Self-Regulation in Colombian Securities Markets SEMINAR ON SRO STRUCTURE January 31, 2006 International Securities Consultancy
Agenda 1. Background Project objectives Key Findings Key Issues 2. International SRO Systems 3. Structure of SRO System 4. SRO responsibilities 5. SFC Oversight of SROs 6. Implementation Plan & Governance 7. Questions 2
Project Objectives 1. Meet with authorities and key stakeholders to discuss the key issues for self-regulation in Colombia 2. Review the impact of the Capital Market Law on the self-regulatory regime 3. Report on self regulatory models and experiences of other relevant countries 4. Propose a self regulatory model appropriate for Colombian capital market 5. Design an implementation plan 3
Process 1. Consult with authorities and key stakeholders on design of new self-regulation system and SRO structure Ministry of Finance SFC Banco de la Republica BVC Industry associations Intermediaries 2. Review international models of self-regulation 3. Analyze Colombian securities markets, regulatory system and needs 4. Develop proposed SRO structure and division of responsibilities with SFC 4
Guiding Principles The structure of SRO system should meet these objectives: All SROs should meet consistent standards of governance, operation and member supervision All SROs rules and supervision programs should establish consistent standards and requirements for the same activities no regulatory arbitrage! Limit and effectively manage conflicts of interest Meets international standards and practices Leads to higher standards of market integrity and investor protection Cost-efficient and results-oriented Supports development of competitive capital markets Clear scope and division of SROs responsibilities Minimize duplication and overlap Avoid gaps in regulation or silo approach 5
Key Findings 1 Primary rationales for expanded self-regulation are 1) need to address regulatory arbitrage ; 2) to expand quality of regulation and resources BVC Supervision regulation has improved greatly since creation of new independent structure 2 years ago BVCS and SFC require greater resources and improved skills and knowledge Strong consensus that 1 SRO for all markets and FIs is preferred Colombian market size does not support multiple SROs Financial groups would prefer 1 SRO for all group entities Single SRO must be fully independent of BVC and free of conflicts SRO requires representative governance structure based on all FIs 6
Key Findings 2 Most stakeholders are unclear about what self-regulation involves Including principles of self-regulation, operations of SROs, and SRO responsibilities Meaning of FI regulation (member regulation) is unclear to most Need a clear division of responsibilities between SFC and SRO FIs recognize that member regulation functions would be more extensive for SCBs than other FIs because SCBs are only in securities business. Main focus of SRO regulation for many FIs will be market regulation Example: Regulation of dealings with customers in securities products would apply mainly to SCBs and to banks but not to apply to insurance companies or pension funds because they do not sell securities. There is only time to create a basic SRO by July deadline Full implementation of SRO rules and programs will take 2 3 years 7
Key Issues 1 Definition of financial intermediation Structure of SRO regime Number of SROs Membership standards Corporate governance SRO responsibilities Division of responsibilities with SFC Division of responsibilities with BVC / market operators Scope of rulemaking, supervision, investigation and enforcement powers Budget and funding Start-up costs and source of funding Operating costs Calculation of members fees Role of BVC and other market operators 8
Key Issues 2 Conditions for SFC approval of SRO SFC program for oversight of SROs MOUs between SRO and SFC, BVC, Banco de la Republica and other Government authorities Content of Decree on self-regulation Implementation plan: 1. Plan for creation of SRO 2. Launch of new SRO organization 3. Establish interim regulation programs 4. Establish new Rulebook and regulation programs 9
Self-Regulation in Colombian Securities Markets International SRO Systems
International SRO Models Model GOVERNMENT MODEL LIMITED EXCHANGE SRO MODEL STRONG EXCHANGE SRO MODEL INDEPENDENT SRO MODEL Description Public body performs most or all regulation functions. Exchanges perform very limited supervision of their markets. Exchange performs front-line regulation functions for its market Exchange performs extensive market and member regulation functions SRO that is purely a regulator, not a market operator, performs extensive regulation functions Examples UK (FSA), France (AMF) Hong Kong (HKEx), Sweden (OMX Stockholm) US (NYSE, CME), Japan (TSE), Australia (ASX), Singapore (SGX) US (NASD), Canada (IDA) 11
SRO responsibilities 1. Member (Intermediary) Regulation 1.1 Membership requirements 1.2 Business conduct Risk management, compliance policies and procedures, books and records requirements 1.3 Dealings with customers (sales compliance) Duties to customers, investment advice 1.4 Compliance inspections 1.5 Prudential (capital) regulation and financial examinations 12
SRO responsibilities 2 2. Market Regulation 2.1 Market conduct rules (market integrity and fair trading principles) 2.2 Market surveillance 2.3 Trading analysis and investigations Exchange SROs also are responsible for: 2.4 Trading rules (trading system operations) 2.5 Market quality rules (eg. market maker obligations) 3. Investigations & Enforcement 3.1 Formal investigations 3.2 Disciplinary actions 13
