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Government's 'once in a generation securities law rewrite' to set out a detailed definition of derivatives for the first time

Posted in Business

By Gareth Vaughan

The Financial Markets Conduct Bill, touted by the Government as a once in a generation securities law rewrite, could end decades long uncertainty about just what derivatives are by recognising them as a category of financial product in their own right.

Bell Gully partner David Craig, a derivatives expert, told interest.co.nz the key change for the world of derivatives coming out of the Bill would be certainty.

"Up until now it hasn't been entirely clear where derivatives fit in the regulatory scheme of things because most of the legislation governing our financial products is relatively archaic and doesn't recognise derivatives, certainly in the form that they've developed into," Craig said.

"So there was always an argument are they a futures contract, (or) are they a security? It is one that that has taken up a lot of our time and our clients time because the consequences are quite different depending on what side of the coin you come out on."

Recognising derivatives as a category of financial products in their own right was a "giant leap forward," he added.

Here's the definition of derivatives from the Bill;

derivative —

(a) means an agreement in relation to which the following conditions are satisfied:

(i) under the agreement, a party to the agreement must, or may be required to, provide at some future time consideration of a particular kind or kinds to another person; and

(ii) that future time is not less than the time, pre- 20 scribed for the purposes of this subparagraph, after the time at which the agreement is entered into; and

(iii) the amount of the consideration, or the value of the agreement, is ultimately determined, derived 25 from, or varies by reference to (wholly or in part) the value or amount of something else (of any nature whatsoever and whether or not deliverable), including, for example, 1 or more of the following:

(A) an asset:

(B) a rate (including an interest rate or exchange rate):

(C) an index:

(D) a commodity; and

(b) includes a transaction that is recurrently entered into in the financial markets and is commonly referred to in those markets as —

(i) a futures contract or forward; or

(ii) an option (other than an option to acquire by way of issue an equity security, a debt security, or a managed investment product); or

(iii) a swap agreement; or

(iv) a contract for difference, margin contract, or rolling spot contract; or

(v) a cap, collar, floor, or spread; but (c) does not include —

(i) an agreement for the future provision of services; or

(ii) a debt security, an equity security, or a managed investment product; and

(d) does not include an agreement in relation to which all of the following subparagraphs are satisfied:

(i) a party has, or may have, an obligation to buy, and another party has, or may have, an obligation to sell, property (other than financial products or New Zealand or foreign currency) at a price and on a date in the future; and

(ii) the agreement does not permit the seller’s obligations to be wholly settled by cash, or by set-off between the parties, rather than by delivery of the property; and

(iii) neither usual market practice nor the rules of a market permit the seller’s obligations to be closed out by the matching up of the agreement with another agreement of the same kind under which the seller has offsetting obligations to buy.

In terms of the creation of new derivatives products in the future Craig said the Bill also addresses this to some extent.

"The definition of derivatives is intended to be relatively future proof in that it includes both a relatively comprehensive list of products that we know about now and are clearly derivatives, but there's also generic wording in there that's intended to capture new products that come along and start to be traded in the financial markets. That's the first backstop to trying to deal with things that aren't contemplated now," he said.

The FMA's key role

The second backstop, Craig suggested, is giving the Financial Markets Authority (FMA) the power to declare certain products derivatives. The Bill defines four types of financial product being debt, equity, managed investment products, and derivatives. The FMA will have the power to designate products into what it deems to be their appropriate category.

Craig argues this is a controversial power.

"Why I say that has been controversial is that it can cut across the certainty that participants in the market are seeking. Because if they look at a particular product, form a view on the basis of the Bill that it's say, a derivative and then the FMA comes along and says in six months time 'we know you've been treating it as this, but we're going to declare that it's now something else,' that has the potential to cause problems," Craig (pictured) said.

"But perhaps one of the upsides of that power is if you do have new products coming along that don't squarely fit within the definition of derivative, the FMA could make a declaration as to where it falls. It's a bit of a double edged sword that power, but it should help deal with the problem of things that aren't contemplated now."

More certainty for banks

For banks looking to offer derivative products Craig reckons the new law won't necessarily make it any easier. There'll be a similar level of regulation, it's just that they'll have more certainty as to where they are in relation to it.

"Under the new regime if they're seeking to offer these products at a retail level they're still going to have to provide a PDS (a product disclosure statement which will replace the current investment statement and prospectus). So it's not really going to make their life that much easier. I guess the upside will be that the things that are required to be in that PDS will be much better tailored to derivative contracts than the generic requirements at the moment because it's going to be a PDS specifically for derivatives and it should be easier for them to put those documents together," said Craig.

And to offer derivatives products such as currency swaps to retail investors or to Fonterra farmers, the offerer will need to be licenced.

The ongoing Commerce Commission probe into interest rate swap products sold to farmers by banks wouldn't be conducted substantially differently under the incoming law.

"It's not as though there's going to be a quantum leap in the standards that are going to be imposed. By and large the same standards will apply to derivatives issues as apply now, which is when you're selling these sorts of products you can't act in a misleading and deceptive way," said Craig.

