Canadian financial services firms and inves-tors aren’t alone in their intuition that the regulatory system is dysfunctional. That sense is pervasive in many markets around the world. But a new report from the CFA Institute’s Centre for Financial Market Integrity is recommending reforms to help regulation keep pace with reality.

The problems with the Canadian system are well known and well documented. Regulation is fragmented, needlessly duplicative and inefficient for firms; inves-tors see enforcement as seriously deficient. In fact, Canada’s regulators are often compared unfavourably with U.S. authorities, particularly the Securities and Exchange Commission.

But the U.S system has problems of its own. Market players complain that the content of its regulatory system is rule-heavy and that its regulatory structure is fragmented (state securities regulators, derivatives and banking regulators, and various SROs exist alongside the SEC). The SEC has even questioned the efficacy of self-regulation after U.S. SROs failed to prevent some of its more serious scandals.

American policy-makers have pointed toward the system adopted in Britain as a possible model. Its chief virtues include:

> no fragmentation, as all its regulatory functions are invested in a single super-regulator (the Financial Services Authority);

> little self-regulation, which has been largely abandoned; and,

> Britain is in the process of eliminating rules and shifting to a principles-based model.

Despite the admiration of those in the U.S. industry, the FSA hasn’t been immune to criticism, either. Firms in that market have charged that the FSA is heavy-handed. Moreover, its reputation is taking a beating in the fallout from the financial markets disruption that threatened to bring down a non-bank lender in Britain, sparking a run on the firm’s deposits when its troubles were revealed.

Given that no one has yet hit on the perfect regulatory system, these issues are forever ripe for study and debate. This ongoing search for a better system, particularly the latest round of doubts about the viability of self-regulation in the U.S., has sparked the CFA Institute’s report. A white paper from its policy arm — the Centre for Financial Market Integrity, which administers the CFA designation — examines the operation of regulation, particularly self-regulation, in securities markets around the world. And it outlines reforms that it believes are necessary if regulation is to reflect the evolving global marketplace.

The paper sets out what it discerns as the attributes of a successful SRO — characteristics such as transparency, independence, efficiency, vigorous enforcement and oversight, among other things. And it enumerates the things that make self-regulation fail, including loss of public trust, unresolved conflicts, increasingly diverse membership and overly intrusive government regulation.

The report explains that the CFA Centre has historically supported self-regulation, but that its support is not unconditional — particularly when investor protection is compromised by the notion.

In Canada, as well, the viability of self-regulation has been questioned in recent years. Indeed, the system has had to contend with several of the pitfalls identified in the CFA Centre’s paper. A couple of years ago, following public hearings in which the regulatory system was soundly criticized, a legislative committee in Ontario recommended a review of self-regulation to consider whether SROs should have any powers and, if so, what they should be. While the government accepted that recommendation, it never followed through with the review.

The new president and CEO of the Investment Dealers Association of Canada, Susan Wolburgh Jenah, has said that it’s important for both the industry and regulators to remember that self-regulation is a privilege, not a right; and that SROs must continually earn that privilege. She recognizes that there are real challenges inherent in self-regulation — particularly in terms of maintaining public confidence.

Beyond the public trust issue, the Canadian system has a grappled with the other challenges enumerated in the paper, which are more about ensuring that self-regulation is effective than whether it is publicly supported. On the issue of serving diverse memberships, Canadian SROs have faced complaints from small firms claiming the industry’s large players dominate self-regulation. Now, market regulation is facing a similar problem as it copes with the transition from overseeing one traditional exchange to serving a variety of upstart trading systems.

Intrusion by government regulators has also long been an issue. Reforms adopted by the SROs can take years to win approval from the provincial authorities. And the SROs have to contend with oversight reviews from multiple jurisdictions.

@page_break@It’s unlikely that many of the issues facing regulators and policy-makers around self-regulation are going away; they are inherent in the SRO concept. But the CFA Centre paper goes beyond flushing out the qualities that make self-regulation succeed or fail and imagines how to improve regulation generally as markets evolve.

