At yesterday’s meeting of the SEC’s Investor Advisory Committee, academics and SEC officials explored the Commission’s approach to regulation in areas with limited competition and how the SEC can address ways to increase competitiveness when formulating new rules. The panelists drew on experiences from the SEC’s own regulatory history as well as lessons that can be learned from antitrust regulation.
Credit rating agencies. Professor Aline Darbellay of the University of Geneva said that credit ratings are an example of how competition and regulation are intertwined. She noted that the industry is highly concentrated in three credit rating agencies: Standard & Poor's (S&P), Moody's, and Fitch Group. There are significant barriers to entry for smaller firms, she observed. The Credit Rating Agency Reform Act of 2008 had made improving competitiveness a regulatory objective by opening the market to newer ratings agencies, she said. She added that in 2015, the SEC amended its rules to remove certain references to credit ratings. Darbellay added, however, that while getting rid of these references can help increase competition, it can have a domino effect on other areas of the financial system, such as bank capital requirements and insurance capital requirements.
Darbellay also discussed credit rating agencies in the European Union. The EU’s regulations have an extraterritorial reach, and U.S. credit rating agencies must comply with these regulations if they want to have access to the EU market, she said. Darbellay noted that there are currently 29 credit rating agencies in the EU, including smaller rating agencies, compared to 10 nationally recognized statistical ratings organizations (NRSROs) in the U.S.
Committee member J.W. Verret, a professor at George Mason’s Antonin Scalia Law School, suggested that one way to overcome barriers to entry in the rating agency industry in the U.S. would be to allow rating agencies registered with ESMA to be automatically recognized in the U.S. This could improve competition among rating agencies, he said.
Unintended consequences. Professor Craig Pirrong of the University of Houston pointed to the adoption of Regulation NMS as an example of the unintended consequences of attempting to increase competition. While Reg NMS increased competition for order flow in the markets and led to remarkable changes in market structure, an unintended consequence was the fragmentation of the market for data. Regulation NMS has effectively created individual monopolies for the sale of data, Pirrong advised.
Lessons from antitrust. Professor Robert H. Lande of the University of Baltimore School of Law offered his thoughts on competition from an antitrust perspective. The “supreme evil” of the antitrust world is collusion, he explained, which can fall into three categories. Classic or Type I collusion involves firms banding together to act like a monopoly through price-fixing, bid-rigging, and the allocation of markets and customers. A second category involves collusion to disadvantage rivals, he said. These methods include the use of boycotts, which allow the colluding firms to raise prices after their rivals are weakened.
Type III collusion is not as intuitively obvious as the other two categories, Lande said. This category relates to collusion to fix the rules of competition without direct agreements. He gave a number of examples of Type III collusion, such as advertising bans for certain legal services, which makes it more difficult to shop around for a lawyer. He also cited an Indiana Federation of Dentists rule which had required insurance agents to actually visit a dentist’s office when investigating a claim, which raised the costs of weeding out insurance fraud.
Yet another example was Detroit car dealers coming together to eliminate shopping after 5 p.m. on weekdays and on the weekend, which would require people to take time off work and reduce the amount of time they could comparison shop for cars, he explained.
Lande noted that some rules that fall into Type III collusion are based in ethics with the public interest in mind. For example, an association of gem dealers forbade members from charging a percentage of the value appraised because it could lead to inflated appraisals against the interest of consumers, Lande said. Regulators should take into account Type III collusion scenarios when assessing regulations aimed at increasing competition, according to Lande.
Views from the regulator. Two SEC officials participated in the panel discussion: Daniel M. Gray, senior special counsel in the Division of Trading and Markets, and Narahari Phatak, associate director in the Division of Economic and Risk Analysis (DERA). Gray noted that in 2008, the SEC decided to take a market-based approach to fees. The SEC’s fee regime has been subject to criticism and litigation by brokers and trading firms who asserted that fees charged by the national exchanges were unreasonably high. Last October, the SEC ruled that NYSE and Nasdaq had not met their burden to show that their fees are “fair and reasonable” and “not unreasonably discriminatory” regarding the two fees being challenged. The Commission also remanded another 400 fees to the exchanges to be reassessed in light of the decision. The exchanges appealed the Commission’s decision, and the matter is currently before an appellate court.
Gray noted that during an SEC roundtable on market data and market access, market participants such as brokerage firms, market makers, and institutional investors urged the Commission to rethink its regulatory approach toward fees because there is not sufficient competition in this area to ensure that fees are reasonable. The exchanges, on the other hand, continued to argue that the actual level of competition among order flow disciplines the pricing because if they raise their prices for market data people can shift order flow and there are alternatives to their proprietary data. He observed that another argument raised by the exchanges is a “platform theory,” where particular fees should not be the focus because in the exchange business, competition is at the platform level. The platform includes data fees, connectivity fees, and all trading services, so the exchanges maintained that the Commission should look at aggregate returns across the platform, Gray added.
