ANALYSIS ON SELF-REGULATORY ORGANIZATIONS IN THE AMERICAS

ANALYSIS ON SELF-REGULATORY ORGANIZATIONS IN THE AMERICAS IOSCO International Organization of Securities Commissions Inter American Regional Council COSRA Council of Securities Regulators of the Americas MAY 2010 1

CONTENTS 1 BACKGROUND... 5 2 INTRODUCTION... 7 3 ACTIVITIES OF SELF-REGULATORY ORGANIZATIONS IN THE AMERICAS... 10 3.1 Analysis of compliance with the IOSCO principles on Self-regulation... 10 3.1.1 Methodology... 10 3.1.2 What IOSCO says about the role of the SROs... 10 3.1.3 IOSCO Principles on Self-Regulation... 11 3.1.4 IOSCO criteria for the authorization and supervision of a SRO... 11 3.1.5 Results... 13 3.2 Analysis of activism based on the COSRA survey... 15 3.2.1 Target... 15 3.2.2 Methodology... 15 3.2.3 Reliance on SROs for the development of regulation, market oversight and enforcement... 16 3.2.4 Models of self-regulation in the Americas and reliance by statutory regulators on the self-regulatory organizations in the rulemaking, supervision and enforcement functions... 19 3.2.5 Sanctions imposed by the self-regulatory organizations... 22 3.3 Relevant findings regarding the activism of self-regulators... 23 4.1 Introduction... 24 4.2 Roles of the Exchanges... 24 4.3 Conflicts of Interest... 25 4.3.1. Fees and Competition... 26 4.3.2. Regulation Charge... 29 4.3.3. Innovation... 30 4.4 International Panorama... 31 4.4.1. United States of America... 31 4.4.2. Brazil... 34 4.4.3. Colombia... 35 4.4.4. Corporate Governance... 36 5. DUPLICATION OF EFFORTS BETWEEN SELF-REGULATORY ORGANIZATIONS AND STATUTORY AUTHORITIES... 37 5.1. Objective and scope of the study... 37 5.2. General Role of Regulatory Authorities... 37 5.2.1. Role of Statutory Regulators... 38 2

5.2.2. Role of SROs... 38 5.3. Relationship between self-regulatory organizations and statutory regulators... 39 5.3.1. Supervision of SROs... 39 5.3.2. Corporate Governance... 39 5.3.3. Approval of Regulations... 40 5.4. Coordination of functions... 40 5.4.1. Costs of Regulation... 40 5.4.2. Compliance Costs... 41 5.4.3. Legal Risk... 41 5.4.4. Gaps in Supervision... 42 5.5. International Panorama... 42 5.5.1. United States... 42 5.5.2. Canada... 45 5.5.3. Colombia... 51 5.5.4. Brazil... 52 5.6. Coordination Mechanisms... 53 5.6.1. Memorandum of Understanding (MoU)... 54 5.7. Reflections on the duplication of efforts between State regulators and self-regulators.... 55 6. Conclusions... 57 7. Annex 1: reference publications about self-regulation between 2007-2009... 60 8. Annex 2: Other survey results... 61 8.1. Survey Methodology... 61 8.2. Criteria used for categorization of the respondents... 62 8.2.1. Market Capitalization... 62 8.2.2. Self-regulation Model... 62 8.3. Results... 62 8.3.1. Self-regulation Concept... 62 8.3.2. Date of constitution of self-regulators by COSRA country member... 64 8.3.3. Activities performed by SROs... 64 8.3.4. Types of sanctions that can be imposed by SROs... 65 8.3.5. Markets/products that are self regulated... 66 8.3.6. Participation by industry in the regulatory process... 66 8.3.7. Self-regulation activities subject to supervision... 67 8.3.8. Members of the SROs... 68 3

8.3.9. Major concerns regarding SROs... 68 8.3.10. Possibility of voluntary withdrawal of the self-regulated, existence of codes of good governance and adequate financing of the self-regulators... 70 9. BIBLIOGRAPHY... 71 4

