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Consultation on request for approval of Austraclear NZ's proposed electronic registry interface under section 7 of the Securities Transfer Act

Background

1. The Securities Commission (the "Commission") seeks comments on a request from the Reserve Bank of New Zealand (the "Reserve Bank") for the approval of a proposed electronic registry interface for the Austraclear New Zealand System ("Austraclear NZ") as an electronic securities transfer system under section 7 of the Securities Transfer Act 1991 (the "Act").
2. Pursuant to section 7 of the Act, the Governor-General may from time to time, on the advice of the Minister of Commerce given in accordance with a recommendation of the Commission, by Order in Council, approve a system or systems that is or are wholly or partly electronic for the transfer of securities.
3. The effect of such an approval is that the registration of securities transferred by an approved electronic transfer system may not be refused on the grounds that the securities have been electronically transferred or that they have not been transferred by other means.
4. The Commission may not make a recommendation under section 7 of the Act unless it has done everything reasonably possible to consult with such persons and organisations as the Commission considers will be substantially affected by any approval pursuant to that section, and those persons or organisations have had the opportunity to comment.
5. Comments should be sent to the Commission by 5.30pm Friday 26 September 2008.

6. The remainder of this consultation paper includes:
   1. a brief description of Austraclear NZ and the part of the system to which an approval under section 7 of the Act would apply;
   2. an overview of relevant policy considerations and the Commission's preliminary analysis of those matters;
   3. an appendix containing a paper prepared by the Reserve Bank in support of its request entitled ESAS Austraclear NZ - Electronic Registry Interface which provides an overview of Austraclear NZ and the proposed electronic transfer system.
7. The Commission also refers interested parties to information on Austraclear NZ on the Reserve Bank's website (see http://www.rbnz.govt.nz/payment/austraclear/), particularly the Austraclear New Zealand System Rules and the Austraclear New Zealand Operating Guidelines.

Austraclear NZ

8. Austraclear NZ is a payment and securities settlement system operated by the Reserve Bank. Securities are held in Austraclear by New Zealand Central Securities Depository Limited ("NZCSD"), a wholly-owned limited-purpose subsidiary of the Reserve Bank, as custodian trustee. The Reserve Bank, which is the system operator, acts as managing trustee for the benefit of respective Austraclear NZ members.
9. A securities transfer is effected in Austraclear NZ by book entry across members' accounts which transfers the beneficial title to the securities between members (legal title remaining with NZCSD). Both parties to a transaction must electronically enter and authorise the transaction for a transfer to occur. However, because a transfer of beneficial ownership of securities in Austraclear NZ between members does not involve any transfer of legal title (i.e. a change of holder on the relevant register), such transfers are not a matter for approval under Securities Transfer Act.
10. To get securities into Austraclear NZ (i.e. to lodge securities) legal title to the securities must be transferred to NZCSD. In addition to being able to lodge their own securities, an Austraclear NZ member can also directly lodge a third party's securities into the system. Where a third party's securities are directly lodged into the system, the member lodging the securities is treated as the sole beneficial owner of the securities, and there is no reference within Austraclear NZ to that third party.
11. To get securities out of Austraclear NZ (i.e. to uplift securities) a member must instruct NZCSD to transfer legal title to the securities back to the member or as otherwise directed.
12. Generally, to lodge or uplift securities an Austraclear NZ member and NZCSD must currently deliver a completed paper transfer form to the relevant registry. At each stage of the process, in addition to having to manually handle the paper transfer form, the transfer is processed through manual data entries. An exception to this is that securities that can be transferred through the NZX's FASTER system can also currently be lodged or uplifted electronically through that system.
13. Currently a transfer form for lodging securities is signed by the Austraclear NZ member, or by the member and by or on behalf of the legal owner where the transfer is from a third party, while a transfer form for uplifting securities is signed by NZCSD on the instruction of the member (i.e. in each case the transfer form is signed by or on behalf of the transferor only).
14. Under the proposed electronic transfer system the member will give only electronic instructions to lodge and uplift securities. Once that instruction has been given, the process for completing and registering the transfer will be fully electronic and automated. That process does involve a transfer of legal title, so the Reserve Bank is seeking approval under section 7 of the Act for the proposed electronic transfer system for lodging and uplifting securities.
15. All securities holders other than NZX FASTER Participants with "owned accounts" have a confidential registry-allocated security holder identification number (FIN) which must be included (as applicable) on the paper transfer form to lodge securities under the existing system. Under the proposed electronic system that number will remain confidential since it will be encrypted on screen entry and will not be displayed nor stored within Austraclear NZ.
16. Under the proposed electronic system, an Austraclear NZ member will lodge or uplift securities by selecting the security holder from a drop down list established by the member. The relevant details for each security holder (other than the FIN, as applicable) will be preloaded and so will not need to be separately entered for each individual transaction. Changes to that list will require two levels of authorisation by the member.
17. The proposed electronic system may also allow direct entry of the relevant details on a one-off basis in respect of securities holders who require a FIN.
18. Members connect electronically to Austraclear NZ through either:
    1. SWIFT, a private international messaging network for financial transactions;
    2. the private ESAS-Austraclear network; or
    3. the internet.
19. Messaging is encrypted and both a member and a personal user log-on are required to access Austraclear NZ. Passwords are required to be complex and accounts are disabled after a set number of invalid log-on attempts. For internet connections, members are also required to provide authentication using special purpose RSA SecurID cards (i.e. two-factor authentication). The system also performs a cross-check for each log-on to ensure that the log-on is from the member's own network or using that member's RSA SecurID card. In this regard the system allocates a unique identifier confidential to the system to identify each member's network and each RSA SecurID card. This means that an Austraclear NZ member can only log-on from its own network or using its own RSA SecurID card (i.e. a valid member logon cannot be used from another member's network or using another member's SecurID card).
20. Members will also control which users have access to the lodge and uplift functionality.
21. Austraclear NZ connects with the two main registries (Link Market Services and Computershare) through the private ESAS-Austraclear network.
22. The Reserve Bank as system operator, NZCSD, and Austraclear NZ members are bound by the Austraclear NZ Rules (the "Rules") which include:
    1. provisions relating to membership - for example there are basic fit and proper requirements applying to applicants (see Rule 3.1.2), the Austraclear NZ membership application pack includes an anti money laundering questionnaire, and the system operator has an unfettered discretion to determine whether or not to accept any application for membership (see Rule 3.1.4);
    2. member warranties and indemnities regarding title to and rights to transfer securities (see Rules 9.4 and 21.6), and
    3. Operating Guidelines (in a stand alone document) setting out the processes for lodging, transferring, and uplifting securities.
23. The Rules may be changed at any time by the system operator (currently the Reserve Bank) in accordance with the process set out in the Rules. Rule changes do not require the consent of members, however, in practice members are consulted about proposed material rule changes. All rule changes must be notified to each member of the system.
24. Austraclear NZ also has a User Advisory Committee (established pursuant to Rule 23). The purposes and functions of the Committee, and the system operator's obligations in respect of the Committee, are set out in Schedule A to the Rules. In practice, all changes to the system, to the Rules and to the operating guidelines are tabled at a meeting of the User Advisory Committee before being taken to the wider membership.
25. Accountability within the Reserve Bank for Austraclear NZ, including Rule changes, rests with the Assistant Governor and Head of Operations and, ultimately, with the Governor.