Self-Regulation - Benefits SROs can deal with detailed issues in markets and conduct of intermediaries that Regulator may not have capacity to address SROs expand overall regulatory resources and expertise SROs Leads to higher overall standards of supervision Front-line regulators are often closer to the market and understand details of exchange operations and members activities better Members have direct input into SRO rules and policies enables specialized expertise to be applied to a complex business and produces more practical rules SROs promote industry buy-in and participation in the regulatory system SROs may be faster, more flexible and responsive to change than public authorities SROs provide a check and balance to Regulators power 14
Self-Regulation - Risks Self-regulation is subject to conflicts of interest SROs require extensive oversight by Regulators Self-regulation introduces another layer of regulation 15
Self-Regulation in Colombian Securities Markets Structure of SRO System
Alternative Structures Model 1. SINGLE SRO Description 1 SRO for all securities intermediaries and markets Example NASD in U.S. -- but all exchanges in U.S. are SROs too. 2. 1 MARKET SRO + SEVERAL MEMBER SROs 3. EXCHANGE SROs + MEMBER SROs 4. PRIMARY SRO + FI ASSOCIATION LIMITED PRUPOSE SROs 1 SRO to supervise all markets (exchanges, OTC and SEN). FIs establish SROs for member regulation functions. Each exchange is an SRO to supervise its own market. FIs establish 1 or more SROs for member regulation functions. 1 SRO for most functions. FI associations may establish an SRO for a limited purpose (e.g. registration of individuals). Market Regulation Services in Canada and IDA in Canada for member regulation. Almost all exchanges globally are responsible for supervising their own markets. Mexico and Brazil investment dealer associations are examples of limited purpose. 17
Alternative Structures Model 1. SINGLE SRO Pros uniform rules and policies (no regulatory arbitrage) uniform regulation programs for all SRO sees full picture of market and FI activities minimizes duplication and gaps in regulation simple and cost-efficient eliminates duplication of SRO infrastructure centralizes mgt. & staff expertise easier for SFC to supervise minimizes conflicts of interest Cons may be difficult to regulate wide range of FIs with different businesses large independent SRO may lose front-line knowledge of markets and members could become autocratic and bureaucratic 18
Alternative Structures Model 2. SINGLE MARKET SRO + SEVERAL MEMBER SROs Pros ensure uniform regulation of all markets and market participants enables different FIs to establish SROs with specialized expertise in their operations. Cons regulatory arbitrage and inconsistency in member regulation. duplication and possible gaps need for coordination (delays) no overall view of member risk higher costs lack of sufficient knowledge and expertise in Colombian market rationale for multiple SROs may if FIs consolidate intermediation activities 19
Alternative Structures Model 3. EXCHANGE SROs + MEMBER SROs 4. PRIMARY SRO + FI ASSOCIATION LIMITED PURPOSE SROs Pros Exchanges supervise integrity of their own markets Specialized expertise in individual markets see # 2 re Member SROs See # 1 for primary SRO Associations can foster best practices in their segment Cons Non-member FIs may not agree to Exchange jurisdiction Inconsistent rules and standards (regulatory arbitrage) Duplication and gaps in regulation Duplication in SRO infrastructure Greater conflicts of interest see also #2 re Member SROs Conflicts of interest with Associations industry lobby and promotion role Additional costs for Associations to meet minimum SRO standards Duplication is some infrastructure potential regulatory arbitrage in limited purpose function (eg. registration) 20
SRO System Structure Model 2 Single SRO to regulate markets; Member SRO for Brokers and Member SRO for other FIs Brokers Other FIs SRO 1 SRO 2 SRO 3 Market Regulation FI Regulation 21
SRO System Structure Model 3 Exchange SROs to regulate markets; Member SROs for FIs S B Brokers Other FIs BVC SRO E N S R O N A S R O SRO 4 SRO 5 Market Regulation FI Regulation 22
Recommended SRO Structure Single SRO for all securities markets and FIs Responsible for most market regulation and some parts of FI / member regulation BNA should create SRO for its commodities market and members Commodities markets are quite different than securities and do not trade in financial instruments; require specialized expertise In future merger of commodities and securities SROs could occur Uniform market integrity rules for all markets (MEC, SEN, equities) Uniform business conduct rules for all member FIs securities business activities Strong Board of Directors comprised of member directors and a majority of independent directors 23
Advantages of proposed model Ensures uniform rules and standards Eliminates regulatory arbitrage and creates a level playing field for FIs to compete Equal standards of protection for customers of all FIs Consistent standards in surveillance, examination and enforcement programs Promotes regulatory effectiveness and efficiency Streamlines rules and procedures Simpler for market participants and investors Limits duplication of regulation activities and SRO infrastructure Reduces costs of self-regulation Limits SFC s burden of oversight of SROs Enhances the competitiveness of Colombia s market 24