1 BACKGROUND The Members of COSRA/IARC expressed their interest in analyzing the following issues: (i) the absence of uniformity in the models and functioning of self-regulation in the Americas; (ii) the mechanisms for coordination of supervisory activities between government regulators and selfregulatory organizations (SROs); (iii) the application of the IOSCO principles on self-regulation; and (iv) the role of SROs in the ongoing financial crisis. To analyze these issues, COSRA/IARC established a Task Force, 1 led by AMV (acronym in Spanish for the Securities Self-Regulatory Organization of Colombia) and comprised of representatives from all COSRA Members that expressed interested in being involved, at its meeting in Santiago de Chile in October 2008. During the First Meeting of Self-Regulators of the Americas, organized by AMV, in Bogota, November 13-14, 2008, an informal meeting of the Task Force was held to review and discuss a draft proposal of the group s mandate to be submitted to COSRA s members for their consideration. The goal of the mandate was to assist COSRA members in analyzing the self-regulatory experiences in the various jurisdictions and to identify and provide approaches for dealing with common issues faced with respect to self-regulation. The analysis takes into consideration the structure and size of the markets, the historical development of self-regulation in the jurisdictions and their ongoing needs. It is developed within the framework of the IOSCO principles and in the context of the ongoing discussions on new regulatory trends. The project mandate consisted of the following three phases: 1. Report on the status of self-regulation in COSRA jurisdictions. 2. Report on common issues stated by the member countries on the effectiveness of selfregulation in practical terms. 3. Report on approaches for dealing with common concerns on self-regulation within the framework of the IOSCO principles. In carrying out the first phase, the Task Force designed a survey aimed at identifying the characteristics of self-regulation in each jurisdiction, the self-regulation model adopted, as well as any changes to this model under consideration for the future. The survey, developed by the Task Force, was sent to the statutory regulators in all COSRA/IARC countries with the understanding that the individual responses would remain confidential. The statutory regulators in 23 jurisdictions in the Americas 2 submitted responses to the survey. The results of this first phase of the project were submitted and discussed during COSRA's annual meeting at Panama City on April 2009. 1 The Task Force included the following entities and jurisdictions: Autorité des Marchés Financiers, Quebec Canada; Autorregulador del Mercado de Valores de Colombia AMV, Colombia; Comisión Nacional del Mercado de Valores, Spain; Comissão de Valores Mobiliarios - CVM, Associação Brasileira das Entidades dos Mercados Financeiro e de Capitais ANBIMA, CETIP - Balcão Organizado de Ativos e Derivativos, BM&FBOVESPA Supervisão de Mercados BSM, Brazil; Financial Industry Regulatory Authority - FINRA, United States of America; Guyana Securities Council, Guyana; Investment Industry Regulatory Organization of Canada IIROC, Canada; World Bank; Superintendencia Financiera de Colombia, Colombia; Superintendencia de Valores y Seguros, Chile; Banco Central del Uruguay, Uruguay. 2 The jurisdictions that responded to the survey include: Uruguay, Bermuda, Mexico, Honduras, Argentina, Panama, Paraguay, Guyana, Canada, Brazil, Nicaragua, Ecuador, Bolivia, El Salvador, Dominican Republic, Chile, Colombia, Costa Rica, Barbados, Trinidad & Tobago, United States, Peru, Bahamas. 5

At the Panama meeting, the COSRA/IARC members asked the Task Force to further examine issues that represent challenges and opportunities for self-regulation as well as any other issues related to self-regulation that were of interest to the members. Therefore, the mandate for the second phase was defined as carrying out a more detailed analysis of specific self-regulatory issues and how these are being addressed in the region. The issues agreed upon as the areas of focus for the second phase of the mandate were: the degree of activism of SROs in the Americas; the conflicts of interest in securities exchanges between the operation and/or ownership of markets and self-regulation; the potential duplication of functions between self-regulatory organizations and regulators; and compliance in the region with IOSCO principles 6 and 7 that relate to self regulation. These four issues were distributed among the members of the Task Force for further analysis and the results of the second phase of the mandate were presented at the COSRA/IARC meeting held at Punta del Este, Uruguay, on November 16, 2009. At this meeting, the COSRA/IARC members agreed that the study should continue further. Specifically, it was agreed that the study should outline general trends observed and the diverse ways in which self-regulation contributes to the fulfillment of IOSCO s regulatory objectives. The final draft of the paper was presented at the COSRA meeting in Washington DC on April 8, 2010. This document contains the results of the study and the main discussions of each phase. 6

2 INTRODUCTION There has been an ongoing discussion regarding the benefits and limitations of self-regulation in securities markets. This document identifies key elements of self-regulation and analyzes some of the main concerns raised regarding self regulation, while highlighting practices and common trends observed in the region. All COSRA/IARC members participating in the survey developed as part of the first phase of the mandate, said that self-regulation exists in their jurisdictions. The survey also reflected heterogeneity among existing self-regulation structures. Therefore, it can be said that self-regulation among the jurisdictions has been structured in diverse ways and the use of SROs varies according to the size and complexity of the markets. The aim of this paper is to analyze experiences drawn from COSRA/IARC members with respect to self regulation, focusing on issues such as the degree of activism of SROs in the Americas, the level of compliance in the jurisdictions with the IOSCO principles related to self regulation, the management by securities markets of conflicts of interests between owning/operating markets, and the mechanisms used to coordinate activities among regulators to avoid duplication. This study does not recommend a particular model of self-regulation nor does it aim to promote selfregulation as a solution for every market. On the contrary, the findings are clear: there is no single or correct approach to self regulation. Nevertheless, the identification of trends can be a useful tool when reviewing the current model of self-regulation that is operating in each country, while taking into consideration the development and characteristics of the domestic capital market. Self-regulation can be a valuable addition to the regulatory framework, as both regulators and SROs are linked with a common purpose of protecting the integrity of the market and the interests of investors, as reflected by Principles 6 and 7 of the IOSCO Objectives and Principles of Securities Regulation 3. In fact, SROs are closer to market participants providing specialized knowledge as input into the regulatory framework and can generally respond more quickly and flexibly to changing market conditions than the statutory regulator. The supplementary functions that SROs perform in some cases can even help in the consolidation of supervision over different jurisdictions, products, markets and types of intermediaries, thus avoiding regulatory gaps. The present study intends to reflect issues identified in the survey while acknowledging the variety of self-regulatory models in the Americas. The diversity among the models of self-regulation found in the region can be attributed to differences in culture, history, legal systems, market size, and legal restrictions, among other factors. For example, the existence of both civil law and common law systems in the region may represent a challenge to a greater reliance on SROs in some countries. We also found that overreliance on SROs could be problematic. Therefore, one can conclude that there is no single approach towards self-regulation that is appropriate for all markets. 3 When drafting this document IOSCO was reviewing the principles for SROs. Principles 6 and 7 were modified and merged into principle 9. The members of the working group consider that the present study can be a useful input for the ongoing discussion about the application of principle 9. 7