Financial products & gambling

Meanwhile, Craig says he's frustrated that financial products, including derivatives, aren't explicitly carved out from the Gambling Act in the Financial Markets Conduct Bill.  The new legislation itself says this hasn't been done on the basis that legitimate financial markets transactions, whether for hedging or for investment purposes, aren't gambling within the meaning of the Gambling Act 2003 and aren't gaming or wagering contracts under the common law.

Craig said this issued had been tackled in the likes of Australia, Britain, and the United States where there is specific legislation that says in relation to defined financial products, state or federal gambling laws don't apply.

"In New Zealand for better or worse we've never had that clarification in the past other than in relation to certain types of futures contracts. It sort of begs the question if someone came along, and there was a rogue case where someone argued that their derivative contract was a gambling contract and was unenforceable, what the attitude of the New Zealand courts would be," Craig said.

"I think the answer is hopefully the court would uphold the contract. But it's such an important issue that it's not really one that you want to leave to chance. And this Bill seemed to be the perfect opportunity to clarify that."

A spokeswoman for Commerce Minister Craig Foss recently told interest.co.nz he hoped to progress the Bill, whose second reading concluded in February, in the House "shortly." Foss has described the Bill as "a once-in-a-generation opportunity to make New Zealand's financial markets more efficient." See a broader article on the Financial Markets Conduct Bill here.

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7 Comments

This is an interesting and

This is an interesting and long overdue piece of legislation. It remains to be seen how the courts will treat the "derivative that isn't a derivative" case, as legal eagles will do their best to create structures, which clearly are derivative (of an underlying asset) but are constructed in a split system. Should be fun to watch that space.
On the gambling front, I'm surprised the government hasn't sorted this out. It doesn't really need a test case, as we had one in the UK back in the early 90s (City Index vs Leslie), which laid out the difference between gambling and a financial transaction (hedging or contract for difference). It was a very intriguing case, not just because Mr Leslie was a good friend of mine, but because it differentiated between a gambling contract (which is not enforceable in law) and an instrument created to gamble on a financial asset (ruled to be enforceable). It was a very contested decision because clearly the "trading" on CFDs was not an investment, nor a hedge but an outright bet.
There would have been some interesting activity behind the scenes for sure! A couple of good links to this issue below
http://www.ucl.ac.uk/opticon1826/archive/issue1/VfPHedgingGamblingPDF.pdf
http://law.ato.gov.au/atolaw/view.htm?docid=TXR/TR200515/NAT/ATO/00001

"Under the new regime if

"Under the new regime if they're seeking to offer these products at a retail level they're still going to have to provide a PDS (a product disclosure statement which will replace the current investment statement and prospectus). So it's not really going to make their life that much easier. I guess the upside will be that the things that are required to be in that PDS will be much better tailored to derivative contracts than the generic requirements at the moment because it's going to be a PDS specifically for derivatives and it should be easier for them to put those documents together," said Craig.
 
And to offer derivatives products such as currency swaps to retail investors or to Fonterra farmers, the offerer will need to be licenced.
 
Are we sure about local banks engaging in collateralised lending /borrowing via currency swaps with retail customers, whether they be farmers or not, at rates that would make financial sense to both parties?
 
I would love to lend NZD to my local NZ bank collateralised by the receipt of USD in my New York A/C @ the correct rate.

Sorry to Rain on the Parade ,

Sorry to Rain on the Parade , but there is no such thing as "certainty" when it comes to derivatives.
While we understand the term "certainty " in the article refers to its treatment from a contractual viewpoint , its in reality  a risky form of betting on price movements
The trade in derivatives is at worst gambling on a future event , and at best Insurance for or against an event , and insurance is as close as dammit is to gambling.
Buying a derivative is simply buying the right to take the slice arising ( clip the ticket)  from a movement in the price of a commodity , either up or down from its present trend line .
Its supposedly done using calculus to see where the price moves on the curve ,  but does not and cannot forsee a failed crop , bad weather , an earthquake , tsunami , political upheaval  and millions of other "unknowns" in formualting a prices for the derivative.
Not even that most secretive of organisations , FONTERRA knows exactly what the price of their commodity will be over the next year , although they are very good at forecasting , and are better positioned than most commodity firms in the world.
 
 

The trade in derivatives is

The trade in derivatives is at worst gambling on a future event , and at best Insurance for or against an event , and insurance is as close as dammit is to gambling.
 
Gambling for the seller or the buyer of the premium?
 
Are you a religious nutter? Or just short of financial product market maker experience?
 
Have you ever had to consider how to hedge adverse interest rate change risk for a multi billion dollar fixed income book without the aid of derivatives, in the form of OTC options and/or exchange traded futures/options contracts?
 
Note - I am not indifferent to the massive volatility introduced into market capital valuations as the behemoths of capital markets lift and reset their hedges. Read more 
 
In respect of this issue, we need to better educate our central bankers around the means they use to transmit their thoughts about future actions. Read more

Stephen - Did you actually

Stephen - Did you actually read Boatman's post?  Good time to admit "oops I got it wrong" or kiss goodbye to a chunk of credibility.

kiss goodbye to a chunk of

kiss goodbye to a chunk of credibility - ok with me, if you say so.

I vaguely recollect one of my

I vaguely recollect one of my tutors telling us insurance is betting - it's a bet against something happening, rather than a bet that something will happen - I think I said that right