The modernisation of derivatives regulation will be welcomed by everyone who has had to battle the vagaries and inadequacies of Part 3 of the Securities Markets Act 1988 and the series of Authorised Futures Notices that, in practicality, define the existing regime.
The scope and direction of this reform has now been mapped out in the Financial Markets Conduct Bill (the Bill). This Brief Counsel describes the proposed framework and puts it in the context of international developments that are now fast approaching and will change the rules of the game.
The context for New Zealand derivatives regulation
As a small, geographically isolated trading country that is heavily reliant on international capital markets for its funding, derivatives play a vital part in New Zealand’s financial system and economy. A pity, then, that our regulation of this area is so antediluvian, inefficient and haphazard.
This is the situation that the Ministry of Economic Development (MED) is trying to address in the first comprehensive review of derivatives law since the late 1980s, when there was barely a swap market and exotica such as credit default swaps, Kyoto units, negative basis trades and volatility indexes were not even contemplated.
The MED’s response has been to bring derivatives within the framework as one of the four “financial products” that are regulated under the Bill. While this is undoubtedly the best way to proceed, it also creates a number of challenges because of important differences between derivatives and the other three financial products, all of which are securities (debt, equity and managed investment schemes).
The shock of the old
Derivatives currently attract their regulation largely from Part 3 of the Securities Markets Act 1988. This regime is now well and truly out of date, being based on a now twice-superseded New South Wales precedent.
The regime is very haphazard and inefficient, having been developed over the past 20 years largely through Authorised Futures Dealers and Futures Contract notices. It is duplicative, in the sense that many “futures contracts” will also be debt securities, under the incredibly expansive meaning accorded to that term in New Zealand. It is also anomalous in that it applies to both retail counterparties (who presumptively require protection) and wholesale counterparties, who in other areas are rightly presumed to be able to fend for themselves.
These and other defects mean that an overhaul is overdue. The MED is to be congratulated for taking an entirely new direction in the Bill, as outlined below.
Navigating the new derivatives regime
Because the derivatives provisions are baked into the infrastructure of the Bill (for example, you won’t find a Part of the Bill labeled “derivatives”), a navigation guide is required to understand how the regime will operate. Making life more difficult in terms of getting to grips with the treatment of derivatives is the fact that obligations and requirements can arise from derivatives being a “financial product” and/or a “regulated product” and from various provisions about listed markets.
In that sense, almost the whole Bill regulates, or potentially regulates derivatives, even though they are the ‘odd man out’ in terms of being the only financial product that is not a recognised security.
One pleasing feature of the Bill is that derivatives have now been defined in a way that maps to the market, by using familiar terms such as swaps, options etc but with sufficient flexibility to accommodate the unusual or novel. The definition is in two parts: subsection (1) being principles-based and subsection (2) being the market terms, such as option and swap.
Also helpful is the fact that the core derivatives products and debt securities are now defined with mutual exclusivity – for almost all practical purposes, if it’s a debt security, it won’t also be a derivative, and vice versa. The potential for wasteful dual regulation should now be very limited or even non-existent.
Other key definitional matters to note are:
- Derivatives issuer: A number of provisions turn on whether a person is a “derivatives issuer”, defined as a person in the business of offering derivatives.
- Regulated products: Similarly, a number of provisions of the Bill are limited in application to offers or sales of “regulated products”. A regulated product in the Bill is an offer of a financial product to one or more persons where the offer to at least one of those persons requires disclosure (i.e. a “retail offer” in the old terminology).
Quoted derivatives: This is the term MED has opted for to describe exchange traded derivatives. Associated terms that can be relevant in this context also include:
- “market services”, which include acting as a derivatives issuer, and therefore potentially require licensing under Part 6 of the Bill, and
- “licensed market”, as a financial products market requiring to be licensed under the Bill may include a derivatives market.
- Issuer and issued: MED has asked respondents to consider technical aspects around who “issues” derivatives, particularly in the area of exchange-traded derivatives.
Status as a financial product
Derivatives are financial products and, as such, are subject to the core regulatory structures in the Bill, including:
- prohibition on false, deceptive or misleading conduct or representations
- governance requirements, to the extent the derivatives are “regulated products” (including accounting and audit requirements, duties to keep registers and send confirmations etc)
- custody and supervision requirements
- insider trading and market manipulation provisions, to the extent that the derivatives are quoted on a regulated market
- civil and criminal enforcement provisions, and
- the exemption regime (in itself a major advance on the existing regime, which is asymmetric in the sense that one can only be authorised for it, not exempted from it).
