An SRO has statutory responsibility to regulate its own members through the approval and enforcement of set of rules of conduct for impartial, ethical, and efficient practices.
The regulatory authority could be employed (i) in addition to some form of public regulation, or (ii) to fill the emptiness of a lack of government supervision and control.
In the securities industry, there are many SROs such as National Stock and Commodity Exchanges (e.g., the NYSE) and the National Association of Securities Dealers (NASD).
The SRO’s purpose is to maximize the welfare of its members. On one hand, to be successful, an SRO should (i) be independent, both in perception and reality, from the entities it purports to regulate; (ii) develop standards that are meaningful and broadly accepted; (iii) be recognized as legitimate and relevant by the market agents; (iv) provide for fair and respected enforcement.
On the other hand, investors expect that an SRO should (a) ef ectively watch its members, controlling their quality provision; (b) punish and publicly denounce any evidence of bad quality provision or fraud, as a credible signal of its level of surveillance and the quality the consumers may expect in the market.
However, self-regulation implies a situation of regulatory capture, hence the incentives for the SRO to do its job are not guaranteed.
In theory, a self-regulatory strategy would exploit many of the rewards of an established market while bypassing many of its weaknesses. In effect, a part of the governance of the financial firm is outsourced to a central SRO, while the firm’s output for financial services is still determined based on free market outcomes.
This central organization is an effective solution to the free rider problem of industry reputability and could help foster a healthy Nash Equilibrium to deter fraud in the hedge fund management industry.
At er the Sarbanes-Oxley Act was promulgated, many criticisms have been addressed to self-regulation. In fact, self regulation has played a key role in protecting investors for a very long time.
Most observers agree that the SRO system has functioned effectively, and has served the government, the securities industry, and investors well. But despite this general agreement, one feature of the system in particular has increasingly drawn the attention of reformers—and that is its reliance on multiple, redundant regulators.
Like public regulators, even self-regulators are experiencing a process that should make the system more safe and sound through a merging route, in order to overcome the causes of turmoil of many SROs (many rulebooks, separate regulatory staffs, and completely different enforcement systems).
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