Abstract
The role of governance systems is a critical factor in understanding how industries grow and change. This paper proposes that by using regime theory, a theory commonly used in political science, researchers can better understand the mechanisms of change. Specifically, it utilizes the norms, principles, rules and decision-making procedures that occur in an industry as the critical variables. This argument is supported through a historical examination of events in the US brokerage house industry, focusing on events from the 1960s through to the mid-1990s. This historical case study shows how different regimes lead to different types of change in the industry.
Introduction
Organizational theorists are increasingly recognizing the importance of a historical perspective if one is to gain an understanding of how industries grow and change over time. However, surprisingly, only recently have organizational theorists paid attention to historical concepts and methods. However, there is now a general understanding that in order to comprehend the factors that make for change, it is necessary to develop theories that incorporate description as well as explanations (Booth and Rowlinson 2006; Clark and Rowlinson 2004; Rowlinson et al. 2010). What is required is the blending of two separate fields of study: the history of organizations and organizational theory. In this way one can gain a greater understanding of how organizations change over time and of the content and meaning of temporal events (Kieser 1994; Mohr 1982).
Moreover, it is now possible to gain new and improved insights into the factors that make for change, the nature of the changes and the consequence of the changes for later developments. That is one reason why many scholars have argued that wise decision making requires a historical perspective (Neustadt and May 1986). But theory can also be used to illuminate history. By so doing, it is also possible to develop historical approaches that go beyond description and incorporate explanatory factors (Leblebici and Shah 2004).
As North (1991: 97) has pointed out ‘history… is largely a story of institutional evolution in which the historical performance of economies can only be understood as part of a sequential story.’
A second concern that has characterized organizational theorists in recent decades is the recognition of the need to adopt a more ‘macro’ approach. The focus of study has shifted from the individual organization or groups of organizations to such units as populations, fields and sectors. These ‘macro’ arenas are often identified as the industry, field or population. Scholars have focused on industry ‘logics’ (Thornton and Ocasio 2008), macro ‘cultures’ (Abrahamson and Fombrun 1994) and industry ‘rationales’ (Fligstein 2001) as a way of explaining different phenomena across groups of organizations, but many opportunities are left for more indepth work on these more macro arenas of activity, especially since specific questions around coordination and control of industries are only beginning to be addressed.
Particularly lacking are well-articulated, organizational approaches to questions of governance at this macro level. In light of the statement ‘governance is a phenomenon that is best conceptualized at the level of industries and industrial sectors’ (Lindberg et al. 1991), it is surprising that studies of governance remain an inter- or intra-organizational phenomenon. Highlighting the effects of boards of directors, top management teams or the interaction between groups of organizations, this work incorporates psychological or sociological insights to discuss how organizations are structured and controlled (Davis 1991; Fiss 2008; Zajac and Westphal 2004). Seldom do these investigations focus on the governance of an entire industry. Work in this domain is beginning and is centred on rule and meaning systems (Dimaggio 2001) or power and conflict over status and other resources (Fligstein and Dauter 2007; Lawrence 2008; Washington and Ventresca 2004). Governance structures are defined as ‘the general rules in society that define relations of competition, cooperation and market-specific definitions of how firms should be organized’ (Fligstein 1996: 658).
Despite the insights provided by organization theory to industry governance, it has not yet dealt adequately with certain key issues. One problem with looking at governance is that industries or fields are made up of individual organizations with varying strength and scope, actors, elites, and groups and associations of organizations that all differ. They are marked by conflict, negotiation and cooperation – many of the same properties that are commonly identified in the international system (Meyer 2008). Second, research in organization theory rarely addresses situations where there is a lack of enforcement mechanisms. Third, mainstream organizational theory tends to consider interests, power and cognitive elements separately and rarely views them as parts of a complex whole.
Within organization theory, institutional theory has provided important insights into how scholars conceptualize industries, fields and regulatory arrangements (Amenta and Ramsey 2010). Particularly relevant is research that has demonstrated how the constituted nature of the environment influences social actors (Jepperson 2002). Even with these broad insights, institutional theory has been criticized for not explaining behaviour adequately (Meyer 2008).
Accordingly, I would like to suggest that by applying a theory commonly used to explain order in the international system, it is possible to enhance our understanding of industry development and change. Regime theory is particularly well suited for this task because of the high degree of compatibility between its core elements and institutional theory – as Scott (2001: 48) argues, institutions consist of ‘cultural-cognitive, normative and regulative elements.’
Regime theory shares this concern but its focus is on how shared agreement (which plays a large role in governance arrangements) shapes behaviour. Regime theory, therefore, permits us to investigate a topic that has not been of central concern to institutionalists, that is the effects of collective agreements on governance. The advantage of such an approach is that ‘using the strengths in one theory to address the weaknesses in another can provide a more nuanced and multi-faceted perspective’ (Wijen and Ansari 2007: 3–4).
Regime theory
Regimes highlight a whole range of complex political, social and economic activity while comprising specified rules that reflect the international order. Regime theory was first introduced in political science and international relations to explain convergence of behaviour between organizations in an anarchic international system, a system without a central authority with coercive power. The question that scholars working in this field have tried to answer is: how do order, cooperation, coordination and collaboration occur in an anarchic international system? Using ideas, beliefs, ideology and governance mechanisms scholars explained why one sees convergence of behaviour at specific times and not others (Keohane and Nye 1977). Regimes are seen as enabling mechanisms and the classic definition of them is ‘principles, norms, rules and expectations around which actor expectations converge in a given issue area’ (Krasner 1983: 2). Scholars regard issue areas as substantive problems of concern to various stakeholders. Thus, regime theory has been used to explain cooperative behaviour in such areas as deep-sea mining (Young 1989), technology transfer (Haas 1991), trade barriers (Finlayson and Zacher 1983) and patterns of international lending (Cohen 1983). Each of these areas possesses the following characteristics: no sovereign authority, complex economic and political behaviour and a variety of international actors. Regime theory has also provided new insights into the dynamics of issue areas by looking at institutional change (Wijen and Ansari 2007).
Since regime theory focuses on behavioural regularity, it is relevant to work on organizations because cooperation in this context is similar to the concept of ‘rivalry’ in the organizations literature and signals agreement about behaviour in highly contentious and political environments. As Keohane (1986: 23) put it, ‘what these arrangements have in common is that they are designed not to implement centralized enforcement of agreements, but to establish stable mutual expectations about behavior.’ This regularization of behaviour indicates the creation of patterns or what the organizations’ literature might refer to as standards – standards of procedure, of compliance to certain normative and prescriptive precepts, and standardized expectations. Thus, regimes can be viewed as mechanisms that instantiate certain patterns of behaviour. But where do these patterns come from and how do they become ‘instantiated’ (Dimitrov et al. 2007)? In answering this question, regime theory has identified formal components and informal elements and has incorporated different levels of analysis: the individual, the organization and the population, in this case, the global system.
The formal elements, most often seen through regulations, are national, international and private rules as well as operating practices. But, perhaps more important are the informal components – those aspects that include norms and procedures that are not formally codified in law but are accepted as important constraints to behaviour. The policy maker is inhibited by how he thinks that he should behave based on these informal standard operating procedures even though there is nothing written in law or any fear of reprisal (Hasenclever et al. 1997).
The task then is to apply a theory used in the international arena to the industrial sector. Perhaps the most important point of using this theory to discuss industry governance is that regimes incorporate the major norms and principles behind them. Industry dynamics and therefore firm behaviour are directly affected by these informal components.