Other than where these matters give rise to issues or difficulties specific to derivatives, they will not be further covered in this Brief Counsel.
Disclosure, modified disclosure requirements and exceptions
As with the other three categories of “financial products”, derivatives require disclosure:
- under a PDS if no exemption applies (clause 24 of the Bill), or
- under a “disclosure document” if exempted AND regulations have been created providing for specific disclosures (clause 24 of Schedule 1 to the Bill).
Where disclosure is required, a retail-targeted PDS must be prepared and registered with the Registrar of Financial Service Providers. There are also likely to be initial and possibly ongoing requirements to provide further information to the Register of Securities.
There are two core exceptions that are likely to apply in the over-the-counter (OTC) derivatives market.
- Offers to wholesale investors (as defined in clause 3 of the first Schedule) – which will include investment businesses, large customers (total assets over $10m or turnover over $20m) and government agencies.
- Offers or sales of derivatives where the offeror/issuer is not a “derivatives issuer” (i.e. a person that is in the business of offering derivatives) (clause 17).
The first is clearly going to be helpful, but the second could see a lot of legal ink needlessly spilled unless there is some better definition of what it means to be “in the business” of offering derivatives. Are gentailers in that business if they occasionally enter into electricity hedging transactions? Is Fonterra in that business because of its participation in DairyFutures?.
Part 4 sets out governance requirements for financial products. Derivatives and derivatives issuers are not required to have governing documents (i.e. trust deeds) or supervisors, which apply only to debt securities and managed investment schemes.
However, the requirements of Subparts 5 and 6 do potentially apply to derivatives, including register and record-keeping requirements. We note below that there are some technical and drafting issues in relation to ensuring that requirements drafted with securities primarily in mind work properly with the different procedures and norms of the derivatives market.
Licensing, market regulation and “quoted” derivatives
The Bill creates a general framework for licensing of the various matters that the Government considered were appropriate. These matters fall into two categories:
- licensing of markets for trading financial products (Subpart 7 of Part of the Bill), and
- licensing of “market services” (Part 6 of the Bill), which is defined to include acting as a derivatives issuer in respect of a regulated offer of derivatives (ie in the retail space).
Licence criteria and the types of licence conditions that may be imposed for derivatives, as for the other relevant areas, will be developed in the regulation-making process over the next year or so.
There are some areas where the licensing provisions may be indirectly relevant. For example, it is contemplated under clause 6 of the First Schedule to the Bill that there will be tailored exemptions for licensed intermediaries to be developed in the regulation-making process.
This seems to contemplate that substantive licensing will provide a partial alternative to disclosure in relevant circumstances (refer for example to clause 24(1)(a) of the First Schedule).
The Bill creates a new concept of “quoted derivatives”, which are derivatives approved for trading on a licensed market. Accordingly, the provisions of the Bill relevant to dealings on such markets apply to both exchange-traded derivatives of the standardised variety (e.g. futures and options) and also to other derivatives conducted through a regulated exchange or market (such as DairyFutures and, at least potentially, electricity hedging contracts).
Other than standardisation, the key feature of exchange-traded derivatives is that the exchange acts as an intermediary to all transactions by way of novation and thus is effectively a guarantor of the market, with its obligations backed up by using pooled margins from both sides of the trade. Trading firms and other participants take no risk on the actual counterparty to the trade, but rather on the clearing house, which is able to take on this risk by margining and through prudential regulation of participants. As a result, it is most efficient to restrict regulation of quoted derivatives to oversight of licensed markets and handling of client money. Because many such markets will not be based in New Zealand, it will also be important to have procedures for recognising such markets as licensed markets where they have appropriate characteristics as – ultimately – they are likely to offer the best means of transparency and investor protection.
Conduct and client property
The conduct provisions are based on those in the SMA, and include a prohibition on insider trading. But the Bill treads new ground in the requirements for client agreements.
These seem to stem conceptually from regulation of intermediary services and are difficult to square with documentation practices for bilateral OTC derivatives, which is the predominant mode of activity in New Zealand.
