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Securities Commission Policy in Respect of Futures Dealer Authorisations

OPTION 3: THE COMPLIANCE REPORTER MODEL
7.1 Another possible model for authorisation has been developed in respect of a recent application for authorisation. The applicant had met the good character standards of the NZFOE and was admitted as a member of the NZFOE. A futures authorisation based on this admittance was granted for the on exchange component of the dealer's business. The dealer also wanted to deal in off exchange futures contracts. In developing an authorisation for this, a supervisory structure needed to be put in place to monitor the off exchange component of the dealer's business. The model developed included a compliance reporter who would undertake inspections of the dealer and provide a copy of the report to the Commission.
7.2 The compliance reporter model represents an alternative model upon which to base Commission authorisation. The main planks for a compliance reporter model of regulation could include:
- appointment of a compliance reporter to undertake extended ongoing supervision of the futures dealer's business;
- periodic auditing of financial statements and systems;
- periodic onsite inspections;
- the futures dealer to provide the compliance reporter with copies of its annual report and monthly financial statements;
- the compliance reporter to report to the Commission;
- an obligation to report to the Commission if the broker or any of its principals:
  - becomes insolvent or bankrupt;
  - has a receiver or liquidator or similar officer appointed, or if a resolution is passed to wind up the company or business;
  - is convicted of an indictable offence;
  - is subject to regulatory or disciplinary action by any New Zealand or overseas regulator or competent self-regulatory organisation;
- for public dealers (those who hold client funds) some capital adequacy requirements;
- potential onsite inspections by the Commission without notice.
7.3    These would attach as conditions to futures authorisations. The costs of the compliance reporter and other obligations would ultimately need to be covered by the dealer.
7.4    The compliance reporter review could be undertaken to ascertain compliance with the dealer's compliance procedures as set out in a formal compliance manual. If so the Commission would need to be satisfied that the dealer's compliance procedures sufficiently cover good futures dealer business practice. This may require an expert's report on the procedures proposed by the dealer.
7.5    Applicants seeking authorisation would also have to demonstrate business integrity, financial probity and good character. They would have to demonstrate that they are able to act with due skill, care and diligence, and to observe high standards of trading conduct. Applicants would also have to demonstrate that any directors are of good character and high business integrity.
7.6    If such a model were adopted the Commission would probably want to establish a panel of suitable compliance reporters from which dealers could select. This would allow for development of expertise.
7.7    The Commission may also consider the appointment of an advisory panel of industry experts (perhaps ex-members of the NZFOE business conduct committee) to assist in evaluating applicants for authorisation and reports from compliance reporters. That role may include ensuring that the compliance reporter undertakes a complete inspection.
7.8    The Commission would take a back-up enforcement role. In particular, it may become involved where the reporter brings questionable practice to our attention.
7.9    While we think there are some merits to this model, we also think there a number of difficulties. These may include:
- cost;
- identifying potential reviewers with sufficient industry expertise to adequately review dealing activities;
- defining the depth of review that the compliance reporter would be responsible for;
- that this model would provide for only periodic supervision of the dealer.
7.10 We would be interested in comments on the model. We would be particularly interested in comments from members of the accounting industry (who may be candidates for the compliance reporter role) on the likely effectiveness of the model and the extent of the role that the compliance reporter should be undertaking.

OPTION 4: THE SELF-REGULATORY ORGANISATION MODEL
8.1 Commission futures dealers authorisation could potentially be based on membership in a self-regulatory organisation (SRO). If there is to be such a body it will need to have industry support. We consider that a credible SRO on which the Commission could rely when considering authorisation would need to have robust bylaws. These might cover the following:
- governance of the SRO;
- criteria for admission to membership (including experience, qualifications and character standards);
- rights and obligations of members;
- rules of conduct for members and traders - e.g. prohibitions on front running / dual trading / insider trading / manipulative conduct / excessive trading on account;
- disciplinary procedures;
- appeal and arbitration procedures;
- client complaint and dispute resolution procedures;
- investigative committees;
- audit of members;
- regular monitoring including onsite inspections;
- segregation and handling of client funds; and
- client agreement forms / risk disclosure.
8.2    As the Commission would remain the statutory body responsible for administering and enforcing the law, arrangements would be needed for the SRO to share information and report to the Commission.
8.3    There may be some advantages to the self-regulatory model in that it would facilitate a closer industry involvement in regulatory supervision, it would be able to provide educative and other support to members and it would facilitate identification of malpractice. If found lacking, members of an SRO could be expelled and the basis of their authorisation removed. The Commission would be available where appropriate to take a back-up enforcement role. Membership of a strong and effective SRO could have positive effects for the reputations of dealers.
8.4    The appointment of regulatory inspectors and a business conduct committee to review the practices of member futures dealers would facilitate both a monitoring role for an SRO and development of a pool of experience and expertise. There may also be cost savings in working together on an industry basis. An SRO may also provide a platform for education and marketing of the industry. In noting this, competition matters under the Commerce Act 1986 may need to be considered.
8.5    We see some advantages in establishing an SRO as a front-line regulator of futures dealers. The difficulty is that such an organisation does not currently exist. It is also not clear to us that the industry is of a sufficient size to enable formation of such a body. There would need to be prompt moves by the industry if it intends to establish an SRO. Interim measures may be needed.

