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Securities Commission Policy in Respect of Futures Dealer Authorisations

FUTURES DEALER REGULATION

INTRODUCTION
1.1    The Securities Commission is reviewing aspects of its policy in relation to the authorisation of futures dealers under section 38 of the Securities Markets Act 1988.
1.2    This paper outlines changes in the industry requiring a review of the Commission's established authorisation policies. It outlines proposals for a new framework for regulating market participants involved in arranging forward contracts and most other derivatives (including futures and options) for clients. Issues for comment are raised throughout the paper and a list of questions is included at the end.
1.3    The proposals are being considered because of changes in the futures industry in New Zealand and in particular the proposed withdrawal of the regulatory functions undertaken to date by the New Zealand Futures and Options Exchange (NZFOE).
1.4    The proposals encompass persons who deal in futures contracts in terms of the Securities Markets Act 1988, principally those dealers who act in a traditional "broking" role, whether as adviser or as public broker. The Commission has also authorised certain funds managers who deal in futures in the course of their funds management business and certain wholesale electricity market participants. At this stage it is not planned to review these authorisations although in the longer term the outcomes of the review may affect authorisations and applications affecting these dealers. For this reason we welcome comment from all sectors of the futures industry.
1.5    The definition of futures contract includes futures and options transactions effected both on and off exchange. It includes forward contracts for foreign exchange arranged directly with a client by anyone that is not a registered bank. It is also likely to include margin contracts for foreign exchange.

BACKGROUND
2.1    The regulation of futures dealing is different from other areas of securities law in New Zealand. Unlike other financial intermediaries, such as stockbrokers, futures dealers need authorisation from the Commission to deal in futures contracts under section 38 of the Securities Markets Act 1988. The Commission considers authorisation applications in accordance with that Act. Before granting an authorisation, the Commission must be satisfied that there is an adequate regulatory framework upon which the authorisation can be based. We note that any change to the regulation of financial intermediaries on a wider basis may lead to further review of whatever framework is developed for futures dealers.
2.2    The existing regulatory framework covering authorised futures brokers is built around the existence of a local futures exchange performing front line regulation of brokers. The Commission has, for the most part, traditionally based its authorisations of futures dealers on their membership of and regulation by that futures exchange. It is an offence under the Securities Markets Act 1988 to deal in futures contracts without Commission authorisation.
2.3    The need to consider new regulatory structures has been prompted by:
- the proposed closure of the only futures exchange in New Zealand (NZFOE) and the integration of its futures markets into the markets operated by its parent company (SFE Corporation) from Australia;
- the resulting gap in front line regulation of futures dealers that will result from such a move; and
- the increasing range of derivative products being offered outside the framework provided by regulated exchanges.
2.4    The decision of the SFE Corporation to withdraw the regulatory function presently undertaken by the NZFOE raises questions as to how appropriate regulation can best be maintained.
2.5    As most authorisations are based on the condition that dealers are brokers within the meaning of the rules of the NZFOE and are bound by the rules of the NZFOE, when this disappears most New Zealand dealers' authorisations will become invalid and they will either have to obtain new authorisation or cease their futures dealing activities.
2.6    The SFE Corporation, in withdrawing, states that in contrast to the existing New Zealand regulatory framework, offshore regimes have increasingly been developing in the direction of government-funded securities commissions assuming greater responsibility for licensing market participants and enforcing detailed legislative regimes directed at ensuring that intermediaries deal fairly, honestly and efficiently with customers.
2.7    The SFE Corporation states that furthermore, those other regimes have reflected changes in technology and scope for regulatory arbitrage by ensuring that, to the greatest extent practical, the same obligations are imposed on all market participants dealing with retail clients, irrespective of the nature of the financial product.
2.8    Currently, many of the organisations that directly execute trades on NZFOE are not full participants of the Sydney Futures Exchange (SFE). These organisations can seek to become full SFE participants and obtain a financial services provider's license from the Australian Securities and Investments Commission. The SFE Corporation inform us that they do not anticipate that many, if any, of the organisations that directly execute trades on NZFOE, not being full participants of the SFE, will seek to become SFE participants (and obtain a financial services provider's licence from the Australian Securities & Investments Commission) before the NZFOE contracts are transferred to SFE.
2.9     Instead, the SFE Corporation expects such organisations to make arrangements with an existing SFE participant for the organisation to enter trades into the SFE market via an interface to the SFE market provided by the SFE participant. Those introducing brokers who already have NZFOE trades executed for them by another dealer will need to ensure that the dealer through whom they arrange trades is an SFE participant. (If the executing broker, through whom the introducing broker arranged trades for its clients, were not an SFE participant, the introducing broker would itself require a licence from the Australian Securities and Investments Commission).
2.10    In respect of both categories of current NZFOE dealer - those who execute directly and those who are introducing brokers - the regulatory issues are essentially the same: if they will no longer be monitored by an exchange (because they will not be a direct participant) they need to demonstrate that they are subject to some monitoring as to how they deal with clients. In the case of a public dealer who holds funds on behalf of a client, the need for monitoring is particularly acute. It is likely that the amount of required monitoring for particular dealers will vary depending on whether or not client funds are held.
2.11    Persons arranging for clients to assume futures contracts, including margin obligations (obligations to make payments reflecting movements in the value of their obligations) and holding client funds are likely to have the following choices:
- cease taking funds from clients (and instead - in the case of futures and options contracts - arrange for a supervised and authorised participant of an approved offshore exchange such as the SFE to receive any funds directly from the client); or
- initiate, and participate in, some form of monitoring of the protection of client funds devised either by the broker or by a self-regulatory association which they help establish.
2.12 Reflecting the reduced need for regulatory investor protection, dealers acting as introducing brokers (i.e. not receiving client funds) may be subject to less rigorous requirements.
2.13 The Commission considers it crucial that the New Zealand market is well regulated and that a credible compliance system remains in place. If New Zealand is to attract overseas investment in local financial products and thus gain the benefits of increased liquidity in them, it is important that we have a regulatory regime that compares well with international standards. Moreover, it will assist local participants to have international credibility if they operate in such an environment.

