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

5.

DECLARATION POWER

5.1

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 aspects of the futures regime and, in particular, the regulation of foreign exchange dealing, leads us to believe that clarification may be needed. We seek comment on how such clarification could best be achieved.

5.2

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

an agreement, option, or right; or
a class of agreements, options, or rights,

to be agreements to which the Securities Markets Act applies; i.e. futures contracts.

5.3

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

5.4

It is important to recognise, however, that the Commission's power to make declarations is quite specific. The Commission's power does not extend to declaring that an agreement, or a class of agreements, is not a futures contract; or that any act or conduct does not constitute dealing in a futures contract. The usefulness of the Commission's declaration power to clarify the scope of the definition of futures contract may be limited in this regard. For example, it would not be open to the Commission to exclude spot foreign exchange transactions from the definition of futures contract.

5.5

There is likewise no power to exempt people from any part of the futures dealing regime. The Commission also cannot make any declaration that would have the effect of including the contracts listed in section 37(2) of the Securities Markets Act within the definition of futures contract.

5.6

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.

5.7

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.

5.8

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.

6.

FOREIGN EXCHANGE CONTRACTS - PROPOSED DECLARATION

6.1

When the futures dealing laws in the Securities Markets Act were introduced, all foreign exchange dealing was subject to regulation under the Reserve Bank of New Zealand Act 1964 and the Exchange Control Regulations 1985. Only an authorised foreign exchange dealer or a registered bank could carry out foreign exchange transactions. As a consequence of this, section 37(2) of the Securities Markets Act originally excluded foreign exchange and interest rate swaps and forward contracts from the definition of futures contract where these were carried out by any authorised foreign exchange dealer or registered bank.

6.2

There are no longer any authorised foreign exchange dealers. As noted above, foreign exchange and interest rate swap and forward agreements are still excluded from the definition of "futures contract" where a registered bank is a party to the agreement. This covers the majority of foreign exchange dealings in New Zealand.

6.3

Recently there have been a number of companies established in New Zealand that offer a variety of foreign exchange trading services. Most of these are simple exchange services, and do not raise any questions in terms of the futures dealing regime. A small number, however, offer dealing services in margined forward exchange rate contracts and foreign currency forward contracts that may be futures contracts under the Securities Markets Act. A few of these businesses have obtained authorisations as futures dealers. Most have not. The reason for this appears to be a real doubt as to the application of the definition of "futures contract" to the foreign exchange contracts offered by these businesses.

6.4

The Commission has been informed that some firms are being advised by lawyers that their business does not require authorisation. Others have been advised differently. In some cases the application of the law to foreign exchange products turns on the legal form of the agreements used by the dealer, rather than the substance of the transaction.

6.5

The effect of this is that some industry participants have sought and been granted authorisations to deal in futures contracts, with attendant oversight and protections for their clients and associated costs for the firms, while others trade unregulated.

6.6

It is desirable for there to be certainty in the market concerning the scope and effect of regulation. It is also desirable for instruments that are used for the same purposes as futures contracts, and that in substance carry the same risks and potential rewards as futures contracts, to be treated as such under the law, so that there is consistency in regulation.

Spot contracts and forward contracts

6.7

Conventionally, over-the-counter (that is, non-exchange traded) foreign exchange contracts can, with some variations, be divided into spot contracts and forward contracts.

6.8

A spot contract is, in its simple form, not a futures contract. It is an agreement under which a person purchases an amount of a foreign currency at the exchange rate that applies at the time (or on the day) of the agreement (the "spot" price). The person takes delivery of the currency. This is, in essence, the simple purchase of an amount of foreign currency.

6.9

A forward foreign exchange rate contract is an agreement to purchase an amount of foreign currency at a fixed exchange rate on a future date. Forward foreign exchange rate contracts are commonly used by exporters and importers to hedge against movements in currency values.

6.10

It is common market practice for currency acquired under a spot contract to be delivered up to two days after the execution of the contract. However, future delivery alone does not, under New Zealand law, make an agreement a futures contract. An agreement is only a futures contract if one of the following applies:

it is understood at the time the contract is made that the obligations of the parties may be satisfied by means other than actual delivery; or
if the contract requires one party to pay the other a sum of money depending on a comparison between a future value or price of a commodity and the value or price agreed on between the parties when the agreement was made.

