The Financial Markets Authority (FMA) has opened its consultation on imposing a new standard condition and varying an existing standard condition (the New Conditions) for all derivative issuer (DI) licences. The purpose of the New Conditions is to help retail investors manage the risks associated with leverage limits and suitability.
Submissions close at 5pm on 7 August 2024, and can be found here.
Who needs to read this? Why?
All licenced DIs operating in New Zealand should become familiar with the New Conditions and will be required to comply, in addition to the existing standard conditions, as part of their licensing obligations. In this consultation, the FMA is calling for public submissions to gain a better understanding of the views of both licence holders and the wider public.
What does it cover?
The FMA published a DI Sector Risk Assessment (SRA) in 2020, which can be found here.
In the SRA, the FMA considered the governance, culture, systems, and controls of DIs in accordance with their compliance obligations. These obligations work to promote the FMA’s objective of promoting fair, efficient, and transparent financial markets. The SRA identified potential compliance risks relating to product sustainability, counterparty risk, derivative investor money, margining, advertising, and outsourcing. The SRA highlighted that the risk presented by highly leveraged derivatives was rated at ‘medium-high’, raising concern about the quality of outcomes that retail customers would be receiving from margin trading and instances of margin requirements exceeding investors’ deposits.
1. Proposed leverage standard condition
There is no limit to the amount of leverage a licensed DI can offer to retail investors in New Zealand under the existing conditions. Significant discrepancies arise from unlimited leverage, where the FMA has identified contracts for difference (CFD) leverage limits ranging between 30:1 to 500:1. Highly leveraged derivatives carry the risk that retail investors may experience greater than expected loss, where the financial impact felt from price volatility increases as leverage levels increase. These impacts are further intensified by low market liquidity.
The proposed New Conditions will set limits for all over the counter (OTC) derivatives offered to retail investors and will capture CFDs, futures, and option contracts. The FMA has opted to apply the conditions to all DIs as most retail investors use OTC derivatives to speculate, where high leverage limits result in a greater risk of monetary loss during speculation. The FMA is seeking feedback on the current use of derivatives and the likely impact of the New Conditions to DIs, as well as whether the leverage standard conditions should take effect six months after the FMA publishes their decision, or whether they should take effect sooner.
2. Proposed suitability standard condition
Under the existing conditions, DIs must take ‘all reasonable steps’ to determine whether retail investors have the ability to understand the particular type of derivative and the associated risk. The FMA’s findings from the SRA indicate that DIs may not be taking reasonable steps to determine investor suitability, in addition to findings suggesting that suitability assessments are poorly designed and sometimes ineffective. This is of particular importance for derivatives which are not straightforward, such as binary options or cryptocurrency CFDs. Under the New Conditions, DIs will be required to determine whether retail investors understand the derivative before investing to lower the volatility of their investment and decrease their level of risk. As with the proposed leverage standard condition, the FMA is seeking feedback on whether the suitability standard condition should take effect six months after the FMA publishes their decision, or sooner.
What next?
We encourage all DI licence holders and the interested wider public to familiarise themselves with the FMA’s proposed changes and engage in the consultation. We will provide updates as we learn more about the consultation and the changes the reform may bring to DI licences. All licensed DIs should carefully consider the changes in accordance with the FMA’s objectives of promoting fair, efficient, and transparent financial markets.
Our experts would be happy to discuss any aspect of the consultation outlined above.
This article was co-authored by Andrew Walker, a Law Clerk in our Financial Services team.
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