01/06 5 Euro. Business Journal Deutsche Börse Group. Trust In the markets Between people In outer space

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1 01/06 5 Euro 1585 Business Journal Deutsche Börse Group Trust In the markets Between people In outer space

2 Vorsprung durch Technik Vom Erfinder des quattro Der Audi Q7. Mehr Fahrspaß mit quattro und adaptive air suspension. Neue Kraft entsteht denn im Audi Q7 stecken die Gene jener Autos, die mit quattro Rennsportgeschichte geschrieben haben. Ihre legendäre Überlegenheit bringt der Audi Q7 jetzt auf die Straße. Und noch mehr: Durch das Zusammenspiel von herausragenden Audi Technologien setzt er neue Maßstäbe in seiner Klasse. Zum Beispiel auf Wunsch mit adaptive air suspension: einer Luftfederung, die sich an verschiedene Situationen anpassen lässt und so die Fahrdynamik steigert. Gemeinsam mit quattro eine Kombination für mehr Fahrspaß. Ab sofort bei Ihrem Audi Partner.

3 1585 ISSUE 01/ Without Trust trust, the commodity and financial markets would simply not exist. Deutsche Börse Group would also be nowhere near as successful if our customers could not place their trust in us, so we felt that this was reason enough to devote our first edition to this key topic. Trust is not just the leitmotif for the content: We entrusted just one photographer Berlin-based Sebastian Pfütze, born 1970 with the photos for this issue. I had an enormous amount of freedom. To be given the responsibility and the opportunity to illustrate an entire issue, that is something really special. We feel the results are worth looking at. 06 FEATURE The economics of trust Adieu, Homo economicus! Contemporary economists prove that people are more altruistic than previously imagined. This has a revolutionary effect not only on the science of economics, but also on the commodity and financial markets. 14 REPORT The market watchdogs Capital markets do not function solely on the basis of trust. But how much regulation do we need and at what point does overly strict financial regulation become damaging? The debate is only just beginning. 26 GUIDE Fast-paced city Shrewd operators like Christopher Morris, Manager at Saxon Financials, make London the financial Mecca of Europe visited him in the British capital a (city) profile including an exciting quiz. 32 PORTRAIT The space traveler In July of this year, Thomas Reiter is set to travel into space to spend six months on the ISS space station. Although the team and the technology are important, Reiter will ultimately rely on one thing: trust in his own abilities NEWS/IMPRINT COLUMN Anthony Hilton on corporate governance INTERVIEW Jochen Sanio on the right degree of regulation DOSSIER The magic behind the Nokia brand REVIEW A soccer referee faces challenges in creating trust PHOTO STORY Robert Adams, winner of the Deutsche Börse Photography Prize

4 ISSUE 01/06 NEWS MODERN OTHELLOS It is the allegedly cool Swedes who are passionate when it comes to love and jealousy. According to a recent survey carried out by a Swedish mobile phone provider, roughly two thirds of Swedes regularly spy on their partners mobile phone and read their text messages. Twenty-five percent of those questioned admitted being motivated by jealousy. One in every two mobile snoopers snatched their partner s phone while they were in the shower or in the bathroom. Interest in text messages received and sent was said to be especially high if he or she had previously been alone in a pub or restaurant. At the same time, the study revealed that 86 percent of all Swedes had flirted via text message at least once. 2. TOP SEARCH ENGINES Google and Yahoo provide the best Internet search results. This is the opinion of 2,000 North American Internet users who took part in a survey by Keynote Systems at the end of last year. Participants in the study searched the Web for specific subjects and images and then evaluated the results on behalf of the Californian company. According to the director of the study, Bonny Brown, there was one clear winner: Google remains the king of the Internet search. Google was ahead in all 13 categories of the test, although its rival Yahoo was not far behind. Yahoo is particularly strong when it comes to new search topics such as images or local content. Third place was taken by Ask Jeeves, the search facility for subscribers to online provider AOL, while Microsoft search engine MSN, ranked third last year, fell back to fourth place. The search engine in the AOL public domain was rated fifth best. Internet: 3. SWITZERLAND S MOST TRUSTED Most Europeans trust their head of state the most, but the pope, tennis players and natural scientists are also gaining recognition. This was the conclusion reached by the survey Reader s Digest European Trusted Brands For the sixth time, the magazine Reader s Digest has carried out Europe s largest representative consumer survey to identify the most trusted institutions, brands and people in 14 European countries (also see the article on page 22). In each country, with the exception of Great Britain, the respondents could only name one trustworthy person. Some of the findings: 43 percent of Russians voted for head of state and government leader Vladimir Putin. Roger Federer, currently the dominating player in men s tennis, attracted only 16 percent of the Swiss vote, although this was enough to secure him the top spot in the national ranking. The Poles trusted Pope John Paul II the most, even after his death. In Great Britain, those interviewed selected their trusted prominent persons from a list of 100 names: It was the popular natural scientist Sir David Attenborough, who received the highest vote of confidence. Federal President Horst Köhler came out on top in Germany. Internet: 4. GOOD CORPORATE CULTURE When it comes to standards of conduct and transparency, Deutsche Börse AG is one of the top companies in Germany. This is the result of two investigations into the corporate governance of the most important German public limited companies. With an excellent overall rating of 1.75, Deutsche Börse took second place behind Deutsche Telekom AG in the ranking

