INTRODUCTION

1. The objective of this Paper is to identify and explore the range of issues relevant to the regulation of Proprietary Trading Systems ("PTSs") which regulatory authorities should consider in determining their regulatory approach to PTSs and to discuss the regulatory issues relating to the cross­border operation of such systems. Attachment A summarizes the regulatory issues identified in this Paper.

2. Technological advancement has produced two powerful, complementary phenomena:  market automation and the globalization of markets. Nowhere are these phenomena more apparent than in the development of cross­border screen­based trading systems.

3. Cross­border screen­based trading systems have the capacity to link directly market participants across jurisdictions without the necessity for intermediation via an exchange floor. They give rise to unique economic, financial, legal and regulatory issues. Securities regulators around the globe are beginning to come to terms with many of these issues.

4. The Technical Committee of IOSCO directed the former Working Party No. 7 to consider issues arising out of screen­based trading systems for derivative products. Working Party No. 7 agreed to limit the scope of its inquiries to screen­based trading systems that:

- conclude or execute a legally­binding transaction;

- are non­proprietary (i.e. not operated by an individual intermediary); and

- trade derivative products.

5. In June 1990, Working Party No. 7 produced 10 Suggested Principles for the Oversight of Screen­Based Trading Systems for Derivative Products (Attachment B).

6. IOSCO Working Party No. 2 on the Regulation of Secondary Markets first met in Tokyo in June 1991. By way of contrast with Working Party No. 7, it discussed the issues which relate to screen based trading systems operated by non­self­regulatory organizations through which cross­border trading is conducted (hereafter "cross­border proprietary trading systems"). Cross­border proprietary trading systems may or may not conclude or execute legally binding transactions, depending on the type of system; by definition, these systems are proprietary; and are not owned and operated by a regulated exchange and they may trade derivative or non­derivative products.

7. At a subsequent IOSCO Working Party meeting in Zurich, it was resolved as a first priority to discuss the regulation of trading aimed at preventing fraud, such as insider trading and market manipulation. The Working Party agreed that the following points needed to be considered:

- what laws and regulations are necessary to prevent fraudulent transactions through the system in accordance with each country's situation in relation to the transactions;

- should regulators request the system operator to submit to self-regulatory rules and the framework of market surveillance;

- should particular attention be paid to whether regulatory differences between exchanges and systems lead to competitive disadvantages or inadequate investor protection;

- should regulators request the system operator to provide regular or timely information in order for regulators to be aware of transactions undertaken in their own countries;

- should regulators exchange information and promote coordination among relevant regulators;

- what are the different responsibilities of regulators in different jurisdictions.

8. The Working Party met in Paris in January 1992 and considered an overview paper prepared by the Australian representatives. It was agreed that a survey of members' attitudes towards the regulation of PTSs be prepared and distributed to assist in further clarification of the issues. At the May 1992 meeting in Washington the discussion by the Working Party concentrated on some of the broader regulatory issues raised by the emergence of PTSs. The issues canvassed included the differing level of experience by members of the Working Party with the operation of such systems, how they would be regulated in the various jurisdictions and the implications of different philosophical approaches to regulation among some participants at the meeting. It was generally agreed that it would be difficult to reach agreement on the issue of a definitive regulatory approach and that it would be useful to explore more generally the regulatory issues to assist authorities determine their attitude to PTSs.

9. The Working Party also formally sought the views on the regulatory issues in relation to PTSs from the IOSCO Consultative Committee in 1994. The Consultative Committee provided its response in the form of comments from individual Consultative Committee members. The Working Party considers that the issues raised in these comments have been covered in the matters discussed in this Paper. A copy of the consultative document forwarded by the Working Party to the Consultative Committee and a summary of responses is contained at Attachment C.

10. The Working Party is also aware of other work being undertaken by a range of groups on issues related to the Working Party's review of PTSs and that parties other than those represented on the IOSCO Consultative Committee, such as current and potential PTS developers and operators, will have views on the regulatory issues involved. The discussion in this Paper is regarded by the Working Party as a contribution to the evolving debate on the regulatory issues for consideration by regulators and other participants in this area.

