Gary Clarke: Head of Legal and Regulation, A2X (Pty) Limited
Introduction
These are exciting times for the South African financial markets with frenetic activity in the market infrastructure space and in particular the launch of new stock exchanges.
The Johannesburg Stock Exchange (JSE) has operated as the only exchange in South Africa for the bulk of the last 129 years. While in the early years, the likes of the Royal Kimberly Exchange and Barberton Exchange existed, it was really only the Union Exchange formed in 1933, closed in 1951 that offered any real competition. The South African Futures Exchange (Safex) – trading financial and commodity derivatives, operated as an exchange in South Africa from 1990 and the Bond Exchange of South Africa (Bond exchange) – trading bonds, was granted an exchange licence in 1996. Both of these exchanges were acquired by the JSE in 2001 and 2009 respectively. From 2009 until August 2016, the JSE resumed its dominant position as the sole licenced exchange in South Africa, providing a multi-product offering to the South African investment community.
At the time of compiling this article, two new exchanges have been licenced as stock exchanges in terms of the Financial Market Act, 2012 (FMA), with a number of other applicants engaging with the Financial Services Board to secure licences.
The Financial Markets Act, regulation and exchanges
If one looks at the sequence of events that led to the recent surge in applications for exchange licences, one needs to start with the introduction of the FMA.
The FMA stemmed from the FSB conducting a review of the prevailing financial markets legislation at that time, that being the Securities Services Act 36 of 2004.
This review process took into account, amongst other things:
- the International Organisation of Securities Commissions’ (IOSCO) policy documents aimed at improving and enhancing standards of regulation applicable to the securities markets;
- The recommendations of the Financial Sector Assessment Programme, an International Monetary Fund and World Bank assessment of, inter alia, IOSCO members’ level of compliance with the IOSCO Principles;
- The effects of the global financial crisis as well as the outcomes and strict timeline-based recommendations of the Group of Twenty Countries;
- Developments in comparable jurisdictions, e.g. the United States, the European Union, Australia, etc; and
- The proportionality and efficiency of the regulatory framework, its flexibility and the timelines and responsiveness of South Africa’s regulatory framework.
Consistent with international trends the FMA introduced, as one of its objects, the promotion of international and domestic competitiveness. It also introduced the principle of proportionate regulation. Consequently the FMA empowers the FSB to regulate in a way that strikes an appropriate balance between the demands of different market participants and their models. This opened the way for direct competition in South Africa, specifically in the spot equities market.
The activity in the exchange licence space has also been driven by the passing of Directive and Guideline Regarding Infrastructure Provided by Companies Trading in Their Own Shares 1 of 2014 issued by the FSB. This regulation was directed at various entities who were providing an infrastructure to trade their own shares through an exchange platform, that is: trading in shares forming part of a restricted ownership scheme of the company. The FSB deemed this practice to be in contravention of the FMA and parties performing this service were given a time period within which to apply for an exchange licence or cease trading. A number of the entities identified this as an opportunity and applied for a licence.
Requirements for an exchange licence
The FMA prescribes in great detail what an applicant for an exchange licence must do to be licenced. This includes a public comment process and the obtaining of an audit report from an independent third party providing assurance that the applicant exchange complies with the peremptory and other requirements set out in the FMA. The licence application process is overseen by the FSB. The FSB also has a formally appointed licence application committee comprised of industry experts, which committee assists the FSB in assessing and approving applications for a licence.
The requirements of the FMA applicable to the licencing of an exchange are onerous. It can be argued that the FMA is impractical as it does not make provision for the granting of a conditional approval. As can be imagined, implementing an exchange is a very large, intricate and capital intense process. To do so without any certainty that a licence will be granted comes with big risk. Consequently, the impact of the said requirements potentially has a prohibitive effect on new entrants which indirectly protects vested interests against competition.
However, despite these stringent requirements, applicant exchanges are achieving compliance with what is required by the FMA and new licences are being granted.