5 NEWS 1585 ISSUE 01/06 5 Deutsche Börse AG on growth course Figures in EUR million 1750 Sales EBITA Source: Deutsche Börse AG 4 5 of the 30 DAX companies compiled by the financial investment company Union Investment. The average rating for all companies evaluated was The final score reflected equally the extent to which companies observe the rights of shareholders, the organization of the Executive Board and the Supervisory Board and, finally, the level of transparency in terms of the companies day-to-day operations and the information they provide. Alexander Bassen, Professor of Business Management at Hamburg University, also attested to the exemplary corporate governance policies implemented by the management of Deutsche Börse. In the autumn 2005 rating compiled by Bassen in cooperation with the Deutsche Vereinigung für Finanzanalyse & Asset Management (society of investment professionals in Germany) as well as economics information provider Hoppenstedt, Deutsche Börse AG came in fourth both among the DAX companies and in the overall DAX, MDAX and TecDAX ranking. The Executive Board and the Supervisory Board of Deutsche Börse were involved from the very beginning in the Government Commission on the subject of corporate governance and fully recognized the German Corporate Governance Code at the time of its adoption in The Executive and Supervisory Boards issue an annual declaration of conformity in respect to this code. The group s strict orientation towards the interests of investors is also reflected by its performance in relation to turnover and profits: In 2005, Deutsche Börse AG reported strong growth in both sales and EBITA (please see the above chart). Internet: > Investor Relations > Reports and Figures > Investor Relations > Corporate Governance 5. PEOPLE LIKE YOU AND I All across the world, the level of trust in state organizations, companies and their representatives is dwindling. In contrast, it is people like you and I who are trusted the most more so than even doctors and scientists. This was the result revealed by the seventh and latest Edelman Trust Barometer, in which almost 2,000 policy makers from eleven countries took part. The erosion of trust in institutional sources of information has continued to progress, commented Richard Edelman, President and CEO of the company, which claims to be the world s largest independent PR network. He went on to say that companies would be well advised to avail themselves of opportunities for dialog with consumers, staff and other stakeholders in order to enhance credibility. Internet: MASTHEAD Publisher: Deutsche Börse AG, Neue Börsenstrasse 1, Frankfurt am Main, Internet: Deutsche Börse Group main editorial office: Dr. Ulrich Meißner (legally responsible for content), Heiner Seidel Publishing house: corps. Corporate Publishing Services GmbH, Kasernenstr. 69, Düsseldorf corps executive board: Holger Löwe, Wilfried Lülsdorf Editorial department: Florian Flicke (Director), Daniel Ferling, Eva Grillo, Hermann Kutzer, Stefan Merx, Nicolas Nonnenmacher, Olaf Storbeck, Dorothee Vogt Publications manager: Jan Leiskau Advertising manager: Ralf Zawatzky, Art direction: formwechsel.de Photography: Sebastian Pfütze Reproduction: ORT Studios, Berlin Printed by: Rademann, Lüdinghausen Order no.: All rights reserved. Reproduction and use subject to prior written permission Deutsche Börse AG

6 ISSUE 01/06 FEATURE Control is good, trust is better, so reads one of the central tenets of modern economics. The experts investigate why even the most self-serving people can be prepared to reach an accommodation with one another and how companies can use the T-factor to drive their profits. The Economics of Trust As you read this article, goods with a value of half a million dollars are changing hands around the world on ebay. The trading volume at the Internet auction house is roughly 1,511 dollars per second. In Germany alone, ebay users are buying a book every two seconds and a laptop every two minutes. Eleven excavators are sold every day on the Internet marketplace. This is everyday life at the beginning of the 21st century, yet from an economic perspective, it is a minor miracle. Every day, millions of people transfer money in advance to complete strangers in good faith that they will not be taken for a ride. They know neither the identity nor the address of the vendor and they have only seen photographs of the goods. Nobody guarantees that the product is actually in the condition described on ebay and nobody knows whether the vendor actually sends it. In this kind of market environment, trust is a decisive factor, says Axel Ockenfels, Professor of Economics at the renowned University of Cologne. From an economics point of view, one can hardly imagine a more hostile environment in which to generate trust than an online trading platform, points out the academic from Cologne. To overcome the anonymity, ebay enlisted the help of economists such as Ockenfels to develop a sophisticated evaluation procedure reputation as the trustbuilding criterion. Ockenfels was one of the first economists to

7 FEATURE 1585 ISSUE 01/06 7 The online trading phenomenon: Goods are being traded around the world on ebay at a rate of 1,511 dollars a second. Within minutes, products with a value of half a million dollars are changing hands. Buyers and vendors trust each other even though their only contact is via the Internet.