PRINCIPLES OF REGULATION
3.1 The Commission believes that investment in New Zealand should be encouraged. We see this being aided by:
- high regulatory standards;
- effective enforcement;
- markets with integrity; and
- investor confidence.
3.2 In devising new structures the Commission's purpose is to strengthen confidence in New Zealand's investment markets by promoting:
- efficiency;
- integrity; and
- cost-effective regulation.
of these markets, thereby fostering investment in New Zealand.
3.3 In order to achieve this purpose in respect of futures markets there are a number of important principles:
- investor protection;
- fair, efficient and transparent markets;
- reduced systemic risk; and
- appropriately qualified and competent advisers.
3.4    Sound regulatory structures for futures dealers are important for maintaining a good international reputation for the New Zealand market and for investor protection. Good regulation should also encourage the benefits of an innovative and efficient futures market.
3.5    Regulation of futures dealers should include granting authorisations on sound principles, ongoing review of market practice, and effective and fair enforcement of breaches of law and terms of authorisation.
3.6    The Commission considers that the regulatory costs applying to different entities offering similar financial services should be reasonably equivalent and accordingly considers that:
- the regulatory structure should not put market participants at an unfair disadvantage to others engaged in similar activity; and
- the regulatory structure should not encourage regulatory arbitrage based on users of one product being unfairly disadvantaged relative to users of a comparable product.
3.7 The SFE Corporation considers that these comparable treatment principles, when applied to the operator of an offshore futures exchange, mean that it would be unacceptable for the Commission to expect one exchange to assume regulatory obligations which another offshore exchange is not expected to assume, in the absence of different risks to the end user. Similarly, the SFE Corporation considers it increasingly unacceptable to expect that one exchange should regulate users of their market as to how those users conduct activities on another, potentially competing, market.

