41. It is agreed that the content of regulation will need to take into account the nature of the system (i.e. information communication, order routing or execution), as well as other features such as the types of securities traded and categories of system participants or clients involved in the securities transactions. The greater the level of participation by unsophisticated investors the more attention regulators will need to pay to ensure that adequate investor protection mechanisms are in place. However, even where the system participants are professional investors regulators should seek to ensure that those systems are not operated in a manner that may be detrimental to the securities markets and investors. It is also agreed that the Principles articulated by IOSCO Working Party No. 7 are applicable to all forms of screen trading including that conducted by a PTS.

42. The approach adopted in this Paper is to identify some key elements, including the core functions identified above, and seek to agree on regulatory issues for each of those functions as the basis for more detailed examination of regulatory standards. This approach is adopted because of the large number of system permutations that are possible and the difficulty of setting specific standards for each possible configuration. This functional approach will also assist in the discussion of an appropriate allocation of regulatory responsibility for the purposes of regulating the cross­border operation of PTSs.

43. In general, it is considered that the PTS should be regulated to promote fair competition between different trading systems and to ensure that the securities markets as a whole facilitate price discovery, the best execution of customer orders, maintenance of fair and orderly markets, and control systemic risk.

44. The regulatory issues relating to the interaction of a PTS with the organized markets will depend on the nature of the activity on a PTS (display of market information, order routing and trade execution) and the manner in which these functions are directly or indirectly linked to an organized regulated securities market ("the regulated market"). If orders are transmitted to the regulated market, the specific regulatory issues in relation to order routing on a PTS should be addressed to ensure fairness, efficiency and integrity of the market as a whole.

45. The key functions for the purposes of discussing issues of regulatory concern in relation to a PTS were identified by the Working Party as follows:

- Approval of the PTS Sponsor;

- Admission of Securities to the PTS;

- Admission of Participants to the PTS;

- Provision of Information on Indications of Interest, Quotations, or Orders to Purchase, Sell or Exchange Securities;

- Routing of Orders to a Trade Execution System;

- Trade Execution;

- Post Trade Reporting and Publication;

- Clearing and Settlement;

- Supervision of the System and Participants by the PTS Sponsor;

- Supervision of the System and Participants by the Regulator.

46. The objective of the discussion is to identify and explore the range of issues relevant to the regulation of PTSs which regulatory authorities should consider in determining their regulatory approach to PTSs. The Working Party recognizes that the introduction of PTSs is a new and evolving issue and that many jurisdictions have so far limited or no experience of PTSs. The following non­exclusive points of consideration are proposed only to give guidance to regulators to find the appropriate regulatory response in their jurisdiction to PTSs and on regulatory issues relating to the cross­border operation of such systems. In particular, the Working Party recognizes that each jurisdiction will need to resolve each issue consistent with the laws, rules and practices in each jurisdiction.

47. It is recognized that various systems will be configured to perform different functions. For example, information communication, order routing and trade execution may or may not be combined in a single system. It is possible for a system to perform one or more of these functions. In relation to each regulatory objective domestic regulatory standards should be consistent with any relevant international standards or principles.¹⁴

48. The primary focus of the Working Party's discussion of regulatory issues relates to PTSs that automate the execution of orders to buy or sell, or that automate the dissemination or collection of quotations, orders to buy and sell securities, or indications of interest, and also provide a mechanism for matching or crossing orders in the system, or for otherwise facilitating agreement between participants on the basic terms of a purchase or sale of a security.¹⁵ This definition excludes systems that merely provide historical information about transactions (information providers) and those systems that automate the collection and transmission of orders by regulated intermediaries to a regulated market and do not provide any facilities for automatic matching, crossing or execution of those orders (internal order routing systems). Such systems may raise other regulatory issues. However, these are outside the scope of the Working Party's deliberations at this stage.

APPROVAL OF A PTS SPONSOR

49. The term "PTS sponsor" means any person or organization who organizes, operates, administers or otherwise directly or indirectly controls a trading system. Jurisdictions have different mechanisms to ensure that those acting as intermediaries, operators of securities markets and other trading systems are of good character and have the operating, financial capacity and technical skills to carry out their required functions. These requirements are often referred to in a shorthand manner as a "fit and proper" test. In many jurisdictions, in order to prevent the creation of arrangements designed to avoid the relevant regulatory requirements, these tests also apply to controlling or major shareholders or other parties that may have the ability to materially influence or control the activity of the PTS sponsor ("indirectly control").

50. There was general agreement that the operator of the PTS should meet the relevant fit and proper tests for the particular function of the PTS that would be applicable in that jurisdiction. The regulator would require sufficient details about the sponsor and proposed system to make this assessment as part of the licensing, approval or recognition process.