8 ISSUE 01/06 FEATURE recognize the relevance of the T-factor. He has been conducting laboratory experiments for many years to investigate when and why people trust each other and what rules and institutions promote mutual trust. In 2005, Ockenfels was awarded the Gottfried Wilhelm Leibniz Prize from the Deutsche Forschungsgemeinschaft (German institute of research) valued at 1.55 million euros in recognition of his work. This was the first time in 17 years that an economist had received this highly respected German scientific prize. The traditional portrayal of mankind It is not only ebay that operates according to the principle of no trust, no business. Trust is also an important commodity on the modern labor and financial markets. Even high-level monetary and economic policy depends on it, which makes it all the more surprising to learn that, up to only a few years ago, economists had only begun to investigate this area. Traditional economic models had no room for this type of soft issue and economics was the science of mistrust, according to successful author and management consultant Reinhard Sprenger. Economists traditionally viewed mankind as human incarnations of machines for maximizing utility: self-serving, rational, free of any moral considerations and ultimately only interested in their own gain. The notion of trusting this Homo economicus was best avoided as he would take every contractual partner to the cleaners without the slightest scruple as soon as he could see an advantage for himself. However, under certain circumstances, even such an egocentric economic subject will behave in a cooperative manner and will court trust if he is likely to have dealings with another party not just once but repeatedly. Israeli game theorist Robert Aumann had already used sophisticated mathematical models to demonstrate this in In these repeated games, even the most rational egoists among us have strong incentives to behave in a cooperative manner despite the fact that they would fare better in the short term if they adopted an uncooperative approach. The 75-year-old professor at the Hebrew University in Jerusalem received last year s Nobel Prize for economics in recognition of this insight. While altruistic behavior and revenge may appear to be rational approaches over the short term, emphasizes Aumann, they make less sense when viewed from a long-term perspective. People are more caring than we suspect In the meantime, another fact has dawned on economists: The image of the Homo economicus is a little out of touch with reality. Egocentric behavior is much less predominant in reality than is assumed by economists. Laboratory experiments and field studies have demonstrated that people are much more caring and socially minded than traditionally assumed. They attach great value to the idea of fairness, they have a propensity

9 FEATURE 1585 ISSUE 01/06 9 Reputation is key: Evaluation systems such as those used on ebay make even the greatest egoists willing to cooperate. The free purchase protection service offered by PayPal provides additional customer protection. to behave in a cooperative manner and they do not always pursue their own advantage. Most people behave in a reciprocal manner, explains Professor Armin Falk, Director of the Forschungsinstitut zur Zukunft der Arbeit (Laboratory for Experimental Scientific Research) at the University of Bonn. This means that they reward fair behavior and punish unfair behavior, even if this is associated with a cost to them. The strategic incentives discovered by Aumann in the course of repeated games are an important key to understanding the economics of trust. Another is the human propensity for reciprocal behavior. This gives rise to the truism: If one extends trust to another person, it is founded on the hope that he or she will not abuse this trust. Conversely, mistrust will be repaid in kind: Adopting a mistrustful attitude towards someone is likely to provoke dishonesty on their part. It was the sociologist Niklas Luhmann who first spoke of the self-fulfilling prophe-cy of mistrust in Trust as a promoter of efficiency Wishful thinking? Escapist theories for an ideal world? Quite the contrary. Numerous studies have shown that these arguments are rooted in reality. For example, the commitment shown by employees in whom their bosses have placed their trust is noticeably higher than those whose work environment is strictly controlled. This is substantiated by the researcher from Bonn, Falk, together with Michael Kosfeld from the University of Zurich in a study that will shortly be published in the American Economic Review. The scientists simulated an internal labor market with 100 participants in a laboratory experiment. Half of the volunteer participants acted as employees and the rest as employers. Each person employed was paid a salary and could decide for themselves their level of commitment to the job, the level of stress they were willing to accept and how much free time they had. Since the remuneration was not tied to their performance, the employees had an incentive to work as little as possible. Adopting a mistrustful attitudetowards someone is likely to provoke dishonesty on their part. Sociologist Niklas Luhmann explains the self-fulfilling prophecy of mistrust. The employers or entrepreneurs had the option of setting a minimum level of performance or trusting the workers to perform without supervision. The remarkable outcome was that the employers who abstained from any form of supervision received on average one third more work from their employees than those employers who monitored their staff. In contrast, those who set a minimum level generally did not receive more than the specified level of performance from their staff. Only a quarter of the employees behaved in a manner consistent with that of Homo economicus. They abused the trust placed in them and did not do any work if left unsupervised. The majority of employees behaved in a reciprocal manner and delivered relatively high levels of productivity relative to their salary. However, as soon as the employer introduced controls, the goodwill so far shown by many of the employees simply evaporated. They interpreted the control measures as a signal of mistrust, to which they reacted by working to rule. Interestingly, one in every five employees was not affected at all by how much they were trusted or mistrusted and showed relatively high levels of commitment. Control is good, trust is better as nursery schools in Israel discovered when they introduced a fine for parents who were late collecting their children. As a result, punctuality did not improve but actually got worse. This was demonstrated by US professors Uri Gneezy (Chicago Graduate School of Business) and Aldo Rustichini (University of Minnesota) in an investigation that received much attention. Even after the late collection fine was abolished, the number of parents arriving late remained at the higher level. Economists explain the phenomenon as follows: The surcharge changed the regulatory arrangement in the social relationship between parents and nursery school. For the parents, it was a matter of decency to arrive on time as otherwise a staff member would have to stay after closing time to look after the children. However, the introduction of the surcharge put a price on coming

