13.2 Scope of this Section

In this document, the word "markets" should be understood in its widest sense, including facilities and services relevant to equity and debt securities, options and derivative products.

In addition to traditional organized exchanges, secondary markets should be understood to include various forms of off-exchange market systems. These systems include electronic "bulletin boards" and "proprietary" systems developed by intermediaries, typically offering their services to other brokers, banks and institutional investors who meet the operator's credit standards.

The organized exchanges are the main focus of regulation. Regulation appropriate to a particular secondary market will depend upon the nature of the market and its participants.

Regulation will increasingly need to take account of the growing internationalization of trading and the impact of technological developments on markets and their infrastructure.

13.3 Securities Exchanges and Trading Systems

The level of regulation will depend upon the proposed market characteristics, including the structure of the market, the sophistication of market users and rights of access and the types of products traded. In some cases it will be appropriate that a trading system should be largely exempt from direct regulation but will require approval from the relevant regulator after proper consideration by the regulator of the type of approval (or exemption) necessary.

The establishment of new exchanges or trading systems, requires proper approval. When direct regulation is appropriate, relevant matters include: ⁵⁶

• Operator Competence - Regulation should assess the competence of the operator of a trading facility as a secondary market. The competence of the operator is an ongoing requirement.
• Operator Oversight - The operator should be accountable to the regulator and, when assuming principal, settlement, guarantee or performance risk, must comply with prudential and other requirements designed to reduce the risk of non-completion of transactions.
• Admission of Products to Trading - The regulator should, as a minimum requirement, be informed of the types of securities and products to be traded on the trading system. The regulator should approve the rules governing the trading of the product. The proper design of the terms and conditions attaching to a product reduces the susceptibility of the product to market abuses, including manipulation. Consideration of product design principles and trading conditions is a critical aspect of ensuring a fair, orderly, efficient, transparent and liquid market.
• Admission of Participants to the Trading System - The regulator should ensure that access to the system or exchange is fair and objective. The regulator should oversee the related admission criteria and procedures.
• Provision of Trading Information - The regulator should verify that all similarly situated market participants have equitable access to trading information. Any categorization of participants, for the purpose of access to pre-trade information, should be made on a reasonable basis. Any differential access to such information should not unfairly disadvantage specific categories of participants.
• Routing of Orders - The system's order routing procedures must be clearly disclosed to the regulator and to market participants. They must be applied fairly and should not be inconsistent with relevant securities regulation (e.g. client precedence or prohibition of front running or trading ahead of customers).
• Trade Execution - The order execution rules must be disclosed to the regulator and to market participants. They must be fairly applied to all participants.
• Post Trade Reporting and Publication - Information on completed transactions should be provided on the same basis to all participants. Full documentation and an audit trail must be available.
• Supervision of System and Participants by the Operator - The regulator should assess the reliability of all the arrangements made by the operator for the monitoring, surveillance and supervision of the trading system and its participants to ensure fairness, efficiency, transparency and investor protection, as well as compliance with securities legislation. The trading system operator should provide the regulator with its dispute resolution and appeal procedures, its technical systems standards and procedures related to operational failure, information on its record keeping system, reports of suspected breaches of law, procedures for holding client funds and securities, and information on how trades are cleared and settled. There must be mechanisms in place to identify and address disorderly trading conditions and to ensure that contravening conduct, when detected, will be dealt with.
• Trading Disruptions - Details of procedures for trading halts, other trading limitations and assistance available to the regulator in circumstances of potential trading disruption on the system should be provided to the regulator.

The rules and operating procedures governing these matters should be available to market participants.

13.4 Ongoing Supervision of Systems and Information About Market Processes

The regulator must remain satisfied that the relevant conditions thought necessary as pre-requisites to approval remain in place during operation.

Amendments to the rules of the trading system should be provided to or approved by the regulator.

Approval of the trading system should be re-examined or withdrawn by the regulator when it is determined that the system is unable to comply with the conditions of its approval or with securities law or regulation.