The work that is of particular importance to understanding the effects of regimes on industries is by Puchala and Hopkins (1983) because they argue that regimes exist in every substantive issue area where there is discernible patterned behaviour. Although they do not explicitly refer to industries, one can logically infer that their definition would encompass them. It is in explanations of this patterning of behaviour within an industry that regimes can make a real contribution. They also discuss four specific characteristics of the regimes that can be easily applied to a discussion of industries.
First, regimes are attitudinal and reflect particular views of appropriateness and legitimacy. In the case of industries, this means that regimes will reflect particular norms about how to do business, how firms compete with each other and how new firms enter the industry. Norms are defined as standards of behaviour that embody terms of rights and obligations. In the airline industry, for example, there is agreement that airlines will honour each others’ passenger tickets in such cases as mechanical failure, inclement weather conditions and so on (Jonsson 1987, 1995). The question of where norms come from and how they evolve is crucial to understanding how regimes form and change over time. Essentially, norms emerge in one of three different ways: proscriptively, through institutions; as the result of a social contract; or through an evolutionary process (Opp 1982). In the case of industries, norms are more likely to evolve through either social contracts or proscriptively.
Second, a regime upholds certain principles (i.e. free markets). Principles are beliefs of fact, causation or rectitude. The principles can be seen as the enactment of norms. These will manifest themselves in various ways including the nature of competition (do firms compete on the basis of price or service?) and patterns of interaction (do firms have many interrelationships or do they remain isolated?).
Third, regimes include tenets concerning the appropriate procedures for making decisions. These take many forms, depending on the nature of the political system. In industries, they may range from self-regulation at one extreme to complete government oversight at the other. Most industries, however, rely on a mixture of these two patterns. For example, members of the diamond industry in Antwerp (who handle 90 per cent of the world’s uncut diamonds) were lobbying the Belgian government to create a governmental oversight committee, which they would help fund, to regulate the behaviour of firms in the industry (Matlack 2007). Such a committee would obviously issue rules concerning the behaviour of the firms. Rule-making is an important outcome of any governance structure and represents an essential dimension in the conceptualization of regimes.
Finally, regime theory recognized that governance mechanisms may involve a variety of actors. In the case of industries these include high-status actors of all sorts including, chief executive officers (CEOs), major policy makers, high-level bureaucrats and industry leaders. In the fashion industry, for example, this is made up of designers, buyers for individual stores, editors of magazines who decide which styles and designers to promote and trade associations like the council of fashion designers.
Regime theory is not without its critics who have levelled charges of its ‘wooliness’ and lack of precision (Strange 1982). Others have responded that this reflects the fact that it is a ‘contested concept’. Some scholars have pointed out that regimes require transparency, legitimacy and a knowledge base and have raised the issue of what if one or more of these assumptions are violated (Kratochwil and Ruggie 1986). However, despite these and other criticisms, such as the theory’s neglect of human cognition and subjectivity, numerous studies using regime theory have demonstrated its utility by effectively providing explanatory power for situations in which shared behaviour is being examined within a particular context (Drezner 2007). Hence, it seems appropriate to agree with the conclusions of those scholars, who after analysing this debate in detail, concluded that progress can best be made by fewer discussions of the theoretical and meta-theoretical problems within regime theory and greater attention to the results achieved by empirical research (Behnke 1995; Rittberger and Mayer 1995). Moreover, at least some of the theoretical objections to regime theory, such as that it is ‘rooted in a limiting state-centric paradigm’ (Strange 1982: 479) may not apply at the industry level, particularly in a study that seeks to understand change over time.
While there is widespread agreement that regime theory does not adequately deal with the factors that cause change, scholars dealing with financial institutions have emphasized the need to focus on actors and on the critical role of incentive structures (Pollin 1997). These may often have perverse consequences because of such factors as uncertainty that lead actors to behave in ways that are damaging to the national economy (Crotty and Epstein 2008). My approach is consonant with these insights because I am concerned not only with the principal dimensions of regime theory – norms, principles, rules and decision-making procedures – but also with the ways in which these evolve and change as a result of a negotiating process between the key actors in the industry, a process that obviously involves incentive structures.
My particular concern is with norms and principles because they are the result of a continually negotiated process. This process involves powerful actors who fight vigorously to maintain their interests. It is vital to recognize how these concepts differ. The norm of ‘investor protection’, for example, which was agreed upon by the industry participants in its earliest years, remains dominant throughout the period of this study. However, the principles that define this norm change dramatically over time, as is documented in the historical analysis that follows. Specifically, one sees different principles at work, ranging from a focus on regulations ensuring that individual investors are safeguarded from fraud and other misconduct by industry professionals, to one where investors are protected by having equal access to multiple markets and transparency and competition among markets.
A regime theory perspective on the brokerage house industry
The securities or brokerage house industry in the USA is a natural site for the examination of these governance issues. First, it has been dominant as a force nationally and internationally for generations as well as a model for the securities industries in other countries. Second, it a highly regulated industry that has undergone major changes over distinct historical regimes. Third, the industry is marked by a large degree of heterogeneity in the size and nature of its firms. Fourth, the industry is comprised of a wide variety of organizations including regulatory (Securities and Exchange Commission (SEC)), self-regulatory (National Association of Securities Dealers (NASD)), trade associations (Securities Industry Association (SIA)) and individual firms (broker-dealers), which all play a role in industry governance.
As noted earlier, a historical approach is desirable to fully understand how an industry grows and evolves. Accordingly, the goal is to examine the historical events in the industry in order to better comprehend how governance occurs and how it changes over time. Any study of the brokerage house industry must look at the earlier period, in particular the events after the stock market crash, to understand the modern-day industry. The main focus of this study will be on the events since the 1960s when the foundations for the contemporary industry were laid. The study of the development of the brokerage house industry is greatly facilitated by the availability of significant primary sources.
In line with historical research methods, this analysis of the brokerage house industry utilizes a variety of primary and secondary sources. Primary sources were obtained from industry associations and regulators. These include annual reports from the NASD from 1960 to 1996. Moreover, conversations with NASD officials provided added contextual insights. In addition, the New York Stock Exchange (NYSE) library proved to be a rich source of primary material about both the exchange itself, and the history of the industry. The SEC’s document centre contained information about both its own activities as well as those of the industry as a whole. Secondary sources included various histories as well as discussions of the changing regulatory environment. These materials provided the basis for the identification of the various regimes.
The emphasis in this analysis is on the contemporary period that begins in the mid-1960s, a seminal era when US Congress passed a series of regulations that significantly amended the previous securities laws. Now, as a result of pressure by the SEC, self-regulation was redefined to create new and broader controls over the entire securities industry. This paper follows the evolution of these agreements around industry governance until the mid-1990s when the prevailing principles of self-regulation were brought into question and new structural arrangements emerged. Although agreement around self-regulation and the importance of investor protection persists over this time, how these concepts were defined and accepted changed dramatically.
It is through regime analysis that one can understand these developments because of its explicit focus on principles, norms, rules and decision-making procedures. Following a brief historical introduction, the regimes that existed in the modern period will be identified on the basis of these dimensions.
