SUBMISSION OF THE NEW ZEALAND FINANCIAL MARKETS ASSOCIATION ON THE FINANCIAL MARKETS CONDUCT BILL

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1 SUBMISSION OF THE NEW ZEALAND FINANCIAL MARKETS ASSOCIATION ON 1. GENERAL COMMENTS THE FINANCIAL MARKETS CONDUCT BILL 1.1 The focus of our submission is on matters related to derivatives and derivatives issuer licences. We have no specific submissions to make on other matters, but generally support the intention of the FMCB. 1.2 Also as a general comment, the Ministry of Economic Development provided a helpful response to many of the submissions raised at the exposure draft stage of the FMCB. We have reviewed the submissions and Ministry's responses and note that many of the comments in relation to derivatives are marked "further consideration required". It would be very helpful for us if the Ministry could provide a further update as to how its views have developed. This particularly applies to some of the general definitions of the FMCB that appear to become awkward or strained when applied to derivatives. This includes the definitions of "issuer" and "derivatives issuer", "acquire", "in the business of", "investor", "offer", and "subscribe" among others. We would be happy to provide a follow-up submission on the Ministry's updated views. 2. DEFINITION OF DERIVATIVE 2.1 Clause 8 of the FMCB sets out the definition of "derivative". We are broadly in favour of this definition, and consider it a significant advance on the current definition of "futures contract" in the Securities Markets Act In particular, the definition includes a "market practice" limb at paragraph (b) which expressly includes contracts for difference, margin contracts, and rolling spot contracts. This closes some major gaps in the current definition of futures contract that have meant that a number of dealers of foreign exchange and contracts for difference (CFDs) (in particular) have managed to escape regulatory scrutiny under the Securities Markets Act. 2.2 However, we believe that paragraph (b) would be improved if it was expanded to include the full list of transactions defined as "specified transactions" in the ISDA Master Agreement. The ISDA Master Agreement is the international industry standard document for institutional and wholesale derivative transactions, and includes a definition of "specified transaction" which lists all types of derivative transactions currently entered into in international and New Zealand derivatives markets. Consequently, expanding the definition in this way should capture all derivatives. This approach is adopted at, for example, section 136 of the Crown Entities Act 2004, which contains the following definition that draws on the ISDA Master Agreement definition of "specified transaction": derivative transaction means (a) a transaction that is a rate swap transaction, swap option, basis swap, forward rate transaction, interest rate option, foreign exchange transaction, cap transaction, floor transaction, collar transaction, currency swap transaction, cross-currency rate swap transaction, currency option, 3

2 commodity swap, commodity option, equity or equity index swap, equity or equity index option, bond option, credit protection transaction, credit swap, credit default swap, credit default option, total return swap, credit spread transaction, forward purchase or sale of a security, or commodity or other financial instrument or interest (including an agreement or option that relates to any of these transactions); or (b) a transaction that is similar to any transaction referred to in paragraph (a) that (i) (ii) is currently, or in the future becomes, recurrently entered into in the financial markets; and is a forward, swap, future, option, or other derivative on 1 or more rates, currencies, commodities, equity securities or other equity instruments, debt securities or other debt instruments, economic indices or measures of economic risk or value, environmental or climatic variable, or other benchmarks against which payments or deliveries are to be made 3. PDS DISCLOSURE 3.1 We broadly support the Product Disclosure Statement (PDS) disclosure regime in the FMCB. 3.2 In particular, we support subpart 6 of Part 8 of the FMCB, allowing for mutual recognition of overseas (particularly Australian) disclosure documents (see further, part 5 below). Many of the Association's members are also regulated in Australia. Allowing passporting of disclosure documents will significantly lower the compliance costs associated with the FMCB, as their current offer documents will still be able to be used. We note this largely reflects the status quo under the authorised futures dealers regime in the Securities Markets Act. While disclosure is not part of the statutory regime, many authorised futures dealers are required, as a condition of authorisation, to provide a disclosure document. For many, their Australian offer documents are expressly recognised under their authorisation. 4. DERIVATIVES ISSUER LICENCES 4.1 Part 6 of the FMCB will require "derivatives issuers" dealing "regulated" derivatives to be licensed by the Financial Markets Authority. The main obligations in the FMCB applying automatically to licensed derivatives issuers will be to make disclosure under a PDS and to have a written client agreement. 4.2 Further (although we believe the FMCB could be clearer as to this point) both licensed and unlicensed derivatives issuers may be subject to client funds rules, perhaps trust accounting or segregated client accounts. Both the detail of these rules and whether or not they apply are to be set by regulation. 4.3 Finally, licensed derivatives issuers may be subject to a range of other possible licence conditions. These other licence conditions are again to be made by regulation, but will only apply if the FMA includes them as part of the licensee's licence conditions. 4