Although there is a wide range of self-regulatory structures and the extent to which the statutory regulator relies on SROs varies considerably in the region, there are several common themes that we can highlight. Since the SROs and the statutory regulators are separate in terms of resources and management, there is a need for coordination and cooperation between these two entities to avoid duplication. The legal framework is generally clear regarding the powers conferred on SROs. Nevertheless, in some cases, the division of responsibilities between regulators and SROs can be ambiguous and the means for practical cooperation between them can be enhanced. Some regulators and SROs sign Memoranda of Understanding (MoUs) that define in some detail the separation of activities and responsibilities. Statutory regulators generally supervise SRO activities and review their corporate governance practices. They also typically approve SRO rules. The enhancement of the oversight of SROs constitutes a general trend in jurisdictions that historically have relied on SROs, allowing the regulators to ensure that the SROs have sufficient powers, resources and independence to bring action against market participants for misconduct and breach of standards. Also there is a need to manage conflicts of interest. A general trend in this area is to separate market operation from the SRO activities. This trend has been more pronounced as exchanges demutualize. Some countries that have a long history of self-regulation have begun implementing an independent SRO model. Also, some countries have managed conflicts of interest between market operations and SRO functions through other corporate governance practices, which provide for reasonable independence of each activity. As a result there is no unique approach to corporate governance practices related to SRO activities. Corporate governance is a recurrent theme in this document, as appropriate standards for corporate governance is a critical factor for the effectiveness of self regulation. Nevertheless, best practices in corporate governance were not included in the survey and therefore are not included in this report. Although some trends and general practices in SRO corporate governance in the Americas can be inferred from this document, effective corporate governance for SROs could serve as a subject for further work by COSRA. The paper is divided into 6 chapters being the background and this introduction the first two chapters. The first topic, which is addressed in Chapter 3, is the degree of activism of self-regulatory bodies in the various jurisdictions in the Americas. Such activism has been considered an important indicator of the maturity and impact of self-regulation schemes. The analysis of activism is carried out in two ways. First, we analyze the results obtained in the assessment carried out in some countries to determine compliance with the IOSCO principles. Specifically, the results from the Financial Sector Assessment Program (FSAP) related to the fulfillment of IOSCO principles 6 and 7 are studied in some detail 4. Second, using the survey results from the first stage of the project, we study in greater depth the degree of reliance on self-regulatory organizations. 4 Principles 6 and 7 were valid when the study took place. 8

Chapter 4 analyses the conflicts of interest present in exchanges that perform self-regulatory activities. Specifically, it examines the different roles performed by the exchanges according to the type of organization (mutual institutions or demutualized), as well as corporate governance practices used to manage the conflicts of interest. The evolution of the Exchange SRO model in the United States, Brazil and Colombia is used to illustrate some of the trends in the management of conflicts of interest observed in markets that vary in terms of their size, history, legal background and complexity. Another important challenge for SROs identified in the survey, and one which COSRA s members asked the Task Force to address, are the problems associated with the potential duplication of activities among statutory regulators and the SROs. This challenge is addressed in Chapter 5, which includes mechanisms that have been established in different jurisdictions to prevent duplication of efforts. This issue is relevant given the costs associated with duplicative procedures, as well as the risks that may result from regulatory gaps. The US, Canada, Brazil and Colombia experiences are described as examples of trends regarding the relationship between statutory regulators and SROs. Finally, the conclusions are listed in Chapter 6. There are two annexes. The first annex contains a list of recent publications about self-regulation and the second annex includes results from the Survey completed during the first phase of the mandate. 9

3 ACTIVITIES OF SELF-REGULATORY ORGANIZATIONS IN THE AMERICAS 3.1 Analysis of compliance with the IOSCO principles on Self-regulation 3.1.1 Methodology The sources used for this analysis have been various assessments of compliance of jurisdictions in the region with the IOSCO principles. This includes the FSAPs that the IMF and/or the World Bank have conducted in the region as well as the assessments made within the framework of the IOSCO Assessment program. Both types of assessments use the IOSCO assessment methodology, which facilitates comparison. In total, results of the assessments conducted in 12 jurisdictions from 2002 to 2007 were reviewed. We were not able to include all of the countries in the Americas, since all jurisdictions have not participated in an FSAP or IOSCO assessment. It is also important to note that there are significant differences in the level of detail and depth in the assessment reports. In any case, the number of countries reviewed is sufficient to identify general issues and trends in the region. The identity of the 12 jurisdictions has been kept confidential. Although those evaluated under an FSAP are public, those that have been assessed by IOSCO retain the privilege of not publicizing the results of the assessment. Please note that when analyzing the results it is important to take into account the different systems of law in the assessed jurisdictions. The legal systems in some of the jurisdictions have roots in common law and others in roman law, which are quite different. These differences will be reflected in the conclusions, without implying that either one of these legal systems is better than the other. Geographically speaking, two of the assessed jurisdictions are in North America, one is in the English-speaking Caribbean, and the rest are in Latin America. In terms of market-size, two jurisdictions could be categorized as large markets, five as mid-size markets, and five as small markets. Given that all the jurisdictions are not represented, the conclusions regarding the assessments of compliance with the IOSCO principles are more qualitative than quantitative. 3.1.2 What IOSCO says about the role of the SROs According to the IOSCO Principles of Securities Regulation, Self-regulatory Organizations (SRO) can be a valuable complement to the statutory regulator in achieving regulatory objectives and can play a significant role in rulemaking, supervision and enforcement. Although there are several models of self-regulation in the region and the extent to which selfregulation is relied upon by regulators varies from market to market, in most jurisdictions the common features of SROs are: they are separate from the statutory regulator, they have regulatory and supervisory jurisdiction over their members; and companies, other sectors and, where appropriate, investors participate in the organization of the SRO. 10

