The New York Stock Exchange: Governance and Market Reform
CRS Report for Congress
The New York Stock Exchange:
Governance and Market Reform
Mark D. Jickling
Specialist in Public Finance
Government and Finance Division
On September 17, 2003, Richard Grasso resigned as chairman of the New York
Stock Exchange (NYSE) after a public uproar over his $187.5 million pay package .
Although Grasso is not charged with any violation of law or other wrongdoing, many
see his compensation as symptomatic of fundamental problems in NYSE governance,
regulation, and operations. Numerous reform proposals are under discussion, both
within the NYSE, among regulators, and in Congress. First, the NYSE has proposed to
restructure its board of directors to exclude representatives of the securities industry.
Second, some see a conflict of interest in the NYSE’s role as a self-regulatory
organization: is its responsibility to enforce trading rules compromised by its devotion
to its members’ financial interests? Finally, the NYSE is the last major stock market
where most orders are executed by humans on a trading floor rather than matched by
computers. Would public investors benefit if the exchange (or its regulators) made
reforms in market structure to foster competition with the NYSE’s electronic rivals?
As the world’s largest stock exchange and a key part of the U.S. economy, the
NYSE is a central focus of Congress’s oversight of financial markets. In October 2003,
the House Financial Services and Senate Banking Committees held hearings on market
structure and the future of the securities industry. Further hearings are planned. This
report sets out the basic issues in NYSE governance and market structure, and will be
updated as events warrant.
The New York Stock Exchange (NYSE) is a membership organization chartered as
a non-profit corporation. Members range from the largest Wall Street firms to specialized
brokers who conduct all their business on the exchange floor. The NYSE is also regulated
at the federal level by the Securities and Exchange Commission (SEC), which has broad
oversight powers, including the authority to modify, abrogate, or require the NYSE to
adopt any rule it sees fit. NYSE management thus answers to two sets of masters: its
membership of profit-seeking firms and individuals, to whom it is a source of revenue,
and its government overseers, the SEC and Congress, who view it almost as a public
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utility, whose fair and orderly operation is essential both to millions of public investors
and to companies that sell stock and bonds to raise capital to create wealth and jobs.
Like most private corporations, the NYSE is run by professional managers who serve
at the pleasure of a board of directors. Membership of the board of directors is divided
between the NYSE’s two major constituencies. Before the reform proposals now under
consideration, the board consisted of 12 members from the securities industry (generally
the heads of major Wall Street firms or NYSE floor brokers and specialists), 12 from
outside the industry (who include CEOs of major corporations, directors of pension funds
and other institutional investors, and other prominent individuals), and three members of
NYSE management, including the CEO, who serves as chairman of the board. Because
the board is responsible for hiring and compensating the CEO, it was the first target of
reform proposals following the Grasso resignation.
On November 5, 2003, the NYSE unveiled a proposal for a restructured board. The
new board would be composed of six to twelve independent members – no representatives
from the securities industry would serve as directors. The board of directors would
appoint a Board of Executives, consisting of about 20 representatives of broker/dealers,
floor traders, institutional investors, and listed companies. The Board of Executives would
act in an advisory capacity; the board of directors would have full control over the
regulatory budget, auditing, executive hiring and compensation, and the nomination of
The proposal must be approved by the NYSE membership. A vote has been set for
November 18, 2003, to approve both the restructuring and an initial slate of eight
directors, only two of whom currently sit on the board. The SEC must also approve. In
a statement on November 5, 2003, the SEC indicated that it approved of the proposal, but
that it might seek additional reforms.
The proposal would address some of the more salient concerns raised by the Grasso
affair. Compensation of NYSE executives would no longer be set by those whom the
exchange is supposed to regulate. Suspicions that the NYSE puts the interests of its
members ahead of its duty to public investors might be allayed somewhat. However, to
the extent that governance problems at the NYSE are judged to be severe, there are
apparent limits to the effectiveness of board restructuring. As in private corporations, the
NYSE board must leave day-to-day operations to management. To critics of the NYSE,
the cause of the exchange’s problems lies deeper; they see intractable conflicts of interest
in the concept of self-regulation. Can an association of intensely profit-driven individuals
and firms be expected to enforce rules for the protection of public investors, who are their
customers — but sometimes also their competitors — in a cutthroat marketplace?
Self-regulation — the principle that the securities markets ought to bear a large part
of the responsibility and cost of regulating themselves — has been a cornerstone of U.S.
stock market regulation since the enactment of the basic federal securities laws and the
creation of the Securities and Exchange Commission (SEC) in the 1930s. Under law and
SEC regulation, stock exchanges are self-regulatory organizations (SROs), charged with
adopting and enforcing rules to maintain fair and orderly trading. To some, this seems
like foxes guarding the henhouse.