The inception of an industry
In 1685 Wall Street was surveyed and established as a place for commodity trading. (The NYSE started as a slave market.) By 1752 merchants and brokers were assembling at the Royal Exchange in New York to auction off additional commodities such as tobacco, cotton, sugar and securities. By the 1790s commodities dealers and the securities brokers parted company and securities were now traded under the buttonwood tree at 68 Wall Street (Wyckoff 1972).
Within two years, however, this pattern underwent considerable change. For the first time the issue of regulation emerged. In 1792 William Duer, a powerful securities speculator, was ruined, prompting a financial panic. The New York legislature responded by forbidding public stock auctions. As a result, the stockbrokers, fearing government regulation, formed their own private organization. The brokers signed a document that stated that they could only transact with each other and not the auctioneers, and fixed the commission at 25 per cent (Teweles and Bradley 1998). This forerunner to the NYSE was known as the Buttonwood Group. Twenty-four brokers, operating informally, met daily under the buttonwood tree in good weather and in the Tontine coffee house in bad weather. The president of the exchange would read the listed stocks and the brokers would make their bids and offers. At the same time, brokers were similarly organizing in Philadelphia (Cowing 1965). Both groups had to confront the issue of how to persuade potential investors that, although risks were involved, the exchanges would transact business in an honest manner. The group agreed that potential customers had to be assured that this was indeed the case and feared that scandals would lead to government intervention. Thus, investor protection was to be achieved through a system of self-regulation.
Regulation and governance arrangements
This pattern continued essentially unchanged for a century. The great stock market crash of 1929, however, brought the problem of regulation to the forefront (Ney 1970). Now the traditional practice of self-regulation was significantly modified as Congress passed a series of laws in order to deal with the causes of the Great Depression. These were designed to control different industry practices, in particular disclosure and market manipulation (Kahan 1997). Although the efficacy of these laws has been disputed (Mahoney 1995), the critical role that they played in the industry is universally accepted. These regulations dealt with the crucial issues of the day but in a way that reflected the general ideological consensus of the need for free markets. One scholar, for example, has argued that underlying the legislation was a sense that the state could not adequately regulate an industry made up of thousands of broker-dealers. However, this opinion reflects a view of state capabilities that may not be consonant with the reality of the American state. More persuasive, is a second factor that Seligman (2003–4: 1347) identifies: ‘a preference for business with its greater practical knowledge of its own affairs to participate in the development and application of SEC rules and reduce the likelihood of unnecessary disruption or inefficiency.’
The first major piece of legislation, the Securities Act of 1933, was known as the ‘truth in securities law’. Until then, little reliable information was generally available to all investors and false information was widely disseminated by unscrupulous dealers. The existing pattern of self-regulation was maintained, albeit modified, by giving the SEC responsibility for supervising the behaviour of the exchanges (Jennings 1964).
This law had two basic objectives: (1) to ensure that investors were provided with material information concerning the securities that were publicly listed; and (2) to prevent misrepresentation and fraud in the sale of securities. These objectives were met through the registration of most securities requiring the disclosure of relevant financial information about the company. The standard in this law was accuracy and fairness, not profitability or risk (Securities and Exchange Commission (SEC) 1994). These regulations reflected wider norms and principles around the importance of investor protection.
The Securities Exchange Act of 1934 extended the disclosure requirements of the 1933 Act to all securities listed and registered for public trading on the national securities exchanges. These laws sought fair and orderly markets by prohibiting certain types of activities and creating rules regarding the operations of the market and its participants. The primary focus of this new legislation was investor protection that would be administered by a government agency, the SEC (SEC 1994).
The 1934 Act provided for the registration of securities and broker-dealers, who for the first time, were under federal scrutiny. New entrants were expected to meet certain standards and all members were required to abide by guidelines set by the SEC and other industry-regulating agencies (Mayer 1992).
These changes, however, did not alter the fundamental governance pattern of the industry, which remained one primarily of self-regulation. The stock exchanges have always been self-regulatory organizations (SROs) whose rules provide for disciplining (through fines, expulsion or suspension) of their individual member broker-dealers. Their influence, however, extended only to the companies listed on the exchange, the firms that are members of the exchange or firms that transact with their members. The 1938 Maloney Act Amendment to the SEC Act of 1934 established the NASD to be a regulatory agency for the entire industry, under the oversight of the SEC. The NASD, the largest self-regulatory organization in the USA, was responsible for the regulation of the over-the-counter (OTC) securities market and the NASD Automated Quotations (NASDAQ), which was established in 1972. The principle behind the 1938 legislation is one of cooperative regulation by which voluntary associations of broker-dealers regulate themselves to ensure fair and orderly securities markets. The NASD is responsible for regulating the activities of all the broker-dealers in the industry. In addition, it works in conjunction with other industry actors such as trade associations, the stock exchanges, listed companies, investors and federal and state regulatory agencies to ensure compliance and promote member concerns (NASD 1992).
In 1940 Congress passed two more laws that extended the scope of regulation to other players in the industry. The Investment Company Act of 1940 placed companies whose activities consist of investing, reinvesting and trading securities or whose own securities were offered to the public, under the purview of the SEC. Thus, companies that sold mutual funds were regulated and required to disclose their financial condition. The Investment Advisers Act of 1940 regulated the behaviour of investment advisors and required that they register with the SEC (Roberts 1965).
The industry continued to grow rapidly over the next 30 years and the SEC became increasingly worried that the control system that consisted primarily of the NASD, the exchanges and regulations passed in the 1930s and 1940s were no longer adequate to cover the growth in the OTC and mutual fund markets. As a result, the SEC initiated a series of negotiations with the NASD to amend the industry’s organization as the SEC believed that the entire industry was neither adequately represented nor controlled. Its concern was twofold. First, it wished to ensure investor protection because of the concern that investors were not adequately safeguarded. Second, it felt that the NASD no longer fully represented its members. In particular, the issue was that small firms, specializing in OTC stocks, were not getting sufficient coverage within the industry. The NASD did not welcome the SEC’s proposals.
Even though there was disagreement between the two main industry regulatory bodies, the SEC and the NASD, about the type of reform that was necessary, they remained committed to a fundamental agreement on several main principles that guided the industry. The first was the great value of responsible self-regulation: that the NASD had the right to design and enforce rules that were in the public interest covering conduct in dealing and trading securities. Second, if investor protection was not vigorously pursued the entire industry would be harmed. Third, that too-rigorous reform would hurt the industry. In short, expectations converged around a pattern of investor protection that continued to define the industry in the coming years. This consensus would play an enormous role in the future governance of the industry.
Regime I: Diffusion (1965–72)
As a result of the agreement around the importance of self-regulation, in 1964 Congress passed a series of amendments to the Securities Act that extended the existing regulatory system to OTC with the goal of improving the availability and calibre of investor information about the mechanics of the OTC market. Furthermore, it gave licence to the creation of a meaningful quotation system for OTC stocks.
Thus, by the mid-1960s a clearly delineated regime had emerged, which lasted until 1972. This new regime emerged as a direct response to the growth and importance of the industry as the old regime was unable to accommodate the dramatic changes in the industry. Regime theory can help illuminate the developments within this new era. During this time the main industry actors, the SEC and the NASD, continued to agree on the norm of investor protection. Individual investors were seen as less sophisticated and needing support in the form of SROs that would protect their interests against unscrupulous actors. However, this was a contentious time, because no agreement on how to achieve this ‘protection’ existed. Conflict between key actors is not uncommon within a regime and the SEC and NASD struggled to establish the principles, decision-making procedures and rules that should apply.