ISSUES AND PROPOSALS
4.1 To obtain or retain Commission futures dealer authorisation from early 2003, any person engaged in arranging margined financial products (that fall within the wide definition of 'futures contract' in the Securities Markets Act 1988)¹ will need to establish, to the satisfaction of the Commission, that they are subject to adequate monitoring as to the conduct of their business.
4.2 The core elements which the Commission considers must be present in any new regulatory structure include:
- requirements for advisers to be appropriately qualified;
- rules against inappropriate trading behaviour by brokers (e.g. front running or churning);
- regular monitoring by an independent person to check that the entity holding funds on behalf of clients does not use those funds for their own purposes; and
- disclosure to retail clients of the risks associated with particular financial products (whether or not the market professional holds funds on behalf of the client).
4.3     Issues of investor protection are likely to be less relevant when dealers are dealing on the wholesale market with institutional bodies rather than on the retail level with members of the public. Generally, institutional investors are able to look after their own interests.
4.4    The question of whether a dealer is holding client funds or is simply acting as an introducing broker is also important in determining the appropriate level of regulatory investor protection. If a dealer holds client funds we think issues of investor protection become more important. We note that if a futures dealer holds client funds the Futures Industry (Client Funds) Regulations 1990 will apply and require investors' funds to be held separate from the dealer's own money and property.
4.5    The principles outlined above are reflected in the following issues and proposals.
Summary of regulatory options
4.6    We outline possible models in this paper that we see as options to meet these requirements. Without limiting the range of monitoring mechanisms that may be acceptable to the Commission, the following broad alternatives are being considered:
- being regulated by an approved exchange and licensed or authorised by the securities commission where the exchange is based;
- Commission front line monitoring and enforcement;
- being a member of a self-regulatory association approved by the Commission; or
- being subject to other monitoring arrangements put forward by individual dealers for the Commission's consideration (including the compliance reporter model outlined below).
4.7 We should emphasise that we are open to and welcome other suggestions from the industry. We have not yet reached a view on what the appropriate regime would be. We see advantages in a regime that is broadly uniform for all futures dealers to the greatest extent possible. Balanced against this is the need for flexible treatment depending on the futures activity. Should different requirements apply to those dealers who only deal for wholesale clients?
Issues for comment
4.8 Whatever model is developed there are certain matters that will have to be addressed. We raise the following matters, most of which are presently addressed by the NZFOE rules, for comment:
- Client funds protections: This issue is dealt with to some degree by the Futures Industry (Client Funds) Regulations 1990.
- Capital adequacy rules: It is argued that a minimum capital base provides some assurance that a dealer will stay in business and the client's position will not suffer from a dealer's insolvency. It is also argued that a minimum capital base reduces the temptation to settle dealer debts with client funds. We welcome your views on whether capital adequacy rules should be imposed and if so, what might constitute an appropriate minimum capital base?
- Educational and competency standards: The Commission could rely on a self-regulatory body, if such were available, to assess these standards.
- Financial reporting: In the past the Commission has taken the view that dealers who hold client funds on behalf of the public are issuers. We propose that dealers be required to comply with the financial reporting obligations of an issuer under the Financial Reporting Act 1993. Should there be regular interim reporting to a monitoring body (e.g. a self-regulatory body or a compliance reporter)?
- Risk, product, and adviser disclosure: Should the futures dealer provide each client with a product and risk disclosure document and an investment adviser disclosure document (and/or an investment broker disclosure statement)?
- Written client agreements: The Commission considers that futures dealers should enter into a client agreement with each client and should act in accordance with that agreement. Do you agree?
- Recordkeeping: The Commission considers futures dealers should maintain proper records. Do you have any comments on this?
- Audited financial statements: In the past the Commission has considered that futures dealers should provide copies of their audited financial statements to the Commission not more than three months after the end of each financial year. Do you think this requirement should continue, or be changed in any way?
- Professional indemnity insurance: Should futures dealers be required to maintain adequate professional indemnity insurance?

OPTION 1: EXCHANGE REGULATION
5.1 We do not discuss the exchange regulation model in detail in this paper. However, we note that we would look favourably on an exchange that is prepared to take a monitoring role for a wide range of classes and activities of futures dealers. If an exchange proposes to regulate only a portion of the dealers activities (i.e. the on exchange activities) there may need to be a combination of monitoring structures. The Commission would prefer to avoid duplication of supervision, but equally seeks to avoid gaps in regulatory supervision.

OPTION 2: SECURITIES COMMISSION OVERSIGHT
6.1 A Commission oversight model would see the Commission undertake both the monitoring and enforcement roles. Similar matters referred to in regard to the other models set out in this paper would need to be addressed. Together with the matters referred to above, this model may include Commission involvement in the following:
- on-site inspections;
- review of systems and procedures;
- receiving reports from the dealer;
- review of capital adequacy;
- review of business and trading practices.
6.2    Certain rules would be attached as conditions to authorisation. There may need to be development of a uniform set of rules for trading and business behaviour. The industry would need to be involved in development of these rules.
6.3    We note that there is significant regulator involvement in a number of other jurisdictions including the United Kingdom, Singapore and Australia.
6.4    There may be reputational advantages for the New Zealand market if the regulator is directly involved in these processes. Disadvantages may include less industry participation and potentially more cost.
6.5    Such a model may have significant funding implications for the Commission. It is possible that it could be at least partly industry-funded. There may be an argument for at least some taxpayer funding. In-depth examination of whether the Commission should be taking such a role and how this should be funded may require analysis of what economic and other benefits are brought to New Zealand by its having a futures market, particularly one that is directly regulated by the Commission. We would be interested in any comment on this issue.

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1: Futures contract is defined to mean:

"(a) 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:

(b) An agreement under which each party has either-

(i) 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

(ii) 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:

(c) An agreement under which each party has either-

(i) 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

(ii) 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:

(d) 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:

(e) 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:

(f) 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:"

We are of the view that this definition includes all foreign exchange transactions other than:

(a) contracts that are to be settled immediately; and

(b) contracts to which an authorised dealer in foreign exchange or a registered bank (within the meaning of S.2 of the Reserve Bank of New Zealand Act 1964) is a party.