“As securities markets undergo cross-border consolidations, national regulation is quickly giving way to global considerations,” the report notes. And, it says, while certain regulatory systems may retain aspects of self-regulation, “a global marketplace requires consideration of broad principles and an oversight framework that is applicable for all systems. Of utmost importance is the creation of a system that is able to provide inves-tors with relevant information and protections.”

With that goal in mind, the paper makes four basic recommendations:

> It calls for market SROs to be independent from the markets they oversee. (As is the case in Canada already.)

> It demands that duplicative, wasteful oversight be eliminated.

> It proposes that a common framework for regulation be established, largely adhering to the principles of securities regulation that have been spelled out by the International Organization of Securities Commissions.

> t suggests that a new global body be established (or an existing one empowered) to rate each market’s compliance with this code.

The paper’s recommendation for an independent market regulator has already been fulfilled in Canada, with the development of Market Regulation Services Inc. , which was spun out of TSX Group Ltd. RS has since become the regulator for a number of alternative trading systems, and its proposed merger with the IDA would take it even further from its former home within the TSX.

The call to eliminate duplicative regulation is obviously relevant in Canada. At a time when national regulation is being viewed by some as anachronistic, Canada has yet to achieve even that modest step. Provincial jurisdiction over regulation means that industry players are subject to different regimes in each province, paying multiple sets of fees and exposing investors to different standards of protection.

Even the self-regulators that aim to be national are subject to regional differences — as they are recognized in some provinces and not in others, are subject to various oversight regimes and must deal with different provincial structures (particularly in Quebec).

The consolidation of the IDA and RS will be a welcome step in reducing the number of regulators that firms must face. And efforts to adopt a passport system should provide some incremental improvement, too. But the reality is the Canadian system remains almost uniquely fragmented and complex.

The CFA Centre’s paper calls for regulatory rationalization. It supports the efforts to streamline broker-dealer self-regulation in the U.S. through the merger of the NASD and New York Stock Exchange’s member regulation functions. But, it argues, efforts at streamlining should not end there.

“As markets consolidate, product lines overlap and jurisdictional issues arise, additional streamlining becomes necessary,” the white paper says. “As with the restructuring that now vests oversight of broker-dealers in one regulatory body, other areas — both within the U.S. financial services arena as well as within various securities markets around the world — would benefit from a reformulated approach to regulation.”

To that end, the paper calls for a common framework for regulation in line with IOSC principles, and for an organization that rates whether specific markets meet, exceed or fall short of these principles.

The purpose of a rating agency for self-regulators would be to ensure that investors understand the regulatory risks they’re taking. Rather than relying on reputations that may be outdated or unwarranted, rating regulators against a standard framework would presumably give investors better information about the quality of various regimes. This may save investors from exhibiting overconfidence in a market that may be lightly regulated simply because it operates in a jurisdiction with a strong government regulator (such as the SEC), the paper suggests.

“As the financial services industry moves toward a global marketplace … we must focus more on the commonly shared goals and principles of regulation and less on the specific jurisdictional issues,” it argues.

Pursuing a common framework, it says, is necessary to harmonize global rules that will, in turn, encourage the development of new markets and products. Moreover, an established framework not only provides a benchmark against which individual markets can be measured, but that standard itself can evolve in an effort to keep up with the innovation of the global marketplace.

The notion of rating regulators is an interesting one, particularly in the Canadian context, in which the system of government regulation remains so stubbornly fragmented. Some have defended the current system by arguing that it could produce regulatory competition, which would ultimately benefit capital markets. If that concept were ever to be tested in reality, a regulatory benchmark and ratings could be one way to help make it work.

For the time being, however, much of this concept is confined to the realm of theory. Until someone hits upon the magic formula for a regulatory system that can actually do what all regulators promise — ensuring fair and efficient capital markets — it’s worth trying to dream up new ways to make it all work. IE