Customers of financial markets, particularly non-professional customers must have a high level of confidence in the markets in which they participate, or else they will not entrust their funds to the financial intermediaries which deal in these markets. To achieve this aim, rules must be drawn up to ensure that customers are dealt with fairly, and are afforded appropriate protection if things go wrong. This includes, in particular the provision of 'safety net' arrangements to protect depositors and investors if a bank or broker goes bankrupt. The tools to achieve the objective of protecting the customer therefore include appropriate insolvency law and a code of sales practices. Customer protection in turn is part of the bigger objective of promoting market integrity, so the dividing line between these key risk concepts is blurred and it is impossible to categorically divide the relevant on-line documents into the different key risk concepts. Nevertheless, the highlighted documents below are have been chosen because IFCI feels that they deal directly with the issue of protecting the customer (ignoring insolvency and sales practices, which have been highlighted in their relevant sections.)
"Client Asset Protection (1996)" issued by the IOSCO Technical Committee analyses the main techniques which securities regulators can use to achieve a satisfactory level of client protection. The report rightly emphasises preventative measures; rather than techniques that can be used to protect client assets when a firm becomes insolvent. The report stresses the importance of transparency in customer protection - clients must be made aware of the level and type of risk to which their assets are exposed. Regular and timely reporting by firms to their customers is thus essential. To achieve this, firms must need robust internal control systems.
The report makes twenty recommendations which regulators must consider when considering client asset protection regimes. These recommendations deal with the protection of client money where banks act as brokers; the regulatory status of custody as an activity; the risks associated with stock lending; the treatment of clients' securities in the course of settlement; the legal status of client positions at authorised firms where the firm is acting as agent for the customer; arrangements to facilitate the transfer of client positions from insolvent firms; and the need for effective identification and segregation of client margin.
Deposit protection schemes are another form of customer protection. The different types of schemes in member countries of the Basle Committee on Banking Supervision are contained in a March 1997 document released by the BIS. "Deposit Protection Schemes in the G-10 countries" is the result of a survey conducted by the Committee to investigate existing arrangements in member countries. Several of the European schemes are under review to bring them in line with the May 1994 European Union's Directive on deposit guarantee schemes. The main changes brought about by this Directive are a standardisation of the minimum amount of protection (i.e. ECU 20,000) and a requirement for deposits with branches (but not subsidiaries) of EU banks to be covered by the home country scheme. Consequently, branches of EU banks will normally be exempted from host-country arrangements, though supplementary cover may be available if the guarantee in the home country provides less cover. Conversely, for competitive reasons, protection by the home country scheme is limited to the ceiling of the host country scheme if the former provides more cover.
"Objectives and Principles of Securities Regulation" (1998) sets out 30 principles, some of which are designed to protect investors. They are grouped into eight categories - principles relating to (a) the regulator, (b) self-regulation, (c) enforcement of securities regulation, (d) co-operation in regulation, (e) issuers, (f) collective investment schemes, (g) market intermediaries and (h) secondary market. The document details each principle. It states for example, that a regulator should be provided with investigative and enforcement powers to:
- Obtain data, information, document statements and records from persons involved in the relevant conduct or who may have relevant information relevant to the inquiry;
- Impose administrative sanctions or order the suspension of trading
- Refer matters for criminal prosecution
- Where enforcement action can to be taken, the power to enter into enforceable settlements and to accept binding undertakings.
When a company is listed on the stock exchange, full and accurate disclosure will help investors' decisions and go some way to protecting their interests. "International Disclosure Standards for Cross-Border Offerings and Initial Listings by Foreign Issuers. " (1998) relates to non-financial disclosure requirements and does not address the issue of which bodies of accounting or auditing principles may be followed by the issuer in preparation of its financial statements. Some of the information the firm is expected to disclose are identity of directors, senior management and advisers; major shareholders and related party transactions; operating and financial review and prospects, key ratios on capitalisation and indebtedness, the risk factors facing the firm and compensation policies.
In the wake of the Barings collapse, the exchange-traded community assembled a task force to look at ways of enhancing the protection of customers' assets. The Futures Industry Association Global Task Force on Financial Integrity included representatives of major international exchanges/clearing houses, brokers/intermediaries (including futures commission merchants and other brokers), and customers from 17 jurisdictions. Their report, "Financial Integrity Recommendations (1995)", provides guidance on member and customer protection. For example, it states that each exchange/clearinghouse and/or regulatory authority should maintain appropriate mechanisms designed to identify and protect customer funds in their custody or control. These include segregating customer property from proprietary property, maintaining appropriate books and records, having adequate capital, and/or having restrictions on how customer property is invested or used.
