ISSN 1045-6333 HARVARD JOHN M. OLIN CENTER FOR LAW, ECONOMICS, AND BUSINESS FELLOWS’ DISCUSSION PAPER SERIES STOCK EXCHANGES AT THE CROSSROADS: COMPETITIVE CHALLENGES - REORGANIZATION - REGULATORY CONCERNS Andreas M. Fleckner Discussion Paper No. 6 10/2005 Harvard Law School Cambridge, MA 02138 Contributors to this series are John M. Olin Fellows in Law and Economics at Harvard Law School or other students who have written outstanding papers in law and economics. This paper can be downloaded without charge from: The Harvard John M. Olin Fellow’s Discussion Paper Series: http://www.law.harvard.edu/programs/olin_center/ This paper is also a discussion paper of the John M. Olin Center's Program on Corporate Governance JEL CLASSIFICATIONS: D4, D18, D23, G1, G2, G3, G18, G28, G32, G38, L1, L2, L3, L5 STOCK EXCHANGES AT THE CROSSROADS COMPETITIVE CHALLENGES—REORGANIZATION— REGULATORY CONCERNS Andreas M. Fleckner* ABSTRACT The world of stock exchanges—the very heart of our economy—is at a crossroads. Traditionally, stock exchanges were owned and managed solely by their traders. But with competition from other marketplaces getting stronger and stronger, stock exchanges are compelled to forgo their exclusivity and restructure as publicly traded corporations, a process referred to as demutualization. In the future, everyone will be able to own a piece of a stock exchange: Shares of stock exchanges will be traded on stock exchanges, like shares of any public company. But stock exchanges will remain unique insofar as they are vested with a public mandate to oversee the securities markets. Demutualiza- tion, listing, and self-listing of stock exchanges challenge this concept of self-regulation. The article discusses the regulatory framework for stock exchanges, identifies the compelling reasons for their transformation into publicly traded companies, and ad- dresses regulatory concerns raised by this reorganization. Based on this analysis, the article proposes amendments to the current regime that would mitigate and overcome the new structure’s negative consequences without reducing its positive ones. Keywords: stock exchange; self-regulatory organization (SRO); regulatory powers; self-regulation; competition among marketplaces; demutualization; conflicts of interest; self-listing; non-profit and for-profit organizations; member regulation; market surveil- lance; listing requirements; going public. * Visiting Researcher, Harvard Law School. LL.M., Harvard Law School, 2005. For very helpful discussions, suggestions, and general critique, I am grateful to Howell E. Jackson and to Noah D. Levin. The normal disclaimers apply. 2 ANDREAS M. FLECKNER ABSTRACT .................................................................................................................................................................... 1 I. INTRODUCTION .................................................................................................................................................... 4 II. BACKGROUND ...................................................................................................................................................... 7 A. Functions of Stock Exchanges........................................................................................................................... 7 1. Market Organizers....................................................................................................................................... 8 2. Information Distributors ............................................................................................................................. 8 3. Market Regulators....................................................................................................................................... 9 4. Corporate Governance Standards Setters ................................................................................................. 10 5. Business Enterprises.................................................................................................................................. 11 B. Or ganization of Stock Exchanges.................................................................................................................... 12 1. Age of Self-Regulation (until 1934) ......................................................................................................... 12 2. Inauguration of the Securities and Exchange Commission (1934) .......................................................... 13 3. Reinvigoration of the Securities and Exchange Commission (1975)....................................................... 14 4. Recent Developments (1993-2005) .......................................................................................................... 15 a) International Trend of Demutualization (starting 1993)...................................................................... 15 b) Failed Attempts in the United States (1999/2000)............................................................................... 16 c) Demutualizations in the United States (2004/2005) ............................................................................ 17 d) New York Stock Exchange—Archipelago Merger (2005).................................................................. 18 5. Overview of the Current Organizational Structure (2005)....................................................................... 19 III. THE CASE FOR DEMUTUALIZATION AND GOING PUBLIC ..................................................................... 23 A. Factors that Foster Competition....................................................................................................................... 24 B. Marketplaces that Compete ............................................................................................................................. 26 C. Subjects of Competition................................................................................................................................... 29 1. Competition for Listings ........................................................................................................................... 29 2. Competition for Orders ............................................................................................................................. 31 D. Co mpetitive Advantages of Public Stock Exchanges ..................................................................................... 32 1. Raising Money .......................................................................................................................................... 33 2. Decision Making ....................................................................................................................................... 33 3. Consolidation ............................................................................................................................................ 34 IV. CONFLICTS OF INTEREST ................................................................................................................................36 A. Regulatory Environment.................................................................................................................................. 37 1. Concept of Self-Regulation....................................................................................................................... 37 2. Regulation of Stock Exchanges (Governmental Powers)......................................................................... 39 3. Regulation by Stock Exchanges (Self-Regulatory Powers) ..................................................................... 42 B. Regulating in General ...................................................................................................................................... 46 1. Incentives for Under-Regulation............................................................................................................... 48 2. Incentives for Over-Regulation................................................................................................................. 50 3. The Organizational Structures’ Indifference Toward Regulation............................................................ 51 C. Regulating Stockholders.................................................................................................................................. 52 D. Regulating Competitors ................................................................................................................................... 53 1. Trading Regulation.................................................................................................................................... 54 2. Issuer Regulation....................................................................................................................................... 55 E. Regulating Oneself........................................................................................................................................... 57 1. Trading Regulation.................................................................................................................................... 57 2. Issuer Regulation....................................................................................................................................... 58 F. Regulating Affiliates.......................................................................................................................................