House of Representatives

Explanatory Memorandum

Circulated By the Authority of the Minister for Financial Services, Superannuation and Corporate Law, the Hon Chris Bowen MP)

Chapter 3 - Regulation impact statement

Assessing the Problem

Conflict of interest issues

3.1 Under section 795B of the Corporations Act 2001 (the Act), an Australian market licence may be granted to an applicant if the Minister is satisfied that, among other things, the applicant has adequate arrangements for supervising the market, including arrangements for handling its commercial conflicts of interest, monitoring the conduct of participants, and enforcing compliance with the market's operating rules. The Act also requires that market operators ensure their markets are fair, orderly and transparent.

3.2 At present, there are 16 licensed financial markets operating in Australia, five of these being licensed overseas markets. The largest of these is the Australian Securities Exchange (ASX) which as at 30 June 2009 had a domestic market capitalisation of AUD $1.09 trillion. For the month of December 2009 there were 9,349,000 equity trades on the ASX market.

3.3 Australian Securities and Investments Commission (ASIC) annually assesses market licensees' compliance with their supervisory obligations, including their conflict of interest arrangements. Failure to adequately supervise a market can result in the Minister directing the market licensee to do specified things to promote compliance, suspension of the licence or cancellation of the licence.

3.4 Australian market licensees work closely with ASIC, which is responsible for enforcing the corporations legislation. Market operators are obliged under the Act to notify ASIC of certain matters, including suspected contraventions of the market's operating rules or the Act and matters that may adversely affect the ability of a participant to meet its obligations as a financial services licensee. As such, market operators are effectively the primary identifiers and referrers of instances of on-market trading misconduct to ASIC. ASX and ASIC have a Memorandum of Understanding which provides guidance on the referral of supervisory matters from ASX to ASIC.

3.5 Market operators are also the primary determiners of acceptable conduct by participants on Australia's financial markets, as market operators are responsible for setting and enforcing their own operating rules. Operating rules cover areas such as client-participant relations and rules regarding the preventing of manipulative trading.

3.6 There has been strong public criticism recently that market operators have an inherent conflict of interest between their supervisory obligations and the operation of their market. Some have stated that the commercial interests of market operators may encourage them to maximise transaction volumes without due regard for market integrity. Commentary has included:

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Professor Clarke from the University of Technology Sydney stated in The Australian on 12 March 2008 that ASX had done a good job with compliance, but 'the time had come for the ASX to end its conflict of interest by spinning out its regulatory and supervisory division'.

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Commonwealth Bank of Australia chief executive Mr Ralph Norris on the front page of the Australian Financial Review on 22 April 2008 stated that the ASX has failed to properly regulate the stock market because it cannot overcome an inherent conflict in its interest as both the market regulator and listed, profit seeking company. He added, 'I don't believe the ASX can be both market participant and a regulator'.

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An article by Adele Ferguson in The Australian in June 2009 stated that 'As a listed entity, the ASX is one of the few exchanges in the world that has been allowed to keep all its supervisory powers intact and continue to police its own customers. As one market watcher once said: "Having this dual role is like the police force being allowed by law to operate a money making business alongside its regulatory duties. The obvious conflict of interest would undermine law enforcers' capacity to perform their duties efficiently" '.

3.7 Confidence in the integrity of the financial system is central to its operation. Perceptions of conflicts of interests in market operators supervising themselves remain, despite the significant improvements in conflict handling arrangements made by markets such as the ASX. The continued perception of the presence of conflicts of interests could result in decreased confidence in the integrity of the market by market participants, which in turn could lead to individuals being unwilling to invest in the market for fear of market misconduct, potentially affecting the liquidity and stability of the market. Confidence is particularly important in times of global market uncertainty such as those recently experienced.

Current arrangements preclude competition between market operators

3.8 In addition, the current regulatory arrangements effectively preclude the consideration of competition in the same listed securities between market operators in Australia. In the last three years, three organisations have lodged Australian market licence applications for trading in ASX listed securities with ASIC. While well established in some other major jurisdictions, allowing multiple venues to trade in the same securities is a new development for Australia. An environment where multiple markets trade in ASX listed securities would raise market supervision and surveillance concerns never before confronted in Australia.