Brokers/intermediaries should prepare and use written agreements that clearly delineate the respective rights and obligations of the former and their customers. The FIA Task Force report also contains a separate section on the responsibilities of customers. The latter are encouraged to ensure that they understand the risks of their trading activities, the nature of their legal relationships with their brokers/intermediaries and the risks of trading on specific exchanges/clearinghouses. Some of the issues on which customers must settle with their brokers/intermediaries before dealing are: (i) the latter's right to close out the customer's account and positions, (ii) the notice periods required for such action, (iii) the broker's right to collect excess margin and the customer's right to withdraw this excess, and (iv) the customer's exposure to the failure of the exchanges/clearinghouse and to other clearing brokers selected by the broker/intermediary.
"Measures Available on a Cross-Border Basis to Protect Interests and Assets of Defrauded Investors (1996)" contains a wealth of information. The compendium details the measures available for preserving and returning the assets of defrauded domestic investors from foreign countries, and the routes available in each country for foreign investors and authorities to preserve and recover their assets. The IOSCO member-countries which supplied relevant information are: Argentina, Australia, Canada, Chile, Taiwan, France, Germany, Hong Kong, Italy, Korea, Luxembourg, Malaysia, Mexico, Netherlands, New Zealand, Norway, Poland, Spain, Switzerland, Thailand, United Kingdom and the United States. Each country provided information on available domestic mechanisms (including relevant legal and regulatory requirements), as well as the methods which they will use to help foreign investors and authorities.
The results of the report indicate that regulators are willing to cooperate with one another whenever possible to facilitate the preservation and recovery of the proceeds of fraud. They will use bilateral and multilateral information sharing mechanisms, including Memoranda of Understanding, to obtain key information such as bank accounts and other relevant corporate records, to help in the return of illicit assets to investors. (see regulatory co-operation).
"Legal and Regulatory Framework for Exchange-Traded Derivatives" (1996) includes a checklist which customers can use to evaluate whether a firm or exchange has the right procedures in place to ensure that customers are treated fairly. The main areas that customers should consider are authorisation procedures, order execution, recordkeeping, sales representation and disclosure, dispute resolution programmes as well as how the firms and markets comply with requirements. For example, if orders are executed electronically, care must be taken to ensure that the algorithm for such execution conforms to rules which ensure that the order was carried out competitively.
"Towards a Legal Framework for Clearing and Settlement in Emerging Markets" (1997) looks at how customers should be protected in a central securities depository (CSD) environment. CSDs form the basis of modern clearing and settlement systems. Because securities in a CSD are either 'dematerialised', i.e. there is no document which physically embodies the claim, or 'immobilised', i.e. they are immobilised in a depositor, which is the holder of record in the register, investors no longer have actual possession of physical certificates. This means that their ownership can no longer be defined in terms of actual possession nor can the interest of an investor be defined as a traceable property right in individual securities. The paper provides some guidelines on how the interests of customers should be protected. For example, it recommends that securities on the books of the depository be segregated into proprietary and customer accounts. It also recommends that insolvency laws be disapplied in respect of clearance and settlement arrangements of the clearing house and the settlement arrangements of CSD. This will ensure that the operations of those organisations are not subject to legal challenge in the event of insolvency of other market participants.
Because mutual funds are such a popular investment tool, there are several IOSCO papers that deal solely with collective investment schemes. A September 1997 IOSCO release, "Principles for the Supervision of Operators of Collective Investment Schemes" tackles investor protection by insisting on high standards of conduct from operators of mutual funds. The paper therefore sets out 10 supervisory principles for such operators. For example, supervisors have to ensure that all the property of a CIS is fairly and accurately valued and that its net asset value is correctly calculated. Supervisors have also to ensure that the assets of a CIS are properly held in safekeeping and segregated from the assets of management and other entities. To spread out the credit and market risks facing investors, Principle 8 requires operators to invest in a minimum number of investments, as well as imposes limitations on the types of investments. Typically regulatory requirements may restrict a holding in an individual investment to 10% of a CIS's net asset value. A CIS must disclose its investment policy in its offering document and supervisors must review these investments to ensure compliance. Two earlier papers, "Report on Investment Management (1995)" and "Discussion Paper on International Cooperation in Relation to Cross-Border Activity of Collective Investment Schemes (1996)" also contain sections on customer protection, and provide good background reading on mutual funds.
In the same vein but concentrating on screen-based trading systems is a 1994 report entitled "Report on Issues in the Regulation of Cross-Border Proprietary Screen-Based Trading Systems."
See also market integrity, sales practices and netting and insolvency
- Report on Issues in the Regulation of Cross-Border Proprietary Screen-Based Trading Systems (1994)
- Report on Investment Management (1995)
- Financial Integrity Recommendations (1995)
- Client Asset Protection (1996)
- Legal and Regulatory Framework for Exchange-Traded Derivatives" (1996)
- Discussion Paper on International Cooperation in Relation to Cross-Border Activity of Collective Investment Schemes (1996)
- Deposit Protection Schemes in the G-10 countries (1997)
- Towards a Legal Framework for Clearing and Settlement in Emerging Markets (1997)
- Principles for the Supervision of Operators of Collective Investment Schemes (1997)