10 ISSUE 01/06 FEATURE late. The task of looking after the children suddenly became another service that was paid for in exactly the same way as all the other services offered by the nursery school. As far as the parents were concerned, lack of punctuality had now become an accepted form of behavior. The stock market Trust is not only important in labor markets, but also on stock markets where the trust that potential investors place in other people in general and in companies in particular is a key factor. People will only invest if they are not afraid of losing out in the process. In addition to having an appreciation of the anticipated return and the risk involved when one decides to buy shares, one must also be able to trust that the information is reliable and the overall system is fair, according to the summary of the study carried out by a team of researchers from two famous American business schools, which recently appeared as a working paper in the National Bureau of Economic Research. Luigi Guiso and Luigi Zingales of the Chicago Graduate School of Business along with Paola Sapienza from the Kellog School of Management discovered that those who generally believe that most people are inherently trustworthy are 50 percent more likely to own shares. They also invest a higher proportion of their income in shares their proportion of shares held is 3.4 percentage points higher on average. However, the better educated they are, the less trust is a factor. More knowledge and information help to resolve the issue of trust was their economic summary. The trust factor can also be used to explain the wide variation in the percentage of people holding shares across different industrialized countries: For example, two thirds of the Swedish population and half of all Americans own shares either directly or indirectly. Links Distrust The Hidden Cost of Control by Armin Falk and Michael Kosfeld, published in American Economic Review, available online as an IZA Discussion Paper No at: ftp://ftp.iza.org/dps/- dp1203.pdf Book tips Freakonomics a Rogue Economist Explores the Hidden Side of Everything by Steven D. Levitt, Stephen J. Dubner (Riemann-Verlag, 288 pages, EUR 18.95): The Chicago-based economics professor Levitt and US journalist Dubner investigate questions relating to everyday life using the instruments of modern economics. Among other issues, they address the question as to when people are honest. Trusting the Stock Market by Luigi Guiso, Paola Sapienza, Luigi Zingales, NBER Working Paper No , available online at: Trust among Internet Traders: A Behavioral Economics Approach by Gary E. Bolton, Elena Katok and Axel Ockenfels, published in Analyse und Kritik (2004), available online at: A Fine is a Price by Uri Gneezy and Aldo Rustichini, published in Journal of Legal Studies (2000), available online at: The same applies to a mere one in five Germans, while in Italy and Austria, not even one person in ten owns shares directly or indirectly. At the same time, a mere 7.2 percent of all Americans and only 6 percent of all Swedes have no trust whatsoever in large companies in Germany and Italy, the figure is more than 17 percent. It doesn t work without rules An intelligently constructed regulatory framework can also act as a catalyst for trust and ebay is a classic example of this. The human propensity for fair behavior on its own is not sufficient to create trust between customers and vendors on anonymous online marketplaces. A German- American research team led by Axel Ockenfels and Gary Bolton (Penn State University) conducted experiments to demonstrate that a potential buyer must have at least a 70 percent chance of finding an honest vendor in order for this type of trading platform to function. However, in an anonymous environment involving one-off business relationships, the probability of this is actually roughly only half as high. How can this dilemma be overcome? Only with effective incentives such as the ebay evaluation system, in which users can rate one another and thus enhance their reputations. This also enables the creation of strategic incentives to promote trustworthy behavior even among the self-serving players, states Ockenfels. The free purchase protection service offered by PayPal provides an additional element of protection to buyers. If the vendor fails to deliver the goods or if the goods received differ substantially from the original description, PayPal will reimburse the buyer up to a maximum of 500 euros or pounds sterling. Put simply: Although trust is a positive and important factor, it must be reinforced with additional control mechanisms.