3.9 For example, the shareholders in AXE ECN Pty Ltd, one of the companies which has made an application for a market licence to trade in ASX listed securities, are large investment banks and brokers. Five of these shareholders are also participants on the ASX market and are among the ten largest participants in terms of volume and value of market turnover. If a market licence was given to AXE ECN Pty Limited these banks and brokers would individually trade on the AXE market and also the ASX market, while also partly owning a direct competitor to the ASX. Under the current regulation market operators are required to supervise trades on their market, take disciplinary action where breaches of the market rules occur and notify ASIC of any misconduct on the market. The potential would arise for ASX to perform their supervisory functions, including investigation and disciplining, against the substantial shareholders of a competing market operator. This would create a serious conflict of interest which would be difficult to adequately manage. At the very least, there would be a perception that ASX was not exercising its powers impartially, but in a way that would damage those brokers with a stake in its competitor, or who are major users of a competitor's market. This would have a chilling effect on competition. Similarly there would be concerns about the impartiality of an operator supervising a participant that is also a major shareholder in the operator.

3.10 Issues also arise concerning the detecting of market misconduct when trading in the same securities takes place on multiple markets. If a person can trade the same securities on different markets which are supervised independently of each other, it is easier to conceal market misconduct. Market misconduct may involve trading activities on more than one market.

3.11 For example, the offence of market manipulation can involve creating the false or misleading appearance of active trading of a financial product on a financial market. The 'false or misleading appearance' aspect arises where a person trades with themselves or an associate in an attempt to create a false impression of demand for a financial product, and consequently increase the price for the financial product. Where there are multiple markets trading in the one security this sort of misconduct would be more difficult to detect. It would be possible for an individual seeking to make a false or misleading impression of demand for a product to trade with themselves on multiple markets. As the conduct would be dispersed across different markets, the actions being performed on each of those individual markets may seem innocuous. It would require a whole-of-market view to pick up the offensive behaviour.

3.12 As this example shows it may not be possible to identify potential misconduct only by observing what occurs on one market; and intervention to prevent or take disciplinary action against suspected misconduct may require co-ordinated action by different market operators. The potential for misconduct to occur undetected if ASX listed securities were able to be traded on markets other than the ASX means that the current regulatory regime, whereby markets self supervise, effectively precludes the consideration of competition for market services.

Objectives of Government Action

3.13 Confidence in the integrity of the operation of the market is central to its effective functioning. The present situation whereby the market operators set their rules and supervise compliance with those rules raises a number of significant issues, as outlined above.

3.14 The objective of Government action in this area is to improve confidence in the integrity of Australia's financial markets by removing the perceived conflict of interest which markets have in supervising their own markets and also to create a regulatory framework which, should competition amongst financial markets be progressed in Australia, would allow for more efficient and effective supervision of cross-market trading activity.

Options

3.15 The International Organization of Securities Commissions (IOSCO) has previously stated in relation to approaches to financial market supervision that 'there is no universal right regulatory path to follow' and 'there does not appear to be a definitive blueprint that can be adopted by all jurisdictions'. Nevertheless, in the last decade, there has been a clear move in major jurisdictions towards centralised and independent regulation or, in some cases, government regulation of markets and/or market participants. Canada has introduced independent, non-government supervision of trading activity in all of its equity security markets, while the United States has separated participant supervision from market supervision and established a non-government, industry supervisor for market participants. In the United Kingdom, the Financial Services Authority, an independent non-governmental body given statutory powers, regulates company listings.

3.16 The move towards centralised or independent regulation in comparable jurisdictions is a direct result of the conflict of interest issues which arise when market operators are responsible for supervision. Australia cannot realistically adopt the non-government model due to the lack of a suitably equipped industry body, consequently a Government entity needs to take on this role.

