Nowhere is the tension between New Zealand's legislative sovereignty and its need to be a player on the world stage more evident than in our financial markets laws.
Anyone remaining of the view that we dictate our own rules need look no further than three proposed legislative reforms:
a substantial extension and re-write of the laws governing financial market infrastructures (FMIs);
changes to insolvency laws to accommodate foreign margin requirements for OTC derivatives; and
a new licensing regime for administrators of financial benchmarks.
In each case, the proposed reform has been prompted by either the direct effect of foreign law on New Zealand businesses or the recommendations of offshore standard setting organisations.
The first of these reforms was discussed in an
article in May 2017, where we tracked a consultation process that began in 2013 and that aims to reform New Zealand's regulation of FMIs. Legislation implementing this reform is expected to be introduced into Parliament shortly.
The second and third of these reforms, which are the subject of this newsletter, have culminated in the introduction into Parliament today of the Financial Markets (Derivatives Margin and Benchmarking) Reform Amendment Bill (the
Bill). The two parts of the Bill are discussed below.
Part 1: Accommodation of foreign margin requirements
publication in July 2017, we discussed a consultation paper issued by the Reserve Bank and the Ministry of Business, Innovation & Employment (the
Agencies) proposing changes to New Zealand's insolvency laws to allow compliance with foreign margin rules. Those foreign margin rules were passed in response to commitments made by the G20 countries in 2011 to reduce the systemic risk posed by OTC derivatives. The rules require 'in scope' counterparties to exchange margin on their uncleared OTC derivatives.
After considering submissions made on the consultation paper, the Agencies made their recommendations to the Government. These recommendations have been reflected in the Bill, which, by and large, does what was foreshadowed in the consultation paper. Here's what you need to know.
A recap of the current issues
Certain aspects of existing insolvency law in New Zealand may impede the immediate availability of margin, which is a requirement of foreign margin rules. The most serious offenders are:
the provisions in the statutory management and administration legislation creating a stay on the exercise of secured creditor rights;
the provisions in the Companies Act 1993 giving a preference to certain creditors in a liquidation (potentially trumping the interest of a holder of cash margin); and
parts of the Personal Property Securities Act, which may not always allow holders of (cash or securities) margin to obtain the priority they require.
How the Bill proposes to fix those issues
The Bill, once enacted, will allow parties to access their margin promptly and in priority to others – despite the impediments mentioned above. While there are subtle differences in the way the Bill achieves that outcome for each piece of legislation, the common thread is the protection of margin posted in relation to "qualifying derivatives" involving at least one "qualifying counterparty". So these two defined terms are the keys to unlocking the scope of the Bill's protection.
A "qualifying derivative" is an OTC derivative in relation to which, among other things, cash or securities margin is posted.
A "qualifying counterparty" is a registered bank, the Accident Compensation Corporation, the Guardians of New Zealand Superannuation, or the operator of a designated settlement system. Additional "qualifying counterparties" could be added by regulation.
There is one important proviso to this common thread. The protection the Bill provides in a statutory management where the qualifying counterparty is a registered bank is slightly weaker than in the case of other types of qualifying counterparties. Specifically, a two-day stay will generally apply where the qualifying counterparty is a registered bank; whereas there is no such stay in the case of other types of qualifying counterparties.
What we think
The Bill is welcomed, and the changes it will make cannot come soon enough. On 1 September last year, we passed another key date in the progressive phase-in of foreign margin rules. On that date, counterparties with an aggregate average notional amount of uncleared derivatives exceeding US$/€1.5 trillion came 'in scope'. This threshold likely catches a number of New Zealand banks that are owned by the big four Australian banks. More counterparties will come in scope over the next two years, as the threshold drops to US$/€8 billion.
Accordingly, if the Bill is enacted and comes into force by mid-2019, the taps should only be turned off for qualifying counterparties in New Zealand for a brief period - if at all.