TIMING
9.1    With the withdrawal of the NZFOE most futures authorisations in New Zealand will become invalid. The SFE Corporation intends to cease its operations in New Zealand from early to mid 2003. All current dealers will need to be authorised before this happens or cease to deal in futures. It is possible that transitional arrangements will need to be put in place to enable time for the full consideration of applications without halting all New Zealand futures activity.
9.2    Affected dealers are encouraged to submit proposals to the Commission at the earliest opportunity.
9.3    Following the transition, the Commission will be considering its options for enforcement action with regard to dealers who carry on the business of futures dealing without authorisation. We consider that strong enforcement is vital to the integrity and reputation of the market. In addition, we expect that futures dealers who are authorised and who comply with the law and their terms of authorisation should be able to expect that enforcement action will be taken against those who do not comply.
9.4    Once the Commission has considered comments on this paper, we expect to publish some guidance for dealers who will need to apply for authorisation in 2003.
9.5    We should note that if input from the industry does not lead to development of an appropriate regime, the Commission may need to consider whether it should make recommendations to the Government for further regulation of the industry.
9.6    This paper may be downloaded from the Commission's website (www.seccom.govt.nz). Comments on this consultation paper should be sent to the Commission by 14 February 2003. They can be emailed to toby.norgate@seccom.govt.nz or sent in hard copy to:
Toby Norgate
Lawyer
Securities Commission
Facsimile: (04) 472 8076
PO Box 1179
WELLINGTON

APPENDIX: QUESTIONS

We would welcome comments on all aspects of this paper. We would be particularly interested in your comments on the questions listed below. We would be interested in the reasons supporting your comments. When answering the questions raised in this discussion document, we request that submitters bear in mind and, where appropriate, reflect in their answers the following considerations:

What are the benefits of the proposal?
Does the proposal impose any additional compliance costs or reduce compliance costs?
If it does impose compliance costs, who will have to bear these costs?
What is the estimated compliance cost?
Are there any longer term implications of the compliance cost involved?
What steps could be taken to minimise compliance costs in relation to the proposal?
Are there any other costs involved, that are not compliance costs, borne by market participants?
Do the benefits of the proposal outweigh any of the costs involved, or vice versa, and why?
Are there any other options that could better achieve the objective?

The preferred model

What is the preferred regulatory model? Why?

General aspects of a futures regime

Do you consider the following matters to be desirable features for a futures regime? If so we would be interested in ideas as to how they could be brought about and what would be the appropriate standards.
1. Client funds protections: This issue is dealt with to some degree by the Futures Industry (Client Funds) Regulations 1990.
2. Capital adequacy rules: It is argued that a minimum capital base provides some assurance that a dealer will stay in business and the clients' position will not suffer from a dealer's insolvency. It is also argued that a minimum capital base reduces the temptation to settle dealer debts with client funds. We welcome your views on whether capital adequacy rules should be imposed and it so, what might constitute an appropriate capital base?
3. Educational and competency standards: We would rely on a self-regulatory body, if such were available, to assess these standards.
4. Financial reporting: In the past the Commission has taken the view that dealers who hold client funds on behalf of the public are issuers. We propose that dealers be required to comply with the financial reporting obligations of an issuer under the Financial Reporting Act 1993. Should there be regular interim reporting to a monitoring body (e.g. a self-regulatory body or a compliance reporter)?
5. Risk product and adviser disclosure: Should the futures dealer provide each client, on whose behalf he or she intends to deal in futures, with a product and risk disclosure document and an investment adviser disclosure document (and/or an investment broker disclosure statement)?
6. Written client agreements: We think the futures dealer should enter into a client agreement with each client and should act in accordance with that agreement. Do you agree?
7. Recordkeeping: We consider the futures dealer should maintain proper records Do you have any comments on this?
8. Financial statements: In the past, the Commission has considered that futures dealers should provide copies of its audited financial statements to the Commission not more than three months after the end of each financial year. Do you think this requirement should continue, or be changed in any way?
9. Professional indemnity insurance: Should the futures dealer be required to maintain adequate professional indemnity insurance?
Are there any other matters that should be included in any futures regime?
Do you agree that the level of regulation should reflect whether or not the dealer holds client funds?
Do you think the level of regulation should differ for those who deal only for wholesale clients?