CROSS­BORDER PROPRIETARY TRADING SYSTEMS DEFINED

11. Screen­based trading systems already take a number of different forms. Joseph Hardiman identifies the six primary types of electronic systems which exist today:  (i) automated quotation systems (e.g. NASDAQ); (ii) order driven systems (e.g. Toronto Stock Exchange's CATS system); (iii) order "negotiating" systems, such as Reuters Instinet; (iv) small order automatic execution systems; (v) crossing systems; and (vi) single price auctions.¹

12. The elements of all such systems are:  a communication system to disseminate buy and sell quotes or bids (display of market information); a system to communicate instructions for trading securities (hereafter referred to as "orders") among participants (order routing); a trading mechanism to transform such instructions into trades (trade execution);² and reporting of such transactions to regulatory authorities and market participants (trade reporting). It is important to identify how these elements interact in the design of a system to determine the regulatory issues involved. There are at least three possible configurations:

- the system operates as an electronic bulletin board that disseminates trading information from other markets or dealers to subscribers to the system who conduct transactions independently of the system on another market or by direct negotiation with a counterparty ("electronic bulletin board");

- the system operates as an order routing system and merely channels orders to buy and sell securities to a market or dealer ("electronic order routing system");

- the system involves both the communication of orders to buy and sell securities and the transformation of those orders into trades ("execution system").

13. Cross­border proprietary trading systems may take any one or more of these forms. The focus of this Paper and the analysis by the Working Party are on screen trading systems that are not operated by an exchange or self­regulatory organization and regulated as such.

14. Cross­border transactions in securities are not a new phenomenon and have been carried out via telephone or other electronic link to intermediaries which place an order into a trading system located in the foreign jurisdiction. The essential differences resulting from recent advances in technology are the ability to 'place' orders directly into a trading system on a real time basis from many different locations simultaneously and that systems may operate from more than one jurisdiction possibly without the need for intervention of the intermediaries. These new facilities offer potential cost savings and efficiencies in the trading process. From a regulatory point of view, a major potential advantage is the complete audit trail such facilities are capable of generating. However, the ability to access the trading system directly, simultaneously and on a real time basis in a range of jurisdictions gives rise to a range of cross-border jurisdictional and other regulatory issues.

15. Many of these issues are common to both PTS and exchange operated cross­border screen trading systems.

REGULATORY OBJECTIVES

16. It is critical to focus from the outset on the appropriate objectives of a regulatory scheme for cross­border proprietary trading systems. Broadly the primary objective of the regulation of organized systems for trading securities is to ensure that the integrity of the trading system is maintained through fair and equitable trading rules that strike an appropriate balance between the demands of different market participants. Such regulation also involves market surveillance and other quality assurance activities. In the case of electronic markets, the issue of market integrity extends to a concern with system design, capacity and reliability. Market participants are primarily regulated to prevent fraud, to eliminate the opportunity to engage in unfair, manipulative or deceptive conduct and to ensure that these intermediaries are appropriately capitalized. The Zurich meeting emphasized that the regulatory regime should be aimed at preventing fraud. Increasingly the interdependencies within the financial system have led regulators to focus on the potential systemic consequences should an intermediary or a large transaction unexpectedly fail.

17. In summary, the regulatory provisions relating to the conduct of trading systems are primarily concerned to ensure:

- fair, orderly, competitive, efficient and informed markets;

- the prevention of fraud, dishonesty and manipulative behavior in relation to systems designed to facilitate the buying, selling or exchange of securities;

- the prudential soundness of markets and their participants; and

- the appropriate monitoring, surveillance and enforcement of national securities laws in relation to organized transactions in securities.

18. The regulatory framework should also not unnecessarily stifle innovation in the development of new systems and trading technologies.

THE REGULATORY APPROACH

19. Two basic regulatory attitudes towards PTSs were identified in a survey of members of the Working Party:  those jurisdictions that would generally characterize a PTS as a broker­dealer:  and those that would generally characterize a PTS as an exchange or stock market. The US,³ Ontario and Quebec would generally characterize a PTS as a broker-dealer while Australia, Japan, Germany, and The Netherlands would generally characterize a PTS as an exchange or stock market. In