6.11

In either of the above cases, it must be contemplated that the contract between the two parties can be satisfied by means other than actual delivery of the foreign currency. Generally spot contracts can be settled only by delivery of the currencies concerned. This is also the case for some, but not all, forward exchange rate contracts. Where this is the case, we do not think that the contract is a futures contract, nor do we consider there is in substance a contract that should be regulated, in terms of the policy of the Securities Markets Act, as a futures contract.

6.12

However, where a contract for a commodity (including foreign exchange) has any forward delivery element (even intra-day) and where it is understood that the contract can be settled rather than delivered, we consider this will be a futures contract under paragraph (a) of the definition in the Securities Markets Act. Our understanding of paragraph (a) of the definition is that it does not capture a contract which can only be settled by actual delivery. If delivery is not the only way the contract can be settled, then the agreement will be a futures contract.

6.13

Where a contract does not contemplate delivery of the commodity at all, but sets out obligations for one party to pay the other depending on the value of the commodity on a future date compared to the value or price agreed at the time of the contract, this is likely to be a futures contract under paragraph (b) of the definition in the Securities Markets Act.

Rolling spot contracts

6.14

While we think the law is sufficiently clear in its application to simple spot and forward contracts, we are aware that there are some instruments, the use of which is growing in New Zealand, about which there is less certainty. The main contract of this type of which we are aware is called a rolling spot. A rolling spot contract may sometimes be referred to as a margined foreign exchange contract. We understand them to be essentially the same thing.

6.15

A rolling spot contract is, most commonly, a leveraged contract under which the return or cost to each party depends on the value at the end of the day of a named currency, compared to its value at the beginning of the day. The actual amount of foreign currency underlying the contract is not deliverable. Instead, the contract is valued on a daily basis and, depending on the movement of the currencies concerned, each party is either debited or credited a sum of money. The contract is valued and renewed on a daily basis until closed, and the client's account is either debited or credited each day. The position is closed by the client taking a notional opposite position for the same quantity of the same currency.

6.16

In practice, dealers offering these products take both initial and ongoing margins from clients to cover potential exposures as exchange rates move throughout the life of the rolling spot contract.

6.17

Most enquiries the Commission has received about the application of the law to foreign exchange products have concerned rolling spot contracts. In substance these contracts are non-deliverable forward contracts of indeterminate duration. In legal form, however, they are intra-day contracts that are renewed daily.

6.18

It seems that the form of rolling spot contracts highlights a gap in the current definition of "futures contract". Paragraph (a) of the definition only applies where the contract is able to be delivered and where the contract value is determined according to the value of a commodity at a specified future time. It may be said that the settlement value of a rolling spot contract is to be determined according to the value of the currency at a specified future time (being the market price at the close of the day), but it does not appear that these contracts are in form contracts for the delivery of a currency.

6.19

It would appear to be more likely that paragraph (b) of the definition of "futures contract" would fit rolling spot contracts. This paragraph says that an agreement is a futures contract if the obligations of the parties are to be determined by whether or not at a future date the value of a commodity is higher or lower than a value agreed upon at the time the agreement was made. In form, however, the payment obligations under a rolling spot are determined according to the value of a currency at the end of the same day on which the contract was made. The definition applies only where a future "date" is involved.

6.20

On the other hand, if the positions are effectively held open indefinitely in spot foreign exchange transactions by being continuously rolled over, this rollover could arguably be viewed as introducing a future date. However, the form of these agreements does not in this respect accord with the economic substance.

Regulation of rolling spot contracts overseas

6.21

It appears that the appropriate regulatory treatment of rolling spot contracts has caused similar difficulties in overseas jurisdictions.

6.22

In the United States the issue was addressed in late 2004 by the Court of Appeals for the Seventh Circuit, in the case of CFTC v Zelener¹. The case looked at whether rolling spot contracts and similar speculative transactions in foreign currency were "contracts of sale of a commodity for future delivery" under the US Commodity Exchange Act and, therefore, within the regulatory authority of the US Commodity Futures Trading Commission ("CFTC").