51. In some PTSs the PTS sponsor may assume some principal, settlement, guarantee or performance risk with respect to transactions effected by system participants through use of the system. In circumstances where such risk is assumed by the PTS sponsor, the regulator may need to assess that appropriate prudential or other measures designed to reduce the risks of non­completion of a transaction. What requirements are appropriate will depend on the nature of the PTSs and its participants. For example, a system that involves a small number of professional participants could be subject to different requirements than that applicable to a large volume PTS that directly or indirectly included retail participants.

52. The Working Party agreed that the following regulatory issues arise for consideration ("Regulatory Issues for Consideration"):

The term "PTS sponsor" means any person or organization who organizes, operates, administers or otherwise directly or indirectly controls a PTS. The PTS sponsor should be a fit and a proper person in accordance with national regulatory requirements applicable to that category of activity, financially sound, competent to operate the system in compliance with national laws, and clearly accountable to the regulator.

Where the PTS sponsor assumes any principal, settlement, guarantee or performance risk, it is important to ensure compliance with prudential or other regulatory requirements applicable in that jurisdiction designed to reduce the risk of non-completion of a transaction in circumstances of a failure to perform by one or more parties. These requirements will differ according to the specific characteristics of the PTS system, system sponsor and system participants.

ADMISSION OF SECURITIES TO A PTS

53. The regulator should be informed of the securities or types of securities to be traded on a PTS to enable it to adequately oversee the maintenance of fair, honest, efficient and informed securities markets. In most cases the regulator would only need be informed of the types or categories of the securities and not of every individual security to be traded on the PTS. This is to provide the regulator with sufficient information for it to be able to monitor activity on PTSs operating in its jurisdiction.

54. Some Working Party members consider that the provision of information on securities to be traded on a PTS while necessary is not sufficient to enable the regulator to ensure the maintenance of fair, honest, efficient and informed securities markets. Accordingly, it was proposed by these members that it would be necessary for the regulator to have the ability to refuse admission of a security to a PTS system where this was required to meet regulatory objectives. The types of regulatory concerns identified that may lead to a requirement for some form of approval mechanism included:

- the need to ensure that adequate financial and non­financial information is available in relation to securities traded on a PTS;

- the need to ensure adequate levels of liquidity for securities, especially those available for retail investors;

- approval of offer documents in the context of public primary offers of securities; and

- where the same or similar securities are already listed on a regulated market.

55. The way in which different regulatory jurisdictions deal with the provision of information in relation to listed and unlisted securities and the other issues noted above varies. For example, in some cases both primary offer and secondary trading disclosure is regulated by the market provider. In other cases this may be a matter for the general securities or company law.

56. Regulatory Issues for Consideration:

The regulator should, as a minimum requirement, be informed of the securities or types of securities to be traded on a PTS to enable it to adequately oversee the maintenance of fair, honest, efficient and informed securities markets.

In addition, some Working Party members consider that in order to ensure consistency with national securities laws, including the regulation governing the information to be provided by an issuer when its shares are offered to, or held by the public, regulators should have the ability to oppose the trading of securities on a PTS when they consider it necessary for investor protection.

ADMISSION OF PARTICIPANTS TO A PTS

57. PTSs may cater for a range of different categories of participants including: regulated intermediaries acting as either principal or agent; direct institutional or professional investors; or a combination of retail and professional investors.

58. A PTS as a commercial operation may wish only to make its services available to particular types of participants or specific market segments that it has identified as providing a viable commercial opportunity. In these circumstances it is considered that admission of participants to the PTS system should be based on objective criteria applied fairly and on a non­discriminatory basis. The regulator and participants should be informed of the criteria to be applied.

59. Where the participants are regulated intermediaries acting as either a principal or agent they would normally be subject to the relevant approval or registration process, legislative requirements, codes of business conduct or rules and procedures of the relevant self-regulatory organization. As regulated intermediaries they would be subject to the relevant fit and proper person test applicable in the jurisdiction for that type of intermediary. It is considered that where participants act as intermediaries for retail customers a "fit and proper" test should always apply.

60. Regulated intermediaries would be subject to any applicable prudential regulation. Regulators will need to assess whether existing prudential controls and monitoring of these requirements sufficiently takes into account any specific risk exposure of PTS participants arising from transactions on the PTS system.

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¹⁴ For example, any regulatory principle on clearing and settlement for a PTS would need to take into account IOSCO endorsement of the Group of Thirty Report. Likewise the regulatory objective relating to technical system standards would need to take into account any IOSCO guidelines in this area when developed. The Principles on Screen­Based Trading from IOSCO WP No. 7 are relevant to all screen­based trading including PTSs.

¹⁵ The SEC in proposed Rule 17a­23 would exclude from the Rule systems that display indications of interest or orders and where the system users utilizes this information to contact the relevant participant directly and execute a transaction without intercession by the system or the system sponsor. Such an arrangement does not allow participants to agree to the terms of a transaction "through use of the system" as required in the proposed SEC Rule. In contrast, in Australia systems that operate in this way would probably fall within the definition of a stock market under the Corporations Law, especially where the information on the system was directly linked to the inducing of offers or invitations to sell, purchase or exchange securities and the execution of transactions.