Publications: OVERSIGHT REVIEW OF NZX 2008


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OVERSIGHT REVIEW OF NZX 2008

J. RESPONSIBILITY FOR THE SUPERVISORY FUNCTION

The NZX Conflicts Management Policy approved in January 2008 contemplates that the dual role of market operator and supervisor may lead to a conflict or perception of a conflict between regulatory and commercial function, because commercial interests have the objective to maximize value for shareholders and the obligation as a market operator is to utilise resources to supervise its market.
Accordingly, the policy requires that commercial interests should not be allowed to influence supervisory decision making; that supervisory activity and information is to be quarantined from commercial activity, and that supervisory activity and decision making must be consistent and transparent.
The NZX Board has responsibility for both the commercial and regulatory sides of NZX's business.
The Board operates subject to a regulatory charter which outlines that the Board and CEO have a dual accountability for commercial and supervisory operations.
Pursuant to this charter, the Board must ensure that strategy of the business will not diminish the high integrity reputation of the capital markets; that no commercial interests will be permitted to unduly influence supervisory strategy or decision-making; that supervisory activity will be performed in a consistent and transparent manner; and that supervisory activity will be resourced to an appropriate level.
The Board has made a joint delegation in respect of regulatory activity to the CEO and the Head of Supervision. The Head of Supervision undertakes the day-to-day management of the supervisory function and the CEO must retain accountability for the supervisory function.
To ensure that the Board is properly informed of supervisory activity and that no undue influence may be brought to bear upon the supervisory activity undertaken by the Head of Supervision and her team, the Head of Supervision presents a regulatory paper to the Board at each of its regular meetings. The report addresses key supervisory activity, inappropriate behaviour of any commercial staff seeking to influence supervisory decision making or strategy, any breach of conflict management protocols, and, until November 2008, adequacy of resourcing.
The Head of Supervision may and does report to the Board without the presence of the CEO. The Head of Supervision also may escalate a supervisory or potential conflict issue to the Board where a difference has arisen and cannot be resolved between the Head of Supervision and the CEO.
Supervisory decision making and information is quarantined from the commercial side and all core supervisory functions are undertaken by a separate regulatory division.
Specifically, the CEO is bound by a regulatory code of conduct in that the CEO may not inappropriately use his power to influence or direct the outcome of a supervisory matter for reasons that are not relevant to the supervisory issue.
The International Organization of Securities Commissions (IOSCO), Objectives and Principles of Securities Regulation (February 2008) outline principles relating to a regulator which include that "[t]he regulator should be operationally independent and accountable in the exercise of its functions and powers" and that "[t]he regulator should have adequate powers, proper resources and the capacity to perform its functions and exercise its powers." These IOSCO Principles specifically recommend that "[t]he regulator should be operationally independent from external political or commercial interference in the exercise of its functions and powers and accountable in the use of its powers and resources."
The assessment methodology for the IOSCO Principles notes that while all exchanges should have procedures in place to address conflicts of interest, there may be more concern for conflicts of interest, or the appropriate use of self-regulatory resources, in the case of for-profit, demutualised markets. One concern is that such an exchange would seek to cut its regulatory activities or standards in order to boost returns for its shareholders.
While NZX continues to manage appropriately the conflicts of interest between its commercial and regulatory functions, this dual delegation remains of concern to the Commission. While this delegation is in place, there remains a potential for conflict to exist.
Demutalised exchanges around the world have taken different approaches to ensure separation of regulatory and commercial functions. While models differ, a consistent standard is that the head of regulation is completely autonomous from any other executive function. The NZX has proffered the view that the dual delegation has worked in practise and no commercial concerns have affected the regulatory exercise of the delegation.
During the period under review the CEO, under the direction of a committee of the NZX Board, exercised fully on occasion the delegation as Head of Supervision. The Commission considers that the function was competently discharged, and no conflict was evident in the discharge of that function.
However the Commission considers that the dual delegation is inadvisable. In the Commission's view the issue which required the exercise of the delegation could have been resolved by the retaining of external counsel or an expert, who could have independently reported to the Board, thereby retaining the separation of the commercial and regulatory functions. The NZX disagrees with this perspective but does agree that the process of obtaining a regulatory outcome is important as well as the outcome itself.
The current legislation makes no provision for resolution of these differing perspectives between NZX and the Commission. This may be a matter that the Government may wish to consider in the review of the regulatory landscape under the Securities Act review later this year.

K. CONCLUSION

The Commission's overall conclusion from this review is that NZX is satisfying its obligation to operate its markets in accordance with its Conduct Rules and the requirements of the Securities Markets Act 1988. Specifically, the Commission has found as follows:

Matters arising from the review of the 2007 year

The Commission is satisfied that NZX has resolved all issues that arose from the 2007 review.

NZX's frontline regulation

The Commission is satisfied with NZX's frontline regulation processes.
NZX informs the Commission that NZX has improved and refined its frontline regulation processes.

Relationship of NZX's expanding commercial activities to its regulatory function

As the NZX expands its commercial activities, the Commission has concerns that there is a risk of potential conflicts arising between NZX's commercial and regulatory functions.

New Zealand Markets Disciplinary Tribunal (NZMDT)

The Commission is satisfied with the NZMDT's execution of its function as an independent disciplinary body dealing with matters referred by NZX.
The review encountered correspondence between the NZMDT and NZX in regard to referrals from NZX to the NZMDT.
The NZMDT believes that the number of referrals from NZX to the NZMDT is an issue for the Commission to review in regard to the performance of NZX and its regulatory function and its oversight of the markets, rather than an issue for the NZMDT. The Commission agrees.
The Commission supports the implementation of meetings every four months between the CEO of NZX and the NZMDT Chairman to improve communication in this important regulatory relationship.
The Commission further recommends that NZX and the NZMDT establish a protocol for referrals from NZX to NZMDT to improve the transparency of their relationship.
The Commission notes that the NZMDT believes that NZX has liberally resourced the NZMDT.

The Special Division of the New Zealand Markets Disciplinary Tribunal

The Commission is satisfied with the NZMDT's execution of its function as an independent regulator of NZX as a listed issuer.

NZX's risk-based approach to supervision

In this review, the Commission placed particular emphasise on NZX's risk-based supervision approach. The Commission finds that this approach provides an appropriate process for assessing market participants' risk of non-compliance with the Participant Rules and a thorough on-site inspection process.
NZX issued most of its draft inspection reports to market participants beyond the time period outlined in its 2008 reporting schedule. While the Commission accepts NZX's position that these delays were caused by NZX's necessary and appropriate reallocation of its regulatory personnel to manage extraordinary market risk during the period, the Commission considers that market participants should be able to expect timely reports.
The Commission recommends that NZX should resource its supervisory function appropriately so that feedback can be provided to market participants in a timely way.
The Commission also recognizes that during this period of extraordinarily difficult market conditions there was no collapse of any NZX market participant. This is a positive endorsement of NZX's performance as a supervisor of market participants.

Responsibility for the supervisory function

The Commission has concerns relating to the dual delegation of responsibility for the supervisory function at NZX and the risk that this will create conflicts of interest that have the potential to compromise regulatory effectiveness.
While there is no evidence that any conflict has caused regulatory activity to be compromised by commercial pressures during the period covered by this review, the Commission considers any structure that imbeds ongoing potential for conflict of interest as inadvisable.

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