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

A Discussion Paper

The Securities Commission is an independent statutory body. The Commission is reviewing its policy in relation to the futures regime under the Securities Markets Act 1988, with particular regard to dealing in derivative contracts.

We invite comment on the matters raised in this paper. Any comments received will be subject to the Official Information Act 1982. It is the Commission's usual practice to make submissions available on request and where appropriate to draw attention to them in any further paper.

If you would like us to withhold information included in comments on this paper please state this clearly in your response. Any request to withhold information will be considered in accordance with the Official Information Act 1982.

TABLE OF CONTENTS

• Executive summary
• Introduction
• Background
  • Futures Regime
  • Securities Regime
• Declaration Power
• CFDs - Proposed Declaration
• Summary / Timing
  • Questions
• Appendix

1. EXECUTIVE SUMMARY

1.1

The proposals set out in this discussion paper are likely to affect people who are dealing in certain derivative contracts. The discussion paper is also likely to be of interest to securities lawyers.

1.2

The Commission has received requests from market participants for clarification of whether certain types of financial instruments are "futures contracts" as defined in the Securities Markets Act 1988 (the "Securities Markets Act"). These requests are in respect of instruments known as contracts for difference.

1.3

There appears to be real doubt within the futures industry in New Zealand regarding the application of the definition of "futures contract" to contracts for difference in respect of shares or other securities ¹.

1.4

The Commission believes it is necessary to clarify this situation. It is important for there to be certainty in the futures industry as to what constitutes a futures contract for the purposes of the Securities Markets Act.

1.5

The Commission proposes to use its specific power under the Securities Markets Act to declare contracts for difference in respect of shares or other securities to be futures contracts.

1.6

The effect of such a declaration will mean that people dealing in these contracts will need to be authorised to deal in futures contracts under the Securities Markets Act.

1.7

It is important to note that the Commission is not undertaking a general reform of futures regulation in New Zealand. Such an exercise is being undertaken by the Ministry of Economic Development as part of its review of Financial Products and Providers. This paper relates to a very specific part of the futures market about which a number of participants have expressed uncertainty.

1.8

The Commission is seeking comments on this proposal. Comments should be sent to the Commission by 5.00p.m on Friday 4 May 2007.

2. INTRODUCTION

2.1

Dealings in futures contracts are regulated in New Zealand under the Securities Markets Act. The Securities Commission is the statutory regulator of futures dealers under this Act.

2.2

The Securities Markets Act requires people who carry on the business of dealing in futures contracts to be authorised by the Securities Commission.

2.3

There are serious penalties under the Securities Markets Act if people deal in futures contracts without authorisation. Many futures contracts are also "securities" in terms of the Securities Act 1978 (the "Securities Act"). For these reasons it is desirable that market participants and investors have certainty about the regulatory treatment of derivative products, so that appropriate authorisations or exemptions can be sought where necessary.

2.4

The Commission often receives requests from market participants for clarification of whether certain types of financial instruments are "futures contracts" under the Securities Markets Act. The statutory definition of "futures contract" is not entirely clear in its application to certain products.

2.5

In particular, as requested by market participants, this paper discusses the application of the law to certain derivative contracts known as contracts for difference ("CFDs") in respect of shares or other securities.

2.6

A CFD is a derivative contract in which an investor can receive the economic benefits of holding an underlying commodity or instrument without having equitable or legal title to that commodity or instrument. The price of the CFD is derived from the underlying commodity or instrument and the counterparties to the CFD agree to settle the difference between the acquisition and disposal price in cash. Therefore, there is no delivery of the underlying commodity or instrument.

2.7

This paper proposes that the Commission uses its power under the Securities Markets Act to declare CFDs in respect of shares or other securities to be futures contracts. The Commission welcomes comments from interested parties on its proposal.

2.8

However, we should note that the Commission's declaration power is limited. Any more general law reform will be a matter for the Government to consider, rather than the Commission.

2.9

The effect of the Commission's proposed declaration will mean that people dealing in CFDs in respect of shares or other securities will be required to obtain authorisation to deal in futures contracts under the Securities Markets Act.

2.10

Issues for comment are raised throughout the paper and a list of questions is included at the end.

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.

4. DECLARATION POWER

4.1

The Commission considers it is important for there to be certainty in the futures industry as to what constitutes a futures contract for the purposes of the Securities Markets Act. The enquiries we have received regarding the regulation of CFDs leads us to believe that clarification may be needed.

