Subject: Online trading and rules of conduct

The Commission has already provided some clarifications concerning the application of rules on specific aspects of the securities industry to the supply of online investment services.

The recent growth in online trading (consisting in use of the Internet as a means of communicating with customers for the supply of the services of dealing for customer account and receiving and transmitting orders) and an analysis of the conduct of the intermediaries operating in this sector indicated the desirability of reiterating that the approach adopted by the Commission, in line with the principles laid down by IOSCO, is to allow intermediaries complete freedom to use the Internet to provide services in a setting designed to ensure continuous compliance with the rules of conduct in force.

* * *

Use of the Internet as a means of communication with customers does not exempt intermediaries from the obligation to apply the existing rules for the supply of investment services, although it may require special methods of compliance owing to the nature of the technique used to establish contact. It follows that intermediaries using the Internet must install systems and procedures permitting full compliance with the rules.

* * *

Within the general framework set out above, it appears desirable to draw attention to certain aspects of the legislation in force that are of special importance for online trading services. In the first place, as regards the establishment of relationships with investors:

-CONCLUSION OF CONTRACTS:as the law stands today, contracts for the provision of investment services must normally be concluded in writing and may therefore be concluded over the Internet only where it is possible to use digital signatures as provided for in Presidential Decree 513 of 10 November 1997 implementing Article 15.2 of Law 59 of 15 March 1997. ⁽¹⁾ The same holds for all other matters that the law requires to be reduced to writing;

- IDENTIFICATION OF CUSTOMERS FOR ANTI-MONEY-LAUNDERING PURPOSES:at the time relationships are first established, intermediaries must identify customers in accordance with Law 197/1991 and the related implementing regulations; ⁽²⁾

- INFORMATION TO BE GIVEN TO CUSTOMERS:use of the Internet to provide services does not exonerate intermediaries from complying with the rules in force on the advance disclosure of information to customers. However, nothing in the rules prevents intermediaries from using the Internet to deliver the document on the general risks associated with investing in financial instruments that they have to give customers before starting to provide investment and related services, ⁽³⁾ although they must put systems and procedures in place allowing them to record the "delivery" of the document. Moreover, insofar as Articles 21.1b) and 21.1a) of Legislative Decree 58/1998 require intermediaries to operate in such a way that customers " are always adequately informed" and to act " correctly and transparently in the interests of customers", the Commission recommends that, before starting to provide services, intermediaries should warn investors that the manner of executing transactions over the Internet (not for nothing known as "trading") may induce them to multiply their transactions and engage in day trading, and that they should draw attention to and explain all the risks of such a strategy, not least as regards the cumulative cost of commissions (even where their unit value is low);

- INFORMATION TO BE OBTAINED FROM CUSTOMERS:Article 21.1b) of Legislative Decree 58/1998 requires intermediaries to " acquire the necessary information from customers" and Article 28.1a) of Consob Regulation 11522/1998 lays down that before starting to provide services they must " ask investors for information about their experience in investing in financial instruments, financial situation, investment objectives and propensity to incur risks". ⁽⁴⁾ The rules currently in force do not specify the ways in which this information is to be obtained, so that it is up to intermediaries to decide how to comply. ⁽⁵⁾ In particular, the Commission recommends that intermediaries should not do anything to encourage investors to refuse to provide the information requested. This general principle is especially important in the case of online trading in view of the aggressive day-trading strategies it may involve. Article 28.1a) of Consob Regulation 11522/1998 lays down that if a customer refuses to supply the information requested, " this must be stated in the contract ... or in a declaration signed by the investor"; no other ways of expressing such refusal are acceptable.