3 4.4 As a preliminary matter, we note that it is very hard to make informed comments on these proposals without knowing the likely content of the regulations. If the Ministry of Economic Development were able to provide a draft of these regulations, or a summary of the intended scope of these regulations, it would be very helpful and enable us to comment more meaningfully. We would be happy to provide a follow-up submission in such circumstances. 4.5 More substantively, there are a wide range of derivatives-related businesses in New Zealand with very different focuses. While there are some common elements (e.g. market movements in the relevant underlying), the risks and other important considerations do vary depending on business model. The factors associated with, for example, purchasing an exchange-traded derivative from a broker are very different to trading a CFD on margin, even though the underlying and exposure may be identical. 4.6 On the face of it, the licensing regime will apply to all types of derivatives without distinction. However we assume that in practice, the combination of regulation and licence conditions (and conceivably Financial Markets Authority exemptions) will enable a sufficiently flexible regime to deal with the wide range of derivatives-related businesses in New Zealand (note however our further comments regarding mutual recognition of licences at part 5 below). 4.7 We therefore cautiously support the derivatives licensing regime. We would however like to better understand its intended operation before forming a final view. As noted, we would be happy to provide a follow-up submission. 4.8 In terms of detailed comments on derivatives issuer licences, we submit the following points. 4.9 First, we fully support the requirements for client funds to be held on trust. As a technical matter, however, we suggest that the FMCB's mechanic for applying such requirements to licensed derivatives issuers could be improved. Clause 401 of the FMCB provides that the FMA can choose to apply a range of additional licence conditions that are to be specified in regulations made under clause 520(1)(c). Clause 445 of the FMCB further provides that other regulations may be made setting client funds rules. We suggest that the regulations to be made under clause 445 relating to client funds rules should be linked to derivatives issuer licence conditions. That is, the requirement for a licensed derivatives issuer to comply with the client funds rules would be set out in its licence conditions We would imagine that virtually all derivatives issuers would be required to comply with the client funds rules as part of their licence conditions. However, it is possible that for some derivative issuers (or perhaps, for some derivative issuers only in respect of certain types of transactions), the client funds rules would be inappropriate. This view is supported by the fact that there are a number of exemptions from the Futures Industry (Client Funds) Regulations 1990 under section 48(1)(d) of the Securities Markets Act currently in force. These exemptions are typically granted where there are other equivalent arrangements in place that mean compliance with the client funds rules is not necessary or would duplicate those arrangements. For example, the Futures Contracts (Commonwealth Securities Limited) Exemption Notice 5

