– an evolving relationship
Economic reasons for establishing stock exchanges
Most investors and traders can spend their entire lives without stepping foot on the floor of a major stock exchange, but it’s hard to imagine functional markets without them. A stock exchange is a hub where buying and selling of stocks takes place, providing a service without which orderly and liquid markets would simply not be possible.
The creation of a stock exchange is a strategy of economic development and provides a means of raising capital for investment. The role of a stock exchange is varied and highly important in the development of the economy of a country as it provides a means to:
- raise capital for businesses;
- market unlisted fund securities;
- create investment opportunities for small investors;
- raise capital for development projects; and
- provide corporate governance and third party oversight.
Why entities list on a stock exchange
Companies often seek to “list” on a stock exchange to raise capital for expansion, or invest in new business projects or ventures. Often, institutions list their securities and bonds on an exchange for ease of trade. Companies can fund growth through either debt (bonds or bank loans) or equity (issuing stock on an exchange).
Sometimes, even if a company does not need extra capital to fund its growth, it will still list on a stock exchange in order to:
- position itself for eventual expansion into national or international markets;
- obtain easier access to new capital from a new source (i.e. the public);
- have better and easier capital management opportunities (e.g. paying off debt when equity is cheaper or just simply more accessible vice versa);
- create a measurable and transparent valuation of the company;
- provide liquidity to existing shareholders; and
- allow access to investors who are prohibited from investing in unlisted securities.
Cayman Islands approved stock exchange regime
The Securities and Investment Business Law (SIBL) requires the Cayman Islands Monetary Authority to specify overseas stock and securities exchanges that hold an “approved” status. In essence, this is a recognition and acceptance of the regulatory and listing requirements applied by other stock exchanges. There are currently more than 50 approved stock exchanges covering the U.S., European, Asian and Latin American markets.
Doing business with a company or client that is listed on an approved stock exchange provides a useful compliance-related exemption in that it reduces the need for a large proportion of the client identification requirements.
The criteria that the authority applies in order to determine whether a stock exchange is “approved or recognized” is set out in Appendix G12 of the authority’s regulatory handbook. To summarize, these are:
- (i) a U.S. licensed exchange – an exchange that has registered with the SEC;
- (ii) an EU regulated exchange – a regulated market that has been recognized by an EU member state;
- (iii) a Canadian licensed exchange – recognized by one or more provincial securities commission;
- (iv) a full member of the World Federation of Exchanges (WFE); and
- (v) any other stock exchange approved by the authority, the exchange must:
demonstrate that it complies with the market principles of the WFE or be located in an IOSCO country and be subject to the IOSCO supervisory framework;
- be significant within its country of origin; or
- demonstrate that there is a sufficient amount of business that exists between the Cayman Islands and the stock exchange in so far as its omission results in significant cost implications for regulated entities.
There is no doubt that the Cayman Islands criteria for a “recognized or approved” stock exchange is a tough one – and for good reason. No jurisdiction wants to be seen as accommodating markets and practices that are detrimental to regulatory and corporate governance regimes.
Since the promulgation of the OECD Principles of Corporate Governance, stock exchanges have often enlarged their regulatory role to embrace a wider palette of corporate governance concerns. The general structure of a stock exchange is that of a “self-regulating” regime, usually with oversight by a country’s regulator or an autonomous body. In the U.S., the Securities and Exchange Commission (the SEC) oversees all of the U.S. stock exchanges and any organization connected with the selling of securities. At the next level is the Financial Industry Regulatory Authority (FINRA) which is an industry self-regulatory body that is responsible for policing the securities industry.
The Stock Exchange Authority is an autonomous body established as the dedicated regulator for the CSX under the law. The authority has statutory responsibility for the policy, regulation and supervision of the exchange.
The financial secretary of the Cayman Islands government is the chair of the authority. Its executive board, appointed by the governor of the Cayman Islands, comprises in addition to the financial secretary, the head of the Cayman Islands Monetary Authority, the attorney general, the deputy financial secretary and the head of the Government’s Economic and Statistics Department.
The authority appoints the members of the exchange’s council that is responsible for administering the business affairs and day-to-day operations of the exchange. The council comprises eleven senior professionals, nine of whom are drawn from the private sector. The assistant financial secretary and the chief executive officer of the CSX also are members of the council.
Rule-making and policy development by the exchange, including any changes to pre-existing rules and policies, is effected in consultation with the authority and is subject to the authority’s written approval. The authority has the statutory authority to require the exchange to make, rescind or amend any of its rules.