The ideal of market regulation is to protect public investors and put them on a level
playing field with market insiders. But the current market price of an NYSE membership,
or seat, is nearly $2 million. In addition to income from sales commissions and fees for
various services, NYSE members earn substantial revenues from trading for their own
accounts. Conflicts of interest may arise from the fact that public investors trading in the
markets are not only NYSE members’ clients, but sometimes their competition as well.
From this perspective, recent allegations that NYSE firms have profited illegally by
“trading ahead” of their public customers, and that the SEC had to prod the NYSE’s
investigation, come as no surprise.1
Arguments like these about the inherent flaws in self-regulation were heard in the
1930s. Still, Congress chose the system and has since expanded it. A common view
would be that of SEC Chairman William Donaldson, who observed that self-regulation2
has worked “pretty well ... despite some hiccups through the years.”
There is widespread agreement that self-regulation has some advantages over direct
government regulation. Government securities regulation has been likened to a buzz-saw,
sometimes the proper tool, but other times less effective than the “surgeon’s scalpel” of
self-regulation.3 In an area where shades of gray must be taken into account, SROs can
set ethical standards for private market participants, an activity difficult or inappropriate
for government. By handling a significant portion of enforcement cases themselves,4
SROs reduce the expense to the government of maintaining a large enforcement staff.
Finally, SEC enforcement tends to be reactive and after-the-fact; none of the worst market
scandals of the past decade — the Nasdaq price fixing scheme, the post-Enron accounting
frauds, or the corruption of stock analysts — was first uncovered by the SEC. (The SROs’
record in these three episodes is no better, unfortunately.)
1 “Trading ahead,” or frontrunning, occurs when a brokerage trades for its own account before
executing a customer order that it believes will affect the market price. It is illegal. See: Laurie
P. Cohen, et al, “NYSE Trading Probe Took Late, Sharp Turn,” Wall Street Journal, Oct. 17,
2 Deborah Solomon, “SEC Won’t Push Radical Change on NYSE,” Wall Street Journal, Oct. 1,
3 Louis Loss and Joel Seligman, Fundamentals of Securities Regulation, 4th edition, New York,
Aspen Law and Business, 2001, p. 734.
4 In 2002, the NYSE pursued 255 enforcement actions. The SEC, with many more firms and
individuals under its jurisdiction, initiated 598 in fiscal year 2002.
In short, abandoning self-regulation entirely is a minority position. However, some
argue that self-regulation on the NYSE could be strengthened by separating the regulatory
and enforcement apparatus from the competitive market operation. The model here is
Nasdaq, which was spun off from its parent company and SRO, the National Association
of Securities Dealers (NASD) following the exposure of widespread price fixing in 1994.
An autonomous regulatory unit — NASD Regulation Inc. — was created, and the Nasdaq
market began a transition (not yet complete) into a for-profit, stockholder-owned
The analogy between Nasdaq in 1995 and the NYSE today is imperfect. The Nasdaq
scandal involved many of that market’s largest dealers and its most heavily-traded stocks.
For several years, public investors routinely received inferior prices. The investigation
of NYSE specialists involves alleged abuses on a much smaller scale; the problem may
not be systemic, as Nasdaq’s clearly was. A blue-ribbon investigation into NASD and
Nasdaq — headed by Senator Warren Rudman — found that the governing structure was
extremely cumbersome, in part because committees representing small groups of traders
were able to obstruct reforms.6
It is possible, but not certain, that insulating the NYSE regulators from the profit-
seeking traders would result in more vigorous enforcement and oversight. A critical
question is how the SRO is to be funded if it becomes a separate entity. Moreover, if the
enforcement function distances itself from the market, it might lose the advantages of an
SRO and become a weaker duplicate of the SEC.
Some critics of the NYSE, including its competitors, view issues of governance and
self-regulation as outward symptoms of an underlying problem. The NYSE’s real
problem, in this view, is that it clings to an obsolete trading model that benefits its
members at the expense of public investors. The NYSE trading floor, where traders buy
and sell in an auction market whose basic framework is two centuries old (supported, of
course, by a vast array of electronics), is seen as expensive and inefficient.