4 2009 and Futures Contracts (J.P. Morgan Securities Australia Limited) Exemption Notice 2010 exempt certain Australian authorised futures dealers from compliance with New Zealand client funds rules, as the dealers already comply with the equivalent client funds rules in Australia We accept that, under the current approach, an exemption under clause 528 of the FMCB can be granted where it is not appropriate for the client funds rules to apply. Thus the same end result can be reached. However, reaching that result by applying the rules to all derivatives issuers and then granting exemptions is an inefficient way to get to that result. It creates an additional process (the exemption process), and therefore additional costs for both the derivatives issuer and the FMA. Consequently, we submit that the approach suggested above is a better approach Secondly, the FMCB will mean that brokers of securities and derivatives will be treated differently, and we see no reason for this. A broker of securities will merely need to register as a broker under the Financial Service Providers (Registration and Dispute Resolution) Act 2008 and hold retail client funds on trust (with no disclosure requirements currently in force). However, a broker of exchange-traded derivatives will be required to register, obtain a market services licence (including satisfying the Financial Markets Authority that the broker and its senior personnel are fit and proper), provide a PDS, have a written client agreement, (likely) be subject to client funds rules, and potentially comply with a range of other licence conditions In our view, there is not a significant difference between broking (i.e. the financial services of acquiring or disposing a financial product on behalf of a client) securities and derivatives. The risk is essentially that the broker becomes insolvent prior to completing its clients' transactions. In such circumstances, client funds may be used to pay the broker's creditors rather than being returned to the clients. Client funds rules are a direct response to prevent this happening. We do not see how the underlying financial product affects this risk. Although derivatives might be seen as more "complex", broking by definition is limited to trade execution, so the complexity is not really relevant in the way that it is for regulation of, say, financial advice We therefore submit that the treatment of derivatives brokers should be changed in the FMCB. From a consistency and equitability standpoint, it seems to us either: (a) (b) all brokers (including securities brokers) should be subject to the full market services licensing regime of the FMCB (which would presumably involve repealing Part 3A of the Financial Advisers Act and shifting the relevant requirements to Part 6 of the FMCB); or all brokers (including derivatives brokers) should be subject to the more limited brokers regulatory regime of the Financial Advisers Act. This would likely involve excluding derivatives brokers from Part 6 of the FMCB We have not yet formed a view as to which of the above options is most appropriate. We would be happy to work with the Committee and officials further on this point.. 6

5 4.16 Further, we observe that clause 19 of Schedule 1 to the FMCB excludes derivatives that are "quoted" (i.e. exchange-traded) on a licensed market from the scope of regulated offers. A broker of such exchange-traded derivatives would therefore be exempt from all the requirements applicable to licensed derivatives issuers except (possibly, subject to regulations) the client funds rules. However, if exchange-traded brokers were not licensed, then they would not be entitled to use the exemption at clause 584 of the FMCB, and would therefore be subject to the brokers regime of the Financial Advisers Act (and its client funds rules) anyway. The result would appear to be that all securities brokers and exchange-traded derivatives brokers are subject to the more limited brokers regulatory regime of the Financial Advisers Act, while brokers of derivatives not quoted on a licensed market would be subject to the full derivatives issuer licensing regime. This further highlights the FMCB's inconsistent treatment of derivatives brokers. Even if our submissions at paragraphs 4.9 and 4.14 are not accepted, we suggest that this anomaly should be resolved in some way, or the rationale behind it clearly explained. 5. MUTUAL RECOGNITION 5.1 As noted, we support the mutual recognition regime in subpart 6 of Part 8 of the FMCB. We submit that this should be extended to apply to market services licensing under Part 6 of the Bill (and potentially other related legislation such as the Financial Advisers Act). We consider that a holder of an equivalent overseas licence should be able to have that licence recognised in New Zealand without being subject to the full requirements of the licensing regime. As noted, many of the Association's members are already regulated in Australia under the Financial Services Licensing Regime. Allowing passporting of licences will significantly lower the compliance costs associated with the FMCB. Conversely, requiring already-licensed providers to satisfy additional license requirements will not provide any tangible benefit consumers. 5.2 This approach would accord with the intent of the Mutual Recognition of Securities Offerings agreement (although we do note that the agreement applies to financial products rather than financial services), the Trans-Tasman Mutual Recognition Act 1997, and the Single Economic Market initiatives. We also note that clause 315 of the FMCB already proposes a streamlined process for overseas exchanges and markets to obtain a financial products market licence. 6. HAGUE SECURITIES CONVENTION 6.1 An earlier draft of the FMCB proposed ratifying the Hague Convention on the Law Applicable to Certain Rights in Respect of Securities Held with an Intermediary (Hague Securities Convention). This convention provides certain rules when dealing with cross-border security transactions, particularly as to which governing law will apply. This is relevant when securities are held indirectly via custodians, clearing houses and other intermediaries. The benefits of the convention are primarily much greater certainty for business, removing some of the need to obtain cross-border legal advice. 7