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12 ISSUE 01/06 COLUMN The two sides of governance British journalist Anthony Hilton detects a new turning point in the discussion between the owners and administrators of companies. Isaw a Western film once where at one point the hero said that it was that people were only ever seriously deceived by their best friends because they would never let their enemies get near enough. These days the financial markets seem to work on the same principle. The boards of directors and the senior executives of publicly quoted companies and the shareholder owners of those companies are supposed to be on the same side, working together to build a successful business for the future. But much of contemporary thinking, particularly in the field of corporate governance, assumes that the two sides are in conflict. It appears that shareholders no longer trust their executives and want to install the machinery of close supervision. They seek to prevent the chief executive from taking excessive risks and in this way the shareholders hope they will avoid unpleasant surprises. In the United States, United Kingdom and across mainland Europe structures are being put in place to curb the powers of executive directors to ensure that they are accountable to their shareholders wishes. We must avoid a situation where excessive governance regulations actually discourage investment and cause the most talented managers to apply their skills elsewhere. It is taken for granted in the United Kingdom anyway that corporate governance leads to improved business performance, though this is something I personally doubt and it is also something which has so far not been proven in any conclusive academic studies. There is on the contrary considerable anecdotal evidence that too much governance inhibits risk taking and major investments and additionally leads to the most talented managers deserting the public company arena to work in private companies away from the spotlight. If this trend continues and the best managerial talent refuses to work for public companies it might even be argued that corporate governance has made things worse. There is, however a bigger and more immediate cause for concern. Executives are seen as agents of the owners and the focus of governance has been to hold them to account to make sure they act in the owners interest rather than their own. However, no one has looked at the other side of the stock market model and seen that there lies an even greater problem. In an era where pooled funds and collective investment schemes have displaced individual direct share ownership, the fund

13 COLUMN 1585 ISSUE 01/06 13 Anthony Hilton: The British journalist has been writing about national and international economic events for 35 years and he has a keen interest in the financial markets. Hilton has spent time in London and New York working for the London Evening Standard, The Times and Sunday Times. He is currently the economics and financial columnist for the City Pages of the Evening Standard. The system of checks and balances relating to companies and funds no longer runs smoothly. We also need a system of governance for fund management. managers the people who run the money should also be considered agents of the genuine principal, the beneficial owner the man in the street whose savings these are. Fund management companies exist to make money, but their primary aim is to make a profit for themselves, not a profit for their clients. In good times the two go hand in hand, but the experience since the 2001 bear market, and the reason why the public no longer trusts the providers of savings products, is that this is not always the case. Indeed, the way in which so much fund management is structured, with fees charged on the volume of funds, and with very heavy performance charges means that fund managers and their companies do very much better than their clients. They make more from gathering assets than from managing them. They pursue strategies of rapid turnover and short term profits with too little regard for the high dealing costs. But what really makes one think the system is dysfunctional is when the fund manager (too often wrongly described as the shareholder) meets the corporate executive. It is a meeting of two sets of agents, both in theory deriving their long-term responsibilities from the one set of owners, but in fact both pursuing their own short-term agendas. That in itself could cause the system to have an excessively short-term focus but it is made worse by no longer being an evenly matched contest. Whereas the executive is constrained by the rules of corporate governance, the fund manager has no such restraint and as a result the system is tilted dangerously in his favor. Shareholder capitalism is an admirable economic system but only if all the checks and balances are working smoothly. At the moment they are not. We have had an extensive program of governance for corporate executives so extensive in fact that it is in danger of going too far. Now we need a similar program for the fund management industry so that it once again becomes worthy of the trust of its clients.


15 REPORT 1585 ISSUE 01/06 15 BaFin in Bonn: BaFin s 1,600 controllers monitor around 2,150 credit institutions, 750 financial service providers, 650 insurers and 6,300 mutual and restricted funds in Germany. Market watchdogs Over the last fifteen years or so global financial markets have changed dramatically and the way markets are regulated has been transformed just as much. America s Securities and Exchange Commission (SEC) dates back to 1934; European supervisory bodies such as the BaFin in Germany and the FSA in Britain are much younger but all three have the same function: to monitor trading activities with the objective of safeguarding confidence in the markets. No one disputes the need for regulation but it is far less clear how much is desired and how much is required. New markets, new products and new players: It is not only price fluctuations that make financial markets so exciting, but also the fact that the markets themselves are constantly changing and evolving. In fact, the last twenty years have been a period of sustained and successful market liberalization and deregulation. It is hardly surprising that national and other supervisory organizations respond to market changes by introducing new rules and regulations as a framework for investor protection and confidence. So far, so good. There is, however, a growing danger that the era of liberalization could be followed by a period of re-regulation. A growthinhibiting bureaucracy is in nobody s interest; neither market participants and organizations, nor investors, not even an EU Commission actively pursuing the goal of harmonization stand to gain from the stranglehold of overzealous regulation. Anyone who followed what went on in the financial markets in the eighties is aware of the sheer number and significance of the changes that took place at the time. The seventies taught the leading industrialized nations that, in the wake of Bretton Woods, monetary stability must be a key priority for all. By the beginning of the eighties this collective realization was coupled with a growing awareness in many regions across the world that intra-dependence was on the increase. As a result, steps were taken to liberalize world trade with the GATT (General Agreement on Tariffs and Trades) and WTO (World Trade Organization) being the most well known developments. With the commodity markets leading the way, the decade also witnessed the beginnings of a far-reaching process to open up and deregulate financial markets resulting in greater internationalization. Eurobonds and the lifting of restrictions on the free movement of capital are just two milestones that spring to mind. Heady days, especially as a counter-movement now appears to be looming. Big Bang and its reverberations London s Big Bang of 1986 and the German Bundesbank s subsequent residual liberalization of the Deutschmark capital markets were pivotal. Such trendsetting events were accompanied and driven by a technological revolution in the information and communications industry. Indeed, there has been a quantum leap between the exchange environment then and now. The last twenty years have seen a general trend of disintermediation, the introduction of electronic trading platforms, new derivatives markets, increasingly complex financial and investment instruments, market segments for start-up companies, the changeover to the European single currency, and the start of the cross-border consolidation of stock markets and clearing and settlement institutions. By 2000, the emphasis for change had progressed from national to international level and this applied to the markets and to their supervisory bodies in equal measure. It is also interesting to note that