Phatak noted that efforts to increase competition can have varied results depending on the context. For example, the SEC, in an effort to enhance transparency, amended its rules last year to require alternative trading systems (ATSs) to file detailed public disclosures. Phalak said that the SEC acknowledged that this could be a barrier to entry, which might inhibit competition. However, the SEC’s rules for NRSROs provided for standardization, which can help enhance comparability. This increased transparency can help smaller NRSROs compete with the large rating agencies in contrast to the SEC’s rules seeking to make ATSs more transparent, Phatak advised.
Darbellay also discussed credit rating agencies in the European Union. The EU’s regulations have an extraterritorial reach, and U.S. credit rating agencies must comply with these regulations if they want to have access to the EU market, she said. Darbellay noted that there are currently 29 credit rating agencies in the EU, including smaller rating agencies, compared to 10 nationally recognized statistical ratings organizations (NRSROs) in the U.S.
Committee member J.W. Verret, a professor at George Mason’s Antonin Scalia Law School, suggested that one way to overcome barriers to entry in the rating agency industry in the U.S. would be to allow rating agencies registered with ESMA to be automatically recognized in the U.S. This could improve competition among rating agencies, he said.
Unintended consequences. Professor Craig Pirrong of the University of Houston pointed to the adoption of Regulation NMS as an example of the unintended consequences of attempting to increase competition. While Reg NMS increased competition for order flow in the markets and led to remarkable changes in market structure, an unintended consequence was the fragmentation of the market for data. Regulation NMS has effectively created individual monopolies for the sale of data, Pirrong advised.
Lessons from antitrust. Professor Robert H. Lande of the University of Baltimore School of Law offered his thoughts on competition from an antitrust perspective. The “supreme evil” of the antitrust world is collusion, he explained, which can fall into three categories. Classic or Type I collusion involves firms banding together to act like a monopoly through price-fixing, bid-rigging, and the allocation of markets and customers. A second category involves collusion to disadvantage rivals, he said. These methods include the use of boycotts, which allow the colluding firms to raise prices after their rivals are weakened.
Type III collusion is not as intuitively obvious as the other two categories, Lande said. This category relates to collusion to fix the rules of competition without direct agreements. He gave a number of examples of Type III collusion, such as advertising bans for certain legal services, which makes it more difficult to shop around for a lawyer. He also cited an Indiana Federation of Dentists rule which had required insurance agents to actually visit a dentist’s office when investigating a claim, which raised the costs of weeding out insurance fraud.
Yet another example was Detroit car dealers coming together to eliminate shopping after 5 p.m. on weekdays and on the weekend, which would require people to take time off work and reduce the amount of time they could comparison shop for cars, he explained.
Lande noted that some rules that fall into Type III collusion are based in ethics with the public interest in mind. For example, an association of gem dealers forbade members from charging a percentage of the value appraised because it could lead to inflated appraisals against the interest of consumers, Lande said. Regulators should take into account Type III collusion scenarios when assessing regulations aimed at increasing competition, according to Lande.
Views from the regulator. Two SEC officials participated in the panel discussion: Daniel M. Gray, senior special counsel in the Division of Trading and Markets, and Narahari Phatak, associate director in the Division of Economic and Risk Analysis (DERA). Gray noted that in 2008, the SEC decided to take a market-based approach to fees. The SEC’s fee regime has been subject to criticism and litigation by brokers and trading firms who asserted that fees charged by the national exchanges were unreasonably high. Last October, the SEC ruled that NYSE and Nasdaq had not met their burden to show that their fees are “fair and reasonable” and “not unreasonably discriminatory” regarding the two fees being challenged. The Commission also remanded another 400 fees to the exchanges to be reassessed in light of the decision. The exchanges appealed the Commission’s decision, and the matter is currently before an appellate court.
Gray noted that during an SEC roundtable on market data and market access, market participants such as brokerage firms, market makers, and institutional investors urged the Commission to rethink its regulatory approach toward fees because there is not sufficient competition in this area to ensure that fees are reasonable. The exchanges, on the other hand, continued to argue that the actual level of competition among order flow disciplines the pricing because if they raise their prices for market data people can shift order flow and there are alternatives to their proprietary data. He observed that another argument raised by the exchanges is a “platform theory,” where particular fees should not be the focus because in the exchange business, competition is at the platform level. The platform includes data fees, connectivity fees, and all trading services, so the exchanges maintained that the Commission should look at aggregate returns across the platform, Gray added.
Phatak noted that efforts to increase competition can have varied results depending on the context. For example, the SEC, in an effort to enhance transparency, amended its rules last year to require alternative trading systems (ATSs) to file detailed public disclosures. Phalak said that the SEC acknowledged that this could be a barrier to entry, which might inhibit competition. However, the SEC’s rules for NRSROs provided for standardization, which can help enhance comparability. This increased transparency can help smaller NRSROs compete with the large rating agencies in contrast to the SEC’s rules seeking to make ATSs more transparent, Phatak advised.