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Remarks by David Wilson
Chair, Ontario Securities Commission
"Addressing the Regulatory Challenges Facing Global Market Intermediaries"
IOSCO Technical Committee Conference
Standing Committee 3 Panel
London, England
November 16, 2006
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Thank you for the introduction.
I'm very pleased to introduce this discussion about IOSCO Standing Committee 3 on Market Intermediaries.
The Ontario Securities Commission is committed to playing an active role in other initiatives undertaken by international regulatory associations such as IOSCO.
Regulatory harmonization is an important part of the steady integration of our capital markets, which are fast becoming one global marketplace.
To echo what chairman Cox of the SEC said earlier today - the speed at which markets are coming together is unprecedented.
In his book "The World is Flat", Thomas Friedman said: "The world is being flattened.
I didn't start it and you can't stop it, except at great cost to human development and your own future.
But we can manage it, for better or for worse."
Regulators and intermediaries are seeing the capital markets flatten before their very eyes. And we're trying hard to manage the flattening of markets - for the benefit of investors and market participants. IOSCO is responding by fostering cooperation among regulators and by providing best-practices guidance to market participants.
In this environment, securities regulators must address a wide range of challenges.
Today, we're going to discuss challenges involving market intermediaries.
I have divided my remarks about the work of Standing Committee 3 into two sections.
First, I'll touch on some of the challenges created by the "flattening" of the capital markets.
Specifically, I'll mention cross-border activities related to outsourcing and compliance.
Second, I want to spend time talking about the management of conflicts by intermediaries - in particular, using information barriers.
1. Standing Committee 3
As many of you know, Standing Committee 3 focuses on the regulation of market intermediaries. SC3's work affects member jurisdictions that, collectively, intermediated transactions in debt and equity securities totalling a stunning $64 trillion U.S. in 2005. That's almost twice the total GDP for that year of the entire OECD.
Today, I want to discuss the Committee's work on challenges relating to the "flattening" of the global marketplace.
2. The World is Flat
Thomas Friedman says we've entered "Globalization 3.0" - the third great era of globalization.
The first era was from 1492 to 1800 when Europe expanded its influence throughout the world. The second era - 1800 to the year 2000 - was marked by the rise of multinational corporations.
In the current era, information and communications technologies are driving rapid and profound changes in the way the world economy functions. One of those changes is outsourcing of core functions.
Outsourcing
The trend toward outsourcing business processes is growing very rapidly.
In fact, Friedman says outsourcing is one of the 10 primary forces that have flattened the world.
A recent study predicted export revenues from India's outsourcing industry will grow from $5.2 billion U.S. in 2005 to about $25 billion U.S. in 2010, a five-fold increase.
More and more types of work are being outsourced to third-party service providers outside the home base. Financial intermediaries are contributing to the trend because they too are outsourcing more activities.
Outsourcing can help improve efficiencies and lower costs.
But what are the risks to intermediaries, investors and regulators?
For example, an intermediary's control over an activity may be diluted when it's outsourced.
A core principle is that regulators must require the intermediary to remain responsible for the outsourced function, as if it was being performed in-house.
After consultations last year, IOSCO published the paper Principles on Outsourcing of Financial Services for Market Intermediaries. These principles provide a framework to guide intermediaries in their outsourcing practises. They can help promote effective controls, business continuity, supervisory access and investor protection.
One principle in the framework applies to functions that are outsourced on a cross-border basis.
Outsourcing to offshore service providers can raise additional issues that should be addressed. For example, a rigorous due diligence process should be conducted when selecting an offshore service provider.
In a global marketplace, the core principle is that the intermediary must retain legal liability and accountability to the regulator for all outsourced functions.
Compliance
This responsibility of the intermediary also extends to the outsourcing of the function of complying with appropriate laws, rules and regulations.
Which brings me to my next theme under the 'World is Flat' heading - Compliance.
As the complexity of the marketplace increases, intermediaries know that it has become more challenging to meet their compliance responsibilities. IOSCO recognizes that providing guidance to intermediaries about enhancing the effectiveness of their compliance function would be helpful in a flattening world.
After consultation, earlier this year, IOSCO published the paper Compliance Function at Market Intermediaries. Similar to the outsourcing paper, the compliance report sets out principles meant to be flexible enough to adapt to the nature, scale and complexity of an intermediary's often global operations.
In keeping with my "world is flat" theme, one of the principles relates to the challenges of having an effective global compliance function in those firms providing services across borders.
The Know-Your-Client requirement, or KYC, is an increasingly important part of the compliance function.
Intermediaries may hire offshore companies to do background checks on clients, often a vital aspect of the KYC function.
In general, the IOSCO paper says where intermediaries operate across borders, the compliance function must assure adherence with the applicable laws in each jurisdiction. If the function is split between personnel in two or more jurisdictions, then a clear delineation of responsibilities is necessary.
One positive by-product of the emergence of flat markets is the improvement of the compliance function across jurisdictions within a single, global intermediary. We've witnessed intermediaries taking the higher compliance standard from one jurisdiction and applying it in other jurisdictions in order to establish a single consistent level inside the firm.
Indeed, the IOSCO paper notes that, for the sake of simplicity and to reduce risk, intermediaries often adopt the more stringent standard for all cross-border compliance arrangements. We often hear the practice of regulatory arbitrage described as a "race to the bottom", well, the trend that I've just described could be easily described as a "race to the top."
Today, intermediaries have the capability to perform outsourcing and compliance activities on a "flat-world platform."
