Re-examining Self-Regulation

Time for new Masters of the Universe to emerge

Self-regulation is the Republican mantra today, but it has a long history of failure, especially in the financial services industry.

Masters-Of-The-UniverseAs events have shown, price manipulations and outright fraud have been part of the daily business practices at some of the world’s largest banks and investment firms. This helps explain why six U.S. banks agreed to pay $5.8 billion in fines since 2008 years, as noted by Bernie Sanders. In addition, there have been major price collusion scandals involving the LIBOR and PIBOR interest rates, as well as gold and currency fixings.

So with the huge fines being paid and federal regulators allegedly on the job policing the business practices of these financial institutions, what should the average American think of self-regulation?

The reality is that even though America’s financial institutions are some of the most recognized in the world, few financial professionals, average investors and most financial journalists have little idea how they operate or are governed. The recent presidential campaign and the movie, The Big Short, have shed light on the 2007 systemic mortgage fraud that precipitated a global recession that still lingers today. But this is not new.

The Old NASDAQ Collusion Story

Take the case of the price collusion charge against NASDAQ and its top dealers. When two finance professors (Bill Christy and Hans Schultz) found that a random sampling of NASDAQ stock prices showed an absence of prices trading in even numbers, they had little idea this mathematical anomaly was part of a pattern of abuse.

After further research, the professors concluded that only the tacit collusion by NASDAQ dealers could explain the appearance of even-only prices. When the study was picked up in the Sunday edition of the Los Angeles Times in May 1994, the story moved from academia to Main Street.

By July 1994, investors had filed class action lawsuits against 30 dealers working at some of Wall Street’s largest firms. Yet as this case evolved, including the initiation of separate probes by the Justice Department and the SEC in October and November 1994, it also led to questions about the NASDAQ stock Exchange’s own self-regulator, the National Association of Securities Dealers (NASD). The key questions were how the NASD allowed price collusion to repeatedly occur under its own supervision and whether self-regulation of member-owned exchanges is even possible?

When $3.3 trillion in stock is traded daily (in 1994 activity) between member-owners on the NASDAQ and their clients, the temptation for abuse is huge. When a customer contacts their broker, a chain of liability is created which results in a fiduciary responsibility to get the best price possible for their client. But that obligation is often subjugated to other more powerful interests.

These conflicts can arise from proprietary trading by that same market-making firm against a customer order, payment for order flow (in which market-makers pay brokers for directing market orders to their trading desks); and allocating the best prevailing prices to preferred customers. In many cases, getting the best price possible (that old fiduciary obligation between broker and client), is pushed farther down the list of possible profitable actions. This may help explain why some brokers said the $14 billion incurred in customer losses between 1989 and 1994 is conservative.

It also helped explain the exchange’s self-governance process. Like the nation’s other equity exchanges, the NASDAQ polices itself and maintains its own surveillance department to detect specific violations, including unusual trading patterns. Yet, as the class action lawsuits stated, the NASDAQ never discovered something as obvious as prices only being traded in even-eighth increments.

JP MorganThe subsequent Justice Department and SEC investigations may have discovered the reason why. The Chinese wall, which theoretically exists between the nation’s stock exchange surveillance departments and its executive management, is repeatedly breached. At the time, exchanges were member-owned, so the possibility of bringing actions on punishable trading practices was often weighed against which firm is the perpetrator. Larger firms driving the most transactions through the exchange carry the most clout, and also set standards for other firms.

When exchanges bring disciplinary actions, they are most commonly brought against independent brokers and rarely against entire firms or trading departments. Exchange surveillance departments cannot fail to detect patterns of abuse by member firms since these actions often are woven into daily business practices. Any such indictment would just mean their entire surveillance effort is faulty.

That leaves it to outsiders to detect a wide range of systematic abuses. It also explains why these patterns must grow into widespread abuses before outsiders can detect them.

Plain Old Secrecy

Another reason why systematic trading abuses continue is plain old secrecy. Unlike the stock exchange listed corporations that must report their executives’ salaries and compensation packages, the New York Stock Exchange did not disclose executive salaries and what transpired at their monthly board meetings until the exchange went public in March 2006. They do this despite the fact that they self-regulate themselves under special dispensation from the Securities and Exchange Commission.


The other gray area in which exchanges operate concerns their ownership status. When I asked exchange executives whether they consider themselves public or private institutions in the late 1990s, the exchanges answered that they were private, member-owned, non-profit corporations. Yet former SEC Chairman David Ruder, then a law professor at Northwestern University, considered the exchanges semi-public institutions since they fulfilled a policing function that could be done by the SEC.

The recent NASDAQ case illustrates that you cannot have it both ways. The temptation for self-regulation when your own members can put their hands into a daily stream translating into millions worth of stock, increasingly being broken down into bite-sized increments of eighths or sixteenths, is too great.

As part of the subsequent Justice Department and SEC investigations, the NASDAQ was forced to spin-off its in-house surveillance department into a separate entity that ideally would have a more arms’ length relationship with its constituents. And in order to deliver possible price improvements to its customers, the exchange adopted a new, externally developed electronic trading system. But the problems at NASDAQ are historic.

Since the Securities Exchange Act of 1933, exchanges have incubated their own complex, often self-serving regulations. For instance, most stock and futures exchanges had rules prohibiting a member from criticizing the exchange and its operations in public. Members who violate this rule can be brought before the exchange’s Business Conduct Committee, where they faced possible fines and suspension. As a result, members who do bring complaints against fellow exchange members often thought twice since they could face formal and informal sanctions meted out by fellow members on the trading floors or in off-floor meetings to arrange stock syndications or new offerings. Being outspoken about everyday practices that violate exchange rules can easily mean being blackballed.

For instance, in the late 1990s, futures traders who complained internally about irregular pit trading practices told me they were subsequently singled out for punishment by having out-trades (trades they did not make) placed into their account. Similarly, there’s the case of a senior executive at a Wall Street firm who reported some irregularities his trading team noted in a NYSE-listed stock to a senior official at the NYSE. A few weeks later, a NYSE auditor visited the senior executive’s office to inform him the exchange would like to examine his department’s books. The executive never heard about any investigation into the trading irregularities he had discovered.

These Serpico-like incidents escape the media’s Wall Street coverage then and today as well. Still, they are inherently part of any financial organization that faces the burden of self-regulation. That’s because self-regulation is too often more than rhetoric about ethical behavior. It’s really about members of the trading crowd (on and off the floor) having the ability and freedom to publicly question another trader or firm’s behavior without fear of recrimination. Without that, self-regulation is just another Wall Street myth. —Chuck Epstein

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Chuck Epstein has managed marketing communications and public relations departments for major global financial institutions and participated in the launch of industry-changing financial products. He also has written by-lined articles for over 50 publications, five books and served as editor and publisher of nation’s first newsletter on the topic of using the PC for personal investing and trading. (“Investing Online, 1994-1999). He also is a marketing consultant, writer and speaker on topics related to investor protection and opportunities in the very dynamic cannabis industry. He has held senior-level marketing, PR and communications positions at the New York Futures Exchange, Chicago Mercantile Exchange, Lind-Waldock, Zacks Investment Research, Russell Investments and Principal Financial. He has won national awards from the Mutual Fund Education Alliance (MFEA) and his web site,, was named best small blog in 2009 by the Society of American Business Editors and Writers (SABEW).


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