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Chapter 2

Matters considered at oversight hearing

2.1        The committee inquired into several matters relating to ASIC's activities. These included:

• ASIC's strategic framework;
• supervision of the stock market;
• ASIC's coercive powers;
• Australian financial services licences; and
• freezing of investors' funds.

ASIC's strategic framework

2.2        The committee was informed that ASIC has adopted a strategic framework to guide the Commission's activities. The strategic framework establishes three priorities; confident and informed investors and financial markets, fair and efficient financial markets, and efficient registration and licensing.[1]

2.3        Mr Greg Medcraft, Chairman, ASIC, advised that the first priority covers three 'foci', namely, education, gatekeepers and consumer behaviour. This priority will drive ASIC's use of new media to promote financial literacy, and the dissemination of standards and guidance material for gatekeepers and consumers. Under the second priority ASIC will 'continue to focus...efforts in market supervision and competition, and also on corporate governance guidance.' The committee was further informed that under the third priority, ASIC will give particular attention to 'small business...where there is perhaps an expectation gap.'[2]

2.4        It was apparent that an emphasis on self-regulation and 'empowerment' underlies ASIC's approach to corporate, markets and financial services regulation. Mr Medcraft advised that ASIC considers that '[i]t is very important that consumers and investors are empowered.' Mr Medcraft further stated:

I think it needs to be underlined that our system still relies very much on the cornerstone of investor responsibility for their own investment decisions, and that remains core – an understanding of risk, reward and diversification remains paramount.[3]

2.5        With regards to gatekeepers, it was noted that ASIC considers that '[s]elf-regulation has an important role to play, with the support of ASIC where needed.'[4] Mr Medcraft elaborated on the concept of self-regulation:

[I]t is important that we hold gatekeepers, in the widest definition of the term, to account because they are a cornerstone of the system. That includes directors, accountants, experts, advisers, product manufacturers and distributors, market operators and participants. Self-regulation is actually very important in complementing regulation.[5]

2.6        It was explained that there are four factors guiding the development of the strategic framework, namely, 'legislative responsibilities, systemic or regulatory risk, stakeholder expectations and government policy.'[6]

2.7        It was noted that the Commission's focus on managing systemic or regulatory risk prompted the formation within ASIC of an 'emerging risks' committee.[7] Mr Medcraft explained that the committee:

'is designed to...really look at thematic risks that may be emerging in particular industries or systemic risks and actually connect the dots across the stakeholder teams in ASIC so that, if we are doing surveillance in one sector, basically we can discuss the lessons that may be impacting. Part of it is looking at what is happening in evolving markets and making sure that we are connecting dots across ASIC.[8]

2.8        Mr Medcraft further explained that the formation of the committee is in response to ASIC's view that '[i]f you really want to be a good proactive regulator, it is all about having a resilient system that is forward looking and seeing what is on the horizon.'[9]

Committee view

2.9        The committee notes with approval ASIC's strategic framework, which appears to cover ASIC's legislative objectives as contained in the ASIC Act. The committee agrees with ASIC's understanding of its role and responsibilities as the corporate, markets and financial services regulator, and particularly approves ASIC's commitment to identifying areas of potential risk. On the basis of the information provided to the committee, it is apparent that ASIC recognises the importance of the Commission's educative role in promoting prudent and fully-informed self-regulation by market participants. The committee considers that the financial literacy tools, standards and guidance material that ASIC provides are a necessary part of promoting confident and informed market participation and are a key tool to assist gatekeepers and investors to self-manage their activities.

2.10      The committee notes with approval the formation of ASIC's emerging risks committee. The committee sees merit in the continual analysis of the system to identify areas of potential risk. Such analysis is a core element of maintaining and improving Australia's financial system that, the committee notes, is part of ASIC's legislative objectives. The committee will seek advice from ASIC's emerging risks committee at subsequent oversight hearings.

Supervision of the stock market

2.11      The committee has continued to track the transfer of responsibility for supervision of real-time trading on Australia's domestic licensed markets from the Australian Securities Exchange to ASIC. ASIC has previously advised, and the committee has noted, that since the transfer of responsibility, the time from problem identification to formal investigation has decreased.[10] The committee notes that this trend continues, 'with approximately 40% of all referrals progressing to investigation in under 30 days from identification of the misconduct.'[11] The committee further notes ASIC's advice that from January to June 2011:

[t]here were 23,494 trading alerts, with 121 matters requiring further consideration. Some 34 matters were referred for further investigation. These matters involved potential insider trading (17), market manipulation (6), possible breaches of the market integrity rules (10) and of continuous disclosure obligations (2).[12]

2.12      As has been noted, ASIC advised that 'fair and efficient markets' is one of the three priorities under ASIC's strategic framework. ASIC's report ASIC supervision of markets and participants: January to June 2011, provides further details of the activities undertaken to achieve this priority:

A core outcome for ASIC is investor confidence that our markets are fair and efficient. This requires our market infrastructure to be robust; trading, clearing and settlement of transactions to be orderly and efficient; and market misconduct to be minimised. We do this through engagement with stakeholders, surveillance of markets and market participants, education, guidance and our deterrence activities.

