The Ministry of Business, Innovation and Employment (MBIE) has published a consultation paper outlining proposed changes to the Financial Markets Conduct Regulations 2014 (FMC Regulations). The proposed changes are intended to clarify the application of the derivatives investor money handling rules (the
Rules)1 to money received in connection with exchange-traded derivatives, and place limits on the use of derivatives investor money to meet obligations relating to exchange-traded derivatives. MBIE has also sought feedback on whether enhanced reconciliation requirements are warranted given the changes to the FMC Regulations outlined in the consultation paper.
Modified application of the Rules to money received in connection with exchange-traded derivatives
Currently, the Rules apply broadly to money received by a derivatives issuer in connection with:
- a derivative offered under a regulated offer, or
- an exchange-traded derivative.
Definition of exchange-traded derivative
The definition of "exchange-traded derivative" captures any derivative that is quoted, or approved for trading, on a financial product market, whether or not that market is principally licensed in New Zealand. The definition is currently broad enough to capture money received from a New Zealand investor in connection with derivatives traded on overseas exchanges. This has proved problematic in practice, and has the unintended consequence of bringing overseas issuers that provide limited services to New Zealand wholesale investors within the scope of the Rules.
The definition is also broad enough to capture money received from an overseas investor in connection with derivatives traded on the NZX.
MBIE proposes to address these issues by limiting the application of the Rules to derivatives investor money received in connection with:
- a derivative offered under a regulated offer, or
- a derivative traded on a local exchange,2 and then only if the issuer is subject to the rules of the local exchange or has a place of business in New Zealand.
These amendments are intended to clarify that the Rules:
- do not apply in relation to money received from an investor in connection with a derivative traded on an overseas exchange, and
- do not apply in relation to money received by an overseas intermediary in connection with a derivative traded on the NZX.
The Rules will, however, continue to apply to NZX participants and New Zealand-based intermediaries in relation to their trading on behalf of both retail and wholesale investors on the NZX.
New limits on the use of derivatives investor money
The FMC Regulations currently allow for derivatives investor money to be withdrawn from the trust account and used to meet obligations relating to exchange-traded derivatives (principally, margin and settlement obligations), if the relevant client agreement authorises the money to be used in that way.
The use of derivatives investor money in this way exposes the investor to increased counterparty credit risk (as against the derivatives issuer), since the money ceases to have the protection of the statutory trust as soon as it is withdrawn from the trust account.
MBIE's proposed mechanism for mitigating this risk is to amend the Rules so that derivatives investor money may only be used to meet obligations relating to exchange-traded derivatives if:
- the issuer is satisfied that the person receiving the money is subject to the Rules, or
- the person receiving the money meets the definition of "hedging counterparty"3 in the FMC Regulations.
In general, "the person receiving the money" will be the relevant exchange, in the case of exchange-traded derivatives, unless those instruments are being traded through a chain of intermediaries. In that case, issuers will be obliged to assess the creditworthiness of the intermediary before engaging them to trade in exchange-traded derivatives on their behalf. This will be particularly relevant to local issuers seeking access to overseas markets.
Amendments to reconciliation requirements
The Rules currently provide for two types of reconciliation:
- a cash-based reconciliation (which reconciles the issuer's records of the amount of derivatives investor money with the amount of money held on trust), and
- an equity-based reconciliation (which reconciles the issuer's records of the amount of derivatives investor money and the net realisable value of the derivative with the amount of money held on trust).
MBIE is seeking feedback on whether derivatives issuers that use derivatives investor money to meet obligations relating to exchange-traded derivatives should be required to carry out equity-based reconciliations. This approach is consistent with the treatment of derivatives issuers that use derivatives investor money to undertake authorised hedging activity and would, in our view, promote the integrity of New Zealand financial product markets by reducing the risk of market participants becoming exposed to large, unaccounted-for losses.
Submissions on the issues raised in the consultation paper are due by
4 September 2017.
Please contact us if you would like assistance in understanding how the proposed changes to the Rules may impact your business, or if you would like assistance with your submissions.
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.