Climbing Mount Improbable - bringing reason to the regulation of derivatives

The modernisation of derivatives regulation will be welcomed by everyone who has had to battle the vagaries and inadequacies of Part 3 of the Securities Markets Act 1988 and the series of Authorised Futures Notices that, in practicality, define the existing regime.

The scope and direction of this reform has now been mapped out in the Financial Markets Conduct Bill (the Bill). This Brief Counsel describes the proposed framework and puts it in the context of international developments that are now fast approaching and will change the rules of the game.

The context for New Zealand derivatives regulation

As a small, geographically isolated trading country that is heavily reliant on international capital markets for its funding, derivatives play a vital part in New Zealand's financial system and economy. A pity, then, that our regulation of this area is so antediluvian, inefficient and haphazard.

This is the situation that the Ministry of Economic Development (MED) is trying to address in the first comprehensive review of derivatives law since the late 1980s, when there was barely a swap market and exotica such as credit default swaps, Kyoto units, negative basis trades and volatility indexes were not even contemplated.

The MED's response has been to bring derivatives within the framework as one of the four "financial products" that are regulated under the Bill. While this is undoubtedly the best way to proceed, it also creates a number of challenges because of important differences between derivatives and the other three financial products, all of which are securities (debt, equity and managed investment schemes).

The shock of the old

Derivatives currently attract their regulation largely from Part 3 of the Securities Markets Act 1988. This regime is now well and truly out of date, being based on a now twice-superseded New South Wales precedent.

The regime is very haphazard and inefficient, having been developed over the past 20 years largely through Authorised Futures Dealers and Futures Contract notices. It is duplicative, in the sense that many "futures contracts" will also be debt securities, under the incredibly expansive meaning accorded to that term in New Zealand. It is also anomalous in that it applies to both retail counterparties (who presumptively require protection) and wholesale counterparties, who in other areas are rightly presumed to be able to fend for themselves.

These and other defects mean that an overhaul is overdue. The MED is to be congratulated for taking an entirely new direction in the Bill, as outlined below.

Navigating the new derivatives regime

Because the derivatives provisions are baked into the infrastructure of the Bill (for example, you won't find a Part of the Bill labeled "derivatives"), a navigation guide is required to understand how the regime will operate. Making life more difficult in terms of getting to grips with the treatment of derivatives is the fact that obligations and requirements can arise from derivatives being a "financial product" and/or a "regulated product" and from various provisions about listed markets.

In that sense, almost the whole Bill regulates, or potentially regulates derivatives, even though they are the 'odd man out' in terms of being the only financial product that is not a recognised security.

One pleasing feature of the Bill is that derivatives have now been defined in a way that maps to the market, by using familiar terms such as swaps, options etc but with sufficient flexibility to accommodate the unusual or novel. The definition is in two parts: subsection (1) being principles-based and subsection (2) being the market terms, such as option and swap.

Also helpful is the fact that the core derivatives products and debt securities are now defined with mutual exclusivity – for almost all practical purposes, if it's a debt security, it won't also be a derivative...