6 6.2 We submit that the ratification of the Hague Securities Convention should proceed as part of the FMCB. The government already has an ambitious law reform agenda underway, and it seems unlikely that ratifying the Hague Securities Convention will be a priority for some time if it is not ratified in the FMCB. 7. PPSA 7.1 One of the possible issues with the FMCB's derivative issuer licences is the uncertain application of the client funds rules to certain OTC collateral arrangements. This issue arises because of a lack of certainty in New Zealand about whether collateral arrangements under a Credit Support Annex (CSA) constitute a security interest. 7.2 A CSA is a standard addition to the ISDA Master Agreement. CSAs provide a mechanism for managing credit risk against a counterparty by way of posting collateral. The standard version of the CSA used in New Zealand (and internationally, other than the United States) is a "transfer of title" CSA. Under this version of the CSA, the party "out-of-the-money" (i.e. the party in a net debtor position) is obliged to transfer property to the party "in-the-money" (i.e. the net creditor). Collateral is usually cash or highly rated liquid financial instruments, such as United States Treasury Bills. The transferor retains no interest in this property. However, in certain circumstances (e.g. where the market has moved) the transferee may be obliged to transfer equivalent property back to the transferor. This mechanism minimises the amount each party owes to the other at any time (i.e. the credit risk), as the party "in-the-money" will have effectively been pre-paid that value. 7.3 Even though the CSA describes the nature of the transaction as an outright transfer with no retained interest in the transferred property, there is considerable uncertainty in the New Zealand market about whether such collateral arrangements give rise to a security interest under the Personal Property Securities Act 1999 (PPSA). The legal position in all other major jurisdictions of which we are aware is that such collateral arrangements under a CSA do not typically give rise to a security interest. However, New Zealand law is potentially out of step with the rest of the world in this regard. 7.4 This uncertainty is resulting in additional legal fees to obtain advice about the potential risks or make complex bespoke amendments to the standard CSA to mitigate those potential risks. This particularly applies to cross border transactions where the international counterparty is less familiar with the New Zealand legal system. In some cases, parties are registering financing statements, which potentially send false signals to the market that their counterparties (often banks) need to raise secured debt. A finding that a security interest was, in fact, created may also place many transferors in breach of undertakings to third parties not to give security over their assets. For these reasons we believe there would be a real benefit in clarifying this aspect of New Zealand law. 8

7 7.5 It is also not clear what the status of such collateral would be under any new client funds rules. We assume an outright transfer of title of collateral could never give rise to client funds. However, it is less clear what the status of collateral that is held subject to a security interest is. 7.6 We are aware that there have been a number of suggestions for specific amendments to the PPSA by various law firms and ISDA, including suggested changes to sections 17 or 23 of the PPSA. We are agnostic to the particular amendments adopted, so long as they correct the issue. 8. CENTRAL COUNTERPARTIES 8.1 As you may be aware, there is a global trend towards central clearing of OTC derivatives (we refer, for example, to the Dodd-Frank Act in the United States). While central clearing is not currently required domestically, New Zealand counterparties transacting internationally will increasingly be required to clear OTC derivatives via a central counterparty. 8.2 We believe the significant majority of such transactions will largely be with wholesale or institutional counterparties, and therefore exempt under clause 3 of Schedule 1 to the FMCB. However, central counterparty clearing changes the nature of an OTC transaction. In particular, the credit risk is against the central counterparty, rather than the counterparty to a particular transaction. Arguably, the central counterparty may be the "derivatives issuer" under clause 10 of the FMCB. 8.3 Clause 387(2)(a) of the FMCB appears to anticipate this, by providing that a designated settlement system (within the meaning of Part 5C of the Reserve Bank of New Zealand Act 1989) does not require a market services licence. However, it is not clear whether or not Part 3 of the FMCB (i.e. relating to disclosure) applies to central counterparties and/or OTC derivative transactions cleared through central counterparties. We suggest this be included at clause 19 of Schedule 1 to the FMCB. This is similar in principle to derivatives quoted on a licensed market. 8.4 As a related point, we suggest that the definition of designated settlement system throughout the FMCB (see, for example, clauses 212, 233, 337 and 387) be consolidated into the definition section. It may also be appropriate to include the ability to recognise a settlement system regulated overseas by a competent authority, at least for the purposes of some provisions such as clause CONFIRMATIONS 9.1 Clause 211 of the FMCB requires issuers to provide confirmation documents to product holders. Clause 212 of the FMCB provides that confirmation documents do not need to be sent in certain circumstances, including where the financial product is transferred in accordance with an electronic transfer system approved under clause 376 of the FMCB. 9