4.2

Under section 37(7) of the Securities Markets Act the Commission may, by notice in the Gazette, declare:

1. an agreement, option, or right; or
2. a class of agreements, options, or rights,
   to be agreements to which the Securities Markets Act applies; i.e. futures contracts.

4.3

This declaration power is also recognised in the definition of futures contract in sections 37(1)(e) and (f).

4.4

The Commission has previously made declarations under section 37(7) mainly 'for the avoidance of doubt' when uncertainty exists over the appropriate treatment of derivative products, especially some equity options.

4.5

Other circumstances that may warrant the use of the Commission's declaration power include:

• providing for new products and new types of futures contracts, which have not previously been contemplated, to be subject to the futures regulatory regime;
• where an agreement is in substance the same as a futures contract, and exposes investors to the same sort of risks in a transaction as those involved in futures contracts, in the sense that the potential harm to investors that is sought to be mitigated exists in the same manner for the agreement as for a futures contract.

4.6

The Commission's declaration power must, like any discretionary power, be used in a manner that is consistent with the purpose of the Act under which the power is used. The Commission cannot use its power to effectively override the Securities Markets Act or to declare agreements to be futures contracts where this would be plainly inconsistent with the intention of the law.

5. CFDs - PROPOSED DECLARATION

5.1

A CFD is a derivative contract in which an investor can receive the economic benefits of holding an underlying commodity or instrument without having equitable or legal title to that commodity or instrument. The price of the CFD is derived from the underlying commodity or instrument and the counterparties to the CFD agree to settle the difference between the acquisition and disposal price in cash. Therefore, there is no delivery of the underlying commodity or instrument. The past two years have seen an interesting use of CFDs in the Australian and New Zealand markets.

5.2

An essential element of a futures contract for the purposes of the Securities Markets Act is that the contract must relate to a "commodity". Commodity is defined in that Act as "any type of goods; and includes foreign currency and a financial instrument". The Securities Markets Act does not define the term "goods".

5.3

CFDs in respect of most commodities are clearly understood by industry participants to be futures contracts, for example CFDs in respect of:

• foreign currencies;
• stock indices; or
• gold and silver.

5.4

However, there is an ongoing uncertainty as to whether or not equity securities are "goods" in terms of the definition of "commodity", which in turn affects whether or not a contract for future delivery of shares or other equity products (which can be settled otherwise than by delivery) is one for delivery of a "commodity" under the Securities Markets Act. For this reason the Commission has made several declarations for individual equity derivative products, including some equity CFDs. We refer to:

• the Futures Contracts (Man Financial Australia Limited Agreements) Notice 2006;
• the Futures Contracts (CMC Markets NZ Limited Agreements) Notice 2006;
• the Futures Contracts (NZFOX Share Options) Notice 2005;
• the Futures Contracts (ABN AMRO Australia Limited Options) Notice 2004;
• the Futures Contracts (Macquarie Bank Limited Options) Notice 2003;
• the Futures Contracts (Options for Quoted Securities) Notice 1992;
• the Futures Contracts (Options for Quoted Securities) Notice 1990.

5.5

The proposed declaration will supersede any current declarations in respect of individual equity CFDs.

5.6

It is desirable for there to be certainty in the market concerning the scope and effect of regulation. Given the synthetic nature of CFDs in respect of shares or other securities, and given the fact that CFDs in respect of other commodities are regulated as futures contracts, we believe it would be more desirable to regulate them as derivative products, under the laws relating to futures dealing, rather than under the Securities Act regime. In particular, this approach has the advantage of providing certainty for the issuer regarding compliance with both the securities and the futures dealing regimes.

5.7

The Commission recognises that CFDs are often created and marketed by a financial institution as a specific product issued by that institution. In these circumstances the Commission has to date made terms of authorisation for dealers (issuers) of these products largely dependent on appropriate product disclosure, recognising that the issuing company is not undertaking an intermediary role. We expect to continue this approach. An example of typical terms of authorisation can be seen in the Authorised Futures Dealers Notice (No. 4) 2006, which requires the CFDs to be marketed in a product disclosure document complying with Australian law.