Rule creation
As the self-regulatory agencies increased their activities and assumed new responsibilities, each of the organizations reacted differently to the new environment. The NASD reorganized internally, decentralizing responsibility throughout the industry. The major regulatory agencies (the SEC and the NASD) worked with the stock exchanges and state authorities in an effort to eliminate overlapping jurisdiction while coming to informal agreements about the scheduling of member exams. During this time, they began to discuss the possibility of reciprocity between the different self-regulatory agencies (i.e. if a firm is barred from the NYSE, it would also be barred from the other exchanges and the NASD) (Faber 1979).
Although tentative agreement existed around the need to increase the scope of governance by the SROs, the SEC and the NASD disagreed over the sanctions because they represented different constituencies: the SEC with the impact on the public of unfair pricing; the NASD with the cost of regulation for the broker-dealers. An agreement had to be reached, since under the 1964 amendment, the NASD had to provide fair and informative quotations on both the retail and wholesale level. The SEC and the NASD finally compromised on a new dealer quote system and upon the importance of maintaining the negotiated character of the OTC market. The SEC wanted greater disclosure requirements for the listing companies, but the NASD and industry members firmly rejected this idea, especially if it would require the disclosure of the amount of profit on all retail transactions. They had other concerns, as shown by a survey of industry members: 80 per cent of those in the OTC business wanted to see change in the OTC system, especially in the quotation system (National Association of Securities Dealers (NASD) 1965).
The mid-1960s ushered in an interest in industry-pricing practices by members within and outside of the industry. Pricing was fixed commission and uniform throughout the industry. The concern was twofold: (1) individual investors were paying too much for certain services; and (2) institutional investors felt that they should be able to pay less for each transaction given their large size. Concerned with investor protection, the SEC wanted to decrease the profits that the firms were making from selling mutual funds (primarily to individuals) and to eliminate a shared brokerage commission (Faber 1979). In response, the industry associations commissioned a study by Booz Allen Hamilton, which predicted that such a move would cause firms to either shift their efforts to other products or to abandon the securities business (NASD 1970). At the same time, the NASD argued that decreasing the amount of money charged for trading mutual funds would force small and medium-sized businesses out of the industry and lead to higher prices and a few large integrated firms. Once again, dissension occurred as the NASD, representing broker-dealers, came into conflict with the SEC’s concern over investor protection. Finally, in 1968, legislation was passed giving the NASD regulatory authority over mutual fund charges.
Industry concerns were not limited to issues of pricing. The late 1960s witnessed a very positive industry development as unprecedented volumes on the exchanges and the OTC market caused the firms’ gross revenues to soar. However, this increased trading activity led to critical problems including an unprecedented number of failures to promptly deliver securities owed to other dealers and customers. Such administrative difficulties escalated costs and decreased firm profits.
These developments fuelled the increasing concern on the part of the SEC and Congress that the SROs (especially the NASD) were not functioning effectively or efficiently to promote investor protection and demanded increased regulation over the handling of back-office paperwork (Stoll 1979). These problems called into question the knowledge and training of industry personnel resulting in an updating of the exams for the registered representatives in order to have better trained members of the industry. Moreover, these exams were changed in such a way as to emphasize certain norms of the industry, especially the ethical training of registered representatives (Jaffe 1977). Since these efforts still did not resolve all the problems of clearing securities in a timely manner, the NASD and the SEC agreed to take further action in the late 1960s, that included a series of new regulations and the creation of regional OTC stock transfer centres.
The NASD and the SEC also reached agreement on the need for a centralized trading exchange to handle OTC stocks. This led to the development of NASDAQ, an electronic stock market under the authority of the NASD (1992). Additionally, it was agreed that the NASD would regulate the OTC market. Given the increased scope and reach of the industry, there was a great deal of apprehension about what might happen if there were failures in the system. As a result, the Securities Investor Protection Corporation (SIPC), a national insurance for securities, much like the Federal Deposit Insurance Corporation (FDIC) for banks, was established. The SIPC is funded primarily through assessments on its members. By 30 December 1970, all registered broker-dealers and members of the national exchanges were required to join the SIPC. Some firms were exempt from this requirement – broker-dealers who deal exclusively with the sale of mutual funds, variable annuities or insurance products, or those broker-dealers who advise investment companies (Loll and Buckley 1973).
These decisions were very significant because they demonstrated that actors with very different interests and agendas agreed on the future structure of the industry. This was especially important given the large-scale changes that were taking place in the industry during the mid-1960s.
Changes in decision-making procedures
Much of the change was coming from new entrants into the industry. According to an NASD survey at the time, new registered representatives were joining firms that clustered in three distinct areas: 40 per cent were employed by firms that dealt only in mutual fund shares; 30 per cent by firms that were registered with the NYSE; and another 30 per cent were with firms that did general securities business, or were members of regional exchanges or had no exchange affiliation (NASD 1968). Facilitating these changes was a stability that reflected agreement within the industry, as evidenced by a 50 per cent decrease in the number of disciplinary actions brought by the NASD and the SEC. This agreement is of central importance because it influenced the behaviour of current industry members and new entrants. As a result of this regime, the knowledge and skills that representatives needed were well established. Therefore similarity of behaviour was seen at the firm level as well.
The NASD continued to protect the boundaries of the industry from the increasing encroachment of two related industries: banking and insurance. It lobbied Congress to forbid banks to sponsor and operate mutual funds because it would be a violation of the Glass-Steagall Act, which required the separation between commercial banks and investment banking. This attempt by the securities’ self-regulating organization to protect its members was only partially successful because, in 1969, the Supreme Court agreed with the banks and ordered that they be allowed to enter the industry in a limited way, through the selling and trading of mutual funds (Wyckoff 1972).
At the same time, the boundaries of the industry were expanding and becoming more flexible as insurance agents entered the merchant equities business (mutual funds or variable annuities). In 1968 five million people owned mutual funds and 130 million owned life insurance policies. The potential of this huge market was recognized by new entrants; nearly one-third of all the new broker-dealer firms were formed by general insurance agents and independent insurance brokers. Of the 45,000 newly registered representatives who joined the industry, 15,000 were representatives of insurance-affiliated members. This growth continued. By the end of 1969 there were 30,000 insurance-affiliated registered representatives with one out of four registered representatives from insurance companies, a greater number than all NYSE members combined. This shift led to greatly increased industry concern with mutual fund dealers and variable annuity products (NASD 1969).
Agreement over principles
The widespread acceptance of the norm of investor protection allowed the diverse actors in the industry to come to agreement across a variety of issues. Even though competing parochial interests caused conflict between industry organizations, the norm of investor protection remained paramount. Thus, the principle emerged in this regime that investors would be protected through the oversight of SROs. The assumption was that if there were a large number of efficient and effective SROs this would ensure that investor interests would be safeguarded.
The shifts during this regime were not the result of happenstance. Industry members accorded legitimacy to different actors who were thus able to shape the standards and rules under which the firms did business. Particularly important was the role of the NASD, because it did not function just as a regulator or industry policeman, but became an important actor in creating the environment in which firms competed (NASD 1966). Even though the SEC and the NASD represented different constituencies, much bargaining was involved, as evidenced by changes that were made in the regulations around bookkeeping and exam requirements for industry professionals to accommodate industry demands. Ultimately, through much negotiation, they resolved their differences and came to agree on the principles, rules and decision-making procedures that were required for the industry to function effectively.