13.5 Transparency of Trading ⁵⁷

Transparency may be defined as the degree to which information about trading (both for pre-trade and post-trade information) is made publicly available on a real-time basis. Pre-trade information concerns the posting of firm bids and offers, in both quote and order-driven markets, as a means to enable investors to know, with some degree of certainty, whether and at what prices they can deal. Post-trade information is related to the prices and the volume of all individual transactions actually concluded.

Ensuring timely access to information is a key to the regulation of secondary trading. Timely access to relevant information about secondary trading allows investors to better look after their own interests and reduces the risk of manipulative or other unfair trading practices. ⁵⁸

Where a market permits some derogation from the objective of real time transparency, the conditions need to be clearly defined. The market authority (being either or both of the exchange operator and the regulator) should, in any such event, have access to the complete information to be able to assess the need for derogation and, if necessary, to prescribe alternatives.

13.6 Prohibition of Manipulation and Other Unfair Trading Practices

The regulation of trading in the secondary market should prohibit market manipulation, misleading conduct, insider trading and other fraudulent or deceptive conduct which may distort the price discovery system, distort prices and unfairly disadvantage investors.

Such conduct may be addressed by direct surveillance, inspection, reporting, product design requirements, position limits, settlement price rules or market halts complemented by vigorous enforcement of the law and trading rules.

The regulator must ensure that there are in place arrangements for the continuous monitoring of trading. These arrangements should trigger inquiry whenever unusual and potentially improper trading occurs.

Particular care must be taken to ensure that regulation is sufficient to cover cross-market conduct, for example, conduct in which the price of an equity product is manipulated in order to benefit through the trading of options, warrants or other derivative products. When the underlying interest is traded in a jurisdiction other than the one where a derivative instrument is traded, or where identical financial products are traded in two jurisdictions, there may be increased potential for fraud or manipulation because of the difficulty of a regulator in one jurisdiction to monitor market activity directly or to conduct complete investigations of market activities in another jurisdiction. There must be adequate information sharing between relevant regulatory authorities, sufficient to ensure effective enforcement.

13.7 Large Exposures, ⁵⁹ Default Procedures and Market Disruptions

The expression "large exposure" refers to an open position that is sufficiently large to pose a risk to the market or to a clearing firm. Market authorities should closely monitor large exposures and share information with one another so as to permit appropriate assessment of risk.

Market authorities should promote mechanisms that facilitate the sharing of the above information through appropriate channels.

Trigger levels are qualitative or quantitative criteria that are used to identify a large exposure. Market authorities should establish trigger levels appropriate to their markets, and continuously monitor the size of positions on their markets. To perform this monitoring function market authorities should have access to information on the size and beneficial ownership of positions held by direct customers of market members. Market authorities can then take the appropriate action, such as requiring the member to reduce the exposure, or increasing margin requirements.

Where a market member does not make the relevant information available to the market authority, the authority should be able to take appropriate action such as imposing limitations on future trading by the member, requiring liquidation of positions, increasing margin requirements, and revoking trading privileges.

Market authorities should make relevant information concerning market default procedures available to market participants.

Regulators should ensure that the procedures relating to defaults are effective and transparent.

Market authorities for related products (cash or derivative) should consult with each other as soon as practicable with a view to minimizing the adverse effects of market disruption. The information that may be needed includes contingency plans, contact persons and structural measures to address market disruption, and information about market conditions (such as actions taken by market authorities, prices, trading activities, and aggregate market data). These matters are further discussed at Section 12.

13.8 Clearing and Settlement ⁶⁰

Clearing and settlement systems are systems providing the process of presenting and exchanging data or documents in order to calculate the obligations of the participants in the system, to allow for the settlement of these obligations, and the process of transferring funds and / or securities. The rules and operating procedures governing the clearing and settlement systems should be available to market participants.

There should be direct supervision of clearing and settlement systems and their operators.

13.9 Regulation and Standards for Clearing and Settlement Systems

Regulators of clearing and settlement organizations should require a framework that permits them to ensure the accountability of such systems, to monitor and, if possible, predict and prevent problems associated with clearing and settlement. This includes the authority of the regulator to promote efficiency and safety through review of system mechanisms and establishment of operating standards. Regulators should be empowered to issue directions which the clearing and settlement organizations must satisfy.