Policy Considerations and Preliminary Analysis

26. An approval under section 7 of the Act gives an electronic transfer system and its participants certainty regarding the registration of electronic securities transfers. As such, an approval under section 7 facilitates the introduction and acceptance of an electronic transfer system.
27. Our preliminary thinking is that there are clear benefits that would flow from Austraclear NZ's proposed electronic registry interface. It will enable the interface between participants and the system, and between the system and the registries to be automated, which presents significant opportunities to make securities transfer processes quicker, more efficient, and less error prone.
28. A key countervailing consideration is whether a proposed electronic transfer system exposes securities holders or issuers to any greater risk of unauthorised or mistaken transfers than under the existing paper-based system. This is discussed in more detail below.
29. A further consideration is whether, if there is an unauthorised or mistaken transfer, securities holders or issuers are any worse off, in terms of being able to establish what occurred and in seeking to remedy matters, by virtue of the transfer having been electronic rather than paper-based. In that regard the Commission notes that the Reserve Bank states in its description of the proposed electronic transfer system that the new system will provide an extensive audit trail.
30. If there is any increase in risk then, in addition to balancing that cost against the anticipated benefits of the proposed electronic transfer system, it may also be relevant to consider:
    1. a. the extent to which any increase in risk is borne by those external to the system,
    2. b. if any increase in risk is borne by those external to the system, the extent to which the system manages that risk and/or expressly allocates that risk back to the system and/or its participants (i.e. those receiving the direct benefit of the system), and
    3. c. to the extent that any increase in risk is borne by the system and/or its participants, whether they are well placed to identify and manage any such increase.
31. Other relevant considerations include the control of automation risk, and controls around the setting and changing of relevant system rules.

