Contracting and Enforcement with a Self-Regulatory Organization

46 Pages Posted: 17 Jan 2002

Date Written: August 2001


Self regulation is a feature of a number of professions. For example, the government delegates aspects of financial market regulation to self-regulatory organizations (SROs) like the New York Stock Exchange and the National Association of Securities Dealers. We analyze one regulatory task of an SRO, enforcing antifraud rules so agents will not cheat customers. Specifically, we model contracting/enforcement as a two-tier problem. An SRO chooses its enforcement policy: the likelihood an agent is investigated for fraud and a penalty schedule. Given an enforcement policy, agents compete by offering contracts that maximize customers' expected utility. We assume the SRO's objective is to maximize the welfare of its members, the agents. We show that in the static case, the SRO chooses a more lax enforcement policy - less frequent investigations and lower penalties - than what customers would choose. A general conclusion is that control of the enforcement policy governing contracts confers substantial market power to a group of otherwise competitive agents. We also investigate government oversight of the self-regulatory process. The threat of government enforcement leads to more enforcement by the SRO. A similar result applies in a dynamic setting where customers can impose discipline by monitoring an agent's reputation for past performance. Here there are circumstances for which the SRO would choose a more aggressive enforcement policy than is preferred by customers.

Suggested Citation

DeMarzo, Peter M. and Fishman, Michael Jay and Hagerty, Kathleen M., Contracting and Enforcement with a Self-Regulatory Organization (August 2001). Available at SSRN: or

Peter M. DeMarzo (Contact Author)

Stanford Graduate School of Business ( email )

655 Knight Way
Stanford, CA 94305-5015
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650-736-1082 (Phone)
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National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
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Michael Jay Fishman

Kellogg School of Management - Department of Finance ( email )

Evanston, IL 60208
United States
847-491-8332 (Phone)
847-491-5719 (Fax)

Kathleen M. Hagerty

Northwestern University - Kellogg School of Management ( email )

2001 Sheridan Road
Evanston, IL 60208
United States
847-491-8345 (Phone)
847-491-5719 (Fax)

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