In its broadest form, an SRO has the authority to create, extend, implement, and enforce conduct rules, market rules, capital rules, "fit and proper" rules, etc. In addition, SROs can have the ability to punish those that break these rules. 3.1.3 IOSCO Principles on Self-Regulation 5 Principle 6 The regulatory regime should make appropriate use of Self-Regulatory Organizations (SROs) that exercise some direct oversight responsibility for their respective areas of competence, to the extent appropriate to the size and complexity of the markets. Principle 7 SROs should be subject to the oversight of the regulator and should observe standards of fairness and confidentiality when exercising powers and delegated responsibilities. IOSCO Principles recognize the important role that a well regulated self-regulatory organization can play and establish general recommendations for their proper approval and inspection. They also concede that self-regulation can offer substantial benefits, such as the following: 1) Compliance with ethical standards that go beyond the governmental regulations 2) Knowledge and considerable experience regarding operational and market practices 3) Capacity to respond to changing market conditions faster and more flexibly than the statutory regulator In addition to Principles 6 and 7, IOSCO has issued various standards and recommendations for SROs that establish a number of guidelines, which are all flexible and adaptable to markets and their level of functioning. 3.1.4 IOSCO criteria for the authorization and supervision of a SRO Under the IOSCO methodology for assessing compliance with the IOSCO principles, principle 6 is a filter that determines first whether or not a regulatory regime includes an SRO. If the jurisdiction does not include an SRO, the evaluation process will not assess Principle 7, and Principles 6 & 7 will be rated as not applicable for the given jurisdiction. There are three key criteria that are part of the assessment of Principle 6. Criteria No. 1 5 PRinciples 6 and 7 were valid when the study took place. 11

The SRO issues eligibility rules that individuals or companies should satisfy in order to participate in any significant securities-related activity. Criteria No. 2 The SRO establishes and enforces binding rules, which govern the market or business conduct of the individuals or companies engaged in securities-related activities. Criteria No, 3 The SRO issues disciplinary rules or establishes procedures to impose fines or other penalties, or to prohibit or suspend the participation of a natural or legal person in securities-related activities. If the SROs meet any of these three criteria, then Principle 7 would be assessed. Principle 7 basically states that before approving the implementation of an SRO the statutory regulator should require that the SRO ensure the adoption of appropriate standards. In addition, once a SRO is operational, Principle 7 states that the regulator shall ensure that SRO processes result in the fair and consistent enforcement of applicable securities laws, regulations, and SRO rules. The effectiveness of a SRO can be compromised by conflicts of interest. The regulator should monitor the potential occurrence of such conflicts of interest. In particular, the regulator must ensure that conflicts of interest do not arise as a result of the SRO s access to valuable information on market participants (whether or not they are members of the SRO itself). The risk of conflicts of interest could be higher if the SRO is responsible both for supervising its members and for monitoring and regulating the market. As a condition for authorization, the legislation or the regulator must require that the SRO demonstrate that it: Has the ability to comply with applicable laws, regulations, as well its own standards, and compel compliance with such laws, regulations and standards for its members and associated persons; Treats all members of the SRO and all applicants for membership in a fair and consistent manner; Develops rules intended to set standards of conduct for members and to promote investor protection; Submits its standards for review and/or approval by the regulator, and ensures that its rules are consistent with public policies established by the regulator; Cooperates with the regulator and other SROs to investigate and enforce laws and regulations; Applies its own standards and imposes appropriate sanctions for violations; Ensures a fair representation of members in the selection of its directors and management of its affairs; 12

