Publications: OVERSIGHT REVIEW OF NZX 2005


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OVERSIGHT REVIEW OF NZX 2005

ARRANGEMENTS FOR SUPERVISION OF MARKET PARTICIPANTS

Role of Participant Compliance

Participant Compliance performs the following functions in relation to supervision of Market Participants and Futures and Options Participants:
1. Review of daily, monthly and annual financial returns submitted by Market Participants, Futures and Options Firms, and Futures and Options Introducing Brokers;
2. Review of Internal Control Checklists, which contain confirmation from Market Participants of their compliance with various Participant Rules;
3. Onsite reviews of Market Participants' compliance with the Participant Rules and Futures and Options Participants' compliance with the Futures and Options Rules;
4. Review and investigation of complaints received from investors relating to the activities of Market Participants that may be referred to NZX Discipline;
5. Review of trading in the shares of Listed Issuers to identify possible breaches of NZX Rules and securities laws; and
6. Reviewing applications from entities and individuals seeking accreditation by NZX.

Conduct of market surveillance regarding trading activity

The Participant Compliance team has the primary responsibility for reviewing the alerts received from SMARTS, the real-time market surveillance system. Members of NZXR also have access to SMARTS.
The SMARTS system maintains an audit trail of the alert and the person who has reviewed the alert. A review of a sample of alerts indicated that alerts were regularly reviewed by members of the Participant Compliance team.

Complaints handling regarding Market Participants

NZX has a complaints manual detailing processes for handling complaints. Participant Compliance team members advised that they use the processes set out in the manual to deal with complaints. The files evidenced that the complaints procedure was followed. All members of the Participant Compliance team handle complaints. Complaints handling is overseen by a Business Leader and the Head of Regulation.
Where complaints raise substantive issues and lead on to referral to NZX Discipline, the Participant Compliance team prepares the Statement of Case which commences the discipline process.

Onsite inspections and periodic reporting

The findings of the inspection and working papers relating to inspections of Market Participants were well documented. Findings of inspections were generally observed to be communicated to Market Participants within the timeframes determined by internal NZX policies. Copies of inspection reports were sent to the Commission at the time.
There was regular communication with Market Participants for correcting the breaches and shortcomings observed in the course of inspection. The inspection files contained well-documented records of regular follow-up correspondence with respective Market Participants.
Some delays in relation to internally determined timeframes were observed in the submission of monthly reports to the Head of Regulation.
Some repeat breaches of Participant Rules, observed in inspection reports selected for sample review, did not result in these breaches being referred for disciplinary action. We understand from discussions with members of the Participant Compliance team that the approach is to provide guidance and advice to the Market Participants and to try to change their behaviour rather than initiate immediate disciplinary action.
The Head of Regulation noted in terms of NZX's approach to participant compliance that it may be a matter of selecting the right regulatory tool to deploy in any given situation. In the course of its inspection programme, NZX focuses on education rather than discipline but depending on the circumstances would bring disciplinary actions as well. The Head of Regulation indicated that the focus on education may change now that NZX has inspected every Market Participant. Material received from NZX Discipline shows that several broker compliance matters have been referred to it. We recommend that NZX take disciplinary action against Market Participants who commit repeat breaches of the Participant Rules.

Accreditation of Market Participants

Market Participants are required to be accredited by NZX under the Participant Rules. The Participant Compliance team processes accreditation applications. NZX seeks to ensure that only fit and proper entities are designated as NZX Participants. In the course of the NZX Sponsor application process, the application is put to a panel of senior NZX staff (comprising the Head of Regulation, the Group Leader - Market Products and the CEO) for review. The files showed that the panel makes comments on the applicant's appropriateness for accreditation. This panel approval process was used for each of the files that we reviewed. The panel's decision was then confirmed to the applicant. Other Market Participant applications are approved by the Head of Regulation following review and recommendation by Participant Compliance staff.

Escalation of issues

The Participant Compliance Business Leaders report to the Head of Regulation from on-site inspections if there are significant issues. The Head of Regulation has been involved in reviewing five inspection reports during 2005. Her focus is on the findings and recommendations, and the timeframes for issues to be remedied. The Head of Regulation also takes into consideration whether the report is raising issues that she needs to bring to the attention of the CEO or Board. A similar approach is taken for escalating significant issues observed in other areas of participant compliance work.
Where repeat breaches occur within a firm there may be increased intervention by NZX. The Head of Regulation always expects to be made aware of situations where a client funds account is in overdraft, liquid capital thresholds have been breached, or "cultural" issues noted at a firm. This expectation has been communicated to the Participant Compliance Business Leaders.

Recommendation

NZX has adequate processes in place for supervision of Market Participants and Futures and Options Participants under the Participant Rules and the Futures and Options Rules and uses its processes consistently. We make the following recommendation:

NZX ensures that, now the "education process" with Market Participants is complete (through the inspection process), NZX takes disciplinary action against Market Participants who commit repeat breaches of the Participant Rules.

While NZX indicated in the course of our review that it is likely to do this in future, NZX noted that disciplinary action may not be the appropriate regulatory tool for dealing with breaches. NZX Discipline has indicated that it does not consider it appropriate for all breaches to be referred to it, in particular less material breaches.

The Commission considers that repeat breaches of the Rules can demonstrate particular attitudes towards compliance. NZX needs to use a mechanism to penalise repeat breaches by Market Participants. Currently, taking a case to NZX Discipline is the only avenue for doing this. If NZX is of the view that current NZX Discipline proceedings may not be appropriate in all cases we think that NZX should consider the sufficiency of the regulatory tools available to it under the Discipline Rules. We plan to keep this under review.

NZX will consider this matter again and has undertaken to report back to the Commission by the end of this calendar year.

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