The development and functioning of regime I can, therefore, be summarized briefly in terms of the four dimensions that are integral to regime theory. The decision-making procedures involved a fundamental conflict between the NASD and the SEC. However, a shared agreement on the norm allowed for a convergence of views and behaviour around a set of principles and rules that was designed to protect investors through the establishment of a large number of efficient SROs that were expected to adhere to specific rules and regulations that had been agreed upon by such key actors as Congress, the NASD and the SEC.
Regime II: Search for uniformity (1972–84)
Regime II was characterized by a new approach to achieve investor protection. The creation of NASDAQ signalled its beginning. For the first time the industry responded to a problem (the lack of coordination and availability of the OTC market) by explicitly establishing a new exchange to deal with it. This was the first event for a regime that was organized around the principles of nationalization and centralization. The majority of industry activity during this time led to uniformity across organizations, groups and regulations, which entailed a considerable amount of institution building.
By the end of regime I, industry players were talking about the need to create a uniform practice code. This code would be designed to standardize relations between the members of the industry. Although the industry had been around for almost 200 years, there were no standardized relationships between the stock exchanges, trade associations, regulatory organizations and the individual broker-dealers. Finally, there seemed to be some agreement in the industry about the need for change. However, consensus about the type of change and how should it be implemented was not agreed upon until later.
By 1972 it was evident that a broad-scale reform, centred on a re-dedication to the investor, was underway throughout the industry. The means of protecting the investor were expanding beyond the traditional view of rule-making and regulation. In this new model, the industry created a series of institutions/organizations to ensure that there were well-functioning OTC markets and that investors had efficient access to those markets.
The first of these was the National Clearing Corp (NCC), a national organization created to handle the majority of the paperwork and assume some of the activities that heretofore were performed by other self-regulatory exchanges (i.e. the American Stock Exchange). The NCC began on a regional basis, and it took until 1976 for it to become truly national. In that year, it merged with the clearing corporations of both the NYSE and the American Stock Exchange to create one unified clearing corporation to handle the majority of transactions for the industry (Bruchey 1991).
Similarly, a new mechanism was established to handle the orders that came in on a national basis; the National Order Routing System (NOR) ensured not only that trades were being executed but that orders were being taken care of and fulfilled in a timely fashion. The NOR reflected both the goals of nationalization and investor protection. Next, the industry created the Composite Limit Order Book to provide a central repository for storage and execution of all limit orders. This push for centralization and nationalization extended throughout the entire industry, not just the top-tier markets. In 1977 the NASD chairman identified the NASD as a ‘nationwide organization’, representative of a fully integrated and nationalized industry (NASD 1978). In reality, however, it took several years to implement the changes and achieve a complete national market, with the organizations and structures firmly in place in the early 1980s.
Other critical aspects in the drive to nationalization took even longer, such as the automation of exams and the establishment of a central registration depository (CRD), designed to store detailed information on all industry professionals in a single location. By 1981 only 32 states utilized the CRD. The Consolidated Quotation Service (CQS) was created to show the volume of all stocks on all the major exchanges. Although conceived primarily to increase the amount of third-market trading volume, the CQS fostered effective nationwide cooperation between the major exchanges and over time, enabled the NASD to comprehensively monitor activities within the industry (NASD 1992).
Additionally, the effort to facilitate the participation of the individual investor continued with the advent of the Small Order Execution System (SOES). This system, which was made possible by the widespread use of computers throughout the industry, allows the small investor to make odd-lot and small-block trades. Additionally, the industry found new ways to use computers behind the scenes with the advent of better forms of transaction processing and an order confirmation transaction service so that brokers no longer needed to phone orders in to the exchanges. This increased automation of industry is important because the industry believed that, by allowing for more specialized services to be available to a wider range of investors, it would enjoy greater protection. All these changes clearly represented a shift in the principles from regime I to ones where the existence of well-functioning markets ensures investor protection.
Industry governance and standardization
Congress was particularly concerned with the lack of consistency across the industry and wanted to see national standards applied. In 1975 Congress passed legislation ensuring nationalization and centralization of the industry by providing formal mechanisms for its enforcement. This emphasis on nationalization and uniformity was designed to strengthen investor protection.
The industry also took several major steps to ensure uniformity in its practices through a mixture of normative and regulatory changes. Agreements and understandings were created across SROs so that one organization could be substituted for another. Second, the industry agreed on the need to decrease the amount of duplication across the SROs. Third, it standardized entry requirements, especially the exams that were rewritten to stress certain uniform principles (discussed below). Finally, the pricing structure was amended to ensure conformity. Industry pricing had always been nationally mandated. Part of the push for nationalization included changing the pricing structure. The 1975 amendment to the Securities Act changed the requirements dealing with what firms could charge for services. Previously, industry sales had a fixed, uniform pricing structure. This meant that all investors paid the same amount for the same services. Congress was concerned that individual investors were being hurt by this pricing structure as they were paying the same prices as institutional investors. Since the industry could not charge clients differently in any way, industry participants were adding extra services (such as institutional research) for institutional investors at no charge. Meanwhile, institutional investors also wanted the pricing structure changed because they wanted to benefit from the economies of scale of their large trades. At the same time industry members worried about remaining competitive if there was a change from a fixed pricing structure. On the basis of various hearings, Congress passed an amendment that moved the industry to a sliding pricing structure with a variable fee schedule that allowed for the advent of new services, such as discount brokerage houses, that were illegal before this time. The impetus for this transformation was twofold: investor protection and a more accurate reflection of the marketplace (Jaffe 1977). All these reforms, including the regulations, the cooperation of SROs and various agencies, and the establishment of central clearing houses, not only led to nationalization but significant consolidation of the industry (Adler and Adler 1984).
Nationalization also applied to industry admission standards for firms as well as individuals. The decision to standardize entry requirements with changes in the qualification system for workers in the industry was of particular importance as the NASD and the SEC created different classes of registration to match specific job functions. To ensure that the examinations for registered representatives accurately reflected the ability to perform the requirements of specific jobs, the NASD, the NYSE and the National Association of Realtors jointly created new exams (NASD 1980).
This uniformity among requirements was not only applied to the broker dealers but to issuing companies as well. Many states extended ‘blue-chip’ exemptions for NASDAQ, which released qualified issuers from qualifying for state securities requirements. The industry was particularly interested in obtaining exemptions from ‘blue sky’ laws that limit the registration of securities (primarily NASDAQ-listed securities), which would thus be on par with the exchange-listed securities.
Standards were also raised for firm entry. New requirements were instituted to ensure the liquidity of the members as well as for such groups as market makers. In formally recognizing the distinction among groups of industry participants, the industry associations were trying to reflect and respond to the changes in the market with the advent of new products, services and members. Development of enforceable standards for member training programmes was also part of this push for standardization, as was a uniform practice code and a uniform code of arbitration (Mayer 1992).
The new legislation also increased the power of the SROs and the SEC. The SEC now had more overall control over the industry, whereas the SROs increased their authority over industry participants. As a result, any registered broker-dealer who was eligible for membership on a national securities exchange, as well as the regulatory activities of the exchanges themselves, became subject to new supervision by the SEC. At the same time, the SROs’ authority extended further over their members. They could restrict the activities of firms until they demonstrated the capabilities of their personnel as well as possess the authority to summarily suspend members or limit their access to markets if they were in financial or operating difficulty and were considered a risk to the public. Additionally, the NASD could deny, bar or place on conditional probation any member that it believed engaged in acts inconsistent with what it defined as the just and equitable principles of trading (Jaffe 1977). The SROs were now effectively intermediaries in the relationship between the SEC and the broker-dealer. The SEC could not directly discipline broker-dealers but had to act through the SROs. This was a complicated arrangement whose success depended on the ability and willingness of all regulatory bodies to work together. Only in this way could both the shift to nationalization and the enforcement of these changes be realized.
