It may be time for self-regulatory organizations to lose their limited liability so that they can improve their policing the market, according to new academic research.

When policy makers decided to stress competition as a governing objective of the Regulation NMS-based market, they lost sight of the exchanges’ responsibility to police the market, noted Yesha Yadav, an associate professor of law at Vanderbilt Law School and the author of the soon-to-be-published paper.

“We have not reckoned with the consequences of that for market policing,” she said. “There’s a gap that is left and it is something I would love people to think about more deeply. It costs everyone in terms of how efficiently and how safely capital is allocated in the marketplace.”

The growing number of SROs and alternative trading system have brought investors the benefits of lower fees and a wider selection of trading venues, but they also have extracted a heavy price from the system as a whole, according to Yadav.

“Exchanges are deeply diminished in their ability to effectively govern the markets,” she wrote in her latest draft. “Lower revenues, fierce competition and incentives to take profitable risks have placed venues on a back foot in their ability to oversee an innovative, sophisticated and constantly mobile market.”

The cost of this “governance gap” is born ultimately by investors and public companies who can no longer rely on the protective oversight of exchanges to allocate capital.

To improve the market policing by exchanges, Yadav suggested that policy makers remove exchanges’ qualified immunity and establish a market disruption fund in which exchanges and alternative trading systems would contribute.

In an instance of a payout, the fund would tap the reserve of the offending exchange or ATS before tapping the fund’s general reserve.

The industry does not have very far to look for a functioning example of this model, according to Yadav.

“The Federal Deposit Insurance Corp. has a risk-based fund that pays out in the event of a bank failure,” she said. “It adjusts contributions to reflect the risk and size of banks according to a certain formula. That model has been extremely successful in the US market.”

This common fund would provide an incentive to the exchange and ATS operators to monitor each other’s behavior since the collected fund would be on the hook to pay out.

“To the extent these venues are not wiped out by liability, the fund may require them to pay in extra funds after the fact in the acknowledgment of their deficiency much like tried and tested mechanisms in insurance,” she wrote. “The fund represents a mechanism for the market to protect itself against risk, to make good on any losses, and reduce the chances of bad actors behaving disruptively.”

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