The “Is competition good for the South African financial markets?” debate
I have a colleague whose favourite expression is that he has yet to hear of an industry where competition is bad for the end user. The experience in other industries in South Africa (e.g. banks and telecommunications) as well as the experience in international financial markets bears this out.
Naturally, and given the nature of financial markets, the introduction of a new exchange into any jurisdiction needs to be handled carefully. It is for this reason that the FMA, which is aligned with international best practice, is in place and contains the arduous requirements that need to be complied with to be approved as an exchange.
From an international perspective, competition in financial markets has become a firmly established principle. Australia has 2 trading venues, the US, Canada and the UK have in excess of 45, 10 and 4 trading venues respectively, with the generally accepted consequences being a reduction in trading costs as well as product innovation.
The Chairman of the Australian Stock Exchange (ASX) summed up the impact of competition in Australia when he stated: “ASX’s response to competition has been substantial and positive. The company cut its fees, introduced new products and invested in its technical services business.”
A study by the Australian Securities and Investment Commission’s (ASIC) strategic Intelligence Unit concluded that for the period from the commencement of competition in May 2011 to January 2013, the benefits amounted to over AUD300m per year.
The benefits of introducing competition in the Australian capital market are consistent with the experience seen in the US and Europe.
It is a generally documented fact that competition and technology in the US financial markets has led to innovation, increased electronic trading capabilities and, most importantly, lowering of trading costs.
“There has been significant competition between trading platforms in the US which has led to a reduction in trading fees, and improvement in technology across all participants… it is not surprising that costs in the US exchanges are amongst the cheapest of the markets reviewed.”
* International Transaction Cost Benchmarking Review, Page 41 et seq. October 2014 – Market Structure Partners.
In Europe in 2007, the EU introduced (and has subsequently refined) the Markets in Financial Instruments Directive (“MiFID”), which was intended to assist with the harmonisation of the European Markets and create greater transparency and competition in the equity markets.
It is generally accepted that not only did the entry of competition in trading in Europe lead to the reduction of headline transaction costs for participants but it also led to an improvement in market efficiencies. In a study undertaken by the TABB Group, it was found that in the period 2006 (pre-MIFID) to 2008 (post-MIFID) the spreads (the quantum between best bid price and best offer price) in the top FTSE100 stocks reduced by between 25% and 75%.
The positive impact of competition is also reflected in the statement made by the UK Financial Conduct Authority in June 2014:
“Efficient competition within the wholesale sector can lead to an increase in institutional efficiency, lower prices, greater innovation and can improve the quality and range of the financial services provided.”
It is interesting to note that in all the jurisdictions referred to above, and as would be expected from sole service providers, the incumbent exchanges were opposed to the introduction of competition in the exchange space, citing various concerns.
Despite these concerns, and as is reflected by the widely available empirical data, the international markets have embraced competition with the consequent benefits to the market and end users.
We are fortunate in South Africa that the FSB has many international case studies to refer to. So it can be guided by international experience when it comes to the process of considering the idiosyncrasies of the South African market and assisting National Treasury in formulating the various policies applicable to a market with more than one exchange, which policies are reflected in the FMA and regulations issued in terms of the FMA.
Conclusions
The process of granting exchange licences in South Africa is governed by the FMA and overseen by the FSB. The FMA was only signed into law 3 years ago and is aligned with international developments and regulatory standards. The FMA is structured specifically to achieve certain objects including ensuring fair efficient and transparent markets, increase confidence in the South African financial markets, promote the protection of regulated persons, clients and investors, reduce systemic risk and promote domestic and international competitiveness, and the exchange licence application process is designed in a way that ensures that any licence granted achieves these objects.
With this as a backdrop, it would seem appropriate to leave the function of approving and regulating exchanges to the FSB.
Whether the South African equity and other markets are large enough to sustain more than one exchange is a question that will be answered swiftly by free market forces. We believe there is plenty of room.
