Oversight Failure in Securities Markets

Statute requires that exchanges police markets and enforce securities laws against the listed companies, investors and trading firms that use their facilities. In convening a large number of participants, exchanges can efficiently monitor a swath of the market and incentivize compliance by threatening exclusion from an essential economic resource. This Article shows that exchange oversight – and the private self-regulation it represents – is ineffective in modern markets. Over the last decade, regulatory policy has aggressively championed competition in the provision of trading services. The result has been a steady fragmentation in market structure, with equity trading divided between a multitude of competing for-profit exchanges and around 37 lightly regulated non-exchange venues (so-called “dark pools”). By promoting competition, however, policy weakens the ability of exchanges to police markets. First, fragmentation increases the costs of performing oversight, with exchanges facing structural information gaps as traders transact across multiple venues. Their disciplinary power is also diminished, as bad actors are able to switch business to another exchange or dark pool. Secondly, exchanges have incentives to under-invest in governance. Within an interconnected network of competing venues, expenditure in oversight benefits an exchange privately but it also confers value on competitors. Additionally, an exchange gains by lax oversight. It wins by lowering fees and capturing business for itself. But the full costs of failure can be externalized to the network of competing venues. In recognizing the economic harms of poor exchange oversight, this Article proposes a stronger “economic consolidation” in market design. It proposes the creation of a new liability regime for exchanges and dark pools to align the incentives of trading venues towards better oversight. In so doing, it harnesses liability levers to bridge the tension between the dueling policy objectives of competition and self-regulation in securities market structure