ASIC is committed to reducing the incidence of market misconduct by:

• ensuring that market participants have better controls in accordance with required standards;
• supervising markets and market participants to detect market misconduct quickly; and
• conducting timely investigations of market and market participant misconduct, resulting in significant penalties where appropriate.[13]

Emerging issues

2.13      The committee's attention was drawn to a number of emerging issues that may affect the performance of Australia's domestic licensed markets, including 'dark pools', high frequency trading and 'white label/indirect brokers'. Areas of potential risk were identified by ASIC and Dr Carole Comerton-Forde, Professor of Finance, Australian National University.

2.14      The committee was informed that, consistent with its policy of seeking to identify emerging issues, ASIC has reviewed indirect brokering, also known as 'white labellers'. Mr Shane Tregillis, Commissioner, ASIC, provided an overview of indirect brokering in the Australian market, noting that ASIC has 'identified a number of weaknesses, in terms of controls and other issues'.[14] However, while commenting that 'there are clearly areas for improvement required in this sector, and it is an issue that we think requires continued focus', ASIC noted that regulation of indirect brokers is a policy matter for Treasury.[15] The committee was informed that ASIC is advising Treasury of the need for policy development in this area.[16]

2.15      The committee was also informed that in the overseas market, internalised/non-transparent trading, known as 'dark pools' have caused 'concerns about both price discovery and liquidity'.[17] Dr Comerton-Forde explained that their increased availability as a result of advances in technology and, therefore, increased use, 'creates more risks, both because there is no longer a strong motivation for why that sort of trading is allowed and because there is no longer a lever for ensuring that sufficient transparency and liquidity are going to the main market.'[18]

2.16      Dr Comerton-Forde explained that 'the current Australian regulatory environment does not provide for a dark-pool class of markets. They are operating currently under the rules of the ASX.' Dr Comerton-Forde advised that it is 'very important...that they [dark pools] are regulated in their own right'.[19] However, Dr Comerton-Forde questioned whether ASIC has the capacity to regulate non-transparent trading:

ASIC regulates the brokers who are operating these venues, but they are not regulating the venue per se. So the brokers have an obligation to the market and to their clients...but they are not regulated as a trading venue. And they probably should be.[20]

2.17      The committee was also provided with an analysis of the risks posed by high frequency trading, which Dr Comerton-Forde predicted will increase with the introduction of competition in the Australian market. While reporting that high frequency trading can add value to the market, Dr Comerton-Forde advised that the trading can increase technology costs and 'create a more complex environment for traders'.[21] Dr Comerton-Forde recommended consideration be given to ensuring that the increased costs 'are borne by those that create the costs rather than by the market as a whole',[22] and further stated 'I think one sensible approach is to charge a fee when the ratio of orders being placed to cancelled orders becomes excessive'.[23]

2.18      Dr Comerton-Forde also noted that risks may be posed by market competition and new forms of trading services. While advising that 'competition in equity markets is very good and very important for the development of the markets', Dr Comerton-Forde stated that competition entails 'risks and issues that need to be managed'. These include 'issues in terms of the fragmentation of the market and being able to access liquidity'.[24] Drawing on experiences of overseas markets, Dr Comerton-Forde further advised:

[t]he new entrants have come into the market with superior and much faster technology and have innovated significantly in the way they offer trading services to the market. Generally this has been good, but there have been some risks along the way. There has been a massive change in the types of orders that are available to investors in the market: hidden orders, pegged orders, flash orders. They have generally been good, but there have been some instances, such as with the flash orders in the US, which have been problematic. It is important that the regulator is on top of those sorts of things and can step in and make changes quickly if needed.[25]

2.19      Regarding ASIC's oversight of the Australian market, Dr Comerton-Forde stated that the challenges facing the market should influence ASIC's resources and approach to market regulation:

Again, the regulators need additional tools, technology and understanding of the market in order to monitor the market effectively. In general, the trends with high-frequency trading, dark pools and competition increase the need for better understanding of the markets and better access to data. It is important as we go forward that ASIC are able to obtain that information and that data to ensure they keep abreast of the market and abreast of developments in the market, and that they are able to be proactive and change quickly in response to the market dynamics.[26]

Committee view

2.20      The committee is particularly interested in areas of potential risk that may threaten the performance of Australia's domestic licensed markets and, therefore, the financial system. In this regard, the committee notes Dr Comerton-Forde's advice that the 'two most important qualities that...we need to keep in mind, as we look at how markets are evolving, are the liquidity and the price discovery process'.[27] The committee draws ASIC's attention to the areas of potential risk to market liquidity and the price discovery process that Dr Comerton-Forde identified.

