CLEARING AND SETTLEMENT

81. Only some PTSs will provide clearing or settlement services. In many cases these services will be provided by other organizations subject to the relevant regulation in that jurisdiction. In some jurisdictions providers of clearing arrangements are subject to specific regulatory requirements and in others these functions are regulated by company rather than securities law. In these circumstances the regulator may need to assess that the PTS and participants will be able to comply with all relevant regulatory requirements as part of any approval process. Where the PTS provides some form of clearing and regulatory services itself, the regulator will need to assess whether these services conform to national regulatory requirements and are designed to minimize risks in the settlement system.

82. Regulatory Issues for Consideration:

The regulator should be satisfied that adequate arrangements exist to facilitate the orderly clearing and settlement of transactions effected on a PTS.

Where the PTS provides for clearing and settlement, those services should be regulated according to national regulatory requirements and be designed to minimize risks in the settlement system.

SUPERVISION OF THE SYSTEM AND PARTICIPANTS BY THE PTS SPONSOR

83. Different jurisdictions allocate regulatory responsibilities for supervision of trading systems in different ways. In some jurisdictions the provider of the trading facility also has responsibilities for the regulation of the conduct of the market and of market participants. In other jurisdictions the responsibility for regulation of participants rests with the statutory regulator or an SRO separate from the entity that provides the market place or trading facilities. In some jurisdictions the regulatory roles will be performed by a combination of these entities. The issue in relation to PTSs is the extent to which the PTS sponsor should assume some or all of the regulatory responsibilities for the conduct of the PTS and its participants.

84. The provision of regulatory activities has some of the characteristics of a public good whose benefits are generally available to all investors. It is recognized that there is a case that the allocation of regulatory cost should be equitably borne by all those who gain a benefit from the regulatory services provided. The possible regulatory controls identified in this Paper are discussed because they may be appropriate in their own right, rather than to redress perceived competitive disadvantage.

85. The regulator should be assured that the supervisory services can be provided efficiently and effectively and that the "contracting out" of supervisory functions will not result in significant regulatory coordination problems.

86. The Working Party discussed potential PTS responsibility in relation to: dispute resolution and appeal procedures; technical systems; record keeping; reports of suspected breaches; and holding of client funds or securities. Some members considered that it would be sufficient for the PTS to provide details of dispute procedures and a description of the technical system to the regulator on the basis that these were largely matters between the system sponsor and participants to assess. Other members considered that there should be a higher obligation on the system sponsor to demonstrate to the regulator that it had fair and appropriate dispute procedures and that the system was secure and would not fail in periods of unusual market activity. The latter issue would assume more importance when the PTS was closely linked to other markets and the failure of the PTS could have adverse consequences for those markets. In some jurisdictions issues relating to client funds are regulated by separate laws and were not seen to be a responsibility of the PTS sponsor.

87. Regulatory Issues for Consideration:

The PTS sponsor should inform and assure the regulator of any arrangements it makes for the monitoring, surveillance and supervision of the trading system and its participants with a view to ensure fairness, efficiency and investor protection as well as compliance with anti­fraud, anti­manipulation and other national securities laws regulating abusive market conduct. Where the system sponsor and provider of the regulatory services are different entities, the relevant entity or entities responsible for the provision of regulatory services should be clearly identified and accountable to the regulator.

Dispute Resolutions and Appeal Procedures

The PTS should provide details of any dispute resolution and appeal procedures to the regulator.

In addition, some Working Party members consider that the PTS sponsor should ensure that there are fair and efficient dispute resolution and appeal procedures, including procedures covering issues related to decisions on access or denial of access to the PTS and that all such disputes and complaints should be promptly reported to the regulator.

Technical Systems Standards and Procedures in Relation to Operational Failure²⁰

The PTS should provide details of technical system standards and operating procedures to the regulator.

In addition, some Working Party members consider that the PTS sponsor should ensure that systems have sufficient capacity so that they do not cease to function in periods of unusual volume or volatility, and that tests of the system are conducted to identify potential areas of vulnerability. The PTS sponsor should also ensure that there is adequate security of the PTS. The PTS sponsor should be required to develop and maintain contingency plans and procedures to provide for the protection of investors and the maintenance of an orderly market in the event of operational failure.

Record Keeping

The operation of a PTS should provide for effective monitoring and surveillance of transactions on the PTS. Accordingly the PTS should be operated in a manner which complies, at minimum, with all applicable record keeping and reporting requirements.

