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An Inquiry Into the Performance by NZX of its Regulatory Functions as a Registered Exchange During 2003 and 2004 Prior to the Collapse of Access Brokerage

13 December 2005

PART IX - FIDELITY GUARANTEE FUND

The Commission received evidence in relation to the role, sufficiency, and use of the NZX Fidelity Guarantee Fund from Mr Allen.
The Fidelity Fund is established under the Participant Rules. It can be called upon, in NZX's discretion, where a client suffers loss as a result of a participant's failure to meet financial obligations. The NZX Participant Rules state that in the event of a shortfall in a client funds account, clients will be paid out pro rata from the available funds. This means that in the event of any misuse of client funds every client is likely to suffer a loss, and is likely to seek to call upon the Fidelity Fund.
The Fidelity Fund originated in the mutual structure of the NZSE where NZSE members (the brokers) had unlimited liability. The Fidelity Fund was retained under the corporate structure and is provided for in the Participant Rules. It is to be managed and controlled by NZX. Participant Rule 8.11 provides:

NZX shall make arrangements for a fidelity guarantee fund (the Fidelity Guarantee Fund) for the purpose of meeting just claims from persons who have suffered pecuniary loss from a broking transaction as a result of any Market Participant involved in Client Funds...being unable to meet its financial obligations, provided that nothing in this Rule, or in establishing and maintaining the Fidelity Guarantee Fund, shall constitute a legal obligation to any such person.

The Commission asked Mr Allen whether the Board of NZX had given any consideration to the adequacy of the Fidelity Fund. He gave evidence that the Board had discussed the issue. The Rules provide a maximum claim of $20,000 per client and $500,000 per event. Mr Allen gave evidence that NZX does not take financial responsibility for regulatory activities. If another Access situation were to happen, NZX has no legal responsibility to pay out the Fidelity Fund, although Mr Allen noted that NZX would be viewed negatively if an investor were to lose money.
Mr Allen gave evidence that NZX paid out the whole Fidelity Fund after the Access collapse and that currently the Fidelity Fund is at zero. The Commission understands that $460,000 was paid out. Mr Allen stressed, however, that recapitalisation could occur before or after any event leading to a call upon the fund.
When asked about recapitalisation possibilities, Mr Allen noted the possibilities included government funding, on the basis that it is a public good fund, a levy on participants or a percentage of each trade. Mr Allen noted that NZX had the right to levy market participants but that there was no requirement for it to do so. He said that the NZX Board has not yet considered how the fund should be replenished. Mr Allen gave evidence to the Commission that he would regard the Fidelity Fund issue as urgent if another Access was on the horizon, but acknowledged that NZX would not know when any such event may occur.

Comment

In the Commission's view the maintenance of a fidelity guarantee fund for stock exchange transactions raises law reform issues that are beyond the scope of this inquiry. These issues will, we understand, be considered by the Government in its current review of securities law. The Commission notes that other countries operate variously fidelity funds, compensation schemes or do not make any such provision. In the Commission's view there may be reasons to re-examine the purpose of and expectations for a fidelity fund, including how this or any similar investor compensation mechanism should be funded.
Any review of the law in this area will take time. In the meantime, the Participant Rules provide for the maintenance of a Fidelity Fund. The Commission considers that the likely public perception created by the provision for this Fund raises a number of issues that require review by NZX. In submissions made to the Commission, NZX noted that the Fidelity Fund is intended to be used as a credit settlement fund between brokers. This is not apparent on the face of the Participant Rules. The Fund currently has a nil balance. NZX has noted that it has a number of options for recapitalising the Fund, including by contribution or insurance, or by levying Participants after a default event has taken place. There are also issues concerning the practical extent of compensation available under the Fund, and its availability to broker transactions other than NZX market transactions.
While NZX does not have a legal obligation to use the Fund in any particular case, we consider that any difference between the public perception of this Fund and its likely application in the event of any default could raise issues of public confidence. We recommend that the NZX Board, as a matter of priority, consider its policy concerning the Fidelity Fund and the manner in which that is communicated to the investing public, addressing the issues described here.

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