As regards the actual online provision of the investment services of dealing for customer account and receiving and transmitting orders, without prejudice to the need to comply with all the applicable rules laid down in Legislative Decree 58/1998 and Consob Regulation 11522/1998, the Commission considers that the following aspects deserve special attention:

- SYSTEM EFFICIENCY:intermediaries that provide online trading services must equip themselves with IT systems that will enable them, taking into account the volume of business they may be required to handle, to carry out orders given by investors promptly, as laid down in Article 26.1d) of Consob Regulation 11522/1998. Since Article 21.1d) of Legislative Decree 58/1998 requires intermediaries " to have resources and procedures ... capable of ensuring the efficient provision of services", it may be advisable for them to conclude agreements with Internet providers and other companies involved in the process so as to ensure the operational efficiency of the service supplied. In order to cope with outages, temporary or otherwise, the Commission recommends that intermediaries should put efficient alternative procedures in place so that investors can continue to trade. Article 30.2c) of Consob Regulation 11522/1998 requires intermediaries to specify these alternative procedures and the manner of using them in their contracts with customers.

Moreover, every precaution must be taken to ensure that the automated systems in use guarantee the maximum confidentiality of data transmitted over the Internet.

- INFORMATION ON THE NATURE AND RISKS OF TRANSACTIONS AND LARGE LOSSES:intermediaries must comply with Article 28.2 of Consob Regulation 11522/1998, which requires them to provide investors with the information on the nature, risks and implications of transactions they need to have in order to make informed investment decisions. This obligation is of a continuing nature and does not come to an end with the first transaction; the information to be given to customers may nonetheless be posted in standard form on a website. ⁽⁶⁾ Intermediaries are also required to comply with Article 28.3 of Consob Regulation 11522/1998, which states that " intermediaries shall promptly inform investors in writing as soon as transactions in derivative instruments or warrants that they have ordered for purposes other than hedging give rise to an actual or potential loss equal to or exceeding 50% of the means provided for the purpose of carrying out and guaranteeing such transactions". Without prejudice to the obligation to comply with this requirement in writing, the Commission considers that it is desirable for intermediaries to give investors advance notice of such circumstances over the Internet.

- SUITABILITY:The obligation to assess the suitability of individual transactions provided for in Article 29 of Consob Regulation 11522/1998 continues to apply where the investment service is supplied on line. ⁽⁷⁾ The article in question requires intermediaries to assess the suitability of transactions in the light of investors' profiles by putting in place and using automated procedures that take account of the objective features of transactions and the subjective profiles of investors. Intermediaries are not exonerated from fulfilling this obligation even where investors have refused to supply information on their financial situation, investment objectives and propensity to incur risks. In such cases the assessment is to be made -- in compliance with the general principles of correctness, diligence and transparency -- on the basis of all the information in intermediaries' possession (e.g. customers' age, job and presumable propensity to incur risk in the light of their past trading, and market conditions).

Where an intermediary receives an order to carry out a transaction it deems unsuitable, the obligation established by Article 29.3 of Consob Regulation 11522/1998 to inform the investor and explain why the transaction is unsuitable applies even when the trading service is provided on line. Intermediaries may nonetheless fulfil their suitability obligations over the Internet, provided they give customers the information required by the rules in a sufficiently clear and evident manner. In the same way, the obligation established in the second part of the same article that " where the investor nonetheless intends to proceed with the transaction, the intermediary may carry it out only on the basis of an order given in writing or, in the case of orders given by telephone, recorded on magnetic tape or an equivalent medium in which explicit reference is made to the warning received" is to be understood, not as precluding use of the Internet to confirm unsuitable transactions, but as meaning that where customers use the Internet to give instructions to proceed with unsuitable transactions, the procedure put in place by the intermediary must require them to give explicit and knowing confirmation of their intention to proceed and oblige them to acknowledge receipt of the warning about the unsuitability of the transactions they have ordered. Moreover, it is indispensable that the procedure should not have confirmation of unsuitable orders as the default setting. Naturally, intermediaries must arrange for appropriate records to be kept in unalterable form of customers' knowing confirmation of unsuitable orders and for customers to have access to them, in accordance with Articles 69 and 28.5 of Consob Regulation 11522/1998.