The operation of clearing and settlement services should be subject to inspection and periodic review by the regulator. The clearing and settlement organizations should be required to make reports to the regulator and may be required to submit to periodic and, if necessary, special audits and examinations.

13.10 Verification of Trades in Clearing and Settlement Systems

The arrangements for clearing and settlement systems should provide for the expeditious verification of a trade. The standard should be as close to real time verification as possible. Information should be available which records the transaction, allows it to be checked and provides the basis for settlement. Fully automated links between the trading system and the settlement system will generally assist in such verification. Where exchanges or trading systems do not provide such links they should require participants to have arrangements that ensure the rapid and accurate transmission of transaction data to the clearing service.

13.11 Risk Issues in Clearing and Settlement Systems: Margining, Netting, and Short Selling and Securities Lending

There should be procedures to identify and monitor risks on an on-going basis. Regulators of the securities market should be interested not only in risk reduction but also in the assumption and shifting of risk amongst participants.

It is crucial that the stability, financial health and activities of participants in clearing and settlement systems be monitored in order to minimize the risk of failure of individual participants and overall risk to the systems. There must be information available on the capacity of clearing members to meet calls in a timely way and clarity of procedures in the event of default. Margin requirements (discussed below) may be used in combination with other mechanisms to manage risk to market participants, clearing houses and exchanges. Other risk controls may include: circuit breakers, position limits, price limits, trading halts, capital adequacy, risk management systems, operational standards, lending limitations, insurance coverage, back-up systems and guarantee funds. ⁶¹

A short settlement period will reduce risk to participants. T+3 is the standard settlement time frame recommended by the Group of Thirty for equities markets. There should be delivery versus payment systems in which transfer of ownership occurs at the same time as payment. Delivery versus payment systems reduce the risk that a participant will deliver full value to a counterparty and receive nothing in return. Such systems provide that ownership should not transfer unless payment also occurs.

A centralized securities depository or registry, linked with clearing and settlement system facilities provides a strong foundation for secure and efficient securities clearing and settlement systems. Over time, jurisdictions should move to de-materialize securities or to immobilize securities in regulated depositories or registries.

Derivatives settlement systems should be symmetric to avoid liquidity risk. Pays and collects should be handled contemporaneously.

13.11.1 Margining ⁶²

Margin calls can play an important role, along with other safeguards, in protecting the financial safety and integrity of markets. Margin requirements should be designed so that sufficient funding is available to cover likely trading exposures. The adequacy of margin requirements should periodically be reviewed.

Margin levels and procedures should be designed to reduce the exposure of market participants, including the clearing house, to credit, market and other risks - in particular, the risk of default by a market participant as a result of price movements in individual instruments and changes in market volatility.

The costs of margin must be considered in light of the benefit of reducing risk. For example, a consequence of high margin levels could be to reduce the leverage effect associated with certain financial instruments and increase the cost of trading which may affect the economic usefulness of a certain products. Consideration should be given to cross-margining and the use of a wide range of reasonably liquid collateral. ⁶³ To cover the volatility of derivatives trading, marking to market and intra-day settlements and margining are widely used and should be encouraged.

13.11.2 Netting

In this context, netting refers to the reduction in the amount of processing or the levels of exposure in a settlement system achieved by setting a participant's debits and credits off against each other leaving a smaller net obligation. Netting with novation and real time gross settlement are efficient settlement mechanisms. The regulator and market participants should study market volumes and participation to determine which mechanism is appropriate for their market place. ⁶⁴

13.11.3 Short Selling and Securities Lending

Short selling is regarded as a useful mechanism in some jurisdictions as an aid to liquidity. ⁶⁵ Where short selling is permitted, regulation must guard against manipulative practices, including those associated with a significant short position. In some jurisdictions this involves a combination of permitting securities lending and restricting short sales to liquid stocks. Disclosure of short sales and securities lending positions (or, at least, their reporting to the regulator) is a tool for the further reduction of risk.