There will also be money handling and trust requirements, which are likely to extend beyond licensed intermediaries and retail derivatives offers (see clause 428 of the Bill), although it is not clear what is the case for such extension where sophisticated counterparties can and do contract for their own credit and other protections.
As can be expected from a radical change of regulatory direction, there are a number of issues in the treatment of derivatives as “financial products” arising from the differences between derivatives and securities. For example, some modifications are required to deal with the way that derivatives are documented and recorded, where concepts of security certificates and registers are potentially problematic.
In other areas, there are provisions that need to be addressed because they are impracticable or over-reaching, whether applied to securities or derivatives – for example the new provisions of clauses 411 to 413 relating to client agreements.
Also, the concept of a imposing obligations on “derivatives issuers” where there is not a regulated offer will not necessarily make sense in some markets where there are two wholesale issuers, neither of which are banks (e.g. gentailers in the electricity hedging market and potentially counterparties to carbon credit transactions).
We are aware that these matters have been addressed in at least some private submissions on the Bill.
An area that may also require some further attention is the prohibition on insider trading, which is adapted from the corporate securities setting, but – in the context of derivatives – is problematic, particularly in commodity derivatives markets.
In principle, there is less of a case for extending inside information prohibitions into the derivatives sphere because the value of the instrument is driven entirely by movements in value of the underlying. In turn, for most derivatives traded in New Zealand, the underlying reflects the views of the market on the direction of interest rates, currencies, share indices etc – each in turn reflecting myriad factors that everyone in the market has some information on but no one has definitive knowledge about.
The issues can be particularly significant in relation to commodity derivatives markets (including electricity hedging, dairy and so on), where participants are likely to possess information that is material to the price of the relevant commodity, but which – for reasons of commercial sensitivity or for compliance with local or international price fixing laws – should not be required to be disclosed to the market.
This is given some recognition through the exception in clause 228 of the Bill related to knowledge of one’s own transactions, business activities or agreements concerning the underlying. But the concern remains that this is all too abstract and vague to form the basis for a criminal provision carrying potentially five years' imprisonment for its breach. It is also difficult to explain to potential international participants in local exchanges, who tend to bring a huge amount of risk aversion to the table.
The old gambling chestnut
The Bill does not address issues arising under the Gambling Act 2004 and, in particular, has no equivalent of section 40 of the Securities Markets Act 1988, which provides that nothing in the Gambling Act 2003 applies to authorised futures contracts. MED has requested submissions on this and has laid out three options, including that a similar provision applies to all licensed derivatives providers and to those who are operating under exemptions.
We do not view the Gambling Act as changing the previous law, which is that a derivative entered into for a legitimate commercial purpose is not “gambling”.1 It may be that some of the commentary in the market raising doubts about this matter arose from comments in the Select Committee report in relation to the Gambling Act 2003, which said:
We acknowledge that such a broad definition of “gambling” can capture some transactions that are not generally considered to be “gambling” such as stock market investments. However, the current legislative approach is to exclude some specified transactions from the Gaming and Lotteries Act. [There followed a footnote reference to what is now section 40 of the Securities Markets Act 1988] If further types of financial transactions are to be excluded, we consider this should occur in financial statutes, which would deal with new financial products as they are introduced into the market.
The issue with this is that formulations and presumptions such as those set out in the Morgan Grenfell case are not particularly amenable to statutory treatment, or at least not in a way that does not either miss the point of the judgement to be made between valid commercial transactions on the one hand and illegal unlicensed gambling transactions on the other.
If an approach is taken along the lines of section 40 of the SMA, the risk is that it obfuscates the position more by suggesting that whether or not a purported derivatives transaction is a gambling transaction should turn on the form of that derivative and the parties to it, which surely cannot be the case (and is not the case under the Morgan Grenfell line of authority).
As a result, we do not see how “financial statutes” can improve the position as set out in the common law. Perhaps the most pragmatic solution is to record some sort of statement about this in an explanatory note or in other statutory materials in connection with the draft Bill.
Recognition of emerging international regulation
Equally important is to ensure that the regime is “future proof”, particularly in light of the fact that the ‘future’ for international regulation of derivatives is almost upon us.
New Zealand parties will need to take and apply these new rules as they find them, so it is important to ensure that the Bill contains sufficient flexibility and an appropriate recognition regime for these licensed markets, which will impact upon New Zealand parties but will not be based here.