For its part, SC3 is trying to establish standards and frameworks to assist intermediaries who operate within the "flat world."
3. Information Barriers
The second segment of my remarks this afternoon concerns managing information barriers to deal with conflicts of interest within an intermediary.
Intermediaries generally need to carefully manage the flow of information, and potential conflicts arising from that flow, among several distinct internal functions.
Each of these activities may deal with different products such as equities, debt and derivatives:
For example:
- Working with clients on capital-raising transactions;
- Providing advice to clients about takeovers and similar transactions;
- Structuring and executing trades in securities for investing clients; and
- Buying and selling securities to generate income for the “house.”
One mechanism that's frequently used is the "information barrier", a term once referred to as a Chinese wall.
As a former investment banker, I learned the crucial importance of robust information barriers, especially given the usual presence of economic incentives inside a firm to maximize profits for the whole organization.
In this final segment, I'll reference the work being done by SC3 about managing information flows, however, some of my remarks represent my own views on this issue.
Conflicts are common in the activities of intermediaries because of the multiple roles that they play. In short, the economic interests of an intermediary may be inconsistent with, or diverge from, those of its clients.
There may also be a conflict between the interests of one group of clients and those of other clients.
Conflicts may be actual, apparent or potential.
IOSCO has high-level requirements about dealing with conflicts, so why are we looking at this?
It's because there's no specific principle about managing conflicts within intermediaries when conducting securities offerings.
As with outsourcing and compliance, IOSCO wants to be proactive by identifying high-priority challenges and formulating effective, workable principles.
Indeed, in 2005, the Technical Committee recommended a review of the issue of conflicts arising from information flows within an intermediary.
This prompted the recent drafting of a working paper by SC3 to deal with some of those issues.
Why is it important to address these conflicts?
As noted in the draft paper, addressing conflicts helps promote consumer protection and maintain market integrity.
Without adequate arrangements, an intermediary whose interests conflict with those of a client could be tempted to take advantage of that client in a way that would harm the client and thereby the integrity of the entire marketplace.
How can intermediaries address these sorts of conflicts?
Prudent, well-managed intermediaries take steps to address the conflicts that they are exposed to in their day-to-day operations. What constitutes adequate arrangements to address conflicts will depend on the nature, scale and complexity of the intermediary's business.
For instance, The Economist magazine has reported that Goldman Sachs puts more of its capital at risk now that it is more dependent on proprietary position-taking to generate profits.
The Economist said this strategy means that: "Today's business focus increases the importance of managing conflicts of interest with its customers to unprecedented levels."
But questions arise about the effectiveness of information barriers:
- Do information barriers work in a global marketplace?
- How do you monitor their effectiveness?
- When is it appropriate for the information barrier to be crossed?
Earlier this year, the Australian Securities and Investments Commission filed civil penalty proceedings alleging that Citigroup's Australian arm breached, among other things, new rules requiring investment banks to manage conflicts of interest.
The case centres around proprietary trading - an important component of contemporary investment banking.
Citigroup, like many investment banks, has separate capital raising, advisory, client trading and proprietary trading functions. Citigroup's proprietary trading desk purchased a significant number of shares in a cargo handling business.
At the same time, another division of Citigroup was advising a logistics company about its impending multi-billion-dollar takeover offer for that same cargo handler.
ASIC alleges a conflict arose because, as a proprietary purchaser of the cargo handler's shares, Citigroup wanted the share price to go up - but as an adviser to the logistics company, it had an interest in the share price remaining stable - so that the takeover target wasn't too expensive for its M&A client.
The central issue is about having arrangements in place to effectively manage conflicts related to information flows within an intermediary.
This is precisely what the SC3 working paper deals with.
The paper focuses on a number of conflict scenarios where it might be appropriate to cross the information barrier within an intermediary firm.
The traditional thinking on information barriers has been that the wall must never be breached - it was impenetrable.
However, a shift in thinking is underway.
When is it appropriate to cross an information barrier?
Who decides?
Who's qualified to decide?
SC3 is developing guidance on just when, and how, an information barrier should be consciously crossed to protect investors and the integrity of the markets.
IOSCO feels it's important to have guidelines within a firm about when it is appropriate to cross an information barrier.
This does need to be clarified.
SC3 is looking forward to working with market participants and the public to develop guidance on principles for using information barriers to manage conflicts between issuers, dealers and investors.
So I urge you to submit comments on the SC3 paper when it's published for comment, likely in February 2007.
4. Key Issues Going Forward
At this point, I'll wrap up by looking at what's on the horizon for SC3.
One part of the Committee's role is to identify trends and issues that deserve the attention of regulators and the industry.
Here are two such issues:
Number 1: Investor suitability for complex products; and
Number 2: Best execution.
With respect to investor suitability for complex products, intermediaries need to be more aware of both their Know-Your-Client (KYC) and their Know-Your-Product (KYP) obligations.
As for best execution, it's been debated by regulators, market participants and investors around the world.
In this context, SC3 has identified issues such as:
- elements of best execution;
- measuring best execution, and
- who has responsibility for best execution?
In conclusion, I've talked about certain challenges in outsourcing and compliance in a world of the 'flattening' of the capital markets, and about managing conflicts using information barriers.
I've also touched on current issues that SC3 is considering.
All of us must adapt to the rapid changes that are shaping today's capital markets.
We must bring innovation and collaboration to this effort so that we continue to provide protection to investors and foster market integrity.
IOSCO is committed to developing regulatory approaches that support these two core goals.
Thank you.
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