16 ISSUE 01/06 REPORT the last few years have seen a shift in focus. America, with its strategy based on one leading stock exchange in New York, is no longer the sole focus of attention for other markets and the SEC is no longer the oft-quoted role model and object of unquestioning admiration it used to be. The Europeans are gaining increasing international attention due to their pioneering role in the modernization of trading, clearing and organizational processes. How big should the safety net be? There is no disputing the fact that new markets require new regulations and changing markets require appropriate amendments to the existing regulatory framework. However, the real questions are: How big should the safety net be drawn, what degree of trust can be placed in the self-regulatory powers of the organized markets and how far should the legislators go? The Big Bang was accompanied by several waves of regulation at national, EU and international levels. The most significant regulatory measures introduced as a result of the liberalization of the financial markets include those dealing with market abuse and insider trading, the use of standardized securities prospectuses for emissions in the EU and uniform principles to govern the regulation of exchanges and trading institutions in the EU, which are soon to be introduced under the terms of MiFID (Markets in Financial Instruments Directive). Nevertheless, concern about the threat of over-regulation is being expressed ever more frequently and forcefully and there is growing criticism of the level of bureaucracy in Brussels. The financial industry is putting increasing pressure on the EU to involve them in regulatory considerations from the start. The Less red tape = more growth: Commission tables package for better regulation paper which the Commission presented a year ago gave the industry some cause to hope that there would be an end to excessive bureaucracy. The paper also held out the promise that existing regulation would be reexamined prior to the setting up of new regulation, indeed that the need for new rules would be closely scrutinized in advance, i.e. better regulation is determined not by the quantity of rules and regulations but by their quality and enforceability. A process actively supported by Deutsche Börse. There are very good reasons to take another look at the current rules and regulations, the most important being the fact that, having undergone various reforms over the last few years at both the national and international level, they are, in fact, pretty effective. It is no small thanks to them that the image of the stock market as a breeding ground for lies and deceit, thriving on crashes, insider knowledge and lurid corporate scandals is very much a thing of the past. However, those flying the flag for investor protection have yet to give the current monitoring and sanction possibilities their full seal of approval. As a result, some in the media have simply transferred the old toothless tiger tag that was pinned to the German Federal Securities Supervisory office (BAWe), founded in the mid-nineties to its successor, the Federal Financial Supervisory Authority, known as BaFin for short, [see the interview with BaFin president Jochen Sanio on pages 20-21]. Such a comparison is superficial and, more importantly, it overlooks the preventative role of supervision. Experienced observers paint a different picture, which makes the change that has taken place quite clear: The flock of sheep (market participants) has become much larger, with the side-effect that there are also more black sheep. While people previously saw themselves as part of a flock of white sheep with the supervisory authority playing the big bad wolf, they now accept the existence of black sheep and the need to separate them from the rest of the flock. Whether, despite the modernization of the supervisory bodies in Germany and abroad, there have been too many incidences of fraud and deceit over the past years depends on one s point of view. However, their frequency and magnitude seem acceptable given the pace of growth and the scope of the markets. For the countries of the EU, the regulatory framework for the financial system is increasingly determined at the European level either directly by decree or by directives that have to be incorporated into the respective national legislation. However, supervisory powers relating to stock exchanges will remain largely under national control until MiFID comes into force in Regulation at a national level for 10 years In Germany, a country with a strong federal structure and several regional exchanges, the securities supervisory office has only been in existence at a national level since Prior to the Second Financial Markets Promotion Act of 1995 a historic turning point the lack of both insider trading rules and of a central institution as a single point of contact be-

