The U.S. Securities and Exchange Commission is in the midst of asking an interesting question: should for-profit exchanges operate as an industry regulator?

SEC

Stock exchanges’ self-regulatory role was established well before the establishment of the SEC in 1934. The exchanges, non-profit entities at the time, derived special status from the regulatory role, such as the sale of lucrative market data and limits on private lawsuits against them, notes a report on the topic in Bloomberg Businessweek.

The SEC is focusing on the exchanges’ regulation of competitors, with SEC Chairman Mary Jo White and Commissioner Daniel M. Gallagher have said the exchanges’ regulatory roles may be a conflict of interest relative to their need to compete with trading venues including dark pools. Private trading venues such as dark pools, unlike traditional exchanges, are not required to provide the same level of transparency nor are they required to submit to the same burdensome regulatory structure.

The Securities Industry and Financial Markets Association, a non-profit organization representing brokers, say the self-regulatory model also creates conflicts of interest for exchanges because it asks them to regulate members that operate competing trading venues, the report noted.

Regulated vs. unregulated exchanges highlight differences in transparency, equal order treatment

Exchanges execute approximately 62% of total share volume, according to data compiled by Bloomberg.  The balance is executed on dark pools such as Credit Suisse Group AG (NYSE:CS)’s Crossfinder and Morgan Stanley (NYSE:MS)’s MS Pool, plus internal platforms at broker-dealers that, unlike exchanges, are not required to publish their rules or treat all orders the same, the report noted.  Transparency and equal order treatment are considered cornerstones of a regulated exchange.

“How should we rationalize the discrepancies in regulatory treatment between a dark pool and an exchange, given that they are expected to perform the same generalized function: serving as a place to match buyers and sellers?” Stein asked in her speech to the TraderForum 2014 Equity Trading Summit, quoted in the report.

Exchanges regulating their most profitable customers creates conflicts of interest

What the report doesn’t mention, and may not be part of SEC’s official consideration, is that since becoming for profit organizations, the exchanges are responsible for regulating their most profitable customers, high frequency traders.  Separate questions have arisen regarding potential conflicts of interest in regard to a market participant that can account for the large majority of exchange volume and profits.

SIFMA last year asked the government to strip exchanges of their status as self-regulatory organizations, saying “Conflicts of interest in this model abound and only worsen as they are left unresolved,” Theodore R. Lazo, associate general counsel at Sifma, wrote in a letter last year to the SEC.