Avoids rules that can lead to non-competitive situations; and Avoids using their monitoring role to allow any market participant to obtain an unfair advantage in the market. Supervisory Requirements Regardless of the self-regulatory scope, the regulator must retain full control over the monitoring of any SRO. It must ensure that an SRO has sufficient powers to investigate or deal with a particular case of misconduct or conflict of interest and where that is not possible to investigate these matters directly. Therefore the regulator shall retain the powers to investigate matters that affect investors or the market. Oversight by the regulator should be ongoing and ensure that: SROs continuously comply with the conditions for authorization If the SRO is unable to perform timely investigations or to take adequate measures, or when there are allegations of misconduct or conflicts of interest, the regulator, and not the SRO, carries out the necessary investigations the SRO provides the regulator with the necessary information to identify at an early stage issues that require intervention by the regulator Professional Standards The legislation or the regulator should require that the SRO comply with standards of professional conduct similar to those demanded of the regulator, particularly in matters concerning: Confidentiality and procedural fairness The appropriate use of information obtained in the exercise of the powers and responsibilities of the SRO Conflict of interest requirements 3.1.5 Results The SRO must have established procedures in place to deal with the potential conflicts of interest. To summarize the results of the assessments, of the 12 jurisdictions only one fully implemented IOSCO principles 6 and 7. Two jurisdictions broadly implemented these principles. Three had significant deficiencies and were assessed as having partly implemented the principles. Three jurisdictions were assessed as not having implemented principles 6 and 7 and three were not assessed as there was no SRO in their markets. It should therefore be concluded that nine of the 12 SROs evaluated present significant weaknesses in the area of self regulation. These SROs do not have the sufficient capacity to meet standards of authorization and/or the power to carry out the functions of an SRO. 13

It is worth highlighting some particularly relevant assessment results: 1) In general the regulation is clear regarding the powers conferred on the self-regulatory entity in the securities market. Effectively, securities law and other regulations in most jurisdictions recognize the existence of SROs and the laws are well-defined in that respect. 2) However, when assessing the implementation of the law, it is necessary to point out that even though the laws are well-defined with regard to powers conferred on the SRO, this does not mean that these powers have been implemented and that the SRO operates in a manner consistent with IOSCO principles for self regulation. 3) In many jurisdictions there has been a failure to implement fully the SRO powers mandated by the law. For example, 50% of the analyzed jurisdictions do not meet the required criteria set forth in IOSCO Principle 6 regarding SROs issue of eligibility rules for their members. Moreover, a majority of markets assessed do not enforce binding rules for market and business conduct. Similarly, it is evident that a majority of the jurisdictions did not establish or forcefully apply disciplinary rules and procedures aimed at imposing sanctions for violations of the above rules. 4) Greater compliance with IOSCO principles for self-regulation is detected in Anglo-Saxon countries versus Latin American countries. The self-regulatory tradition is deeply rooted in the former. In Latin American countries, however, the powers and duties conferred on the statutory regulators must be strictly complied with and cannot be modified by any other entity. In a number of these countries, the regulator is the only national authority with the mandate to regulate and monitor securities markets and is not allowed to transfer the functions that it has been assigned. 5) The biggest and most widespread weakness is the absence of continuous supervision programs by the statutory regulator over the SROs and their members. This weakness can be explained by the false belief that, since the law confers self-regulatory powers on the SROs, the regulator must de facto delegate its monitoring powers. Moreover, it is evident that the lack of implementation of supervisory plans is also related to shortages of resources and technical expertise. 6) As a result of the absence of continuous supervision programs, there is insufficient infrastructure in the securities markets linked to the activity of supervision, as well as a lack of independence and transparency when it comes to the self-disciplinary function. 7) In many cases, supervisory procedures, systems and manuals have not been adopted to oversee the market operators (SROs) and the intermediaries and insufficient resources have been allocated for efficient supervision. 8) There is also some overlap or duplication in the responsibilities and powers between the selfregulatory organization and the regulator, that may result in inefficient monitoring. The lack of 14

definition of clear jurisdiction between the two organizations may also produce gaps in the monitoring of the market as a whole. 9) In a majority of regulatory models the distribution of responsibilities and powers between regulators and SROs is ambiguous. For example, there isn t a clear and transparent delineation of who is responsible for establishing the eligibility criteria for market intervention, applying conduct rules, and to investigating, monitoring, and punishing those market participants who do not comply with market and conduct rules. 10) In many cases, there is a lack of a policy of practical cooperation between the regulator and the SRO. 11) With respect to potential conflicts of interest, particularly as they relate to demutualized stock exchanges, it is necessary to modify the organizational structures in order to minimize the potential conflicts between shareholders and their search for benefits, on the one hand, and ensuring there are rules of the game in place that guarantee equal treatment and market efficiency, on the other hand. In most cases, the adoption of appropriate corporate governance structures to mitigate this conflict of interest has not been achieved. In some cases, it would be desirable to improve transparency in the decision-making processes of the securities exchanges, by making their rules and procedures public, as well as disseminating their actions and agreements. 3.2 Analysis of activism based on the COSRA survey 3.2.1 Target The survey found that 90% of the jurisdictions have SROs. However, in a first analysis of the survey there was no review of the level of self-regulatory activity in each jurisdiction. Therefore, COSRA/IARC members proposed that the Task Force further analyze, as part of the second phase of the mandate, the level of activity of the self-regulatory organizations in each jurisdiction. This chapter provides a detailed analysis of the survey results with respect to the level of self-regulatory activity. 3.2.2 Methodology The Task Force felt that the best way to address this topic was to further analyze the results of the survey performed in the first phase of the mandate. This analysis is divided into two components: (i) assessment by jurisdiction of the reliance on the selfregulatory organizations to comply with the regulatory objectives of IOSCO 6 ; and (ii) assessment of the sanctioning activities of the self-regulatory organizations. (i) Reliance on SROs 6 1) The protection of investors. 2) Ensuring markets are fair, efficient, and transparent, and 3) The reduction of systemic risk. IOSCO 15

