Clemente L. del ValleLead Capital Markets Specialist

April 30th 2010

The Future of Self-Regulation in Securities Markets

Agenda

1. Main Objective and Scope2. International Regulation Models3. International Trends

– Conflicts of Interest4. Reforming SRO Systems5. Lessons for the EMC

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Main Objective and Scope

Presentation based on a ongoing research being lead by the SMG (and John Carson main consultant) to develop a policy framework for use in advising the World Bank’s clients on employing self-regulation in capital markets.

Towards this objective, the paper1. Analyzes major experiences in developed and

developing countries with respect to employing self-regulation

2. Focuses on issues such as level of reliance on SROs, division of responsibilities with regulator, managing the COI, governance and government oversight

3. Indentifies dominant trends and extracts key lessons for the developing world

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Reliance on SROs – Continuum

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Reliance on SROs – Models

GOVERNMENT MODEL

LIMITED EXCHANGE SRO

MODEL

STRONG EXCHANGE SRO

MODEL

INDEPENDENT SRO MODEL

• Public authority performs most or all regulatory functions. Exchanges have very limited role

• Exchange performs front-line regulatory functions for its market

• Exchange as SRO performs extensive regulatory functions

• SRO that is purely a regulator, not a market operator, performs extensive regulatory functions

• UK

• France

• Emerging model in EU

Trend towards this model

Most prevalent

model

Trend away from this

model

Only developed in a few

countries

• US (NYSE)

• Hong Kong (HKE)

• Singapore (SGX)

• Sweden (OMX)

• Dubai (DIFX)

• US (CME)

• Brazil (BSM)

• Japan (TSE)

• Malaysia (BM)

• Australia (ASX)

• US (FINRA, NFA)

• Canada (IIROC)

• Japan (JSDA)

• Colombia (AMV) 5

Corporate Governance of SROs

Exchange SROs

(Listed model)Independent SROs

Public, Shareholder ownership

For-profit corporation

SRO functions may have separate or special governance system

Private, Member organization

Non-profit entity

Corporate board – mainly from financial sector and customer groups

Directors elected by shareholders

Majority of directors are independent of the Exchange and regulated firms

Stakeholder-based – representatives of Members and independent directors from financial sector, academia, professional services etc.

50% or more of directors should be independent of regulated firms

Board Nominating Committee nominates candidates for election by shareholders at AGM

Regulator applies fit and proper test

Board Nominating Committee nominates candidates for election by Members at AGM

Regulator applies fit and proper test

Regulator sets principles for governance structure and policies

Regulator reviews effectiveness of governance periodically

Regulator sets principles for governance structure and policies

Regulator reviews effectiveness of governance periodically

Ownership & Structure

Compositionof Board

RegulatoryOversight

Selection of Directors

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Strong Exchange SRO Model

Description Pros ConsExchange performs extensive regulatory functions that extend beyond its market operations.

Examples

US (CME)

Brazil (BSM)

Malaysia (Bursa Malaysia)

Australia (ASX)

Japan (TSE)

Based on existing institution and capacity

Greater use of industry expertise and resources in regulating markets and member firms.

Reduces burden on Government regulator and resource requirements

Potentially serious conflict of interest problems

Exchange is not focussed on core mandate of business and market development

Regulatory costs may reduce Exchange’s competitiveness

Regulator has less control over regulation issues and operations

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Independent SRO Model

Description Pros ConsIndependent SRO that is not a market operator performs extensive regulatory functions

Examples

US (FINRA)

Canada (IIROC)

Colombia (AMV)

Japan (JSDA)*

Minimizes conflicts of interest between business of exchange and SRO functions

SRO has clear mission: its only job is to provide effective regulation

SRO is seen as a neutral and unbiased regulator

Supports business mandate of exchange and competition among exchanges / market operators

Greater use of industry expertise and resources in regulating markets and member firms

Reduces burden on government regulator and resource requirements

Potentially less efficient than full Government model due to duplication and need for coordination

Regulator has less control over detailed regulation or day-to-day operations of markets and member firms

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Division of ResponsibilitiesUS UK Australia

Market Regulation

Exchanges are primary regulators of their markets (FINRA on contract for some)

SEC sets high level anti-fraud rules

Several authorities regulate debt markets

FSA is responsible for market conduct and surveillance

Exchanges monitor trading on their markets

LSE lists all types of bonds

ASX sets trading rules. Full market surveillance responsibility for ASX: rules + identifying breaches of law.

Debt is not traded on ASX

Listings SEC regulates offers. Exchanges (mainly NYSE and Nasdaq) set listing requirements and approve listing. Sets some Listing Rules.