The two-day stay that will apply to registered banks in statutory management, while not ideal from the perspective of its counterparty, is unsurprising. Such temporary stays on the enforcement of security interests in the insolvency of a financial institution are becoming more common globally: see, for example, article 70 of the EU Bank Recovery and Resolution Directive.
The proposal that the amendments in Part 1 of the Bill only apply to qualifying derivatives entered into on or after the commencement of the legislation will, if it remains, be a major headache for the industry. Hopefully common sense will prevail and this provision will disappear at the Select Committee stage.
The enactment of the Bill will enable New Zealand lawyers to give cleaner opinions on collateral enforceability than is currently the case. The opinions will not be totally free of qualifications (e.g., clawback risk will remain an issue). But they should be sufficiently clean so that New Zealand is seen as belonging to the same 'compliant' group as the G20 countries, and not as a rogue outlier.
A number of submissions on the consultation paper supported the view that New Zealand should, like Australia, have a standalone omnibus Netting Act. The Bill does not propose that. And that is a good thing. While there is an obvious attraction to having all provisions governing a common legal issue covered by a single Act, the piecemeal approach New Zealand has previously adopted for netting has worked for the last 20 years. We shouldn't try to fix something that isn't broken, especially if that comes at the cost of delaying truly necessary reform, such as proposed in the Bill.
Part 2: Licensing of financial benchmark administrators
Financial benchmarks are at the core of many financial products. The most important benchmark of the all – the London Interbank Offered Rate (or
LIBOR) – sets the floating rate on around US$370 trillion of derivatives and loans. The pre-eminence of LIBOR, and the potential to manipulate its calculation, provided the backdrop for the so-called LIBOR rigging scandal in the UK in 2012.
Partly in response to that scandal, in 2016 the EU adopted benchmark regulations, which are set to come into full force on 1 January 2020. Among other things, those regulations prevent EU-supervised entities from using a non-EU benchmark rate (such as New Zealand's BKBM rate) except in three circumstances – referred to as equivalence, recognition, and endorsement. Part 2 of the Bill represents New Zealand's choice to proceed down the equivalence route.
To qualify for equivalence, the following requirements must be met (among others):
the benchmark administrator must comply with binding requirements that the EU determines are equivalent to its own regulations;
a competent regulatory authority in the non-EU state (i.e., the FMA in New Zealand's case) must oversee and enforce compliance with those equivalent regulations; and
co-operation arrangements must exist between ESMA (the European regulator) and the regulator in the non-EU state.
What the Bill will do
The Bill aims to satisfy these requirements by introducing a new licensing regime for benchmark administrators in New Zealand. That regime will sit alongside the other licensing regimes in the Financial Markets Conduct Act 2013. The FMA would then supervise licensed administrators.
While any benchmark administrator could opt in to this licensing regime, it is expected that only the New Zealand Financial Markets Association (which administers BKBM) will choose to do so.
An interesting, and perhaps controversial, aspect of Part 2 of the Bill is the proposed power of the FMA to give directions to benchmark contributors (e.g., to continue to provide data for the benchmark) or to benchmark administrators (e.g., to change the procedure by which the benchmark is generated).
What we think
The big four banks in New Zealand, directly and through their clients, are estimated to have an NZ$1.1 trillion exposure to EU counterparties in instruments referencing BKBM. If the banks were shut out of this market as a result of the EU benchmark regulations, the business disruption, loss of liquidity, and increase in funding costs would be substantial. Others, such as swap counterparties and Kauri issuers, might also be affected.
Part 2 of the Bill is, therefore, a 'no-brainer'. The various parties will need to move fast though to ensure the Bill is enacted, the NZFMA is licensed, and the EU equivalence decision is made before the prohibition kicks in.
The next step
We expect that the Bill will shortly be sent to a Select Committee, which will call for submissions.
If you would like assistance in preparing a submission, or would like to discuss how the Bill might affect your business, please contact
David Craig or your usual
Bell Gully advisor.
This publication is necessarily brief and general in nature. You should seek professional advice before taking any action in relation to the matters dealt with in this publication.