For the first component, the Task Force assessed the level of reliance on SROs for the development of regulation, market oversight, and enforcement based on the results of the survey. First, the reliance of the jurisdiction on SROs to regulate, supervise and discipline the securities market activities and participants was assessed. This information was then cross referenced against two other criteria: the self-regulatory model in the jurisdiction and the overall size of the market. The following classifications were utilized for this analysis: LEVEL OF ACTIVISM Equal or greater than 4 (4 x 5) Greater than 3 and less than 4 (3<x<4) Less than or equal to 3 (0 x 3) Table 1 Level of Activism CLASSIFICATION Highly active Moderately active Low activity (ii) Sanctioning Activities For the second component, the level of sanctioning activities of SROs in the respective jurisdictions was assessed. Sanctioning activities are the result of a legal framework that permits the development of disciplinary processes to address non-compliance with rules and regulations. The issuance of sanctions also indicates that the SRO has sufficient tools to oversee the market, including the capacity to identify alerts that signal abuses affecting market transparency and to take action to investigate these alerts. The ability to identify misbehavior and to take disciplinary action indicates that the self-regulatory organization has the necessary resources and independence to carry out its functions. Similarly, disciplining market participants in a timely manner prevents these participants from affecting markets for prolonged periods of time, which translates into greater security for market participants. Therefore, the level of sanctions imposed constitutes an objective indicator of the true level of the activities of SROs in the jurisdiction. The aim of component two is to establish the level of activity of self-regulation through the number of sanctions imposed in each jurisdiction in relation to its market size. 3.2.3 Reliance on SROs for the development of regulation, market oversight and enforcement A positive relationship was found between the level of activity of the SRO in the market and the degree of reliance by the jurisdiction on SROs for the development of regulation, oversight, and enforcement. The greater the reliance by the statutory regulator on the self-regulatory body, the greater its level of activity in the market. When regulators observe more self-regulatory activity, they tend to rely more on SROs. Therefore, a virtuous circle is achieved, where increased levels of self-regulatory activity provides more assistance to the statutory regulator, which in turn begins to have a greater appreciation for the benefits of self regulation, and therefore starts to rely more on the SRO. Using the survey results, it is possible to quantify the level of reliance by the regulators on the SROs in the development of rules, supervision, and enforcement. It is important to note that the statutory regulators and not the SROs themselves were the respondents to the survey. Therefore from the 16

survey results, it was possible to confirm the regulator s perception of its level of reliance on the SRO, which is an important indicator of the actual level of activism of the SROs. The following table shows level of activism of the SRO by market size. Table 2. Reliance on the SROs by the regulators to carry out regulation, supervision, and market 7 discipline functions Surveyed 8 Regulation Supervision Enforcem ent Level of Activism 3 5 5 5 5 Large Market 9 10 5 4 3 4 20 5 5 5 5 Average 5 4.6 4.3 8 4 3 2 3 Medium-sized Market 10 13 1 4 3 2.6 15 4 4 4 4 16 4 NA NA 4 22 2 2 2 2 Average 3 3.2 2.7 1 3 3 3 3 Small Market 11 2 2 2 2 2 4 3 1 1 1.6 5 4 4 4 4 6 5 5 5 5 7 3 1 1 1.6 9 1 1 1 1 11 2 2 2 2 12 2 1 1 1.3 14 1 1 1 1 17 2 3 2 2.3 18 3 3 3 3 19 1 1 1 1 21 - - - - 7 The support provided is grouped between 1 and 5, 5 being a high degree of support and 1 a low degree of support. The level of activism corresponds to the simple average of the responses to the questions related to regulation, supervision and enforcement. 8 The first column (surveyed) assigns a number to each jurisdiction to preserve the confidential nature of the survey. 9 According to the methodology used for the analysis of the survey, Large Markets refer to those whose stock market capitalization is above 1.000.000 million US dollars (USD). 10 Medium -sized Markets are those with a stock market capitalization above 50.000 million US dollars (USD) but below or equal to 1.000.000 million US dollars (USD). 11 Small Markets are those with a stock market capitalization equal to or lower than 50.000 million US dollars (USD). 17