Issuer regulation shared with SEC

FSA sets listing rules and approves listing

FSA regulates offers. LSE has minor admission to trading standards.

ASIC regulates offers

ASX sets listing requirements and approves listing. Sets Listing Rules.

Issuer Disclosure & Governance

Mainly SEC. Exchanges monitor compliance with timely disclosure.

FSA ASX sets some rules and monitors compliance with timely disclosure

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Key International Trends

1. Value of self-regulation has increasingly been questioned

2. Reduced reliance on SROs (esp. in Europe)3. Exchange SROs’ roles cut back due to conflicts

– Independent SRO units in Exchange retain important role

4. Self-regulation is stronger and more credible in many countries that rely on it

5. Move to independent governance and away from Member control

6. SROs must be responsive to broader stakeholder interests

7. Stronger oversight and direction from statutory regulators

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Exchange SROs’ Reduced Role

Why have Exchange SROs’ roles been cut back?• Reduces conflicts of interest in self-regulation• Positions exchanges to focus on product and

market development, and competitiveness– Business focus– Reduced costs– Relationship with participants and issuers is mainly as

customers

• Public regulators are often more effective – Broader jurisdiction and power

• Public regulators may impose higher and more consistent standards of regulation

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Exchange SROs - Conflicts of Interest

Type of Conflict Description1. Conflict between

Business and Regulation Mandate

Regulation of major customers such as members and listed companies produces tensions between business interests and regulation responsibilities

2. Funding of Regulation Competition for resources between business and regulation needs

Desire to drive down costs puts pressure on non-revenue-producing areas such as regulation

3. Integrity of Regulation Program

Maintaining high regulatory standards and rules may negatively impact business development and customers

Thoroughness of regulatory programs could be reduced

Conflicts could result in biased administration of rules

Pressure on independence of investigations and enforcement program

Misuse of regulation to stifle competition

4. Ownership and Governance Conflicts

Regulation of significant owners (e.g. members or listed companies) is difficult

Directors’ duty to shareholders vs. public duty as a regulator

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Managing SRO Conflicts of Interest

• Separate governing body to oversee regulatory operations

• Separate organizational structures for regulatory and business operations

• Firewalls to separate regulatory operations from business or advocacy operations

• Separate and secure premises for SRO operations

• Contract out all or part of the SRO’s regulatory responsibilities

• Establish policies and procedures on managing conflicts of interest

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SRO Oversight – Overview

REGULATOR

SRO

Approves rules Adopts rules

Sets principles for corporate governance

Adopts corporate governance policies and

procedures

Review reports Files financial and other reports

Ongoing monitoring and communication

Administers & enforces rules and supervision

programs

Inspection of operations Prepares self-assessment of operations

MOU oversight process

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Oversight Examinations of SROs

FULL AUDIT RISK-BASED

COMPLAINT / EVENT -DRIVEN

Regular inspections, tending to review all areas, or the same pre-identified areas, each time. Differentiation in scope is often limited for different areas reviewed.

Targeted inspections, focused on higher risk areas. The areas reviewed and scope of review often changes from one inspection cycle to the next.

Ad hoc inspections to address specific issues. Used in both models.

Preferred model

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Reforming SRO Systems - Policy Issues

1. What are the imperatives for change?• Positioning capital markets to be competitive

• Address exchanges’ conflicts of interest and core mandate

• Need for greater supervision and compliance capacity

• Unregulated sectors or products

2. Strategy for capital markets development• How should exchanges and markets be positioned?

3. Public policy on reliance on self-regulation

4. Capacity, resources and credibility of potential SROs

5. Legal framework

6. Stakeholders’ views and commitment16

Main Lessons for the EMC

1. SRO frameworks could be a valuable addition to an effective regulatory framework

2. However, there is no single “right” approach3. Each market has to find its “right” solution

based on its size, complexity and history4. The traditional closed club approach is no

longer valid5. Demutualization does not preclude the

exchange’s involvement but does require a new framework

6. The Independent SRO model has advantages but also big challenges (e.g., costs, regulatory capture)

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Main Lessons for the EMC ctd.

7. The relationship between the SRO and the regulator has also changed

8. However, a strong regulator is a must for all models9. Deciding what model to follow demands a serious

strategic analysis (cost/benefit, political commitment)10.The implementation of a new framework relying on

SROs also presents risks that need to be managed11.The recent crisis has highlighted the vulnerability of

regulatory frameworks and the need for good governance and effective management of the COI

12.NO concluding answers and need for ongoing improvements

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Thank you.

Questions?

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