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OVERSIGHT REVIEW OF NZX 2006

CONCLUSION

85. The Commission's overall conclusion is that NZX is satisfying its obligation to operate its markets in accordance with its Conduct Rules.
86. The Commission expects that future reviews of NZX will follow a similar format to the 2006 oversight review, in that they will focus on particular issues regarding NZX's performance of its statutory functions. The Commission believes that annual reviews of NZX are valuable because they allow the Commission and the market to receive information about NZX's performance on a regular basis.
87. The Commission's concerns and recommendations recorded as a result of this review, NZX's actions and response to these recommendations, and relevant intervening matters, will be reviewed next year.

APPENDIX

Scope of review

1. Section 36G of the Securities Markets Act 1988 says that NZX must operate each of its securities markets in accordance with approved rules for that market. The Conduct Rules include Listing Rules, and Business Rules that govern the conduct of persons authorised to undertake trading activities on the market.
2. NZX's obligations under section 36G are to secure compliance with its listing and business rules, and to perform any obligations that lie on NZX under those rules. To do this, NZX has established a Market Supervision Group with responsibilities for discharging NZX's regulatory function. The NZX Discipline Rules establish a dedicated body, NZX Discipline, to determine questions of non-compliance with the listing or Business Rules. Decisions can be appealed to the Appeal Panel. An independent body, the Special Division of NZX Discipline, exercises the powers and functions of NZX in relation to NZX as a Listed Issuer and its related entities.
3. The Commission has statutory functions to review practices relating to securities and activities on securities markets, and to comment on these. In relation to NZX, performance of these functions requires the Commission to keep under review and comment on NZX's obligations as a registered exchange. The oversight review was conducted under sections 10(b), 10(c) and 10(caa) of the Securities Act 1978.
4. The Commission's Terms of Reference for the review were:
   
   The Securities Commission ("the Commission") is conducting an oversight review of New Zealand Exchange Limited ("NZX") under sections 10(b), 10(c) and 10(caa) of the Securities Act 1978. The purpose is to review NZX's performance of its co-regulatory function, in particular its obligations under section 36G of the Securities Markets Act 1988 and, in respect of futures and options dealers, NZX's regulation of dealers under its Futures and Options Participant Rules.
   
   In particular, in respect of the 2006 calendar year, the Commission will review the following aspects of NZX's activities:
   1. the management and operation of the NZAX market, including resources, practices and procedures, and the ongoing maintenance of that market;
   2. the processes undertaken by NZX in considering the admission or approval of listed issuers and market participants to its markets, and any particular issues which arise as a result of those processes; and
   3. NZX's role in minimising the risk of non-compliance by listed issuers and market participants in relation to their obligations under the Listing Rules and Participant Rules;
   The Commission's review will consider any new developments in relation to the following areas:
   1. supervision of market participants and enforcement of the Participant Rules;
   2. supervision of listed issuers and enforcement of the Listing Rules;
   3. allocation of human, technological and financial resources as it affects performance of the regulatory functions of NZX;
   4. internal practices and procedures associated with investigations, price enquiries, complaints-handling and referrals;
   5. discipline practices, procedures and resources;
   6. arrangements for market infrastructure development and maintenance;
   7. Special Division practices, procedures and resources; and
   8. corporate governance arrangements, including board composition, policy setting, crisis response and oversight of executive management, with reference to regulatory standards relating to governance of demutualised exchanges under IOSCO and other international principles.
   The review may also consider any issues arising in the course of the review in relation to the above areas.
   
   The Commission's review will consider the progress made by NZX (up to the date of the Commission's report on this oversight review) towards implementing the Commission's recommendations set out in its report dated 26 September 2006.
   
   AND accordingly, will obtain, consider and utilise information for the purposes of any recommendation, report or comment the Commission may decide to make under sections 10(b), 10(c) or 10(caa) of the Securities Act 1978 in relation to the above matters.
   
   SUBJECT to the Commission's discretion to amend these Terms of Reference as it may consider fit.
   