Surveyed 8 Regulation Supervision Enforcem ent Level of Activism 23 3 3 3 3 Average 2.3 2.0 2 We find that in large markets, regulators rely more on self-regulatory organizations for the abovementioned activities. Indeed, in these markets the range in the level of reliance by regulators is between 4 and 5. While reliance by regulators on self-regulatory organizations in medium-sized markets is low, one jurisdiction has a level of reliance of 4. The results are similar in small markets where the degree of reliance in the majority of jurisdictions is below 3, with the exception of two jurisdictions that rated the support from SROs for all activities listed above as a 4. Based on these results, there is a positive relationship between market size and degree of activism. The larger the market, the greater the reliance on self-regulatory bodies for the performance of regulatory functions. On the other hand, in small markets the regulators tend to receive less support from self-regulatory organizations. However, in a few jurisdictions with small markets there is a high degree of SRO activism. Therefore, countries with small markets are not necessarily destined to have a low level of SROs activity. Most jurisdictions have a low degree of activism. Only six countries out of the twenty three surveyed stated that reliance on self-regulatory organization is high. Since there are no jurisdictions with a medium degree of activism, it can be argued that moving from low SRO activity to a higher level of activity is not an easy task and may require structural adjustments. (Table 3). The obstacles to moving towards a greater reliance on self-regulation were not included in the topics surveyed. Nevertheless, a number of structural issues have been mentioned throughout the survey analysis and include costs (relative to the size of the market), corporate governance practices, the legal/regulatory framework, and cultural background, amongst others. For effective self regulation, having the buy-in of industry representatives for a move towards more active reliance on self regulation, is also necessary. The mechanisms that some jurisdictions have used to address these obstacles could be a matter for further study. Table 3. Level of SROs activism in the Americas Number Degree of Activism Classification Jurisdictions 6 Greater than or equal to 4 (4 x) Highly active 0 Greater than 3 and less than 4 (3<x<4) Moderately active 15 Less than or equal to 3 (0 x 3) Low activity 2 No answer It is also interesting to note that in jurisdictions where there is a high level of SRO activism, the ratings were high with respect to all SRO functions. Conversely, in jurisdictions where the degree of activism is low, the ratings are low for all functions: rulemaking, supervision and enforcement. This indicates that the level of activism of the self-regulatory organization cannot be understood by 18

analyzing each self-regulatory function as an independent activity. Rather, these activities must be analyzed as related and interdependent activities. 3.2.4 Models of self-regulation in the Americas and reliance by statutory regulators on the selfregulatory organizations in the rulemaking, supervision and enforcement functions Although a wide range of self-regulatory structures exist in the Americas, the most prevalent are the following 12 : (i) (ii) (iii) (iv) (v) Governmental model: A government entity performs most regulatory functions and exchanges perform very limited or no market supervision. Limited exchange SRO model: Exchange performs front-line regulation of their markets. Strong exchange SRO model: Exchange performs extensive market and member regulation functions Independent SRO model: The SRO is exclusively a regulator, performs extensive regulatory functions and is not a market operator Voluntary SRO model: The SRO is a non-governmental organization which has jurisdiction over its members via contract and not due to any law or regulation The study examined whether there was a correlation between the model of self-regulation found in each jurisdiction and the level of SRO activity. To this end, the rating given to the self-regulatory organization for each activity (regulation, supervision, and enforcement) was cross referenced with type of self-regulatory model. Given that a jurisdiction many have two types of self-regulatory organization, it may appear more than once in this exercise. It is possible, through this methodology, to analyze the impact of the adoption of a specific self-regulatory model on the level of activism of the self-regulator. Results are available in Table 4. 12 Models taken from the Presentation of John Carson in the First Congress of Self-Regulation of the Americas held in Bogotá, Colombia between November 13-14, 2008. 19

Table 4 Reliance on the SRO to pursue the functions of regulation, supervision and enforcement by SRO model Regulation Supervision Enforcement Degree of Activism Range Governmental Model AVERAGE 1,9 1,6 1,6 1,7 From 1 to 3 Voluntary SRO Model AVERAGE 3,4 2,8 2,3 3,0 From 1 to 4 Limited Exchange SRO Model AVERAGE 3,2 3,1 2,9 3,1 Strong Exchange SRO model AVERAGE 4,0 3,7 3,4 3,7 From 1,3 to 5 From 1,7 to 5 Independent SRO Model AVERAGE 4,7 5,0 5,0 4,7 From 4 to 5 Based on the survey results, the government model has a lower level of SRO activism, which indicates that there is less space for the development of self-regulation. In these cases, the regulatory functions are carried out exclusively by the regulator, which is the only entity with the capacity to ensure compliance with the IOSCO principles 13. On the other hand, under the independent SRO model, the degree of reliance on the self-regulatory organization is the highest 14. Under this model, the relationship between the SRO and the regulator is based on cooperation 15. The SROs are the front-line supervisory organizations, which complement the regulatory activities carried out by the statutory regulator. In the three jurisdictions that have adopted the independent SRO model, the degree of reliance on SROs by the statutory regulator is rated highly, with a range from 4 to 5. Therefore, the results of the survey indicate that the level of activity of SROs within jurisdictions is higher when there is an independent SRO. This result, however, may be partly due to the fact that the three countries in the Americas that rely most heavily on SROs, have implemented the independent SRO model. Furthermore, two of those countries have a long history and tradition of relying extensively on self regulation. In addition, these three countries at some point utilized or still utilize the strong exchange SRO model. For the limited stock exchange, strong stock exchange and voluntary self-regulatory models, reliance on SROs is medium, with respect to rulemaking, supervision and enforcement. It is important to point out, however, that the results for specific jurisdictions vary widely, which may indicate that the existence of any of these SRO models is not directly correlated with the level of activism of SROs. 13 IOSCO (International Organization of Securities Commissions). Objectives and Principles of Securities Regulation, May 2003 14 This result does not imply that the independent SRO model is necessarily stronger or more active than other forms of self regulation. Historically, there have been many examples of exchanges that are strong and active SROs. 15 Howell, E. and Gkantis, S. Market as a Regulator: a survey. Harvard Law School, October, 2006. 20

