Circular D4/EB/2002/2 on Compensation of Transactions on Euronext

BANKING AND FINANCIAL COMMISSION Prudential supervision of investment firms 99 Louise Avenue, B-1050 Brussels Phone 02/535.22.11 - Fax 02/535.23.08 Brussels, July 10, 2002.

CIRCULAR D4/EB/2002/2 TO STOCKBROKERS REGARDING THE COMPENSATION OF TRANSACTIONS ON EURONEXT

Madam, Sir,

As part of the progressive realization of the Euronext market, several stockbrokers have decided not to remain members of the clearing organization, but to entrust the clearing of their transactions on Euronext to another intermediary with the status of clearing member of Clearnet. In some cases, stockbrokers also renounce the status of market member and have their transactions on this market executed by another intermediary with or without the status of clearing member of Euronext.

The subcontracting of the physical execution of orders on the market and/or the clearing and settlement of these transactions has significant consequences for the stockbrokers concerned. The purpose of this circular is to draw the attention of stockbrokers who subcontract the services mentioned or offer clearing services to some essential aspects concerning the organization required for this purpose as well as the application of certain legal and regulatory provisions.

1. Subcontracting of execution and/or clearing services of transactions

The subcontracting of the physical execution of orders on the market and/or the clearing of these transactions generally does not affect the relationship between the stockbroker and its clients. It is therefore important that the stockbroker maintains an overview and sufficient control over the processes it entrusts to third parties, and that it knows and manages the risks arising from them. Subcontracting cannot in fact compromise the permanence and continuity of the stockbroker's service provision, nor harm the protection of investors or the integrity of client data.

To assess the adequacy of the organization, as referred to in Article 62 of the Law of April 6, 1995, the Commission will take into account, in accordance with its subcontracting policy, the following elements:

a) General aspects:

• The management of the stockbroker identifies the risks of subcontracting and takes the necessary measures to monitor these risks;
• Management must be sufficiently attentive to the potential concentration of operational and financial risks on the same counterparty and must, if necessary, proceed to segregation of functions; in this regard, particular attention will be paid to the possible accumulation, within the same counterparty, of the functions of order execution, clearing, and custody of assets;

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• Emergency plans have been put in place to ensure, in the event of interruption of the counterparty's service provision, the continuity of the stockbroker's activities;
• Subcontracting cannot hinder internal and external control of operations;
• Internal audit and the approved auditor include subcontracted operations in their audit work;

b) Organizational aspects:

• The rights and obligations of each of the parties concerned by the subcontracting are established in writing;
• The stockbroker ensures adequate segregation between proprietary transactions and transactions for client accounts; the use of securities belonging to clients, given as collateral, must be carried out in compliance with the applicable legal and contractual provisions in this matter¹;
• The stockbroker has all the information required to ensure adequate monitoring of the individual positions of each client (payment and delivery, coverage of receivables, margin requirements for ongoing transactions);
• The stockbroker and the counterparties concerned exchange all data allowing permanent reconciliation between receivables/payables and reciprocal rights/obligations recorded in their books;

c) Quality of the counterparty or counterparties:

• The stockbroker has a precise view of the identity of all parties involved in a subcontracting contract, and in particular of any subcontractors of the counterparty or counterparties;
• The counterparties are first-class institutions, with a satisfactory track record, sufficient financial and organizational capacity, as well as efficient securities administration and securities accounting. To verify these aspects, the stockbroker can rely notably on the status of general clearing member of the counterparty and/or on the capital and organizational requirements imposed in this regard by the clearing organization. If necessary, the stockbroker performs due diligence on its counterparty;
• The counterparties have all the required approvals to provide their services.

¹ The stockbroker that uses a client's securities with a counterparty for the hedging of operations other than those of the client concerned, or that places these securities on an account with a clearing organization, must have previously received the written authorization of the client in question. Violations of this rule are, pursuant to Article 148, § 3, of the Law of April 6, 1995, considered as breach of trust and punished by the penalties provided for in Article 491 of the Penal Code.

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2. Application of existing regulations

The stockbroker must fully apply the existing regulations concerning the placement of client funds² and concerning the own funds of stockbrokers³.

Particular attention will be paid to the following aspects in this regard:

a) Placement of client funds: Stockbrokers are not authorized, for the placement of client funds, to open "client" accounts with correspondents who are not credit institutions, except when it comes to foreign currencies.⁴ Since January 1, 2002, stockbrokers can no longer, regarding client assets they hold in € with foreign correspondents, record them as reinvested client funds, in accordance with the regulation.

On the other hand, stockbrokers can, under certain conditions, place with correspondents funds exempt from the placement obligation, in the framework of the execution and settlement of transactions for their clients. On the one hand, these are so-called "settlement" funds which can be held for a maximum of five working days with professional counterparties in the framework of the settlement of stock market operations.⁵ On the other hand, these counterparties can also be custodians of "hedging securities" for client transactions, provided that they cannot assert, on these funds, rights resulting from their own claims held against the stockbroker⁶;

b) Concentration of risks: The regulation on the own funds of stockbrokers provides for a limitation of the concentration of the stockbroker's risks towards the same counterparty. The standards for limiting "all risks" on the same counterparty, as calculated in accordance with the regulation, must be strictly respected.⁷

Without prejudice to these limitation standards, the stockbroker must, in general, ensure that the potential failure of a counterparty does not compromise the continuity of its own activities. It can, for this purpose, take various measures such as, for example, calling upon specialized depositaries for the custody of assets, or ensuring that the counter-value of the assets it holds with correspondents is in line with their financial capacity or takes into account the amount of insurance concluded in the specific case.

3. Provision of one or more services relating to the execution and/or clearing of transactions for other stockbrokers

Stockbrokers that provide execution and/or clearing services for other intermediaries identify their own risks and take measures to manage them adequately.

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The aspects developed in points 1. and 2. above apply mutatis mutandis. It is also appropriate to emphasize that the provision of the services mentioned poses strict requirements in terms of organization and internal control, as well as requiring very efficient securities administration and securities accounting. As necessary, the Commission once again draws the attention of stockbrokers to the conclusions communicated to them in its circular letter of January 31, 2001, following its control of the securities deposit activity.

It notably requested stockbrokers to take appropriate measures to strengthen their policy in terms of control and security of securities movements, paying particular attention to physical movements of securities and the development of accounting and management systems, internal control, segregation of functions, and internal audit.

We remain at your disposal for any additional information you may wish to obtain.

Please accept, Madam, Sir, the expression of our most distinguished sentiments.

The President, E. WYMEERSCH

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² Regulation on the placement of client funds, approved by Royal Decree of December 31, 1995 ³ Regulation on the own funds of stockbrokers, approved by Royal Decree of December 31, 1995 ⁴ Cf. Articles 5 and 6 of the regulation on the placement of client funds. ⁵ Cf. Article 8, § 1, 3°, of the regulation on the placement of client funds. ⁶ Cf. Article 8, § 2, 2°, of the regulation on the placement of client funds. ⁷ Cf. Articles 80-81, 83-84 and 89 of the regulation on own funds.