2.21      The committee has previously noted that ASIC is consulting on whether additional market integrity rules are required to address broader market developments, including non-transparent trading.[28] The committee will seek ASIC's advice regarding whether prudent regulation of non-transparent trading and the other matters identified requires additional transfer of responsibilities to ASIC.

2.22      The committee also notes ASIC's view of the risks posed by white labellers/indirect brokering. The committee approves ASIC's role in proactively screening the market for potential risks and, consistent with its responsibilities under the ASIC Act, alerting the Government to this risk. At subsequent oversight hearings, the committee will seek an update on the progress of measures to respond to the risks posed by indirect brokering.

2.23      The committee will continue to seek ASIC's estimation of emerging risks, and the development of regulations to address the risks. To assist with monitoring risks to the market, the committee considers it appropriate for ASIC to continue to publish six monthly reports regarding the Commission's supervision of markets and participants.

ASIC's coercive powers

2.24      ASIC has been granted facilitative, regulatory and enforcement powers consistent with its responsibility to enforce and give effect to relevant Commonwealth law. These include the power to enter premises and seize documents pursuant to a warrant, and to compel persons to provide ASIC all reasonable assistance in connection with an investigation and to appear before ASIC to answer questions on oath.[29] A person may commit an offence if he or she refuses to comply with ASIC's directions or otherwise hinders ASIC in exercising its powers.[30]

2.25      The Rule of Law Institute of Australia commented that such coercive powers are 'intense and broad ranging' and 'diminish fundamental human rights'.[31] The Institute suggested that such powers require transparent and accountable use:

Given the gravity of the powers which we give our regulators, including ASIC, we say we need to question first of all whether they are really needed. We need to question whether they have due process around them, whether there are checks and balances, whether there is transparency both in process and in outcome and, finally, [whether] there is accountability on the regulator about how they use those powers.[32]

2.26      It was noted that the accountable use of coercive powers is consistent with the Administrative Review Council's 20 best-practice principles regarding the use of coercive power by Commonwealth agencies. [33] The principles are based on administrative law values of fairness, lawfulness, rationality, transparency and efficiency, and seek to balance agencies’ objectives and individual rights.[34]

2.27      The Institute reported that compared with other Commonwealth regulators, 'ASIC does not exactly come up as the model disclosure regulator'.[35] The Institute argued that, where appropriate, ASIC should attempt to obtain information from third parties on a voluntary rather than a compulsory basis,[36] and also recommended that:

• ASIC publish in its annual reports 'detailed statistics on its use of coercive powers, along with a discursive statement that notes their use and key trends'
• ASIC's website contain 'a policy statement on how it uses its coercive powers', and
• ASIC's use of its coercive powers be reviewed against the Administrative Review Council's best-practice principles.[37]

2.28      ASIC advised that the Commission has recently reviewed its procedures and policies regarding coercive powers. The committee was informed that '[o]verall, the review concluded that ASIC's policies and procedures are appropriate, and subject to a number of internal controls'.[38] Ms Belinda Gibson, Deputy Chairman, ASIC, elaborated, stating '[b]y and large, as a result of the discussions with our stakeholders...we did not identify grave concerns.'[39] Regarding ASIC's adherence to the Administrative Review Council's 20 best-practice principles, the committee was advised that ASIC complies with all bar the two principles concerning transparency and accountability.[40]

2.29      However, the committee was informed that the review has prompted ASIC to undertake several measures to improve the Commission's use of its coercive powers. The measures appear to address the Administrative Review Council's best-practice principles and the Institute's recommendations, and include additional training for relevant ASIC staff, amendments to ASIC's internal policies to include additional guidance regarding appropriate use of the powers, and publication of guidance material and statistics.[41] As Ms Gibson further explained:

[w]e have committed to provide information in our annual reports about the exercise of our coercive powers. That will be in this upcoming annual report...We are close to completing a notice about transparency–that is, setting out what our powers are, the scope for those powers and so on. At the moment they appear at the bottom of our notices but we will put that on our website.[42]

2.30      With regards to seeking information on a voluntary, rather than a coercive, basis, ASIC stated that 'in terms of surveillance we generally take a voluntary approach where possible'.[43] However, it was noted that a voluntary approach could not be taken where ASIC is 'investigating a criminal prosecution or a civil prosecution', or in circumstances where 'companies cannot do it voluntarily because they need a direction of law to provide...information'.[44]

Committee view

2.31      The committee considers that it is best practice for regulators to exercise powers necessary to fulfil their regulatory responsibilities in a transparent and accountable manner. The committee also considers that regulators should exercise powers cautiously, giving due regard to individual rights and ensuring that the most appropriate power is utilised.