3.17 Two possible options were identified and dismissed for not adequately addressing the issue. These options are:

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providing for industry to establish a private company which would be responsible for the supervision of the markets - unlike in the United States and Canada which have long established industry self-regulators, there is not a readily identifiable organisation or market stakeholder that might seek, and be competent to perform, such a not for profit role. In addition, supervisory responsibility is a serious function, central to maintaining market integrity and confidence. As such there is a need for significant Government accountability in the performance of this function which would not be obtainable if it was given to a private body to perform; and

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establishing an independent whole-of-market supervisor: the cost of establishing a new entity is a fundamental impediment to this option.

3.18 Two main options were identified. These are set out below.

Option One: Retain the status quo (no regulatory action)

3.19 Section 792A of the Act requires holders of an Australian market licence to have in place adequate arrangements for supervising the market including:

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handing conflicts between the commercial interests of the licensee and the need for the licensee to ensure the market is fair, orderly and transparent;

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monitoring the conduct of participants on or in relation to the market; and

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enforcing compliance with the market's operating rules.

3.20 Australian market licensees are currently required to manage their conflicts of interests and conduct supervision of their respective markets and are subject to annual compliance assessments by ASIC.

Option Two: Move to a Government whole-of-market supervisor

3.21 A single whole of market supervisor would consolidate the current individual supervisory responsibilities into one entity, streamlining supervision and enforcement, and providing supervision of trading on Australia's domestic financial markets. Consequently, a whole-of-market supervisor would be expected to enhance stability in the market.

3.22 The transfer of supervisory responsibility to ASIC would address the need for an effective whole-of-market supervisor. It would also allow for the Government to undertake the development of a framework of common rules required for all markets. This would in turn allow for consideration of the outstanding market licence applications, which have been awaiting consideration.

3.23 ASIC would perform similar functions to the present market supervisors. Specifically ASIC would: supervise participants who trade on Australia's markets, monitor market conduct and trading activity, create rules and enforce compliance with these rules.

Impact Analysis

Option One: Retain the status quo (no regulatory action)

3.24 This option would have the benefit of imposing no additional regulatory costs on businesses, investors or the Government. However it would result in the present situation continuing, adding to regulatory weakness, retaining regulatory, supervisory and enforcement gaps and negatively impacting on our market's ability to spread risk and liquidity across more than one effective monopoly market.

3.25 This option would prevent Australia from pursuing the benefits flowing from competition between market operators, should it choose to do so. Under the status quo the barriers to market competition and the risks outlined in the problem section remain.

3.26 The only way for whole-of-market supervision to take place where markets self-supervise is for there to be information sharing arrangements between the market operators.

3.27 However information sharing arrangements between market operators are not a satisfactory means of addressing this supervisory issue for a number of reasons. Firstly, as stated above, this option does not address the inherent conflict of interest problem which occurs when market operators supervise themselves. Secondly, such arrangements between competitors are problematic. Thirdly, information sharing arrangements do not provide for sufficient whole-of-market supervision. The likely outcome is that relevant market misconduct information is likely to fall between the cracks.

Option Two: Move to whole-of-market supervision by ASIC

3.28 An entity under the jurisdiction of the Commonwealth Government is the most appropriate body to provide whole-of-market supervision. The present situation whereby the market operators supervise themselves raises a number of significant issues, as outlined above. In addition, unlike in comparable jurisdictions overseas, there is no organisation or market stakeholder in Australia who might seek and be competent to perform a not for profit supervisory role. As such it is necessary that the Commonwealth Government take on the role of market supervision. ASIC is the Government body most appropriate to take on responsibility for supervision of Australia's financial markets. ASIC has increased its proximity to the market during its recent organisational restructure, and considers it is capable of performing this function.

3.29 The Australian Financial Markets Association (AFMA), Australia's peak industry association for Australia's wholesale banking and financial markets, has conducted an analysis on the market supervision issue and advocated the transfer of whole-of-market supervisory responsibilities to ASIC.