8 9.2 OTC derivatives are almost invariably traded under a form of master agreements such as the ISDA Master Agreement or bank terms and conditions. These master agreements create a framework for trading derivatives. The details of an individual trade are then set out in a confirmation. For at least some types of derivatives, the details of an individual trade are often agreed orally, and the confirmation merely documents the previously-agreed terms. 9.3 Generating and dispatching confirmations is increasingly moving into electronic format. This will increase as derivatives trading moves further to central counterparties (see part 8 above). Depending on the particular system used, often no confirmation document is provided by either party, rather electronic matching of details takes place between each party to the derivative. 9.4 We therefore submit that the FMCB should be future proofed to reflect the changing methodologies for confirmations. One simple way of addressing this may be to amend clause 211 to provide that a confirmation document must be received by, or be otherwise available to, the product holder. That is, the issuer does not necessarily have to send a confirmation, so long as the information required in a confirmation document is available to the product holder. This would align the FMCB with market practice to ensure that it is not necessary to send a second confirmation document. 10. NEW ZEALAND INTERNATIONAL REPUTATION AND FSPR 10.1 A number of firms catering to overseas clients are registering as financial services providers on the New Zealand Register of Financial Service Providers. The primary motivation for this registration appears to be to gain some form of legitimacy by claiming they are regulated under New Zealand law. Due to the nature of their business (particularly the focus on overseas clients), most firms are probably outside the scope of substantive New Zealand law, both current law and the proposed law under the FMCB. For example, a firm providing CFDs only to overseas clients may register as a financial service provider, but not be required to comply with the authorised futures dealers regime of the Securities Markets Act nor the derivatives dealers regime of the FMCB. We refer in particular to clauses 26 and 34, which provide that the territorial scope of the FMCB is limited to conduct carried out in New Zealand, and financial products and financial services offered in New Zealand This issue has recently gained prominence because the Reserve Bank has issued a number of warnings about such firms. New Zealand newspapers and financial markets commentators have also recently highlighted the issue Our view is that this practice harms New Zealand's international reputation as an appropriately regulated financial jurisdiction. Further, it puts legitimate firms that do comply with substantive regulation at a competitive disadvantage against their substantially unregulated competitors We therefore submit that registration on the Register of Financial Service Providers should only be allowed in certain categories if the registrant is also appropriately licensed under the FMCB. For example, a person should only be allowed to register as a dealer in CFDs if that person is 10

9 also licensed as a derivatives issuer under the FMCB. That is, a firm can only claim to be "regulated" under New Zealand law if it actually is regulated under New Zealand law As a related issue, we also submit that the categories of financial services set out in the Financial Service Providers (Registration and Dispute Resolution) Act should be aligned with the categories of FMCB market services licences. 11

10 APPENDIX: NEW ZEALAND FINANCIAL MARKETS ASSOCIATION MEMBERS Financial Markets Members ANZ National Bank ASB Bank Bank of New Zealand Westpac Deutsche Bank Citibank Financial Intermediary Members CMC Markets (NZ) Ltd HiFX Ltd ICAP New Zealand Ltd KVB Kunlun New Zealand Ltd OM Financial Ltd Velocity Trade Ltd Hong Kong Shanghai Banking Corporation Kiwibank Partner Members Bell Gully Affiliate Members Reserve Bank of New Zealand Buddle Findlay Interactive Data (Australia) Pty Ltd NZ Debt Management Office International Members BNP Paribas Credit Suisse AG JP Morgan Chase Bank NA Morgan Stanley 12