Toward a Robust Policy Development Process

Author Name: 
Daniel M. Labovitz

This article presents ways in which an exchange can structure its rule development processes so that they are effective, transparent, and consistent.

Exchanges tend not to focus on rule development unless it threatens to impede business initiatives they want to implement. And that’s not surprising – new rules can be abstruse, time consuming to vet once they’re written, and complex to code or implement, particularly if rule-writers and programmers don’t work together. Amending existing rules, or even clarifying them to describe what actually happens in the market, can be daunting, especially if the rules were originally crafted to favor entrenched interests, or to protect local market participants.

But rule development is a project like any other that an exchange undertakes. The challenge for a management team who are used to implementing complex projects, therefore, is to see rule development through the lens of project management. Because the fact is, properly supported and managed, rule development can be a positive asset to an exchange as it prepares to implement new technologies, update old ways of doing business, and convince potential market participants that their capital will be treated consistently and fairly.

Why Rule Development Matters

Why have a standardized policy development process in the first place? Many exchanges have had ad hoc processes in place for years, and even if the resulting rules are quirky, they work, more or less. Why invest in establishing a new process?

The answer is that a robust policy development process performs several essential functions for self regulatory organizations. First and foremost, it is a risk management tool: it forces the exchange to examine, as a matter of course, whether a particular regulation is necessary, and if not, to identify in what situations a regulation or policy could become necessary. Put another way, the policy development process helps identify which potential risks are real, and guides the exchange’s response accordingly. If the exchange determines that a regulation or policy is genuinely needed, then a robust policy development process helps to ensure that the ensuing regulation is effective at achieving the regulatory goals; and that the proposed policy will be efficient in application.1

The benefits of this approach are evident: If a rule proposal isn’t necessary to achieve a particular goal, constituents (those subject to the rule) will see it as arbitrary or illegitimate or, at the very least, a pointless nuisance. They will likely be less careful in their compliance efforts, if they comply at all. And a regulator who insists on upholding these types of rules will eventually be perceived as arbitrary and capricious.

A rule proposal that is not effective at achieving a particular goal suffers from a similar defect. If constituents concede that some sort of rule is necessary to achieve the regulatory aim, but do not believe that this iteration of the rule will accomplish it, then they are more likely to push back during the development and implementation phase, and unlikely to be careful in their compliance, because they believe that compliance won’t actually address the admittedly legitimate regulatory concern.

Like the previous situation, a regulator who insists on enforcing a rule known to be ineffective will ultimately be perceived as arbitrary and capricious.

A rule proposal that is necessary and effective, but not efficient, at achieving its goals is still problematic. Because regulatory resources are limited, an inefficient rule unnecessarily burdens both the regulator and the regulated, or crowds out better uses of regulatory resources, or both. Equally problematic, it can create the “appearance” of regulation without adding actual regulatory value. This can lead to regulatory complacency: one or more participant (constituent or the regulator) may conclude that because there is a regime and constituents are complying with it, nothing more needs to be done to improve the regulatory environment. In fact, however, a more efficient process might be better or faster at identifying potential violations or minimizing the damage such violations may cause.

Beyond these basic principles, a well-designed rule development process should create buy-in from all market participants, who can be confident that the regulator is acting fairly and transparently. In this regard, the process of rule-making is as important as the result.

That implies, of course, that an exchange’s rule development process is clear and transparent, and is consistently applied. It is tempting to cut procedural corners on the “easy” projects, where it appears everyone’s interests are aligned, or where it appears the opposing points of view are widely known. But it’s often a mistake to assume everyone’s positions are known or adequately represented, and even if they are, cutting corners misses an opportunity to easily model and reinforce the policy development process, and may even squander goodwill that would be useful in harder rule development situations.

Recommendations for a robust Rule Development Process2

1. The Rules Department should function as a regulatory project management office

Whether it is housed within the legal department or is a stand-alone unit, there should be a dedicated group that is responsible for rule development (the “Rules Department”).

This group should function like a regulatory project management office for all projects of the exchange that touch, or are touched by, the exchange’s existing rules, or that would affect the exchange’s role as the first-line regulator of its marketplace. This means that instead of the substantive department that originated the need for a rule change managing the rule writing, the rule change is managed by the Rules Department. The originating department should provide substantial input, but final say on the language and structure of a rule should come from the Rules Department.

Viewing the Rules Department as project management office establishes this department (and through it, all of the Exchange’s regulation department) as an essential partner with the nonregulatory elements of the exchange (operations, listings sales, etc.). As the rules project manager, the Rules Department must be accountable to the senior management of both Regulation and the broader exchange. The surest way to do this is to set the expectation at the outset that the Rules Department will regularly report in writing on the progress of rule development projects. In addition, the Rules Department should hold regularly-scheduled face-to-face meetings, with senior representatives from each originating department present, to resolve bottlenecks or resource deployment issues as they arise.

