Emissions Units Bill - more than meets the eye

Friday 15 February 2008

Hot on the heels of the package of financial services legislation introduced by the Government at the end of last year (covered in a previous FSQ Bulletin) comes the draft Emissions Units Settlement Systems and Futures Bill (the Bill). The Bill was released for comment by the Ministry of Economic Development earlier this week.

But don't let the title of the Bill mislead you. While the principal purpose of the Bill is to facilitate the trading of emissions units in New Zealand, significant parts of the Bill introduce legislation that will affect financial markets participants generally.

This note outlines both the specific rules proposed for emissions units and the general rules proposed for the broader financial markets.

Specific rules for emissions units

The Bill proposes to introduce a series of technical rules that, broadly, have the effect of treating a new class of asset (emission units) like an existing one (company shares). For example, the Bill replicates for emissions units provisions dealing with the registration of, and transfer of title to, shares. The Bill also extends to emissions units a provision in the Personal Property Securities Act 1999 (the PPSA) that gives priority to purchasers of "investment securities".

This parallel treatment approach should be welcomed by banks and others who may be financing the purchase of these units or taking security over them. Such persons will not need to become familiar with an entirely new regime governing title to, and security over, these assets.

The Bill also states that emissions units are a "commodity" for the purposes of the Securities Markets Act 1988. Therefore, certain types of emissions units derivatives will be "futures contracts" for the purposes of that Act. The effect of this is that those entities who carry on the business of "dealing" in these emissions units derivatives will require Securities Commission authorisation to do so.

General rules for financial markets

These general rules relate to three areas:

• the regulation of futures markets;

• the regulation of "designated settlement systems"; and

• the priority of clearing house collateral.

Futures markets

Currently, there are separate regimes under the Securities Markets Act governing the regulation of securities exchanges and futures exchanges. Given the small size of the market and the limited number of likely candidates to operate a securities or futures exchange, this structure is seen as unnecessarily duplicative and costly for an entity wanting to operate both types of exchange.

The intention is, therefore, to merge the two regimes and allow a securities exchange to be registered either for the trading of securities only or for the trading of both securities and futures.

Designated settlement systems

Currently, Part 5C of the Reserve Bank of New Zealand Act 1989 regulates "designated payment systems", of which there are two - CLS Bank International and the Reserve Bank's Exchange Settlement Account System. Designation of a payment system confers a number of statutory protections, designed to ensure the stability of the system if a participant becomes insolvent.

There is currently no equivalent regime for a settlement system (such as a clearing house). Therefore, in theory at least, a settlement system is more vulnerable to the failure of one of its participants than is a designated payment system.

The Bill aims to correct this anomaly by extending Part 5C to cover settlement systems. The fundamental protections provided by Part 5C will remain unchanged, but the Securities Commission will join the Reserve Bank in the joint regulation of this regime.

Clearing house collateral

From a bank's perspective at least, this is probably the most interesting part of the Bill. What is proposed here is that collateral posted by a member of a designated settlement system in favour of the system operator should have a "super priority". That is, it should trump the interests of all other parties in that same collateral. Again, the policy behind this proposal is the need to ensure the stability of the system in the insolvency of a member.

What this will mean in practice for banks and others who deal with clearing house members is that they can never safely assume they have first-ranking security over the cash or securities of the member (cash and securities being the most likely clearing house collateral). In some cases, this may require banks to re-price the risk those entities represent.

Submissions

The MED has called for submissions on the Bill. These are due by 10 March. If you would like assistance in the preparation of a submission, or wish to discuss how the Bill might affect your business, please contact one of the following:

David Craig
Partner

Hugh Kettle
Partner

Murray King
Partner

David McPherson
Partner