A good example of how regulatory oversight is reached can be seen via the specific regulatory objectives of the Cayman Islands Stock Exchange which are to:
- protect investors and the public interest and prevent unfair discrimination between customers, issuers or broker members;
- ensure that broker members deal honestly and fairly with investors, and have sound finances and management;
- ensure that business is conducted in an orderly manner and so as to afford proper protection to investors;
- ensure the effective monitoring and enforcement of compliance of broker members with its rules; and
- promote and maintain high standards of integrity and fair dealing in the carrying out of business by broker members.
The Cayman Islands Stock Exchange is a member of the Intermarket Surveillance Group. The ISG provides a framework for sharing information and coordinating regulatory efforts among its multinational members. Members of the ISG agree to share information with other members on surveillance, investigation and enforcement matters and on related practices and techniques.
Stock exchange regime
Over the past 15 years, the stock exchange industry has been in a state of continued flux: they have demutualized and in most cases become listed, consolidated through mergers and acquisitions, and have become subject to stiff competition from a host of new alternative trading venues. In other words, stock exchanges have become engaged in intensified competition. This, in turn, is creating a new reality in an exchange’s role in the regulatory framework.
The dichotomy between a listed exchange’s “regulatory function” and its role as a “for-profit entity” has given rise to an active debate regarding their incentives to regulate. The incentives faced by exchanges to establish and maintain high regulatory standards might weaken as they weigh the risk of deterring listings altogether or losing them to competing market places. This risk may be exacerbated by the pressures an exchange is subject to from its shareholders to give top priority to maximizing profitability.
Exchanges have suggested several rationales for establishing themselves as a source of corporate governance-related police. In essence, by raising transparency and discouraging illegal or irregular practices, exchanges are themselves able to accumulate an amount of “reputational capital.” The responses provided by stock exchanges to the IOSCO Consultation Report on Regulatory Issues Arising from Exchange Evolution (2006) generally took issue with the report’s suggestion that “for profit” exchanges may be tempted to lower standards to try to generate additional revenue. This line of argument has increasingly become a cornerstone of many exchanges defense of their regulatory functions.
However, the difficult issue for compliance departments arises due to the fact that a considerable number of stock exchanges are “self-regulating.” This has resulted in significant regulatory variations and an overall scheme which is hardly harmonious.
In addition, each country’s domestic law will be enforced in widely varying degrees of intensity and so the ultimate compliance decision on whether to treat an approved stock exchange as exempted for compliance purposes is influenced by many factors.
The common denominator in the decision making process will usually be that of “regulatory trust” and consideration should be given to the regulatory framework behind the approved stock exchange.
The following are considerations for compliance officers in making a determination on whether to exempt a client from providing full client identification (CDD) due to being listed on an approved stock exchange:
Are the stock exchange’s stock listing disclosures meaningful and do they provide detailed requirements for the enforcement, suspension and cancellation of those companies listing on the exchange?
The most direct power of stock exchanges to enforce compliance obviously pertains to those standards which are also incorporated in the listing requirements. The responsibility for company listing in many other OECD member countries is shared between the stock exchange and the securities regulators. In the United States, the decision to list a particular issuer is made by the exchange however; an issuer must comply with all SEC requirements applicable to listed companies.
Corporate governance and codes of conduct
Does the exchange adopt the “comply or explain” approach to its listed companies, the alternative being a full disclosure of corporate governance arrangements and are enforcement rules based on soft punitive measures or a full de-listing authority? More often than not, the thrust of an exchanges’ responsibility in the enforcement function lies in their capacity to monitor market developments and bring cases to the attention of securities regulators. Hence, exchanges can obviously make an important contribution to the prevention of fraud and other abusive practices.
Part of what is commonly referred to as an exchanges’ “regulatory function” is often a delegated authority exerted on behalf of the securities regulators. As a consequence, the scope of an exchange’s rulemaking authority may, in practice be more limited than it may seem. In North America, certain regulatory functions of exchanges have been delegated or contracted to third party non-governmental regulators, while others, notably in the area of listing, have been retained by exchanges themselves. In Europe, in most cases, it is the capital market regulators, not exchanges, who have an upper hand in issuer regulation.
In addition, a variety of measures have been implemented to safeguard the regulatory role of exchanges e.g. the separation of exchange’s profit making and regulatory functions.
The way forward
Whilst no system can guarantee against poor decision making or inappropriate behavior, it is clear that good corporate governance has never been more important to the continued health of the world capital markets. It seems likely that the attention paid to corporate governance standards at a market level will increase. In addition, investors will look to the relevant stock exchanges to provide a quality mark for the companies listed by it and expect a genuine commitment to governance. It is clear that the CSX, in partnership with the Stock Exchange Authority, are well placed to lead the way in corporate governance standards.