5.8

We believe the Commission's proposal to use its declaration power to declare that CFDs in respect of shares or other securities are futures contracts for the purposes of the Securities Markets Act would be consistent with the policy of that Act.

6. SUMMARY / TIMING

6.1

The Commission has received requests from market participants for clarification of whether CFDs in respect of shares or other securities are "futures contracts" under the Securities Markets Act.

6.2

The Commission appreciates that regulation of derivatives will be considered by the Government as part of its review of securities laws. However, the Commission believes it is necessary to clarify the situation in the interim.

6.3

The Commission proposes to use its power under the Securities Markets Act to declare CFDs in respect of shares or other securities to be futures contracts.

6.4

The effect of the Commission's proposed declaration will mean that people dealing in these products will be required to obtain authorisation to deal in futures contracts under the Securities Markets Act.

6.5

We welcome submissions from all participants in the futures industry on whether it would be effective and appropriate to clarify the application of the Securities Markets Act to CFDs in respect of shares or other securities by way of the Commission making a declaration.

Questions

6.6

The Commission welcomes comments from interested parties on the following:

• Should a CFD contract in respect of equity securities be regulated as a futures contract under the Securities Markets Act? If so, should there be any exceptions to this?
• Is the term "contract for difference" sufficiently understood within the industry to form the basis for a declaration in this area? If not, how should the term be defined?
• Should the Commission's current approach to regulating dealers (issuers) of CFD products with the focus on product disclosure, rather than supervision, continue? Are there any other terms and conditions of authorisation that may be appropriate?
• If the Commission does decide to make a declaration in this area, is a transition period needed before any such declaration comes into force? If so, what would be an appropriate lead-in period?

6.7

We also welcome comments on any other relevant issues arising from this discussion document. Comments should be sent to the Commission by 5pm Friday 4 May 2007.

Postal:
Securities Commission
PO Box 1179
WELLINGTON
Attn: Meredith Pearson
Email: meredith.pearson@sec-com.govt.nz
Facsimile: (04) 472 8076

This discussion paper is available from the Commission's website:
www.seccom.govt.nz/publications/documents/derivative-contracts/

APPENDIX

Securities Markets Act - Definition of Futures Contract

Section 37(1) of the Securities Markets Act defines the term "futures contract", as follows:

"futures contract" means-

1. an agreement under which one party agrees to deliver to another party at a specified future time a specified commodity or a quantity of a specified commodity at a price which is fixed when the agreement is made but under which it is contemplated or understood that the obligations of the parties may be satisfied by means other than actual delivery:
2. an agreement under which each party has either:
   1. an obligation to pay a sum of money to the other or to credit the account of the other with payment of a sum of money; or
   2. a right to receive payment, or a credit, of a sum of money from the other,
   depending on whether at a future date the value or price of a specified commodity calculated in a manner specified by, or in accordance with, the agreement is greater or less than the value or price agreed upon by the parties when the agreement was made:
3. an agreement under which each party has either:
   1. an obligation to pay a sum of money to the other or to credit the account of the other with payment of a sum of money; or
   2. a right to receive payment, or a credit, of a sum of money from the other,
   depending on whether at a future date the value or level of a specified index calculated in a manner specified by, or in accordance with, the agreement is greater or less than the value or level agreed upon by the parties when the agreement was made:
4. an option or right to assume, at a specified price or value, or within a specified period, or by a specified date, rights and obligations under an agreement of a kind described in a preceding paragraph:
5. an agreement, option or right which is declared by the Commission, in accordance with this section, to be an agreement, option or right to which this Part of this Act applies:
6. an agreement, option or right which is of a class of agreements, options or rights declared by the Commission, in accordance with this section, to be a class to which this Part of this Act applies.

This definition applies to contracts whether they are traded on an exchange or not.

Certain agreements or contracts are excluded from this definition by section 37(2) of the Securities Markets Act. These are:

1. a currency swap agreement to which a registered bank is a party:
2. an interest rate swap agreement to which a registered bank is a party:
3. a forward exchange rate agreement to which a registered bank is a party:
4. a forward interest rate agreement to which a registered bank is a party.

An agreement or option that is described in the definition of "futures contract" is a futures contract whether or not it:

1. has any other effect; or
2. contains any other provisions; or
3. is capable of being varied or discharged before the time fixed for performance.

Footnotes

1. The statutory definition of the term "futures contract" is included in the Appendix to this paper.