The PTS sponsor should be responsible for the implementation of sufficient audit trails for monitoring and the surveillance by both the PTS sponsor and PTS regulator of transactions occurring on the PTS. Regulatory reports should be made available on transactions, with the regularity required by the regulator, regarding trading information and trade execution to permit the regulator to monitor trading volume occurring on the system and to verify that a PTS sponsor is complying and / or enforcing compliance by participants with the conditions of any regulatory approvals and the national securities laws.

SUPERVISION OF THE SYSTEM AND PARTICIPANTS BY THE REGULATOR

88. The Working Party examined the role of the regulator in the supervision of the PTS system and its participants. Areas of responsibility addressed included: amendments to rules; system approvals; compensation arrangements; and trading halts. Some members considered that in the case of PTSs involving retail customers there should be access by those investors to compensation arrangements comparable to those applicable to similar types of transactions undertaken on the regulated markets in that jurisdiction. Other members considered that it was not appropriate to require a PTS to provide the same protection as is available on a regulated market. All members agreed that it was necessary to ensure that all participants and their clients should be fully informed as to the existence and nature of any compensation arrangements.

89. In relation to trading halts, Working Party members generally considered that the regulator should have the power to implement circuit breakers, other measures designed to ensure orderly markets and to require cooperation of the PTS sponsor in times of potential market disruption. Some Working Party members considered that these requirements, while relevant to the regulated markets, were not necessarily appropriate to PTSs.

Regulatory Issues for Consideration:

System Rule Amendments

Amendments to any system rules should be notified to or approved by the regulator when considered necessary by the regulator to ensure consistency with national securities laws and the continued fair, efficient and orderly operation of the system.

Rescind or Vary System Approval

Any approval of a PTS should be re­examined or withdrawn by the regulator if the PTS proves unable to comply with the conditions of any approval or in circumstances where its operation is inconsistent with national securities laws.

Compensation Arrangements

System participants and their relevant clients should at least be clearly informed about compensation arrangements for transactions on a PTS unless those arrangements apply in the same way as they apply on regulated markets and there has been general disclosure about those arrangements.

In addition, some Working Party members consider that in the case of transactions involving retail customers there should be access to compensation arrangements comparable to those applicable to similar types of transactions undertaken on a regulated market in that jurisdiction.

Trading Halts

Details of procedures for trading halts, other trading limitations and assistance available to the regulator in circumstances of potential trading disruption on the PTS or regulated market should be provided to the regulator.

In addition, some Working Party members consider that the regulator should have the power to order a trading halt or other trading limitation and require the assistance of the PTS sponsor in relation to transactions on the PTS where the regulator considers it necessary in the interests of fair and orderly trading on the PTS or on a regulated market.

CROSS­BORDER REGULATORY STRUCTURES

90. The allocation of responsibilities for regulation of cross­border proprietary trading systems involves responsibility for the regulation of the system. The basic regulatory framework for considering the options available in choosing the appropriate regulator for cross-border proprietary trading systems is as follows:

- home market regulation ­ regulation solely by the country where the market place is situated;

- shared regulation, where the system and the participant broker­dealers must register in each country in which the system operates. A primary home or lead regulator is not identified;

- shared regulation with a primary home market or lead regulator. The PTS registers in multiple countries and is subject to the investigatory authority of each regulator, while day­to­day regulation is delegated to the home market or lead regulator;

- universal regulation, i.e. each jurisdiction in which market conduct occurs regulates the relevant activity within its jurisdiction.

CHOICE OF CROSS­BORDER REGULATORY REGIME

91. Universal regulation is adopted for internationally active broker-dealers. However, where market activity occurs in more than one jurisdiction, more than one regulator may assert jurisdiction over the same conduct or activity. Thus some coordination among regulators may become necessary to avoid investor confusion and regulatory costs.

92. Home market or lead regulation is one model for the allocation of regulatory responsibilities. However, for some cross­border proprietary trading systems it may be impossible or almost impossible to state with precision where the "home" market is located. One criterion to resolve this issue may be by deeming the home market to be the one where the market has set up its matching facility or, if no such facility exists, the market where the central administration of the facility is located. It will be necessary to develop practical solutions for the designation of a primary home country for the purposes of the regulation of cross­border proprietary trading systems.

93. It is not clear that a system of home market or lead regulation can be achieved without a detailed regime of common regulatory standards in investment and commercial activities.

94. Some Working Party members consider that in the medium term the most feasible arrangement may be some form of shared regulation with a home country as the primary regulator, as the host country will seek to retain some regulatory controls over the operations and conduct of the PTS undertaken in its jurisdiction. This may, however, involve some concessions in recognition of the nature of the entities involved and the existence of foreign regulation. Some of the issues that will need to be addressed include whether:

- the PTS and its foreign affiliates, where these are integrally involved in the operation of the system, need to be registered or authorized in the host jurisdiction; and

- the securities quoted on the system will be subject to host country disclosure, trading halts or other requirements.

