data Services

Compliance and Education Services

Dispute Resolution


Responsibilities of FINRA as an SRO

• Registers member firms

• Writes rules to govern firms’ behavior• Writes rules to govern firms behavior

• Examines firms for compliance

• Performs market surveillance

• Disciplines those that fail to comply

• Provides education to industry professionals and investors

• Provides services to members to support their compliance efforts

• Plays an important role in promoting international discourse

B i t t k t• Brings transparency to markets

• Operates the securities dispute resolution forum


RevenuesRevenues

FINRA’s revenues consist of 6 key sources and approximate $680M based on 2007’s actuals.Member Regulation Fees – primarily support examination, enforcement and rule writing activities (GIA, TAF, PA, etc).

% of Total Revenues -- 2007

6%

8% 9% 1%

User Fees – driven by member demand. (Registration, Testing Continuing Ed Fees, Corp Fin, Advertising, Transparency Services)

Di t R l ti F F f

51%25%

6%

Regulatory fees User feesDispute Resolution Fees – Fees for administering the arbitration and mediation programs

Regulatory fees User feesDispute resolution fees Transparency service feesContract service fees Other fees

Transparency Service Fees – Fees for use of TRACE, ADF, OTCBB and ORF

Contract Fees – Contract revenues from Nasdaq, Amex, ISE and various other exchanges for real-time market surveillance and other contractual services provided.

Other Fees – Primarily represents the annual contribution from the investment portfolio


Options Regulatory Surveillance Authority

(ORSA)(ORSA)

12

Options Regulatory Surveillance Authority (ORSA)

• Established in 2006 by consortium of 6 options exchanges (7th joined in March 2008) to perform consolidated electronic surveillance for insider trading and investigate alerts in options classes traded across participanttrading and investigate alerts in options classes traded across participant exchanges (AMEX, Boston Stock Exchange, CBOE, International Securities Exchange, NYSE Arca, and Philadelphia Stock Exchange).

• ORSA is a contractual agreement under Rule 608 of Securities Exchange Act of 1934 (Filing/Amendment of National Market Systems (NMS) Plans);Act of 1934 (Filing/Amendment of National Market Systems (NMS) Plans); Rule 608 allows creation of NMS Plans among SROs, subject to SEC approval and ongoing supervision.

• ORSA Plan specifies a formula for dividing costs among participants with afi d ti h d ll d i bl ti b d b ffixed portion shared equally, and variable portions based on number ofoptions classes and volume traded; system development costs were borneentirely by one service provider (CBOE).

• Each exchange remains responsible, as a SRO, for the regulation of itsg gmarket and for initiating enforcement proceedings if it appears that personsunder its jurisdiction have violated exchange rules or the federal securitieslaws.


ORSA Governance

ORSA Plan authorizes the participants’ acting jointly to administer, operate, and maintain a surveillance system to d t t i id t di ( ith ibilit f i t thdetect insider trading (with possibility of expansion to other violations).Governance by a Policy Committee with one representative from each participant exchange having one vote and majority voteeach participant exchange having one vote, and majority vote determining:

The extent to which regulatory, surveillance, and investigative functions are performed per exchange participant;

fProcurements of goods and services;Surveillance standards and parameters;Annual budget and other financial matters; andResolution of disputes arising from the PlanResolution of disputes arising from the Plan.


ORSA Governance

Policy Committee has delegated to CBOE responsibility for performing daily surveillance and conducting investigations pursuant to a Regulatory Services Agreement with other participants; CBOE uses its own systems and personnel.

Consolidated quotation and transaction data are provided by the Options Price Reporting Authority.


ORSA Model’s Benefits

• Delivers comprehensive, cross-market surveillance for standardized options traded via multiple exchange-SROs

• Surveillance responsibility resides in an industry utility that has an economic incentive to be efficient because the alternative would cost the participants more

• Saves duplicative costs in systems development and staffing

• Facilitates better coordination among SROs, particularly in large cases

• Facilitates coordination with SEC on referrals

• Supports SRO model with outsourcing of surveillance function, but not regulatory responsibility/enforcement authority of participants

• Structure/experience make expansion easy (e.g., front-running surveillance)Structure/experience make expansion easy (e.g., front running surveillance)

• Inter-market competition for order flow remains

• Recognition in SEC Enforcement Releases


National Futures Association

(NFA)(NFA)

17

National Futures Association (NFA)

NFA BackgroundSingle industry-wide SRO for the US futures industry launched in 1982Single, industry wide SRO for the US futures industry launched in 1982

Concept of futures association/SRO was included in 1974 legislation that created the CFTC (Commodity Future Trading Commission Act of 1974 (CFTC Act))

A 1978 amendment made membership in an association/SRO mandatoryThis accelerated FSA’s formation and launch after its 1981 registration with the CFTCEvery firm/individual that handles customer funds on any US futures exchange mustEvery firm/individual that handles customer funds on any US futures exchange must join

Membership: 4,200 firms and 55,000 natural persons (2007)

Subject to CFTC oversight (e g review of rule changes and disciplinarySubject to CFTC oversight (e.g., review of rule changes and disciplinary actions, access to NFA databases, periodic business/financial reports, case referrals, etc.)


NFA Organization and Governance

NFA was established as a not-for-profit entity funded by futures exchanges and industry participantsexchanges and industry participants

NFA does not act as a lobbyist for the futures industry

277 staff and two offices (New York/Chicago)

25 member Board of Directors composed of 5 public directorsIndustry segment directors (representing exchanges futures commissionsIndustry segment directors (representing exchanges, futures commissions merchants, introducing brokers, commodity pool operators)


NFA Mission Statement and Priorities

When launched, to clean up an industry plagued by a few large firms that lacked a compliance culture and gave the industry a negative public imageimageTo deliver innovative regulatory programs/services that promote integrity, protect market participants, and assist members in meeting their regulatory obligationsTo achieve a highly efficient/effective regulatory environmentEarly priorities:

Registration process and qualification standards for membersKnow-your-customer and disclosure rules on risksEthical standards for advertisingDefinition of supervisory standards aimed at questionable sales staffAggressive enforcement stance and willingness to impose fines and revokeAggressive enforcement stance and willingness to impose fines and revoke business privileges in appropriate cases


NFA Mission Statement and Priorities

Comprehensive rulemaking with input from industry advisory committees

Provide arbitration forum to resolve customer-member disputes

Deliver regulatory education and training programs for industry


Recent Developments at FSA

Reorganizing compliance department along three functional linesA single audit/inspections team (flexibility and cause capabilities)A single audit/inspections team (flexibility and cause capabilities)Formation of a risk management group tasked with developing new audit, risk management, and relationship tracking systemInvestigations group to support case development in collaboration with g g p pp pEnforcement team (in Office of General Counsel)

Adapting rules and market surveillance techniques to off-exchange trading venues for foreign currency aimed at retailexchange trading venues for foreign currency aimed at retail segment

Strengthening of AML rules for customer identification


Conclusion

Some Common ThemesNeed to evolve regulatory practices and rules to meet changing market g y p g gstructures and new productsDemutualization of market operators drives search for more efficient ways to perform self-regulatory functionsIncreased use of technology for surveillance and inspectionsIncreased use of technology for surveillance and inspectionsMore emphasis on preventive compliance– Application of risk management principles– Expanded education and training to facilitate complianceExpanded education and training to facilitate compliance– More communication with end-users

Harmonization to global standards and participation in policy making bodies that influence global standards

SROs must evolve as the markets and products change to remain relevant


Independent Self-Regulatory Organization Models in the United

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