Advantages of proposed model 2 SFC, SRO and BVC can focus on their core missions Concentrates expertise on market regulation expertise and members securities activities in SRO Positions BVC and other markets to focus on business and market development Enables SFC to focus on overall financial supervsion and key risks Minimizes conflicts of interest SRO has no conflicts of interest with customers of a business (listed issuers, participating FIs) Conflict inherent in self-regulation by members mitigated by the proposed model 25
Self-Regulation in Colombian Securities Markets SRO Responsibilities
Scope of self-regulation FIs MARKETS ACTIVITIES PRODUCTS Intermediaries subject to selfregulation that are SRO members Exchanges and markets whose trading is supervised by SROs Types of Securities Business activities that are regulated by SROs Types of securities products that are subject to SRO rules In each area responsibilities will be divided between SROs and the SFC 27
Scope of self-regulation Financial Intermediaries banks SCBs (broker-dealers) commodity brokers fiduciaries (trusts) pension funds insurance companies interdealer brokers money tables Marketplaces BVC markets: MEC Equities Other markets: SEN OTC debt market (Inverlace) BNA commodity markets Securities Products Government bonds Corporate bonds Depository notes Equities Investment funds Commodities Foreign investments Securities activities of FIs debt trading equities trading derivatives trading commodity futures trading investment banking / underwriting brokerage / sales to customers margin lending investment advice for customers asset management investment funds management 28
Recommended SRO responsibilities MARKET REGULATION CLIENT DEALINGS* FI BUSINESS CONDUCT REGIST- RATION PRUDENTIAL & CAPITAL INVESTMENT FUNDS Banks SRO SRO shared SRO SFC SFC SCBs SRO SRO shared SRO SFC SFC Trusts SRO SRO shared SRO SFC SFC Insurance SRO SRO shared SRO SFC SFC Pension Funds SRO SRO shared SRO SFC SFC Money Tables SRO SRO shared SRO SFC SFC Commodity Brokers BNA BNA shared BNA SFC - * Client dealings in securities products including funds 29
Layers of Regulation The analysis of regulation responsibilities must reflect all levels of detail in each area of regulation. Example: Market Regulation Layer of Regulation 1. Market Regulation 2. Market conduct 3. Marketplace trading rules 4. Marketplace supervision Responsibility Overall supervision of markets and FIs market conduct and trading practices Principles of fair dealing, insider trading, deceptive and manipulative trading Market integrity rules and practices for each marketplace Monitoring of trading in each marketplace for compliance with rules Activities Rulemaking Supervision Enforcement Rulemaking Supervision Enforcement Rulemaking Supervision Enforcement Market surveillance Trading analysis Investigations and enforcement 30
Scope of SRO Responsibilities SFC regulation Other banking activities All bank activities SRO regulation* Securities activities Illustration of responsibility for bank regulation * SRO regulation is subject to SFC oversight. 31
Division of Responsibilities We recommend that SROs regulatory responsibilities cover 3 main areas: MARKET REGULATION FI / MEMBER REGULATION ENFORCEMENT Set overall market integrity rules for all markets Market surveillance and examinations for compliance with SFC regulations, SRO rules, and each market s trading rules Set SRO Membership Rules and approve members Dealings with customers (sales compliance) Business conduct rules for securities activities (eg. compliance policies and procedures, supervision) Compliance examinations of members Registration of professional staff Investigations of potential breaches of SRO rules and each market s trading rules Disciplinary action for violations 32
Division of Responsibilities - Rulemaking SFC SRO(s) BVC / Marketplaces MARKET REGULATION Set regulations based on laws on insider trading and market fraud Set overall market integrity rules applicable for all markets (may include specific rules for debt, equity, commodity segments) Set operational and conduct rules for specific markets Set Listings standards and rules FI / MEMBER REGULATION Set overall standards for licensing FIs Set prudential rules / capital requirements Set overall business conduct rules (corporate governance, risk management etc.) Set membership rules and requirements Set business conduct rules for securities activities Set rules on dealings with customers in securities Set additional membership requirements for BVC participants REGISTRATION Set registration requirements and qualifications for individuals employed by FIs Administer procedures for registration and oversee certification Set requirements for traders using BVC markets 33
Self-Regulation in Colombian Securities Markets SFC Oversight of SROs
Purpose of SRO Oversight The purpose of SRO oversight is to ensure that the SRO meets its responsibilities, not to substitute the regulator s judgment for the SRO s or to review all of the SRO s decisions. Specific purposes include: Ensure that the SRO has appropriate corporate governance policies and procedures. Ensure that the SRO s rules cover its regulation responsibilities, and are fair and balanced. Assess whether the SRO s regulation responsibilities have been met (including that its systems and processes meet appropriate standards). Assess whether the SRO has adequate resources. Ensure conflicts of interest are identified and addressed. Identify any shortcomings or needs that require a response from the SRO. 35
Overview of SFC SRO Relationship SFC Approves rules Reviews CG standards Review reports for issues and risks Ensures SRO meets its responsibilities Inspection of SRO Oversight of SRO Drafts rules SRO Adopts corporate governance Files surveillance and inspection reports Administers & enforces SRO rules Prepares self-assessment of its regulatory operations 36
