Commentary: Why the Market Can't Police Itself

By Paula Dwyer

Now that 10 Wall Street firms have agreed to settle charges of biased research, Congress and the Securities & Exchange Commission are facing a new question: Does self-regulation by Wall Street work?

The answer is a resounding no. It's not just that the New York Stock Exchange failed to act on phony research. More proof came when Sanford I. "Sandy" Weill, chairman and CEO of Citigroup (C ) (whose Salomon Smith Barney (C ) unit was implicated in the research scandal), was invited to represent the public on the NYSE board. Weill withdrew after a storm of protest.

Reports that NYSE Chairman and CEO Richard A. Grasso's compensation totaled $10 million last year were another troubling sign. Grasso's pay is set by a board-compensation committee, but he regulates most of its members. Among them: the chairmen of Bear Stearns (BSC ), Goldman Sachs (GS ) and Merrill Lynch (MER ). And on May 20, Grasso was reelected to the Home Depot (HD ) Inc. board, putting him in the position of both serving on it and policing its conduct. Grasso declined to comment. Says New York Attorney General Eliot Spitzer: "Fixing self-regulation is perhaps the most important policy issue facing the SEC."

Spitzer is right. Since 1934, the markets have policed themselves via self-regulatory organizations, or SROs. The NYSE is its own SRO, while the National Association of Securities Dealers performs the task for NASDAQ, which became independent in 2001. The SEC monitors them both. Says Annette L. Nazareth, who oversees the markets at the SEC: "Their job is to protect investors and ensure that their markets have integrity. They hold a sacred trust."

Periodically, they break that trust. The NASDAQ was remiss in the '90s, when it failed to see that its dealers were lining their pockets by keeping price quotes artificially wide. NASDAQ had to clean house and set up a separate regulatory group. Also, it wasn't until the SEC forced their hand, after a string of accounting failures, that the exchanges required companies to have a majority of independent board members.

Most experts agree that the NYSE and the NASD do certain chores well, such as overseeing day-to-day trading and rooting out insider trading. It was an NYSE analyst who triggered an investigation recently when he discovered that some floor specialists, who are charged with running an orderly market, were wrongly jumping between buyers and sellers to make a quick profit.

Too often, the SROs can't see the forest for the trees. "When the conduct is embedded in the mainstream firms, the SROs don't see it as abuse but as the way business is done," complains Barbara Roper, director of investor protection for the Consumer Federation of America.

The simplest solution would also be cheap and quick: The SROs should swallow the same medicine they are prescribing for public companies. By October, 2004, they want businesses to have a majority of independent board members, who are more prone to enforce the rules strictly, ask tough questions, and act in investors' best interests. Independents on exchange boards must not be either an exec at a listed company or employed in the securities industry. The NYSE would have to replace 10 of its current 27 directors; NASDAQ, 6 out of 21.

Unless the exchanges act voluntarily, they may find that other solutions now being discussed in Washington are far more distasteful. For instance, Congress could create a superregulator, similar to the oversight board that replaced the SRO functions of the accounting industry. But that might undermine the thing that markets do best: conducting day-to-day surveillance of members. Still, it's more attractive than turning over SRO duties to the SEC, an expensive option nobody seems to like but that Congress might consider implementing unless the SROs prove they can do the job.

It's urgent to put the "public" back in public markets. Exchanges were given quasi-governmental powers precisely because of the public function they serve -- not to protect their members' vested interests.

Dwyer follows the markets from Washington.

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