17 REPORT 1585 ISSUE 01/06 17 tween the numerous regulatory bodies were obvious deficiencies much lamented by foreign market participants in particular. Regulatory duties are currently performed in a three-tier system comprising the federal government, the Länder, or states, and the self-regulatory institutions of the respective stock exchanges. This division of responsibility is the subject of ongoing discussions with critics demanding greater concentration of authority. Since spring 2002, supervision of securities at national level has been in the hands of BaFin (Bundesanstalt für Finanzdienstleistungsaufsicht), a comprehensive financial service supervisory authority that incorporates the BAWe and is directly responsible to the Federal Ministry of Finance. Individual Länder remain responsible for supervising the legality of the administrative and market activities of the stock exchanges and therefore supervision of their trading activities. Finally, the exchanges themselves have self-regulatory institutions with two main functions: the enactment of stock exchange regulations that require approval by the fedaral states supervisory authority and the setting up and operation of market surveillance. And it is this market surveillance that, even for the most critical observers, is an important seal of quality and the basis of investor confidence in German stock exchanges. Such market supervision stands up to international comparison, and demonstrates on a daily basis the strength of selfregulation within a legislative framework. Strong supervision: BaFin s securities and asset management supervisory arm is based in Frankfurt am Main, its bank and insurance arm is in Bonn. As a result of EU directives, the balance is shifting increasingly in favor of the central authority, BaFin. For example, responsibility for checking the prospectuses of issuers has migrated from the exchanges to BaFin as a one-stop competent authority at EU level. BaFin is, however, occasionally the target of criticism. Regulation in Germany still places too much emphasis on formal criteria, as if it were looking more at the box the product comes in and less at the product itself. It would be better to adopt a qualitative approach and align regulations with risk or investors needs for protection, argues Stefan Seip, Director General of BVI Bundesverband Investment und Asset Management e.v. in Frankfurt. Praise, how ever, is forthcoming from other quarters. Since last year, Germany has been making progress. Our impression is that BaFin has increasingly taken sector development and the importance of Germany as a business location into consideration alongside the traditional goal of investor protection, states Wolfgang Mansfeld, member of the Board of Managing Directors at Union Investment.

18 ISSUE 01/06 REPORT The area of financial regulation in Great Britain has also undergone considerable change since the 1980s. Along with liberalization measures which had direct impact on market developments, such as the opening-up of the market to new participants and the liberalization of fees, what was referred to as the Big Bang was designed to give Europe s leading financial center a more modern regulatory system with greater focus on competition. However, the Financial Services Act of 1986, which came into effect in 1988, was only the starting point. In a comparative analysis in its monthly report for January 2006, the Deutsche Bundesbank noted: As a result of obvious and serious deficiencies in the area of supervision, further and far-reaching changes were implemented in May The principle of self-regulation was abandoned and the decision was taken to introduce statutory regulation instead. Inspector computer: State-of-the-art hard and software help controllers at BaFin and the FSA to unmask insider trading and other illegal trading activities. Comprehensive financial supervisory body As a result, the Financial Services Authority (FSA) was founded as successor to the Securities and Investment Boards (SIB) and it also incorporated the self-regulatory institutions SFA, PIA etc. In 1998 responsibility for supervising the banking system passed from the Bank of England to the FSA. Since then, the FSA has also taken over responsibility for regulating the mortgage market and general insurance business and is moving ever closer to becoming a comprehensive financial service supervisory body. Better regulation is not just a long-term FSA goal, it is ongoing practice. At the beginning of December 2005, the FSA announced measures to dismantle bureaucracy and reduce costs for businesses some regulations are to be relaxed or streamlined while others are to be abolished altogether. The British Financial Services Authority is headquartered in the heart of London, at the center of financial power, facilitating communication between the authority and financial service providers. Luxembourg offers niche benefits The market supervisors in Luxembourg have played an important role in the country s development as a financial center, even if it has been a role rarely in the limelight. You don t have to be headline news every day to achieve results states Jean-Nicolas Schaus, Director General of the Commission de Surveillance du Secteur Financier (CSSF). The Commission s area of responsibility is widespread and covers banks, investment funds, brokers, asset managers, other financial service providers and stock exchange dealing. It is financed through contributions from the financial entities domiciled in Luxembourg.