   December 2006

Background to review

5. In 2002 the Securities Markets and Institutions Bill created a co-regulatory regime for registered exchanges. NZX is the only registered exchange in New Zealand. Under the co-regulatory regime it is intended that the Commission monitors the performance of NZX's statutory responsibilities.
6. In 2003 the International Monetary Fund conducted a Financial Sector Assessment Programme (FSAP) review of New Zealand. The FSAP measured New Zealand's framework of securities regulation and its operation against the Objectives and Principles of Securities Regulation published by the International Organization of Securities Commissions. The IOSCO Principles include principles for self-regulatory organisations.
7. One of the recommendations in the FSAP report was that the Commission develop a formalised oversight plan for regulated exchanges, providing for risk assessment criteria and periodic inspections that take into account best practices for self-regulatory organisations and exchanges. It recommended that there should be public disclosure summarising the objectives of the oversight plan and of the key findings of such reviews. The Government response noted that the Commission had decided to develop a formal oversight plan for regulated exchanges and had informed NZX.
8. Demutualisation and listing of stock exchanges has been an emerging phenomenon overseas in the past decade. In all cases we have seen, regulatory structures have been put in place accompanying such moves, reflecting the core importance of stock exchanges to countries' capital markets and broader economies. In New Zealand these regulatory structures include an ownership cap, regulatory review of exchange rules, and oversight by the Commission. Different approaches have been taken in various jurisdictions overseas. The approach taken in New Zealand was settled after consideration of international models existing at the time, and the particular circumstances of the New Zealand markets. It has not been a part of this review to reconsider these arrangements.
9. However, as encouraged by the FSAP review, we have looked to the emerging high-level standards in overseas jurisdictions to gain an insight into best practices for exchanges. We have taken into account the report of the FSAP inspectors, the IOSCO Objectives and Principles of Securities Regulation, and the methodology used for assessing compliance with these standards, in particular the principles applying to self-regulatory organisations.
10. The Commission has also looked to the legal obligations of exchanges in similar jurisdictions to gain an understanding of the expectations that overseas investors in particular are likely to have for the conduct of a registered exchange. While there are differences in the approaches taken by each jurisdiction, there are a number of standards that can be taken from an overall assessment of the IOSCO Principles and overseas law and practice. These suggest that a stock exchange should:
    1. meet and maintain adequate standards of integrity and fitness to operate a market;
    2. develop rules for the conduct of listed issuers and market participants;
    3. develop and operate fair procedures for the enforcement of its rules;
    4. conduct a fair, orderly, informed, and efficient market;
    5. maintain effective trading, clearing, and settlement systems;
    6. have adequate capacity to carry out its regulatory functions and enforce its rules; and
    7. have procedures in place to manage conflicts of interest.
11. Development of rules is addressed in New Zealand under the statutory approval and disallowance process for conduct rules. The IOSCO Principles also address competition issues, which are outside the remit of the Securities Commission. The remaining matters have been addressed in this review.
12. The oversight review conducted this year is the second oversight review of NZX conducted by the Commission. The review focussed on the 2006 calendar year.

Process

13. The Commission requested information from NZX under section 36ZK of the Securities Markets Act. Section 36ZK says that a registered exchange must give the Commission (or any person authorised by the Commission) information, assistance, and access to the exchange's facilities if the Commission reasonably requests it to carry out its functions.
14. The Commission sent questionnaires to NZX, NZX Discipline and the Special Division seeking information the Commission considered necessary to effectively evaluate NZX's performance of its regulatory functions. The questionnaires covered the areas identified in the Terms of Reference.
15. The Commission requested copies of any procedures manuals and process documents that evidenced NZX's policies and procedures for each of the areas covered by the questionnaires. Where written procedures and policies were not available, we requested written explanations and information from NZX in response to each specific information request.
16. NZX provided information in response to the questionnaires, including procedures manuals and process documents where relevant. Questions relating to NZX Discipline and the Special Division were answered by the Chairs of those bodies.
17. Commission staff selected and reviewed a sample of NZX's files across a range of regulatory activities.
18. Commission staff conducted interviews with NZX personnel and Board members. Commission staff also interviewed the Chairman of NZX Discipline and the Chairman of the Special Division. A total of 11 interviews were conducted and the interviews were recorded.
19. Confidentiality and privacy orders were in place throughout the review.