Self-Regulatory Organizations: A Private Oversight Model

Understanding Self-Regulatory Organizations

The nature of a particular industry, level of competition in the sector, and its need for regulation usually will determine if a self-regulatory organization (SRO) is necessary. Either the member firms of an industry agree and create the organization themselves, or the government could mandate the creation of an SRO. In many cases, SROs also serve as forums for producing educational materials or managing certifications within their industry. Financial Industry Regulatory Authority (FINRA), for example, administers the Series 7 exam, which must be passed by anyone who wishes to become a general securities representative (broker). In addition to making and enforcing regulations, SROs serve as industry watchdogs. Along with other organizations, they can help to guard against fraud and unethical practices in their industries. FINRA also helps to structure and enforce Anti-Money Laundering (AML) and other compliance programs.

Self-regulatory organizations have the autonomy to create their own policies, maintain guidelines and best practices, enforce their policies, and resolve disputes. Self-regulatory organizations are private organizations, but they are subject to government oversight; if there’s a conflict between the two bodies’ rules, then the government agency prevails.

FINRA and the SEC

FINRA’s rulemaking process is exhaustive and involves its government partner, the Securities and Exchange Commission (SEC), from beginning to end. There are 10 distinct steps in the FINRA process that need to occur before it may send its proposed regulations to the SEC for approval and posting. As part of its process, FINRA submits its proposals to various internal and external entities, including the public, to ensure that any new guidelines protect both investors and the market’s integrity. When a self-regulatory organization sets regulations, those rules become binding, and SROs hold companies in their jurisdictions accountable for failing to align with their agreed-upon policies.

A well-run self-regulatory organization should possess certain key characteristics, which include but are not limited to the following:

• Legislative Authority: If the government approves a self-regulatory organization’s regulations, then the SRO does not need to be granted the authority to enforce those regulations. For example, FINRA already has the authority to enforce its regulations because it’s an SRO. If an SRO is micromanaged by a government entity, then it ceases to function as a true SRO and becomes just another arm of the government.

• Regulatory Database: Self-regulatory organizations need to maintain organized records documenting people and groups within companies for a number of reasons, but primarily to mitigate potential risks to companies within the SRO member firms and the industry at large. SROs also need to keep records of previous complaints and disciplinary actions taken against regulated persons or entities.

• IT Disruption Procedures: Self-regulatory organizations must have procedures in place to detect any disruption to or interference with their computer systems. They also must have automatic backup and recovery software installed on every computer, telephone, and other communications devices. 

• Resolution Process: Self-regulatory organizations, particularly because of their unique role as liaisons, should have sound procedures in place for resolving disputes.

• Strong Governance: All of a self-regulatory organization’s activities must be transparent. It must create a defined process that it will use for gathering input about how rules are established, and should not deviate from that process. An SRO should be impartial.

Self-Regulatory Organizations and the Cryptocurrency Sector

Self-regulation is an ongoing topic in the realm of cryptocurrency, with exchanges, government organizations, and commentators weighing in with proposals and hosting various discussions. Although no global consensus has been reached yet, government regulators across major financial jurisdictions are increasing their regulatory oversight of crypto companies. Some think that a crypto self-regulatory organization’s oversight will not have sufficient authority to effectively regulate and shape the crypto regulatory landscape. Others believe that SRO regulation is unduly burdensome or antithetical to the open and democratic philosophy on which cryptocurrency was founded.

Still, various efforts are underway or in discussion on the SRO front. In August 2018, four U.S. cryptocurrency exchanges — Bitstamp, bitFlyer, Bittrex, and Gemini — formed the Virtual Commodity Association with a mandate of “establishing an industry-sponsored, self-regulatory organization to oversee virtual commodity marketplaces.” Just months later, 10 institutional trading firms created the Association for Digital Asset Markets (ADAM), which is “focused on bridging the gap between firms in digital asset markets and regulators.”

These efforts are not just taking place in the U.S. In early 2018, Japan and Korea individually began creating self-regulatory organizations for their crypto markets as a way of preempting potential legislative action. The Japanese Virtual Currency Exchange Association (JVCEA) officially formed in April 2018, while efforts in Korea are still ongoing. Progress in Europe has been slow to date regarding SROs, with Switzerland as the notable exception. Many Swiss-based crypto businesses have come together to create their own standards via a self-regulatory organization — The Financial Services Standards Association (VQF), which provides services like compliance training to interested parties. The VFQ also offers supervisory, inspection, audit, and various advisory services to its members.

What Makes Collaboration Between SROs and Governments Effective? 

Combining subject matter experts with government agencies can be an effective and complimentary model. Self-regulatory organizations are, by nature, more deeply and consistently involved in everyday affairs within their industries. The SRO model facilitates collaboration between industry experts and government policymakers when establishing policies and regulations. Governments and self-regulatory organizations help all financial markets constituents by maintaining an ethical and equitable playing field. In this way, self-regulatory organizations can offer an effective form of regulation for the complex and ever-changing financial services industry.