2.32      The transparent and accountable use of coercive powers is consistent not only with the Administrative Review Council's best-practice principles but also with the requirement, under section 1 of the ASIC Act, for ASIC to ensure that information is available as soon as practicable for access by the public. The committee encourages ASIC to disclose appropriate information regarding its use of coercive powers without compromising its activities as a regulator. The committee considers that it is appropriate for ASIC to make available, for example through its annual reports, data regarding the incidence of ASIC's use of its coercive powers, the kinds of powers used and the outcomes of the use of those uses of power.

2.33      The committee notes ASIC's advice that the Commission is currently implementing measures to significantly improve the transparency of its use of coercive powers. The committee approves these measures, and will routinely revisit this matter in future oversight hearings following the release of ASIC's annual reports.

Australian financial services licences

2.34      The committee was informed that the Corporations Act contains a presumption in favour of granting applicants an Australian financial services licence (AFSL). Mr Price stated:

[t]he law basically says that ASIC must grant a licence unless there are certain areas where we have reasonable grounds to think they will not comply with the law or we have evidence that the a person is not fit and proper...[45]

2.35      However, on the basis of evidence provided to the committee, it was not clear that the presumption in favour of granting a licence undermines market integrity. Mr Medcraft informed the committee that stakeholder due diligence should be taken into account when considering risk:

Our system is a very free system and it is up to investors to undertake their own due diligence very carefully as to who they deal with. That is the nature of our system. Highlighting this is quite interesting because it is important that people who are investors understand that if you are a director or an AFSL holder the only judgement we can make is if, for example, you have committed fraud or a monetary crime.[46]

2.36      The committee was further informed of misperceptions amongst investors and consumers of the significance of an AFSL, which may result from licensees claiming their product or advice is 'ASIC approved'.[47]

Committee view

2.37      The committee is concerned with any confusion regarding the significance of Australian financial services licences. Consistent with the Commission's legislative responsibility to promote informed participation in the financial market, the committee considers that it would be appropriate for ASIC to publish information to address any such confusion.

2.38      The committee also notes ASIC's advice regarding the preconditions for obtaining an Australian financial services licence. The committee will subsequently raise this matter with ASIC to determine if the preconditions are appropriate and adequate to promote the confident and informed participation of investors and consumers in the financial system.

Recommendation 1

2.39      The committee recommends that ASIC amend its website to include an explanation of the meaning and significance of holding an Australian financial services licence. The information could also be usefully included on the MoneySmart website.

Freezing of investors' funds

2.40      The committee has continued to track the outcomes of the global financial crisis on Australia's economy and financial markets. This includes developments regarding the significant number of illiquid managed investment schemes frozen in accordance with requirements under the Corporations Act 2001.[48]

2.41      Mr Medcraft advised that as of November 2008, the value of funds frozen totalled $22.5 billion. As of June 2011, the value of frozen funds totalled $18.2 billion. The committee was further advised that, while the funds are frozen, 'some of them are...actually providing limited access to the money, such as quarterly withdrawal of money that has come in over time'.[49]

2.42      The committee was informed that the significant increase in illiquid funds, along with a resulting increase in the number of frozen funds, has affected market behaviour. Mr Medcraft stated '[t]he sector...is actually really trying to restructure because they basically want to win back the trust and confidence of investors.'[50] The committee was also informed that the lessons of the global financial crisis regarding freezing of investors' funds are informing market regulation. In March 2011, ASIC advised that the Commission is 'consulting on benchmarks for the future of the mortgage trust sector' to determine measures that can be taken to promote 'a more robust sector for the future'.[51] At the hearing on 24 June, ASIC confirmed that the Commission is 'in the process of issuing a new regulatory guide to really focus on PDS [product disclosure statements] disclosure in terms of when you invest in a mortgage fund.'[52]

Committee view

2.43      The committee considers that, consistent with the legislative requirement to promote the confident and informed participation of investors and consumers in the financial system, ASIC's functions must include disseminating information regarding the possibility of funds being frozen and what options are open to investors should this occur.

2.44      The committee notes that in May 2010 ASIC released an information sheet for investors in frozen funds, which particularly included information for investors in funds frozen as a result of the global financial crisis.[53] While this is a significant step in ensuring investors are appropriately informed, the committee considers that such information should be given to potential investors as an aid to making fully informed investment decisions. The committee therefore approves the measures ASIC is taking to improve disclosure regarding frozen funds.

2.45      The committee considers that the significant volume of funds frozen as a result of the global financial crisis provides a substantial opportunity to assess whether the rules regarding frozen funds in the Corporations Act are operating effectively. The committee will continue to raise this matter with ASIC, to determine if improvements can be made to the operation of the Corporations Act.[54]

 

Mr Bernie Ripoll MP

Chair

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