Self-Regulation and Securities Markets

Abstract

Exchanges have a powerful incentive to regulate insider trading and market manipulation because of the effect that those practices have on liquidity. Markets known for insider trading and manipulation risk a downward spiral as investors depart seeking out alternative, safer investments. Exchanges, through the design of transparent trading mechanisms, vigilant monitoring of trading, and the imposition of demanding listing standards, can help create the trust that leads to deep and liquid securities markets. This essay compares the institutional incentives of securities exchanges and government to regulate abuses in the securities markets. I conclude that exchanges are more likely to regulate in a way that optimizes the trade-off between investor protection and the cost of regulation. Concerns about problems with conflict of interest in exchange regulation have been substantially reduced by the changes that international competition has brought to the securities markets. I propose a model that allocates regulatory authority between the exchanges and the government in a way that ameliorates the limitations of both institutions as regulators. In this regulatory model, exchanges would play the paramount regulatory role, with government playing the role of auditor of exchange regulation. The government's role would be limited in areas allocated to exchange regulation to ensuring that exchanges actually enforce their rules as written and aiding in the enforcement of those rules.