Proposal to Declare Certain Derivative Contracts to be Futures Contracts Under the Securities Markets Act 1988

A Discussion Paper

3. BACKGROUND

Futures regime

3.1

The Securities Markets Act was originally called the Securities Amendment Act 1988. Part III of this Act establishes a regime for the regulation of dealing in futures contracts. The law envisaged regulation under a framework involving the Commission and authorised futures exchanges. This law was passed because of concerns that futures contracts were, for the most part, securities in terms of the Securities Act, but that the Securities Act did not provide an appropriate mechanism for regulating dealings in futures contracts.

3.2

The Securities Markets Act prohibits dealing in futures contracts by anyone who is not authorised by the Commission. The Securities Markets Act also defines what a "futures contract" is and gives the Commission a power to declare that other instruments are futures contracts for the purposes of the law.

3.3

Any person who carries on the business of dealing in futures contracts without being authorised to do so can face heavy criminal penalties.

3.4

The Commission has granted two class futures dealers authorisation notices in respect of:

• futures and options participants under the NZX Futures and Options Rules (The Authorised Futures Dealers Notice (No 3) 2004); and
• participants in the Sydney Futures Exchange (The Authorised Futures Dealers Notice (No 2) 2004).

3.5

As the statutory regulator of futures dealers, the Securities Commission continues to authorise dealers on an individual basis who do not fall within the categories covered by these class authorisations. Further information regarding the authorisation of futures dealers in general and the role of the New Zealand Exchange Limited as frontline regulator of futures dealers who operate under the NZX Futures and Options Rules is discussed on our website at www.seccom.govt.nz/notices/futures-dealers/.

3.6

All authorised futures dealers are also subject to the Futures Industry (Client Funds) Regulations 1990, which prescribe rules regarding the operation of clients' funds and require these to be kept separate from those of the dealer. These rules seek to protect clients' money and property in cases where the dealer becomes insolvent.

Securities regime

3.7

Most futures contracts are also likely to be "securities" under the Securities Act. A futures contract by its nature will give a party a right to be paid money in certain circumstances. This makes it likely that a futures contract will fall within the broad definition of "debt security" in the Securities Act. Other types of futures contracts may be viewed as participatory securities or, in the case of equity options, as equity securities.

3.8

The Commission, and many in the industry, are of the view that most futures contracts could be subject to both securities regulation and futures contract regulation. This raises a serious doubt as to which legislative framework should apply to such products. The application of both regulatory regimes to a product increases costs for market participants without appreciably benefiting the market or investors.

3.9

The Commission has addressed this by granting an exemption from the Securities Act for authorised futures contracts: the Securities Act (Authorised Futures Contracts) Exemption Notice 2002. The notice unconditionally exempts persons who deal in authorised futures contracts from the trustee, statutory supervisor, prospectus and investment statement requirements of the Securities Act and all of the Securities Regulations 1983 (except regulation 8 - misleading information) in respect of any authorised futures contract.

3.10

This exemption was enacted to provide certainty of regulatory treatment for futures contracts that are securities for the purposes of the Securities Act, as was the entire body of futures legislation. The Securities Markets Act is generally viewed as being the regulatory framework that more sensibly fits futures contracts.

3.11

Unlike many jurisdictions New Zealand has no general regulation for derivative products, other than that provided for futures contracts under the Securities Markets Act. We understand that regulation of derivatives will be considered by the Government as part of its review of securities law.

3.12

This paper proposes that the Commission should declare CFDs in respect of shares or other securities to be futures contracts. The effect of the declaration, together with a futures dealer authorisation, would be that a futures dealer could take advantage of the Securities Act (Authorised Futures Dealers) Exemption Notice 2002. This would mean that, to the extent that the CFDs in respect of shares or other equity products are securities, they are exempt from the disclosure provisions of the Securities Act. The advantage of this approach is that it gives certainty as to the status of the product and the compliance obligations on futures dealers.