Armed with their new authority, the SROs moved to deter fraud and manipulation through improved monitoring and control mechanisms. They also, along with government regulators, enacted controls to prevent broker-dealers from favouring particular funds or stocks, as well as imposed more stringent regulations for new issues (Stoll 1979). A new mandatory fingerprinting programme for all members was established, providing further controls (NASD 1976). Now, the activities of broker-dealers could be tracked throughout the USA and registered representatives could not just work as a broker-dealer in another state under another name if suspended or expelled from the industry.
Nationalization eliminated many redundancies, including reporting requirements and the duplication of state regulatory practices. The industry created a single uniform registration form for all individuals that was not fully implemented until 1979 (NASD 1981).
National control of the industry was facilitated through the development and dispersion of new technologies (especially the computer). Automation was present throughout industry – in the stock exchanges, actual trades, brokerage houses and examinations. But now firms were investing in and upgrading these systems. As computer capabilities increased, this new technology helped to coordinate activity both in terms of securities trading and also in tracking the activities of the brokers and dealers.
The principle that markets should be fair and competitive continued to operate, and as a result, concerns over the amount of insider trading increased. By the early 1980s the inter-market surveillance group was formed to coordinate and monitor trading in listed equities and options in multiple marketplaces. This monitoring was coupled with an increase in the severity of consequences for illegal behaviour. The increased use of computers allowed regulators to track this information, and in 1984, Congress imposed new penalties (treble damages) for trading on inside information.
Growth of the industry
During regime II the industry grew in many ways: one was the amount of activity on the exchanges. In each successive year, volume increased across the industry. The expansion of the industry was not just limited to trading volume; it extended to areas directly involved, such as the type of securities, the number of regulations and a variety of new actors. The number of regulations increased, as did the areas that regulation covered. For the first time, municipal bonds would come under the purview of industry regulation through the establishment of the Municipal Securities Rulemaking Board (MSRB). The MSRB was responsible for the rules regulating the municipal securities marketplace, including all broker-dealers and banks that underwrite and trade municipal securities and come under the purview of the NASD. Anyone involved in the municipal securities business had to register with the NASD. In addition to this, the Fair Practices Rule was passed, which codified the basic standards of conduct for municipal securities covering almost all aspects of the business including arbitration proceedings, underwriting of new issues and sales (Stoll 1979). This created an explicit regulatory framework for the municipal securities dealers and led to the increased professionalization of the industry.
The diversity of actors involved in the industry increased during this time, with Congress passing legislation that mandated that at least one member of the board of governors of the NASD must be a representative of the issuers of securities and another a member representing the public. This acknowledged the widening scope of the industry and recognized the importance of the public and other stakeholders (NASD 1979).
Efforts to increase the scope of the industry came from firms which wanted access into the industry. Insurance companies lobbied to be exempt from NASD and SEC regulations but they were not successful. This was critical since it allowed the same access that all other broker-dealers had. Thus, any entrants into the industry would be under the continuing oversight of the major self-regulatory bodies. During this time, the number of insurance firms that joined the industry decreased; however, the number of registered representatives with insurance licences continued to increase (Mayer 1992). Even though the insurance companies lost their battle for exemption from industry regulation, this did not stop cooperation between the insurance and securities industry. The insurance companies appointed securities firms as the principal underwriters of variable annuities issued by insurance companies that were generally funded by investment companies.
The effects of industry norms on foreign firms, heretofore unexplored, began to be investigated. The principle of uniformity was applied to US and foreign firms after Congress passed the International Banking Act in 1978, which enforced competitive equality between domestic and foreign companies, in this case, banks. This Act brought foreign banking activities under the purview of many of the same laws that the domestic banks had to abide by (NASD 1979). This was critical in reinforcing the boundaries between the banking and the securities industry. Banks, regardless of their provenance, or the requirements needed to trade securities elsewhere, were granted only limited accesses to the industry.
By 1985 the industry was truly nationalized and uniform with all 50 states plus Washington, DC and Puerto Rico participating in the CRD. Individual state laws had been changed to be more amenable to NASDAQ and other exchanges so that all securities would be afforded the same consideration (except for penny stocks). The pricing structure had been changed to reflect a sliding-fee schedule. In fact this entire period had been marked by standardization and increased automation that led to increased monitoring of industry participants and SROs.
All these changes created a regime that was distinctly different from the preceding one. It was now marked by uniform standards, rules, and regulations across the USA. Investors were thus assured of the same level of protection regardless of where they traded. Furthermore, new rules, principles and decision-making structures had emerged. The focus on ensuring well-functioning markets that were easily accessible to all potential investors was achieved through the creation of new rule-making bodies that imposed enhanced capital requirements and standardized entry requirements for industry professionals.
Regime III: Internationalization (1984–96)
The scope of the industry increased not only in terms of its activities but also its geographic spread. As the mechanisms that enabled a national marketplace were established and solidified (standardization), the industry began to consider the advantages of global growth. The first steps were taken in the late 1970s – in 1977 NASDAQ began to gain international legitimacy as the Japanese securities listed on it were declared eligible for purchase by Japanese investors. This trend accelerated in the mid-1980s.
Expanding industry boundaries
Now the industry focused on the world beyond the USA – the NASD estimated that cross-border equity trading would increase up to $3 trillion by the year 2000 (NASD 1990). The expansion abroad took several different tacks: (1) the diffusion of US securities technology and regulatory frameworks abroad to structure emerging markets elsewhere; (2) agreements between US and foreign securities markets and international trade associations; (3) an increase in the number of foreign companies listing and investing in the USA; and (4) the number of US companies pursuing equity financing on other international markets.
The first tack, diffusing its governance system, is exemplified by the decision in 1984 by the London Stock Exchange (LSE) to model its new equity-trading system on the NASDAQ market – a system where they would have competing market makers connected on a computer system. The British were interested in creating a ‘virtual’ exchange like NASDAQ, where geography would not be an issue. Accordingly, NASDAQ and the LSE agreed that some NASDAQ stocks would be listed on the LSE with price information reported in real time. This represented a first step by the industry to fulfil the basic need for solid international price quotations. In time, it was expected that other international exchanges would join the effort. However, before this could be implemented, a regulatory framework had to be created to deal with clearance and settlement linkages. This required creating a minimum level of infrastructure (Lo 1996) and standardization between exchanges.
As a result of all of this inter-market work and the sharing of regulatory information between NASD and British stock exchanges, in 1988 NASDAQ became the first market to be granted status of an ‘overseas recognized investment exchange’ by the British Department of Trade (NASD 1988). The following year, the exchanges introduced real-time trading for both the NYSE and NASDAQ in London (NASD 1989). The continued building of infrastructure between different markets led to the installation of market-making facilities in 1991 in the UK to support the extension of NASDAQ in Europe. This allowed for market-making during European trading hours. In 1987 NASDAQ-like systems were created in Singapore (SEADAQ) and Japan. Since this system could be implemented anywhere, this model proved particularly attractive to many other equity markets (Chorafas 1992).