Survey Repondents Govenmental Model Limited Exchange SRO Model Strong Exchange SRO model Independent SRO Model Voluntary SRO Model When crossing the type of self-regulatory models with market size, the prevailing pattern found in small markets is the governmental model. In fact, eight out of the fifteen jurisdictions considered to be small, utilize the governmental model. This result is shown in Table 5. Table 5 Self-regulatory models for large, midsized and small markets Patern Selfregulatory Model 3 Large 10 Market 20 Total 0 2 2 2 1 8 Medium- 13 sized 15 Market 16 16 22 Total 1 4 1 1 2 Small Market 17 1 2 4 5 6 7 9 11 12 14 17 18 19 21 23 Total 8 3 4 0 2 Total 9 9 7 3 4 16 Medium sized Markets are those with a stock market capitalization greater than 50.000 million US dollars (USD) and less than or equal to 1.000.000 million US dollars (USD). 17 Small Markets are those with a stock market capitalization is lesser than or equal to 50.000 million US dollars (USD). 21

Percentage % 39 39 30 13 17 In medium-sized markets the most common SRO model is the limited exchange SRO model. The independent SRO model is present in only three jurisdictions, two of which are larger markets. These results support the previous finding that there is a positive relation between market size and the level of activity of the self-regulatory organizations within the jurisdiction. It is interesting to note that in most of the medium-sized and large markets, two or more selfregulatory models coexist. In general, the independent SRO model coexists with the limited and/or strong exchange SRO models. This implies that the implementation of an independent SRO does not necessarily impact the traditional self-regulatory role that stock exchanges have played. 3.2.5 Sanctions imposed by the self-regulatory organizations Self-regulatory organizations may take enforcement action where there is a regulatory framework in place that allows for the imposition of sanctions in the event of rule violations and a supervision program that is sufficiently effective to detect these violations. The level of sanctions imposed by selfregulatory organizations provides an objective measure of the level of self-regulation in each jurisdiction. The SRO survey includes the level of sanctions imposed by the self-regulatory organizations in each jurisdiction during 2008; an analysis of the survey results on sanction levels provide a good indication of the level of self-regulation in each market. Survey respondent Table 6. Imposed Sanctions Warnings Fines Suspensions Selfregulator's expulsion Expulsion from the market Total Sanctioning activity Large Market Mediumsized market Small market 3 18 25 10 4 0 57 10 15 3 7 0 N/A 25 20 (2) 158 159 324 390 390 1421 8 1 2 0 0 N/A 3 16 1 22 9 1 1 34 22 0 0 0 N/A N/A 0 2 0 1 0 0 0 1 9 0 1 0 N/A 0 1 (2) Expulsions and suspensions of both entities and individuals are included. This analysis, however, has an important limitation; only nine jurisdictions responded to this survey question. The lack of response, however, may itself be significant, and may be an indication that the sanctioning activity by the self-regulatory organizations in these jurisdictions may be low. It is important to point out some other observations regarding the methodology used during this analysis. The first is that sanctions imposed in some jurisdictions may be duplicative, since several sanctions could be imposed from the same set of facts. The second is that there is no standard for 22

comparison across market sizes. In the large markets, there is a higher level of transactions, number of participants, etc. Therefore one would expect to have a higher number of infractions. As expected, in larger markets a high level of disciplinary activities is observed. On the other hand, in small and medium size markets there are almost no disciplinary actions, with the exception of one medium-sized market jurisdiction. This further demonstrates the existence of a positive correlation between market size and the level of sanctioning activity of the self-regulatory organization. However, given that in one medium-sized jurisdiction a certain degree of disciplinary activity was observable, it cannot be said that effective supervision only exists in large markets. 3.3 Relevant findings regarding the activism of self-regulators From the responses analyzed by the Task Force, it is possible to obtain a more in depth understanding of the level activism of the self-regulatory organizations in the Americas. As it is shown throughout the document, the practices of SROs and their level of activism vary from jurisdiction to jurisdiction. In general, it was found that the size of the market and the self-regulatory model used impact the degree of activism. There is a positive correlation between the size of the market and the level of activity of the selfregulatory organizations in the jurisdictions surveyed. For example, it is well established that the US, Canada and Brazil have strong self-regulatory systems with important responsibilities in regulating both securities dealers and trading on exchanges and other markets. This conclusion is reinforced by the analysis of the level of sanctioning activities. The results of this analysis shows that there is a positive relation between the size of the market and sanctioning activities carried out by the self-regulatory organizations in the jurisdictions surveyed. Although 90% of jurisdictions responded that self-regulation exists in their markets, in most cases the level of SRO activity is considered low. It is important to highlight that no jurisdictions reported a medium level of reliance on self-regulation. In some medium-sized and small markets there is a high degree of self-regulatory activity; for example in Colombia, which modified its regulatory regime to introduce a significant degree of reliance on self-regulation several years ago. This allows us to conclude that the size of the market is not necessarily an obstacle to the statutory regulators placing greater reliance on self-regulation in the market. The degree of activism of self-regulation varies, depending on the model of self-regulation adopted by the jurisdictions. In general, where SROs have a higher degree of independence from the state regulators and the markets, the SROs are more active and have greater responsibilities. For example, in countries that employ the Independent SRO model, such as the US and Canada, selfregulatory activity is high and the SROs play a bigger role in regulating the markets. 23