95. The following consequential issues require consideration under a scheme of shared regulation with a primary home regulator.

96. The first is what are the appropriate criteria for recognition by one jurisdiction of another jurisdiction's regulation of a PTS. A general principle is easy to state; its translation into practice somewhat more difficult. The principle may be that the level of supervision of the trading system in its home jurisdiction should be comparable to that of the jurisdiction in which it seeks to operate.

97. Difficulties arise because regulatory approaches, effort and market structures differ. Examples include different laws on market manipulation, insider trading, price stabilization, short selling and a range of other areas that one or more regulators may regard as essential to the maintenance of the integrity of their own markets. A starting point is to agree on the basic regulatory principles that should apply to each element of the system as the basis for acceptance of primary home jurisdiction regulation. In some areas there will need to be continued efforts to harmonize key regulatory requirements at an international level.

98. The second issue is to identify which specific powers the host country should be able to reserve in relation to the operation of the system in its jurisdiction and whether a host country that is the primary market in particular securities:  (i) should be able to generally impose higher regulatory standards; and (ii) impose higher standards in specific areas such as the approval of securities able to be traded on a system in the host country and halt trading for regulatory purposes.²¹

99. The third issue is the need for international cooperative arrangements between the relevant regulators to enable information sharing, dispute resolution procedures, investigation and enforcement action. At a minimum, consistent with the current UK model for recognition of foreign exchanges, this will require that the foreign proprietary trading system operator agree to cooperate via information sharing and other mechanisms with the domestic regulator. Appropriate Memoranda of Understanding will be required between regulators.

100. The fourth issue is the question of the allocation of regulatory costs between regulators, system proprietors and market participants. These costs could result from the imposition of reporting requirements from market surveillance activity and from measures to ensure that participants observe the relevant system and regulatory rules. There is also concern that the proprietary systems will in fact impose costs on existing self regulatory organi1ations.

101. Regulators may also be required to address similar issues in relation to the allocation of regulatory responsibilities for participants who utilize the system. One issue to be addressed is whether participants transacting on the system and resident in another jurisdiction will require registration or authorization in the host jurisdiction.

102. In the Ontario Securities Commission ("OSC") hearing into Instinet, for example, OSC staff commented that categorization of foreign broker­dealer participants as market intermediaries in Ontario would require them to register under the international dealer category. This category was introduced to enable foreign market professionals and brokers not wishing to establish a presence in Ontario to undertake a limited range of activities with Ontario residents.

CONCLUSION

103. The purpose of this review has been to identify regulatory issues specific to the regulation of cross­border proprietary trading systems. It can be seen that many of the issues identified overlap substantially with other work currently being undertaken by IOSCO Working Parties. It is considered important that duplication be avoided.

104. The paper has sought to outline the general regulatory issues that will need to be addressed by regulators when faced with the emergence of PTSs. It has not sought to be prescriptive given the difference between regulatory approaches adopted across some jurisdictions and the wide variety of forms that PTSs may take.

105. It is proposed that the regulatory issues for consideration identified by the Working Party relating to PTSs be used by IOSCO members to guide their regulatory approach to PTSs in their own jurisdictions and on regulatory issues relating to the cross­border operation of PTSs. These regulatory issues for consideration need to be read in the context of other work in IOSCO to develop common international regulatory standards applicable to some of the regulatory issues identified.

106. It is proposed that IOSCO consider further an appropriate allocation of regulatory responsibilities in relation to the cross-border operation of PTSs.

²⁰ Note the relevant Principles for screen­based trading developed by IOSCO Working Party No. 7.

Reports of Suspected Breaches of the Law

The PTS sponsor should identify the action it takes to ensure the integrity of the trading system it runs and to avoid damaging the integrity of the wider market. It should also identify on a continuous basis the procedures for reporting suspected breaches of the laws to the regulator.

Procedures in Relation to the Holding of Client Funds and Securities

Where the PTS sponsor holds customer funds or securities in relation to transactions on the PTS, the PTS sponsor should demonstrate that procedures are in place to safeguard customer funds or securities, and to prevent misuse of customer funds or securities by the PTS sponsor and PTS participants in accordance with national regulatory requirements.

²¹ ICSA 1993, "Working Group Paper on the Regulation of Cross­Border Electronic Trading Systems", submitted to the ICSA Annual Meeting, April 27.