Encouraged by the success of the LSE relationship, the US industry initiated a variety of international agreements to create market linkages. As part of this effort the NASD created the NASDAQ International Market Initiative (NIMI) to assist emerging and established securities markets around the world with both technology and regulation. One of its first successes was the creation in 1994 of a Russian national SRO (PAUFOR). It also worked to establish a pan-European small growth company securities market (EASDAQ) and its related trade association, the European Association of Securities Dealers (EASD). Although this took several years, the exchange opened in 1994. Additionally, NIMI helped the foundation of an Australian small-cap market (AUSDAQ) (NASD 1991) that went online in 1994. Not only did these activities serve to standardize the international market, they also disseminated the principle of self-regulation and norms of investor protection.
This process of globalization also included the emerging world equity markets. In fact the NASD recognized these markets as the next dimension for the industry (NASD 1985). The industry wanted to benefit from the new business opportunities abroad created by the growth of foreign markets. As a result, the NASD worked in cooperation with industry and government officials worldwide to create new markets. In addition the NASD joined the International Organization of Securities Commissions (IOSCO) in order to represent the interests of the US industry and shape global regulatory policy. This action ensured that the US industry had a voice in international regulation and standardization. Furthermore, the NASD along with several US exchanges helped to create the International Council of Securities Dealers and SROs, an organization that was formed in 1988 to promote and encourage the harmonization of procedures in international securities markets and the effective regulation of cross-border securities trading (NASD 1989). During this time, another trade association, the International Federation of Stock Exchanges, focused its attention on the international regulation of securities markets. In particular, this trade association was concerned with regulating trading on ‘automatic’ or screen-based markets (NASD 1988).
The process of internationalization also occurred within the USA. Many investors had acquired a global orientation and sought global asset management. There was a large increase in the geographic scope of every type of security in the industry. Further, the industry encouraged international companies to list in the USA and the number and volume of foreign securities and American depositary receipts (ADRs) listed and traded continued to increase dramatically. Additionally, the SROs wanted to make sure that US markets were open to international investors. At the same time, the major US issuers wanted an international mix of shareholders. In an attempt to get international shareholders and issuers, and to increase the visibility of the US securities market worldwide, the NASD opened a London office to serve European companies seeking to list directly or through ADRs on US exchanges (NASD 1986).
Increased worldwide regulatory cooperation and the number and quality of international services led to the globalization of the industry, a development that, by expanding competition between markets, enhanced the protection that investors received. Competition occurs at different levels – between different markets and between multiple market makers within a given market. Market makers are an important alternative to auction-based exchanges. Market makers specialize in specific stocks (i.e. Microsoft). Each stock may have several different market makers, each of which may be willing to buy or sell at a different price. Through fostering this competition between market makers, exchanges believe that the buy and sell prices most accurately reflect the market (Stone 1975). Moreover, the greater the competition, the more disclosure, the fairer the markets. As a result, the number and importance of market markers increased as more and more markets used them (Amihud et al. 1985). All of these developments were widely viewed by the industry as enhancing investor protection.
Industry boundaries
The industry also sought to maintain traditional inter-industry boundaries. In particular, the SEC was concerned that the investor would be less protected if related industries offered similar services. Therefore, it ruled that banks must conduct all securities activities through broker-dealers. Bank-affiliated broker-dealers were required to explain to clients that they functioned separately, were not an extension of the bank, and that their products had different risk characteristics than certificates of deposit and other traditional bank products that are protected by the FDIC.
Even though the industry did not want other industries encroaching on its territory, it sought to expand its control over related industries. The NASD expanded its regulatory responsibilities domestically to previously unregulated products, often through legislation. For example, the Government Securities Act of 1986 required that brokers and dealers working with government securities must register with the SEC and become a member of an industry SRO (NASD or a national securities exchange) (Mayer 1992). Additionally, financial advisors now came under the purview of the NASD and were monitored and inspected in the same way as broker-dealers.
Changes in rules and decision-making procedures
The norm of investor protection was strengthened during this time by new regulatory programmes. The new securities regulations were designed to ensure that risk was understood but not mitigated or eliminated and that market professionals dealt fairly with their customers. The industry agreed that it was in its best interest for customers to be satisfied and to understand the nature of the markets. This would result in increased industry profits due to growing trading volume that depended on customer satisfaction and repeat business. Markets, therefore, had to be concerned not just with efficiency but also with fairness. Hence the industry sought to improve the quality of markets by paying attention to such problems as insider trading and the quality of testing centres.
Therefore, the issue of controlling individual behaviour remained very important. One way to do this was to monitor personnel changes. Accordingly, the SEC and the NASD sought and obtained the right to gather more detailed information about changes in industry personnel within firms. Regulating the behaviour of firms and individuals through deterrence became increasingly important as the regulatory bodies made a large effort to inform member firms of typical industry rule violations and their corresponding disciplinary consequences. Using guidelines rather than fixed sanctions to ensure these goals, the disciplinary committee sought and was able to achieve greater consistency, uniformity and fairness when imposing sanctions.
All these industry changes were consonant with the new regulatory and enforcement programmes. Increased joint efforts with state regulators, the SEC, the Federal Bureau of Investigation (FBI) and US attorneys sought to increase deterrents to wrongful actions. This took four major forms: (1) eliminate ceilings on fines; (2) increase the disciplinary information about member firms and registered representatives (the disclosure to investors about firms and broker-dealers in the industry was made easier); (3) increase efforts to make regulatory information more available to the public; and (4) allow arbitrators to make disciplinary referrals to appropriate agencies. As more large and complex cases went to arbitration, the industry developed procedures and rules to streamline the process.
Changes to the regulatory process were divided into three main arenas: (1) cooperation with government agents to increase enforcement; (2) the use of technology; and (3) changes in firm activities. The growth in the prevalence and strength of computers meant that they became an important regulatory tool. By utilizing technology to identify high-risk firms, individuals, practices and products, regulatory agencies could more effectively sanction members both monetarily and through suspensions. Firm regulations were also changed through new auditing requirements (NASD 1993). Regulations around mutual funds capping fees to protect investors from unfair pricing structures were also changed.
The growth in market activity was not just in traditional activities like stocks and bonds. Using the model of NASDAQ, the industry decided to create markets for other types of products. The desire was to create a technological platform from which the NASD could design custom-made systems. The industry believed that this combination of technology, competition and regulatory programmes ensured fairness for all participants. Accordingly, it created a new NASDAQ-like system that handled private offerings and reciprocal trading. This system provided a highly regulated market of unregistered, international securities. By opening the PORTAL market (electronic market for private placements) in 1990, which was limited to brokers, dealers and large institutional investors, it expanded the opportunities for trading private placements. Its development was made possible in part by the passage of SEC rule 144a, which was enacted to overcome the historical fragmentation and obscurity of restricted securities market (NASD 1992).
In order to ensure that all types of securities were available to the public, several markets were created. One was for companies not able to meet the listing requirements of NASDAQ to be traded easily. The OTC bulletin board made this market more visible, liquid, easily regulated and competitive by increasing the number of market makers per security and having trades in real time. The second used the screen-based, market-making model on the bond market. The Fixed Income Pricing System (FIPS) for the high-yield bond market provides a real-time screen-based quotation system real-time quotes for high-yield, fixed-income securities (NASD 1993).