6.23

The Court of Appeals found that these contracts were not futures contracts. It did not consider that an absence of delivery was critical under US law.

6.24

The Court held that the transactions involved in the case were, in form, spot sales for delivery within 48 hours as opposed to "contracts of sale of a commodity for future delivery". In the Court's view, the rolling-over of the transactions and the consequent increased gain or loss over a longer period of time did not make the transactions future contracts.

6.25

Following this decision, we understand a legislative change has been proposed in the US. This would broadly include as a futures contract any agreement, contract or transaction in foreign currency that is offered, or entered into, on a leveraged or margined basis, or financed by the offeror, the counterparty, or a person acting in concert with the offeror or counterparty on a similar basis; but would not include:

a security that is not a security futures product; or
a contract of sale that:
- results in actual delivery within two days; or
- creates an enforceable obligation to deliver between a seller and a buyer who have the ability to deliver and accept delivery, respectively, in connection with their line of business.

6.26

There are similarities between the US Commodity Exchange Act and the relevant provisions of the Securities Markets Act, but there are also important differences that we think make it unsafe to place too much weight on decisions by US Courts for assistance in determining the appropriate regulatory treatment in New Zealand. For example:

the fact that a contract can be settled other than by delivery is a defining characteristic of a futures contract in New Zealand under section 37(1)(a) of the Securities Markets Act (section 37(1)(b) also assumes that delivery will not occur);
section 37(1)(b) does not appear to require that a specific expiry date must be fixed when the contract is first entered into.

6.27

United Kingdom financial services legislation treats rolling spot foreign exchange contracts as futures. It does this by expressly including rolling spot contracts in the definition of "futures" under the financial services legislation. This supports our view that rolling spot contracts are in substance the same as futures contracts, but is not helpful in determining whether they are legally futures contracts under New Zealand law.

6.28

In Australia we understand rolling spot foreign exchange contracts are regulated by the Australian Securities and Investments Commission as a financial product under the Corporations Act 2001.

Proposed declaration

6.29

Trading in rolling spot foreign exchange transactions is likely to involve the same risks, and have the same economic result, as trading in standard non-deliverable forward foreign exchange contracts.

6.30

If the rollover of a spot foreign exchange transaction could be viewed as introducing a future date 'in substance', a party's gains or losses would depend on price movements in the future. On the other hand, section 37(1)(b) does appear to require that 'in form' the contracts must involve a future "date" rather than being effectively intra-day like spot foreign exchange transactions. This appears to be one of the key differences between rolling spot foreign exchange transactions and standard futures contracts.

6.31

Nevertheless, it is relevant to bear in mind the policy reason behind the New Zealand law: that the speculative nature of futures contracts, and the manner in which they are traded, appears to require particular regulation. From the perspective of investors, it appears that the need for protection is the same in relation to a rolling spot foreign exchange transaction as a standard futures contract. This is particularly so given the practice of calling for margins to support exposures in these contracts. If these agreements are futures contracts, margin payments should be held in separate client funds accounts under the Futures Industry (Client Funds) Regulations. If the agreements are not futures contracts, there is no requirement for this protection to be afforded to client funds, including margin payments.

6.32

We consider a rolling spot foreign exchange transaction shares sufficient similarities with a futures contract so that it should be regulated under the Securities Markets Act, despite the form of the contract being intra-day. In our view, because the economic substance of a rolling spot foreign exchange transaction and, accordingly, the issues involved for investors, are essentially the same as that of a standard non-deliverable forward foreign exchange contract, we believe rolling spot foreign exchange transactions should be regulated as futures contracts.

6.33

The Commission proposes to use its declaration power to declare rolling spot foreign exchange transactions to be futures contracts. We believe such a declaration would be consistent with the policy of the Securities Markets Act.

6.34

For discussion, it appears to us that wording similar to the US proposal mentioned in paragraph 6.25 may be appropriate to clarify the situation in New Zealand as well.

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Footnotes

1: Commodity Futures Trading Commission v Zelener et al., (2004) 373 F.3d 861 (7th Cir) rehearing denied, 378 F.3d 624 (7th Cir).