Commission oversight model

Do you think the Commission should take a front-line monitoring and enforcement role with regard to futures dealers?
How should this be funded?
What benefits do you see to this structure?
What disadvantages do you see to this structure?
What compliance costs do you see for this structure?
Do you consider the following matters desirable features for a futures regime based on Commission oversight:
1. on-site inspections;
2. review of systems and procedures;
3. receiving reports from the dealer;
4. review of capital adequacy;
5. review of business and trading practices.
Should the Commission, in conjunction with the industry, prepare standard rules of trading and business for this model if it were adopted?
Are there any other matters that should be included in a futures regime based on a front-line monitoring and enforcement role for the Commission?

Compliance reporter model

On what aspects of a dealer's futures business should a compliance reporter be expected to inquire and report?
How should this be done (i.e. by on-site inspection, reporting etc)?
Will combining the roles of an auditor and a compliance reviewer in one body bring conflicts of interest?
Do you consider each of the following matters desirable features for a futures regime based on a compliance reporter model:
1. appointment of a compliance reporter who will undertake an extended ongoing supervisory audit role of the futures dealer's business;
2. periodic auditing of financial statements and systems;
3. periodic on-site inspections;
4. the futures dealer to provide the compliance reporter with copies of its annual report and monthly financial statements;
5. the compliance reporter to report to the Commission;
6. an obligation to report to the Commission if the broker or any of its principals:
  - becomes insolvent or bankrupt;
  - has a receiver or liquidator or similar officer appointed, or if a resolution is passed to wind up the company or business;
  - is convicted of an indictable offence;
  - is subject to regulatory or disciplinary action by any New Zealand or overseas regulator or competent self-regulatory organisation.
7. for public dealers (those who hold client funds) some capital adequacy requirements;
8. agreement to on-site inspections by the Commission without notice?
What benefits do you see to this structure?
What disadvantages do you see to this structure?
What compliance costs do you see for this structure?
Are there any other matters that should be included in a futures regime based on a compliance reporter model?

SRO model

Are traders prepared to work under such a model?
What steps would you be prepared to take to establish such a model?
How should such a model be structured?
What rules should be in place?
How should it be funded?
Do you consider the following matters desirable features for a futures regime based on an SRO model:
1. governance of the organisation;
2. criteria for admission to membership (including experience, qualifications and character standards);
3. rights and obligations of members;
4. rules of conduct for members and traders - e.g. prohibitions on front running / dual trading / insider trading / manipulative conduct / excessive trading on account;
5. disciplinary procedures;
6. appeal and arbitration procedures;
7. client complaint and dispute resolution procedures;
8. investigative committees;
9. audit of members;
10. regular monitoring including on-site inspections;
11. segregation and handling of client funds; and
12. client agreement forms / risk disclosure.
What benefits do you see to this structure?
What disadvantages do you see to this structure?
What compliance costs do you see for this structure?
Are there any other matters that should be included in a futures regime based on front-line regulation by a self-regulatory organisation?

Other

Is there another more desirable model on which to base futures authorisations? If so please outline the model.
If you are involved in futures dealing, what is the scale of your futures dealing in New Zealand?
What economic and other benefits are brought to New Zealand by its having a futures market?
What economic and other benefits are brought to New Zealand by having an active futures dealing industry in New Zealand?
Are there any other matters that we should be considering relating to futures dealer regulation?

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