Self-Regulation in Colombian Securities Markets Implementation Plan
Implementation Plan 1 Plan for SRO launch SFC establishes conditions for approval of SRO and application process Agree on SRO Corporate Governance structure Agree on scope of SRO responsibilities Obtain financing for start-up costs Draft proposed organization structure Define required resources, tools and infrastructure Draft proposed corporate plan, budget and fee model SFC and SRO establish oversight program Prepare draft MOUs between SRO and SFC, BVC etc. Review existing BVC rules and draft proposed interim SRO Rulebook (and new BVC Rules) Corporate identity plan Draft communications and education plan for media, investors, members and authorities Propose staff training program 38
Implementation Plan 2 Launch SRO Establish SRO as legal entity Form interim Board of Directors and appoint President Obtain formal SFC approval of SRO Define SRO responsibilities in detail Adopt interim SRO Rulebook and obtain SFC approval of interim rules Approve organization structure, corporate plan and budget Apply interim membership policy and finalize membership list Implement communications and education plan Transfer BVC Supervision staff and infrastructure Begin recruitment of new staff Install systems and infrastructure Implement staff training program 39
Implementation Plan 3 Implement interim Regulation programs Adapt existing market and member regulation programs to SRO s new responsibilities SRO begins market regulation of all markets and members Integrate MEC and SEN market surveillance programs Acquire new market surveillance system SRO begins member regulation of all members based on existing SFC and BVCS supervision programs Develop policies and procedures for programs 40
Implementation Plan 4 Develop new Regulation Programs Start SRO Rulebook project (in consultation with members and SFC) New uniform market integrity rules New member business conduct and dealings with customers rules Establish revised market regulation program for 1) debt markets; 2) equities markets, based on new rules for all markets and member FIs Establish new member regulation program based on new rules for all member FIs Sequence introduction of new rules and programs by priority / risk level Update policies and procedures based on new rules and programs Create communication, education and training programs for members based on new rules and programs 41
SRO Board of Directors Recommend a small board with majority of independent directors President should be ex-officio director Board s Nominating Committee to nominate candidates for independent directors Members nominate candidates for member directors All directors must be elected by members SFC should approve nominated directors based on a fit and proper test Independent directors Member directors President of SRO 42
Corporate Governance Principles All directors should have the same broad duties: to act in the best interests of Colombian investors and capital markets Member directors should broadly represent members and provide industry expertise Independent directors should broadly represent other stakeholders in capital markets (investors, issuers and the public) Directors should not represent specific groups (for example brokers, banks or investors) SFC and Government should not be represented Responsibilities should be based on corporate principles: Board is responsible for strategy, planning, budget and policies Management is responsible for managing programs, operations and specific files and cases 43
Governance: Committees Board Committees should include: Finance & Audit Committee Corporate Governance and Nominating Committee Regulation Oversight Committee Human Resources Committee Member Committees Member input on rules and policies is vital to self-regulation Proposed member committees: Debt Markets Committee (MEC, SEN, OTC) Equity Markets Committee Member Regulation Committee Committees are advisory to management and Board 44
Disciplinary Hearings Panel Create new Disciplinary Hearings Panel Appointed by Board of Directors Key principles for selection of members: Credibility in the financial industry High level of integrity Industry members: Securities markets experience and knowledge Independent members: Financial markets knowledge and legal expertise Composition of Disciplinary Hearings Panel: New Panel will need more members due to much larger SRO structure and responsibilities Members must reflect all FIs that are members of SRO and the scope of its responsibilities Hearing panels should have 3 members: 2 industry members and 1 independent member 45
Funding and Resources 1. Estimate start-up costs for new SRO Need temporary financing until members start paying fees Potential sources include loans from government, BVC and FIs that will become members of SRO 2. Assess funding needs for operations Calculate staffing and infrastructure requirements for each department and regulation program Resources will start fairly small and increase fairly rapidly in years 1 3 as reflected by implementation plan above Estimate annual budget, including operations and capital investments 3. Determine revenue sources and fee structure Set small fixed annual membership fee to cover basic costs per member Small transactions tax spreads costs based on firms volume of activity BVC, SEN and other markets to pay for services provided on contract to markets (e.g. administration of compliance with exchanges rules) 46
Self-Regulation in Colombian Securities Markets Thank you! QUESTIONS?