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

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. This makes futures dealers the only financial intermediaries who are required by law to seek authorisation from a regulator to conduct business in New Zealand (other than the requirement under the Sharebrokers Act 1908 for sharebrokers to obtain a licence from a District Court).

3.3

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.

3.4

The effect of this is that any person who carries on the business of dealing in futures contracts without being authorised to do so will face heavy criminal penalties.

3.5

Until recently, much of the futures dealing in New Zealand was conducted under the front line regulation of the New Zealand Futures and Options Exchange Limited ("NZFOE"), an authorised futures exchange. The NZFOE was a wholly owned subsidiary of SFE Corporation, the owner of the Sydney Futures Exchange ("SFE"), which is also an authorised futures exchange in New Zealand.

3.6

In December 2002 the Commission published a discussion paper about the regulation of futures dealers, following the decision by the Sydney Futures Exchange Limited to close the NZFOE in New Zealand and integrate its futures markets into the markets operated by SFE.

3.7

In September 2003 SFE reached an agreement with New Zealand Exchange Limited ("NZX"), New Zealand's only registered stock exchange, whereby SFE would provide a trading platform for equity options contracts promoted by NZX, called NZFOX. At the same time, NZX announced that it would take on a role as a front line regulator of futures dealers in New Zealand. The Commission welcomed this move, which was in line with the preferences expressed by the great majority of people who responded to the Commission's discussion paper in 2002.

3.8

The NZX Futures and Options Rules were approved by the Commission in March 2004. These rules provide a framework for dealers to seek accreditation as NZX Futures and Options Participants. The Commission has made a class authorisation which permits any person who is an NZX Futures and Options Participant to deal in futures contracts under the terms of the NZX Futures and Options Rules.

3.9

The NZX Futures and Options Rules have their basis in agency trading by intermediaries and are designed primarily for firms dealing in futures contracts that are derived from securities. This means NZX regulation is likely to be most suitable for firms that:

receive and pass orders in futures and options products to an exchange; or
deal in futures and options products with similar characteristics to those traded on an exchange.

3.10

Dealers whose business activities fit within the scheme of the rules should seek accreditation from NZX, rather than direct authorisation by the Commission.

3.11

However, there may be circumstances when the NZX Futures and Options Rules do not provide an appropriate framework for a dealer's business. NZX and the Commission consider that NZX regulation is unlikely to be suitable where the dealer:

acts as an issuer of derivative products;
acts primarily as the market provider itself;
trades solely in its capacity as a funds manager;
trades exclusively or primarily in foreign exchange futures, and related products; or
trades exclusively for wholesale clients.

3.12

Applicants who believe they come within the categories noted in paragraph 3.11 should approach the Commission directly to seek authorisation. The Commission is able to grant individual authorisations on such terms and conditions as are appropriate to the case.

3.13

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

3.14

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.

3.15

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 two regulatory regimes to a product increases costs for market participants without appreciably benefiting the market or investors.

3.16

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.

3.17

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.

3.18

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.

3.19

Because derivatives are synthetic products that derive their value from the value of an underlying commodity or instrument, the disclosure and other regulatory requirements that are suitable for these products are often different from those for more conventional securities. The Commission has addressed this, in respect of various types of products, either by a tailored exemption under the Securities Act or by authorisation of the issuer under the Securities Markets Act, subject to terms and conditions.

3.20

We believe rolling spot foreign exchange transactions are closer to futures contracts in substance, and should, therefore, be regulated under the Securities Markets Act. However, people dealing as principals in rolling spot foreign exchange transactions could be subject to the requirements to register a prospectus and have a trustee on the basis that the contracts may be debt securities under the Securities Act.

3.21

This paper proposes that the Commission should declare rolling spot foreign exchange transactions to be futures contracts. Any declaration would have the advantage of exempting dealers in any contracts that were the subject of a declaration from regulation under the Securities Act, as the Securities Act (Authorised Futures Contracts) Exemption Notice 2002 would be applicable.

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