2. An exchange should assign specific staff to write and revise rules.

There is often an assumption within exchanges that anyone can write rules. As a general observation, this bias against rule drafting as a specialty is an anomaly. After all, purchasing, network operations and legal services are each overseen by a specialized unit within the company. Rule development should be no different.

A dedicated rule development staff is likely to be more efficient at the process of drafting rules because it will develop deep experience in doing it; they may have deeper insights into the apex regulator’s views on various subjects because they are in regular contact with their counterparts there; and they may be aware of nuances of the rulebook that other departments are not because the rule development staff specialize in understanding the contours of the rules and the interplays between various rules. The bottom line is that the Rules Department should be treated as the experts in developing rules, and workflow should be structured so that it has primary responsibility for producing rule-related work product.

3. Rules Department approval should be required for any project with rule implications.

As a self-regulatory organization, an exchange is responsible for implementing rules and procedures that fairly carry out the purposes of the SRO consistent with the country’s securities laws, and for ensuring that those rules and procedures are capable of being appropriately surveilled and enforced. To do this, the exchange’s regulation department must have the opportunity to review and sign-off on rule proposals before they are implemented.

A rule that cannot be surveilled or enforced is not a “rule” per se – it is merely a suggestion with no real consequences if it is violated. If Regulation believes it lacks the tools or manpower to detect a violation of a proposed rule, or that the proposed rule sets up an impossible standard for enforcement, then it must be able to call for the proposal to be revised. As importantly, senior management should show active support for Regulation’s conclusion.

4. Consistently require executive summaries of proposed rules.

It is tempting to assume that everyone understands the problem that a program or policy proposal is designed to address, that everyone understands the way in which the proposed program or policy will address the problem, and that everyone agrees which mechanism will best address the problem. Often, however, one or more of these assumptions is incorrect.

Requiring rule proponents to prepare a summary of the proposal (including the essential elements, implementation time frames and project dependencies) forces them to articulate all key assumptions and to explain the policy or program in enough detail that other participants can assess the risks and impacts on areas in which they are the primary responsible actor. In general, the executive summary should lay out briefly, but clearly (1) the problem or opportunity that the program or policy is meant to address; (2) the key actors who will be involved in implementation; (3) the key constituent groups affected by the change; (4) how the program or policy is intended to work; and (5) why the program or policy is consistent with the interests of public investors and the exchange’s duty to maintain fair and equitable markets for all participants.

Ideally, the proposal should also suggest language for the core rule changes that are required. It can sometimes be difficult to articulate a rule in a precise-enough manner to match the thrust of the proposal, and thinking through the actual language to be used forces people to think rigorously about whether or not the program or policy, as conceived, is surveillable and enforceable. For example, a rule may prohibit “all instances” of an activity, but the trading system may allow users to do the prohibited activity in exceptional circumstances; if so, the rule needs to spell out specifically which exceptional circumstances do and do not qualify, and the term “all instances” needs to be modified accordingly. While that might seem self-evident, systems designers sometimes build logical exceptions into trading system-flows that are not covered in the rules, and these come to light only after implementation, such as when an end-user is caught taking advantage of an exception.

5. Solicit outside comments and feedback on rule proposals.

Affected constituencies and the investing public should have a chance to review and comment on proposals before they are final and implemented.3

Available research suggests two key times for commenter influence: (1) before a rule has been formally promulgated, either by influencing the language and scope of a proposal to be more favorable to a particular interest, or killing it altogether before it is born; and (2) after a rule has been proposed but before it has been finalized.4

Exchanges should seek input and comment at both stages. Before a proposal is formalized, constituents with business interests directly affected by the proposal will want to have their say. Their feedback can be invaluable, because the consultations tend to be more informal and can help the exchange gather information and consider the broadest range of possible solutions. Early commenters can offer information on regulatory design, its likely effectiveness and the burden it would impose on participants. They may also have technical expertise or knowledge that can shortcut the exchange’s efforts and make the process more efficient.

Alternatively, an exchange can formally propose a change and solicit feedback from interested parties during a public comment period. Exchanges should avoid ad hoc processes for collecting input from interested parties once a policy is publicly presented; because they are ad hoc, interested parties who were not consulted may resort to other feedback mechanisms, including complaints to the apex regulator or public criticism in the media. These responses create an adversarial posture where it can be difficult for the exchange to respond effectively.

A formal comment period, by contrast, ensures that all interested parties have an opportunity to respond, and sets productive parameters for input within manageable time frames. A call for public comments typically consists of three parts:

  • A notice of rulemaking announcing the rule and describing both the process by which interested parties can submit comments and the deadline for doing so5;
  • A description of the purpose of the rulemaking, how the rule will work, and why the proposed rule is best suited to that purpose; and
  • The proposed rule text, showing additions and deletions to the rules.