Several versions of computerized, screen-based trading offer competition to the
trading floor. Most major stock markets around the world have abandoned face-to-face
trading. In the United States, computerized trading was pioneered by Nasdaq in the 1970s
and 1980s, and refined in the 1990s by a new set of computerized exchanges, called
“electronic communications networks,” or ECNs. The basic concept of an ECN is to take
full advantage of increases in computer speed and technology to handle the billions of
shares that change hands daily in U.S. markets. Offers to buy and sell are matched
5 See CRS Report RS21193, Nasdaq’s Pursuit of Exchange Status and an Initial Public
Offering, by Gary Shorter.
6 National Association of Securities Dealers, Inc., Report of the NASD Select Committee on
Structure and Governance to the NASD Board of Governors, 1995, 3 v.
electronically and often executed instantly.7 In contrast to the thousands employed by the
NYSE, an ECN handling a similar volume might have a staff of a few dozen.
The ECNs now handle over half the trading volume in stocks listed on the Nasdaq
market, but only about 5% of NYSE volume. Why the discrepancy? The NYSE argues
that its floor-based trading system produces superior prices, that orders sent to the
specialists on the floor are often filled at prices better than the publicly quoted price, or
“inside the spread.” This “price improvement” disappears when the trading mechanism
does nothing but match offers to buy and sell.
The ECNs counter that regulatory barriers act to preserve the NYSE’s monopoly in
its own listed shares, specifically the “trade through” rule, which mandates that orders in
shares listed on an exchange be sent to the registered exchanges that make up the
Intermarket Trading System and “exposed” there for a minimum of 30 seconds in search
of price improvement.8 This rule may sound innocuous to the layman, but NYSE rivals
complain of an “eternity of seconds” which negates a primary advantage of ECN trading:
speed of execution.9
It is difficult to evaluate the competing claims of execution quality and speed, market
liquidity, and so on. Proponents of various market models have strong financial stakes
in the outcome of the debate; the results of independent empirical studies are mixed; and
the markets continue to evolve rapidly.
In the long run, the ECN market model may offer significant economies for traders
and investors. NYSE member firms that do business with the public had gross revenues
of $148.7 billion in 2002.10 In an age of cheap computing power, this may simply be too
high a price for intermediary services. In the short run, questions remain about the ECN
trading model. How will it perform in a market crash? What are the effects on price-
setting mechanisms and market liquidity of dispersing trading among many market
centers? Can the ECN model support vigorous self-regulation and market oversight?
While ECN order handling systems may prevent certain trading abuses seen on traditional
exchanges, what new forms of abuse could emerge?11
To the unhappiness of some, but the satisfaction of others, the SEC has moved very
slowly to address fundamental market structure issues. In 1997, the SEC issued rules that
brought ECNs into the mainstream of trading of Nasdaq shares, and allowed them to
increase their share of market volume. Recent testimony does not suggest that the SEC
plans to sweep away the barriers that are said to keep ECNs from handling significant
7 For general background on ECNs, see CRS Report RL30602, The Electronic Stock Market, by
8 For background on the ITS, see CRS Report RS20632, The Intermarket Trading System and
NYSE-Listed Stock, by Gary Shorter.
9 Prepared testimony of Nasdaq Chairman Robert Greifeld before the House Financial Services
Subcommittee on Capital Markets, Oct. 16, 2003, p. 2.
10 A breakdown by source is available at: [http://www.nysedata.com/factbook/main.asp].
11 See, e.g., Robert Greifeld, op. cit., on sub-penny trading. (Quotes priced in increments smaller
than one cent are invisible to some market participants.)
volumes of trades in NYSE-listed stocks. On October 15, 2003, SEC Chairman William
Donaldson, before the Senate Banking Subcommittee on Securities, took note of the
limited access to the NYSE. “The existing compulsory market-to-market linkage in
stocks — the Intermarket Trading System (ITS) — applies only to NYSE and Amex
stocks and, in the view of many, has been less than successful in overcoming obstacles
to providing effective intermarket access.”12 At the same time, however, he endorsed the
existence of separate market structures: “... I firmly believe our system of multiple,
competing markets — on balance — has worked remarkably well. We have the world’s
most competitive and efficient markets.”
No legislation bearing directly on market structure is before the 108th Congress. The
SEC has authority under existing statutes to direct the NYSE and other SROs to modify
any of their rules, and thus can effect changes in trading mechanisms (or exchange
governance) by regulation. Continuing congressional interest, evidenced by hearings and
other oversight activities, is driven by concerns about fairness to public investors and the
efficiency and competitiveness of U.S. financial markets, and the existing statutory
mandate that the SEC facilitate the development of a national market system for trading
12 Testimony before the Subcommittee on Securities and Investment, Senate Committee on
Banking, Housing, and Urban Affairs, Oct. 15, 2003.
13 Pursuant to the Securities Acts Amendments of 1975.