A proposed rule change filed by Nasdaq OMX Group with the Securities and Exchange Commission would give the exchange greater responsibility for regulatory oversight and reclaim some of the surveillance activity it has traditionally outsourced to the Financial Industry Regulatory Authority.

The Securities Exchange Act requires that national securities exchanges enforce their members' compliance with federal securities laws and rules as well as the exchanges' own rules. As a self-regulatory organization, NASDAQ must conduct surveillance of trading on the exchange as part of a regulatory program that includes member examinations and the investigation and prosecution of suspicious activity. Since it first became a national securities exchange in 2006, Nasdaq has contracted with FINRA, another SRO, to perform surveillance and other regulatory functions on its behalf.

The Nasdaq proposal points out that, despite outsourcing these efforts, it still bears primary liability for self-regulatory failures. This responsibility has led it to bolster efforts in real-time surveillance.

Nasdaq proposes to reallocate operational responsibility from FINRA for “a limited number of equities surveillance patterns and related review functions.” Specifically, the exchange would leverage its internal expertise to focus on trading activity in the opening and closing cross process, and minimum bid listing standards. It would also monitor attempts to manipulate the market by leveraging small orders to drive up the pricing of larger ones, a practice known as “odd lot manipulation” and “mini-manipulation.”

“Nasdaq believes that its expertise in its own market structure, coupled with its continued monitoring of these activities in real-time, will enable it to better detect improper activity on its market,” the proposal says. The exchange also proposes to assume operational responsibility for real-time compliance monitoring of market makers that are part of an underwriting syndicate.

Nasdaq plans to monitor trading patterns using the SMARTS surveillance system, a platform it acquired from an Australian company in 2010 that is used in 26 markets and by nine government regulators.

“Nasdaq anticipates being able to refer a broader cross section of problematic activity to FINRA for expedited review than was previously the case,” the rule proposal says. Nasdaq and FINRA “have developed comprehensive plans covering the transition” and have met regularly for more than nine months to “ensure a smooth transition and prevent any gaps in surveillance coverage.”

Nasdaq notes that its proposal is consistent with surveillance work performed by other national securities exchanges. The SEC has approved BATS Exchange's application to perform most surveillance for its markets. Similarly, Miami International Securities Exchange performs the majority of its surveillance operations in-house.

The proposal comes on the heels of a renewed push by the Securities Industry and Financial Markets Association – which represents securities firms, banks and asset managers – for the SEC and Congress to reexamine whether stock exchanges should continue to exercise rulemaking and enforcement authority over their members. Its concerns were detailed in a letter to SEC Chairman Mary Jo White earlier this month.

“Exchanges face an irreconcilable conflict of interest in the performance of their SRO responsibilities,” Theodore Lazo, SIFMA's managing director and associate general counsel wrote. “On the one hand, they are bound by a fiduciary duty to maximize profits for their corporate shareholders. On the other hand, they are required to be fair and impartial regulators of the broker-dealers with which they compete.”

The letter points to competitive benefits gained from exchanges' status as SROs, including limitations on legal liability. Courts have held that an exchange “steps into the shoes” of the SEC with respect to the regulatory functions delegated to it and is therefore entitled to immunity from private liability with respect to those activities.

One of Lazo's main points of contention, that exchanges “delegated a substantial majority of regulatory functions” to FINRA, would be somewhat mitigated if the Nasdaq proposal is approved.