The risk of unauthorised or mistaken transfers

32. The Commission notes that, because an Austraclear NZ member can lodge a third party's securities into the system and can also uplift securities directly to a third party, the risk of unauthorised or mistaken transfers is not only borne by Austraclear NZ members themselves, but potentially also by securities holders more generally (i.e. including those who are not members of Austraclear NZ) and issuers. While this functionality is not being introduced by the proposed electronic registry interface, it is a point to bear in mind in framing the issues and considering the consequences.
33. The Commission also notes that securities lodged in Austraclear NZ are already dematerialised and it is just the transfer instructions and processes that are becoming electronic. Dematerialisation removes physical possession of unique security certificates as a key factor in managing the risk of unauthorised or mistaken transfer. Dematerialisation therefore gives rise to a number of issues concerning the allocation and management of risk arising from no longer being able to physically possess security certificates. In comparison, paper transfer forms are not unique and so do not perform the same function as physical security certificates. As such, the range of issues concerning Austraclear NZ's proposed electronic registry interface is narrower than what might be the case if the proposed electronic transfer system also involved introducing the dematerialisation of securities.
34. Unauthorised transfers into or out of Austraclear NZ could in theory result from:
    1. the actions of an Austraclear NZ member itself in respect of someone else's securities, or
    2. the actions of staff of an Austraclear NZ member, or an unrelated party holding themselves out as the Austraclear NZ member, in respect of either the member's own or someone else's securities.

Unauthorised transfers into Austraclear NZ by a member

35. Our preliminary thinking is that the proposed electronic registry interface does not increase the risk of an Austraclear NZ member intentionally (as opposed to mistakenly) lodging securities into Austraclear NZ without being authorised to do so by the securities holder. The reasons for that are as follows:
    1. While the existing paper-based process requires a signed transfer form, the paper form is more of a formality than a security measure since:
       1. registries do not hold specimen signatures against which to verify signed transfer forms, and
       2. Austraclear NZ does not have any connection with securities holders more generally or issuers, so is in no position to verify transfer forms purportedly signed by or on behalf of non-members.
    2. As such, removing the need for a signed transfer form will not increase the risk of an Austraclear NZ member intentionally (as opposed to mistakenly) transferring securities into Austraclear NZ without being authorised to do so by the securities holder.
    3. The main security measures for preventing unauthorised transfer in both the paper-based and electronic transfer processes is in securities holders keeping FINs secure, and in the system operator having and administering appropriate fit and proper requirements as part of the access criteria for becoming an Austraclear NZ member.
    4. A third party security holder can request a change of FIN in conjunction with withdrawing an Austraclear NZ member's authority to deal on their behalf.
    5. For securities holders who do not have FINs the risk of an Austraclear NZ member intentionally lodging securities into Austraclear NZ without being authorised to do so by the securities holder is no greater under the electronic system than under the paper-based system. We note there is more control in this respect under the proposed electronic system since a third party who does not have a FIN must be pre-loaded onto the system, which requires additional levels of authorisation (as opposed to simply completing a paper form).
36. The proposed electronic transfer system may increase the risk of an Austraclear NZ member mistakenly lodging securities into Austraclear NZ without being authorised to do so by the securities holder since the process will involve fewer steps and there may be less opportunity to discover or halt an unauthorised transfer. In practice, it is very unlikely that an Austraclear NZ member would mistakenly lodge an unknown third party's securities where a FIN is required since it would be unlikely to have access to or inadvertently enter the required identification numbers. Preloading a third party's details to then select in each instance from a drop-down list would make the risk of mistakenly lodging an unknown third party's securities even more remote. For one-off direct entries the risk is no different under the electronic system than under the paper-based system.
37. Where the Austraclear NZ member is lodging third party securities by selecting from a drop down list, as opposed to manually entering the details each time, it is potentially easier to select the wrong person. If a FIN is required, the third party selected still needs to match up with a manually entered FIN for the transaction to occur. As such, the risk of mistakenly lodging a known third party's securities would not seem to be any greater under the proposed electronic process than under the paper-based process where a FIN is required, but is potentially greater if no FIN is required.
38. We note that an Austraclear NZ member can itself easily rectify mistakenly lodging a third party's securities because it retains control over the securities. Also, securities holders who do not have FINs are likely to be monitoring their holdings regularly enough to promptly identify any mistaken transfer and seek to have it remedied.
39. Our preliminary thinking is therefore that, while the proposed electronic registry interface may expose third party securities holders or issuers to some increased risk of an Austraclear NZ member mistakenly lodging securities into the system, that increase is either negligible (especially as regards unknown third parties) or the consequences are such that the risks and costs would be outweighed by the benefits of the proposed electronic transfer system.

Unauthorised transfers out of Austraclear NZ by a member

40. Our preliminary thinking is that the proposed electronic registry interface does not increase the risk of an Austraclear NZ member intentionally uplifting securities from Austraclear NZ without being authorised to do so. The reasons for that are:
    1. Each Austraclear NZ member is entitled to uplift securities held on its account in Austraclear NZ so there is no issue concerning an Austraclear NZ member's authority to uplift securities held on its own account.
    2. An Austraclear NZ member cannot hold itself out as another member and uplift securities into their own or a third party's name because each member's log-on only works from its own network or in conjunction with its own RSA SecurID cards (and each network's and each RSA SecurID card's identification within Austraclear NZ is confidential to the system operator).
    3. Having to deliver a paper transfer form for the depository (i.e. the transferor) to sign does not add any extra security to that process and, if anything, the proposed electronic interface would seem to improve security around the uplift of securities.