Coordination across these markets emerged as a major priority because of the growing complexity and specialization of the industry. The 1987 market break, the single largest drop in volume up to that time, highlighted for different groups the importance of standardizing activities across markets. Therefore, the industry created an inter-market policy group made up of senior management from SROs to plan and coordinate the markets and the upcoming changes (NASD 1988). These policies of coordination were also driven by industry personnel’s need for heightened knowledge regarding regulatory requirements and new products. Thus, the NASD, in conjunction with five other SROs and a representative group of member firms, developed a required continuing education programme for all registered representatives and principals. This two-tier programme’s regulatory element was administered by the SROs and the firm element (consisting of specific job-function- and product-related material) was administered by each member firm. Since the firms were more aware of the specialty needs of the registered representatives, they were held responsible for ensuring that their employees were appropriately trained.
The norm of investor protection continued during this time, but the principles were completely different. Now investors were to be protected by fair markets that were to be achieved through competition. By doing so, customer satisfaction would increase and the industry would benefit. As new products and services became easier to offer, the rules changed dramatically to reflect the growing specialization that came to characterize the industry. Moreover, the SROs became concerned with the qualifications and behaviour of individuals in the industry due to the growing complexity of products and services. As a result, a series of regulations were passed around the activities of individuals. The decision-making during this period focused on the creation of new SROs to handle the increasing specialization as well as the international focus.
This regime was also marked by an increase in the number of actors involved in decision-making as new international trade associations and regulatory agencies rose to prominence. These new actors, however, shared US norms and principles and there was little conflict between the various organizations. The US industry hoped that its new international activities would lead to the adoption of standards and regulations that would make it possible for US investors and companies to be actively involved in these markets on a major scale (Chorafas 1992). Obviously, the greater the compatibility between existing and emerging markets, the easier it would be for US investors to take advantage of these new opportunities.
Emergence of a new regime
The industry changes that occurred in the mid-1990s culminated in the emergence of a new regime in 1996. The groundwork for this new regime was laid by the growing industry concern about possible conflicts of interest within the NASD. Because of its dual roles as the main self-regulatory organization of the industry and its control over NASDAQ, it became increasingly obvious that the NASD was not adequately policing its members. A Journal of Finance paper (Christie and Schultz 1994) demonstrated that the NASD had failed to halt widespread price fixing on stocks by market makers on NASDAQ. After an 18-month investigation by the SEC, the regulatory structure was completely transformed. For the first time since its inception, the NASD separated the responsibility for the NASDAQ market and the regulation of broker-dealers into two distinct, independent and related organizations. NASD Regulation, Inc., created in 1996, was now the industry’s primary self-regulator. In order to ensure that it adequately represented investors, at least 50 per cent of the governing board members had to come from outside the industry. Moreover, the budget for enforcement increased by over 20 per cent in 1996. However, the NASD, now the parent organization of NASD Regulation, Inc. and of the NASDAQ stock market, sought to maintain its influence by establishing and coordinating policy agendas for the two subsidiaries and providing essential corporate services (NASD 1996).
These changes, along with the repeal of the Glass-Steagall Act, led to a dramatic shift in the norms, principles, rules and decision-making procedures in the industry. It was completely transformed by new regulatory arrangements, new actors and procedures. As a result, the norm of investor protection, although nominally in place, was severely undermined by the new principle that assumed that deregulation would create a market environment that would protect investors. Although the application of regime theory to the post-1996 period would enable us to better understand the mechanisms that led to the financial meltdown that began in 2008, doing so would require the detailed consideration of a new regime involving actors, actions and policies that differ markedly from the preceding periods. Since the purpose of this work is to illuminate the ways in which the application of regime theory can be used to enhance our understanding of industry change, the eras preceding 1996 provide ample data for this purpose.
Conclusion
The early 1960s represent a useful starting point for a historical analysis that enabled us to test the utility of regime theory for an enhanced understanding of growth and change within the industry. Although the roots of the industry can be traced back to the mid-1700s and the 1930s witnessed large-scale changes, the modern period began in the 1960s. This decade represented a major turning point with the entrance of powerful new actors and expansion that continued through the 1990s. By identifying the distinct and specific regimes that characterized various epochs between 1960 and 1996, it has proved possible to better understand how and why change occurred within the industry.
As noted earlier, regimes are characterized by four dimensions: norms, principles rules and decision-making procedures. Although these regimes shared certain characteristics, such as norms (i.e. investor protection), the ways in which they were realized varied greatly owing to the specific characteristics of the competitive environment at the time. Thus, these regimes created various models of competition.
These models varied along particular dimensions. First, the levels of governance that determined how firms competed changed greatly over the almost 40 years of this study. Regime I was characterized by local-level governance that created a great diversity of competitive environments at the state level. Regime II witnessed the beginnings of a push to nationalization resulting in standardization and uniformity. These developments enabled the industry to focus on international markets during regime III and begin to export its model of governance to Europe, Japan and later emerging markets.
The second dimension involved the norm of investor protection. Although the importance of this norm remained constant and agreed upon, the principles that operationalized it changed dramatically. In regime I investors were seen to need direct protection in order to ensure that they would not be exploited by industry members. In regime II investors were protected by competitive interaction among nationwide organizations. In regime III investors were considered protected if markets were competitive and if they had access to those markets. This view continues to the current day.
The third dimension, regulation, enables us to better understand the underlying driving forces that propelled the concern for regulatory change and the ways in which these influenced the emergence of new structures. Regulations reflect the wider principles and norms that shape the nature of competition in the industry. Thus, in regime I regulations dealt with controlling the activities of broker-dealers in local arenas as well as new entrants, such as insurance agents. In regime II regulations reinforced the push to nationalization. Finally, in regime III, enhanced regulations led to increased enforcement efforts and standardization of practices across multiple markets.
The fourth dimension involved decision-making procedures. The questions of where, how and who makes decisions within an industry is answered by using a regime perspective. The power of actors and how they make decisions change over time and regimes acknowledge and reflect these changes. In the case of the securities industry, a shift is seen in the role of the SEC, the NASD, the exchanges and the broker-dealers themselves in how they make decisions and the role they play in changing the industry.
In other words, a regime approach provides us with an understanding of the critical elements that shape an industry and how they interact to produce a particular pattern. By considering the totality of the factors that are involved within an industry, we are better able to understand how and why change occurs. Regime theory also identifies not only the areas of conflict that often mar interaction by key actors, but also focuses on the ways and degree to which their expectations converge. It is through common systems of meaning that resolution of conflict occurs and governance mechanisms are created. With multiple solutions for any problem, industries can evolve in numerous ways. Regime theory enables researchers to understand why and how industries evolve along a particular path.
In short, an historical analysis of an industry, informed by a regime perspective provides some new and important insights into the temporal nature of industries and how they change and evolve. Applying regime theory to historical events enables us to better describe and explain the nature and drivers of change. By doing so, individuals, groups and organizations are no longer seen merely as agents; rather, they are placed in a broader context where governance is both a mechanism and a target of change.
Regime approaches could also be used to look at this industry in other countries, thus permitting comparative analyses. Regime approaches could also be utilized to understand action in other industries, especially those that enjoy a high degree of self-regulation. But what about industries that are not self-regulated? The governance of such an industry might be better understood through a thorough analysis of the norms, principles, rules and decision-making procedures that are at play. Finally, in light of the recent economic turmoil, an analysis of the brokerage house industry after 1996 provides interesting insights into the tumultuous events of the past few years.