19 REPORT 1585 ISSUE 01/06 19 The regulators take into consideration the preservation of the niche benefits Luxembourg offers as a financial center, as these are very much part of Luxembourg s ability to attract new fields of business. The Grand Duchy s financial market has traditionally been international in character and oriented towards competition. And its supervisory authorities are credited with being open to the market s suggestions for improvement. It is therefore not surprising that regulators are all the more fearful of the threat of overregulation at European level. As one Luxembourg official emphasized, It is precisely because we favor market-driven regulation that our markets and supervisory authorities work so well. The speed of the prospectus approval process in Luxembourg is a prime example of this. Self-regulation with a statutory framework America continues to initiate trends that influence all walks of life the world over, and the financial markets are no exception to the rule. Consequently, experienced regulatory experts in Europe follow regulatory developments on Wall Street closely; they know that the EU Commission tends to adapt these developments at some point, despite the fact that the European securities industry as a whole has become more critical of the US as a role model. The US securities market has traditionally stressed the principle of self-regulation. However, since the stock market and banking crises of the 1930s, selfregulation has been subject to clear provisos. The guiding principle of market regulation in the US is to ensure that investors are in a position to take informed investment decisions by having access to all pertinent issuing company and market information. Although public debate in the USA focuses almost exclusively on the SEC and its regulatory strength, a large number of regulation entities are actually involved. Aside from the SEC and its sister organization for the futures market, the Commodity Futures Trading Commission, from which the outline provisos actually originate, the US exchanges themselves are self-regulating organizations. Exchanges are responsible for laying down their specific rules and regulations by which market participants must abide. And together with the registered stock exchanges, the National Association of Securities Dealers also plays an important role; as a private sector regulatory body, it supervises the electronic stock exchange Nasdaq and the OTC markets. The Deutsche Bundesbank sums up the situation: In view of the globalization of financial markets, we have long since passed the point at which regulation can solely be pursued from a national perspective. Competition on the financial markets goes hand in hand with competition between the different regulatory systems. To keep their competitive edge, both regulatory standards and regulatory systems in the various financial centers around the world will probably become increasingly similar. What does the future hold? For this very reason, financial sector lobby groups have much praise for the policy the European Commission is following in the field of capital market legislation. Over the next few years its policy is to concentrate on consolidating the existing statutory framework, with changes and additions only in a few selected areas. However, this policy is not met with praise all round. The damaging consequences of excessive harmonization also seen as damaging for investors are being highlighted at the same time. The Berlin-based Association of German Banks complains that national markets continue to exhibit far greater structural differences than one would expect to find in a genuinely integrated market. Bringing about a change in this regard won t be an easy matter, as this would require genuine consensus on the need to create uniform structures within the EU. All European participants will have to do their homework and come up with answers to the following questions if they really want better regulation. Should there be a single supervisory body in the EU or not? Should there be greater international cooperation beyond EU boundaries or should the focus be on the EU? Should there be more harmonization via directives and regulations or should competition between the different frameworks continue? Hermann Kutzer began his career in journalism in 1969 at the vwd news agency, and has worked for Verlagsgruppe Handelsblatt since The stock market expert is a well known TV commentator and financial columnist.

20 ISSUE 01/06 INTERVIEW A little bit of mistrust never hurt anyone Interview with Jochen Sanio, President of the Federal Financial Supervisory Authority (BaFin) The past decade at the stock exchange has been fast-paced, but also associated with numerous scandals. Is the German securities market deserving of greater trust from investors than was the case ten years ago? Investors can afford to place greater trust in the German securities market today than they could ten years ago. At that time, the supervision of securities was in its infancy. Important responsibilities had only just been transferred to it. I am thinking, for example, of the banning of insider dealing and the requirement to issue ad-hoc announcements. Today, the supervision of securities at BaFin performs these tasks extremely effectively and it has also gained additional powers in several new areas. Which areas? BaFin supervises the ban on market manipulation and the implementation of takeover procedures, is involved in the control of accounting procedures and regulates the financial service institutions. Another significant development is the fact that we are now cooperating much more closely with our colleagues abroad, primarily with those in Europe. However, this does not alter the fact that investors are themselves responsible for their actions. Vigilance and a healthy dose of mistrust never did anyone any harm. Do you agree that too many statutory and other regulations are being drafted in the meantime and that we are threatened with excessive regulation, following the deregulation that took place during the 80s? This concern is partially justified also and especially in the context of securities supervision. New, complex financial products are popping up everywhere and the regulatory framework has to keep in step with this trend. Otherwise, we the supervisors will always be one step behind the developments in the market and will lose sight of one of our key objectives, namely that of maintaining the integrity of the markets. However, going down the path of creating ever more detailed and therefore more comprehensive regulations, which even the experts have difficulty getting to grips with, is a pointless exercise. For this reason, the BaFin has adopted a position that conforms to the European Commission s new policy of promoting better regulation, which envisages a strict and principle-based style of regulation. What does that mean precisely? This type of regulation permits flexible solutions in individual cases. Our understanding of principlebased supervision is exemplified by the new minimum requirements for risk management (MaRisk) that we have incorporated into our banking supervision policies. The concise approach adopted by the MaRisk will enable it to adapt to face the challenges that lie ahead. In your opinion, what are the key challenges facing the supervision of securities in the context of globalization? Transactions across national borders, internationally positioned players on the financial markets we would be fighting a losing battle if we did not have uniform standards and if our institutional and market supervisory bodies did not cooperate with our counterparts abroad. One organization that has gained a great deal of merit over many years is the International Organization of Securities Commissions (IOSCO). It develops the international standards that we need to form a basis for our principlebased regulatory approach. At the same time, it enables faster and more efficient cross-border cooperation in individual cases. Today, IOSCO has around 180 members and all the main regulatory authorities from around the world are represented there. Achieving a balance between global and national interests is undoubtedly a challenge. The trick here is to formulate the standards in such a way that they raise the operational activities of the

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