3.30 This option would have the benefit of eliminating the real or perceived conflict issues which exist in the current model of market self-regulation and would also provide a mechanism for whole-of-market regulation and surveillance. The transfer of supervisory responsibility to ASIC would allow for one body, ASIC, to be responsible for ensuring compliance with the corporations legislation and any ASIC set rules, consequently adding to the integrity of Australia's markets. A single whole-of-market supervisor would consolidate the current individual supervisory responsibilities into one entity, streamlining supervision and enforcement, and providing complete supervision of trading on the market. Consequently, ASIC's role as a whole-of-market supervisor would be expected to enhance stability in the market.

3.31 This option would affect the Government and market operators in Australia's financial market. The impact on the Government would be derived from the transferring of a responsibility which is currently performed by market operators to ASIC.

3.32 Market operators would likewise be affected. The removal of responsibility for supervision of participants and trading would reduce the regulatory burden on market operators. It would also make it possible for ASIC to consider the outstanding market licence applications.

3.33 Market operators and participants on Australia's financial markets will be affected to the extent that they will be required to comply with any rules which are set by ASIC. The extent of any compliance costs will be determined by the rules which ASIC makes and as such can not be quantified at this stage.

3.34 The Wallis Inquiry, which reported in 1997, made a recommendation that regulatory agencies should collect enough revenue from the financial entities which they regulate to fund themselves. The principle is that for reasons of equity and efficiency, the costs of financial regulation should be borne by those who benefit from it. It is intended that the costs associated with the establishment and ongoing operations of the new whole-of-market supervisor will be fully recoverable by ASIC via a levy issued against market operators. When the levy is issued it will impose a direct cost on the market operator. The cost of the levy for market operators will depend on the method of calculation, which will be determined at a later date by amendments to the Corporations (Fees) Regulations 2001. A separate regulation impact statement will be prepared for these amendments to the Regulations.

3.35 It is intended that the imposition of fees by ASIC on market operators will not have a significant impact on the cost of trading on financial markets in Australia. The Government's decision to transfer supervisory responsibility to ASIC will remove the regulatory obligation on market operators to supervise their markets. It is expected that this saving to operators will be offset by their need to pay the ASIC fees. This cost recovery proposal has similarities to the ways in which costs are recovered from market operators and/or market users by a number of self-regulatory organisations responsible for market supervisory activities globally.

Consultation

3.36 A draft bill and consultation paper (the Paper) were released for public comment on 2 December 2009. In addition Treasury officials conducted roundtable discussions with industry groups, Australian market licensees, and Australian market licence applicants on the paper.

3.37 The paper sought comments on the proposed regulatory framework, including the establishment of ASIC as a whole-of-market supervisor, the creation of ASIC set market integrity rules, and the provision of additional enforcement powers to ASIC.

3.38 There were 23 submissions to the paper, including submissions from the ASX, the AFMA, the Stockbrokers Association of Australia, the Investments & Financial Services Association, the Australian Bankers Association and Chi-X Australia Pty Limited.

3.39 Most submissions were supportive of the proposal for ASIC to take on the role of market supervisor. Based on comments provided in the submissions to the Paper minor changes were made to the Bill.

Conclusion and Recommended Option

3.40 This document outlines a range of possible policy options to address the issues which arise with the current regulation of market supervision in Australia. Options considered include:

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retaining the status quo (no regulatory action); and

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moving to a whole-of-market supervision to ASIC.

3.41 Based on the impact analysis outlined above, option 2 has been selected as the recommended approach. This option achieves the regulatory outcome of enhancing confidence in the integrity of Australia's financial markets without imposing significant regulatory burden. This option primarily proposes to alter the body which performs the supervisory function, transferring the supervisory responsibility from individual markets to a statutory whole-of-market supervisor. Although minimal transitional regulations may be required to ensure continued market integrity over the transfer period, any such regulations would be designed to have minimal regulatory impact on markets and participants. In addition, any such regulations would take place via regulatory amendment and would be subject to an additional regulation impact statement.

3.42 The other options fails to sufficiently address the identified issue as they would retain the real or perceived conflict of interest associated with market operators supervising their own, and others', markets and would inhibit the development of competition in Australia's financial market.

Implementation and Review

3.43 The Government will continue to monitor the application of the regime to ensure that it is operating effectively.