To be effective, the call for comments needs to be adequately publicized. At a minimum, the proposed rule text and discussion should be posted on the exchange’s website, with some kind of announcement directing people to the materials. The comment period should be reasonable, but need not be overly long – a typical comment period for rule filings is 21 calendar days, though a 14- calendar-day comment period may be sufficient for less controversial filings.

A key component of the rule making notice is the narrative description of the rule proposal. This “purpose section” is meant to explain what the exchange is proposing to do and why.6 It should cover the proposal in detail (if the proposal involves proprietary information, it should be generalized enough to protect the proprietary nature of the information, but should still convey the sense of what the exchange proposes to do). It should also explain why the exchange’s proposal is consistent with fair and equitable principles of trade and is in the public interest.

Commenters should be required to respond in writing. Exchanges may want to give commenters a mechanism for submitting comments directly through the exchange’s website or establish a special email account to receive comments. Exchanges may also want to consider making comments publicly available through the same mechanism that rule proposals are posted.

When finalizing a proposal and preparing its application to the apex regulator (if that’s required under local law), the exchange should summarize in its application letter the comments received, and justify in categorical terms any decision not to follow suggestions by one or more commenters.

6. The exchange’s rulebook should be kept up-to-date.

Though obvious, it is worth repeating that transparency requires keeping the exchange’s rulebook as up-to-date as possible so it is clear what rules apply at any given time. The task of updating the rulebook should be managed by the Rules Department.

Rule development is a combination of art and science, and therefore requires some flexibility. Nevertheless, it benefits from predictable routines and procedures so that participants understand how policies are proposed and finalized, and where they may appropriately have influence. If undertaken thoughtfully and consistently, rule development enhances an exchange’s reputation for integrity by modeling transparency, fairness, and thoughtful decision-making.

 

1 Adapted from David E.M. Sappington, “Principles of Regulatory Policy Design,” World Bank, Office of the Vice President for Development Economics (January 1994); and “The Generic Policy Development Process,” Cabinet Office Manual, Office the Prime Minister, New Zealand (1996).

2 This article primarily address the question of how to structure and streamline rule development within an exchange’s various departments. It does not address the interface between an exchange and its governing body or apex regulator with regard to the approval of rule changes. I note that, in many exchanges, a governing body will delegate the approval of new or amended trading rules to a senior officer of the exchange (either a chief executive officer or a chief regulatory officer) rather than review them itself.

3 See, e.g., International Organization of Securities Commissions, “Model for Self-Regulation,” United Nations Conference on Trade and Development, Expert Meeting on the Trade and Development Implications of Financial Services and Commodity Exchanges  (3 September 2007); International Council of Securities Associations, “Rule Making and Regulation in Financial Markets: Principles for Better Regulation” (November 2006); cf. John Carson, “Self-Regulation in Securities Markets,” World Bank Global Capital Markets Department (2011) (“SROs have evolved into organizations that must be responsive to the interests of a wider range of stakeholders and that are more publicly accountable.”)

4 See Keith Naughton, et al., “Understanding Commenter Influence During Agency Rule Development,” Journal of Policy Analysis and Management, vol. 28 No. 2, pp 258-277 (2009). There is a third influence point, namely the period after a rule has been finalized, but before clear enforcement standards have emerged. During this period, outside actors who may have been unable (for political or commercial reasons) to influence the formulation of the rule may nevertheless attempt to influence the manner and degree of its enforcement. An exchange may encounter this type of “lobbying” in connection the surveillance and enforcement of a rule, but since it generally occurs after the development of the rule is over and done with, I do not address it here.

5 It is worth noting that mere notice of a rulemaking is not sufficient; as one commentator has observed, “[m]echanisms providing organized interests with increased access (and not merely increased notification) serve to increase their impact on administrative rules. Thus, those seeking to stimulate involvement by affected interests may do better to incorporate such provisions, rather than relying solely on increased publicity of rulemaking actions.” Neal D. Woods, “Promoting Participation? An Examination of Rulemaking Notification and Access Procedures,” Public Administration Review, pp. 518-530, March/April 2009.

6 The purpose section’s narrative will usually grow out of the initial executive summary that was created at the outset of the project, while a proposed rule is in its earliest stages. The narrative in the purpose section would be crafted by Rules Department, with input and consultation from the originating department.

About Daniel M. Labovitz

Daniel Labovitz is the founder and Managing Director of MarketReg Advisors. The firm is a boutique consultancy that advises securities exchanges and regulators on designing and implementing regulatory policy, working primarily in emerging and frontier markets.

Mr. Labovitz was most recently the head of rule and regulatory policy development for NYSE Regulation, Inc., the regulatory arm of NYSE Euronext’s markets in the United States, where he was responsible for advising regulatory staff on rules and policy interpretations; working with the NYSE’s business teams to develop and implement new trading products and trading platforms; and interfacing with the U.S. Securities and Exchange Commission on regulatory policy matters. From 2005-2010, he also taught securities law at the Zicklin School of Business at the City University of New York’s Baruch College.