- CONFLICTS OF INTEREST:the considerations put forward above with regard to suitability, logically apply also to Article 27.2 of Consob Regulation 11522/1998, which lays down that " intermediaries may not carry out transactions ... on behalf of their clients where they have directly or indirectly a conflicting interest, ... unless they have previously informed the investor in writing of the nature and extent of their interest in the transaction and the investor has expressly agreed in writing to the carrying out thereof. Where the transaction is concluded by telephone, compliance with the foregoing information requirements and the issue of the related authorization by the investor must be demonstrated by a recording on magnetic tape or an equivalent medium". The existence of conflicts of interest may also be made known over the Internet, provided the information is given in a sufficiently clear and evident manner and investors can download and save it in a permanent form. Customers may use the same medium to authorize the execution of transactions (despite the existence of a conflict of interest), as long as the intermediary's procedure requires explicit and knowing confirmation by customers of their intention to proceed. Here again, it is indispensable that the procedure should not have confirmation of such orders as the default setting and intermediaries must arrange for appropriate records to be kept in unalterable form of their fulfilment of the disclosure requirement and customers' confirmation of such orders, and for customers to have access to them, in accordance with Articles 69 and 28.5 of Consob Regulation 11522/1998.

- CONFIRMATION OF ORDERS AND TRANSACTIONS AND PERIODIC REPORTS:where orders are received over the Internet, intermediaries may use the same medium to fulfil their obligation to send customers paper-based order confirmations (Article 60 of Consob Regulation 11522/1998) and transaction confirmation notices and periodic reports (Articles 61 and 62 of Consob Regulation 11522/1998), provided their systems and procedures allow recipients to download and save the documentation in a permanent form (Article 75.3 of Consob Regulation 11522/1998) and the content of each document complies with the applicable rules. ⁽⁸⁾

- PROCEDURES:the manner of providing services and the fact that many interactions with customers are carried out on line make it especially important to ensure compliance with Article 56.2a) of Consob Regulation 11522/1998, which requires intermediaries to " establish procedures serving to reconstruct the times and types of action taken in supplying services".

- RELATIONSHIPS WITH SUPERVISORY AUTHORITIES:intermediaries must adopt procedures for storing documentation delivered or received over the Internet that ensure it is unalterable and promptly retrievable for examination by the supervisory authorities.

THE CHAIRMAN
Luigi Spaventa

_______________________________________________________

1. See Communication DI/99052838 of 7 July 1999 and Communication DI/99091709 of 15 December 1999 for the definition of the Internet as a "means of distance communication" within the meaning of Article 32 of Legislative Decree 58/1998 and the specification of the limits of the applicability of the obligation to use financial salesmen for distance promotion and marketing over the Internet.

2. See the recent clarification concerning possible forms of "distance identification" issued by the Italian Foreign Exchange Office (UIC) in a circular dated 31 January 1999.

3. See Communication DI/99065403 of 3 September 1999.

4. Resolution 11522 and the attached Regulation are published in Gazzetta Ufficiale della Repubblica italiana, no. 165 of 17 July 1998, Supplemento Ordinario no. 125, and Consob, Bollettino mensileno 7, July 1998. Consob Regulation 11522/1998 replaced Resolution 10493 of 30 September 1997 and Resolution 10418 of 27 December 1996 and was subsequently amended by Resolution 11745 of 9 December 1998, published in Gazzetta Ufficiale, no. 297 of 21 December 1998 and Consob, Bollettino mensileno. 12, December 1998 and by Consob Resolution 12409 of 1 March 2000, published in Gazzetta Ufficiale, no. 58 of 10 March 2000 and Consob, Bollettino mensileno. 3, March 2000.

5. See Communication DI/99065403 of 3 September 1999.

6. See Communication DI/99091709 of 15 December 1999.

7. See Communication DI/98063298 of 30 July 1998 and Communication DI/99091709 of 15 December 1999.

8. See Communication DI/98063298 of 30 July 1998.