If online brokers have made full-service commissions seem old-fashioned, evolving electronic trading platforms soon may do the same for in-house securities regulation. Funny thing is, these new trading systems may find the

New York Stock Exchange

and the

National Association of Securities Dealers

squarely in their corner.

Faced with competition from nimble electronic communication networks gunning for exchange status, the NASD and the Big Board are considering combining their regulatory functions, spinning them off into a separate company and eventually even offering regulatory services to competitors. For the exchanges, such a merger would cut down on duplication as well as costs.

A merged NYSE-

Nasdaq

regulation body could end up competing with regional exchanges, such as the

Philadelphia Stock Exchange

, that are also considering selling regulatory services to new exchanges.

For investors, competition among regulators could mean lower trading costs. And ECNs that outsource regulatory functions would be freed up to focus on making trading more efficient.

"There are certain benefits to protecting the individual, but with more levels of intermediation, you certainly have added costs," says Jim Laird, a senior analyst at Boston consulting firm

Yankee Group

.

Alternative trading systems, including the nine ECNs, became such a significant market force in the past year that the

Securities and Exchange Commission

in April began allowing them to apply for national exchange status. (ECNs account for more than 20% of Nasdaq volume and about 5% of listed volume.) But executives at the trading systems and the SEC have remained mum on how these potential exchanges will regulate themselves, though it seems likely that the SEC will allow ECNs to outsource regulation.

"I don't think the SEC will be happy with a proliferation of small ECNs, each of which is its own self-regulator," says John Coffee, a law professor at

Columbia University

who specializes in securities law.

While it's not clear how much it would cost to build a regulatory division,

Datek Holding's Island

ECN has guessed it will spend $10 million to become an exchange. The NYSE and Nasdaq don't break out regulation costs, but experts say personnel is a major factor. In 1998, the NASD spent $281.7 million and the NYSE spent $204.7 million on total compensation.

To keep costs down, these potential exchanges are considering outsourcing regulation of market participants, which involves surveillance, auditing, arbitration and disciplinary action. They may also pay other companies for market regulation, such as determining and enforcing customer order-handling rules. Exchanges could even outsource day-to-day market regulation, such as trading surveillance, but could end up holding on to that exchange-defining area.

All of this depends on the SEC, which so far is working with an electronic options exchange known as the

International Stock Exchange

and with Island on their applications.

The door to outside regulation opened wider a few weeks ago when Frank Zarb, the NASD's chairman and chief executive, said in a speech that he's considering spinning off

NASD Regulation

, or NASDR, the NASD's regulatory body. And, he said, the NASD is talking to the NYSE about merging regulatory businesses. Like all exchanges, the NASD and NYSE are self-regulatory organizations.

So far, the NYSE is holding back on any move. An NYSE spokesman says that in any situation, the Big Board wants to keep regulating its member firms. But last week's agreement in which the NYSE settled with the SEC over having failed as a regulator by allowing illegal floor trading by brokers might throw a wrench into those plans.

That settlement, says Columbia's Coffee, could make it more difficult for the NYSE regulation department to resist what would essentially be a takeover by the NASDR, which is headed by Mary Schapiro, a longtime regulator with an SEC pedigree.

"I actually think the stock exchange behaved in an exemplary fashion once this was brought to light, but it ends the era of the stock exchange being the Tiffany regulator," Coffee says. "That is going to hinder the attempt of the NYSE to avoid a merger."

If the NYSE and the NASD do merge some or all of their regulatory functions into one independent body, that would create a friendly environment for the growth of new exchanges, says Ian Domowitz, a finance professor at

Penn State

. And it would finally show what regulation costs. Currently, various exchange fees cover operating costs as well as the surveillance of both members and the markets themselves.

And for small regional exchanges, selling market surveillance could be a way to survive, says one regional exchange official. Hypothetically, the Philadelphia Stock Exchange, for instance, could carve out the surveillance technology and staff it uses to monitor trades on its own trading floors and market it as a licensed, SEC-sanctioned, pay-as-you-go surveillance package for other trading platforms. That would work if that package is cheaper or gets to market before the NYSE and the Nasdaq get their act together.

But all this is perhaps a bit ahead of the game. The SEC could face some opposition over fee-based surveillance because it amounts to effectively privatizing something that has long been the burden of self-regulating firms. And as questions about changes in securities legislation increasingly head to

Congress

, any new regulation roadmap is likely to pass by the Hill as well.