A self-regulatory organization (SRO) is a non-governmental entity that has the power to create and enforce industry regulations and standards. SROs are typically granted authority by a governmental agency or through legislation, allowing them to oversee the conduct and practices of their members to ensure compliance with established rules and regulations.
Overview and Legislative Background
The Securities Exchange Act of 1934 (“Exchange Act”) lays out a comprehensive registration process and reporting scheme. It makes clear that the Securities and Exchange Commission (“SEC”) does not single-handedly ensure industry compliance. All securities exchanges must register with the SEC under Section 5 of the Exchange Act. Section 6 outlines the requirements for registration, including a mandate that all exchanges adopt a regulatory regime for their members in the form of exchange rules.
See: 15 U.S. Code § 78iii - Functions of self-regulatory organizations
Role and Function of SROs
Each securities exchange has a set of rules applicable to any market participant trading on that exchange. Recognizing the potential for conflicts of interest (the “fox guarding the chicken coop” problem), Congress required more stringent oversight. Thus, Section 6 of the Exchange Act prescribes standards and regulatory objectives that SRO rules must fulfill. Through the rulemaking process, SROs must establish standards to prevent fraud and market manipulation and promote “just and equitable principles of trade.” They must also provide for disciplinary actions against exchange members who violate federal securities laws and address fee structures for brokers.
Regulatory Authority and SEC Oversight
Section 6 gives the securities industry substantial power to supervise itself under the SEC’s watchful eye. This provision allows for upfront regulation by the SEC, which sets the goals and targets of regulation by prescribing the content of SRO rules. The SEC also regulates at the back end to ensure that the exchanges fulfill their statutory duties in enforcing the rules and monitoring their members. The actual process of rulemaking and enforcement against members is left to the securities exchanges.
The SEC retains the power to ensure that exchanges fulfill their regulatory responsibilities on an ongoing basis. Under Section 19 of the Exchange Act, the SEC can take enforcement actions against SROs that violate rules of good practice and fail to police and discipline their members. Despite having the power to review any disciplinary actions taken by an SRO, the SEC rarely reverses these actions. Section 19 also requires securities exchanges to receive SEC approval for any rule changes. While the SEC often defers to SROs on disciplinary matters, it uses industry-wide standards to indirectly regulate SRO members through rulemaking, which involves a public notice and comment period.
Broker-Dealers and Securities Associations
Broker-dealer firms must register under the Exchange Act and can only transact in the over-the-counter market if they are members of a registered securities association. Given that the vast majority of securities are traded over-the-counter, this provision effectively requires almost all broker-dealers to register with a securities association. A securities association, in turn, must develop rules of conduct and good practices for its members and discipline members for rule violations and breaches of federal securities laws. These rules cover ethical behavior, duties of brokers towards their clients, and specific problems such as market manipulation and unauthorized trading. Securities associations can take disciplinary actions against their members, with the SEC retaining the statutory power to review these actions.
Historical Context and Modern Developments
Historically, each securities exchange constituted an SRO, with the New York Stock Exchange (NYSE) being the largest and most well-known. The sole securities association registered with the SEC used to be the National Association of Securities Dealers (NASD). In July 2007, the SEC approved the merger of NASD and the regulatory operations of the NYSE to form the Financial Industry Regulatory Authority (FINRA). This merger aimed to create a single efficient regulatory body that saved costs for members and protected investors effectively by combining the regulatory operations of the two SROs. FINRA has undertaken a process to consolidate the rules from each SRO and provides a single forum for investors to seek arbitration for claims against broker-dealer firms and their employees.
[Last updated in June of 2024 by the Wex Definitions Team]
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