FMA consultation on standard conditions for derivatives issuer licences

The Financial Markets Authority – Te Mana Tātai Hokohoko (FMA) is seeking feedback on proposed changes to the standard conditions for licensed derivatives issuers (DIs). These changes include:

• A new standard condition limiting the leverage licensed DIs can provide to retail investors, depending on the type of underlying.
• A variation to the standard condition for assessing suitability of a derivative for retail investors.

This consultation is relevant to all licensed DIs in New Zealand. Licensed DIs may wish to make a submission by the Wednesday 7 August 2024 deadline.

Background

In mid-2020, the FMA published a DI Sector Risk Assessment (SRA) which involved a self-assessment survey of 25 licensed DIs on governance, culture, systems and controls. The FMA identified there was a risk DIs may not be taking reasonable steps to determine whether derivatives are suitable for their retail investors. The FMA also highlighted that cryptocurrency contracts-for-difference (CFD), high leverage, and binary options are generally not suitable for most retail investors.

Proposed Standard Condition 14: Leverage Limits

The FMA is proposing leverage limits on over-the-counter (OTC) derivatives offered to retail investors. Currently, New Zealand has no limits on the leverage licensed DIs can offer. This differs from the position in other jurisdictions such as Australia, the UK, the US and Europe. Some New Zealand DIs voluntarily impose limits on leverage, but these vary widely, from 30:1 to 500:1.

Proposed Standard Condition 14 would require the terms of any OTC derivative offered to retail investors to require initial margin based effectively limiting leverage at time of issue to:

• 30:1 for an exchange rate for a major currency pair
• 20:1 for an exchange rate for a minor currency pair, gold or a major stock market index
• 10:1 for commodities (excluding gold) or a minor stock market index
• 2:1 for cryptoassets (including cryptocurrency)
• 5:1 for equity securities or other underlying assets.

The condition would also impose standardised terms for margin close out by:

• requiring the licensed DI to maintain and enforce the applicable margin requirements for as long as the derivative position(s) connected to the retail investor's account are open.
• Requiring, the licensed DI, when closing out a retail investor's open position to do so as soon as market conditions allow and on terms most favourable to the retail investor. The FMA's proposed explanatory note sets out FMA's expectation that this means taking into account best execution and preferring the retail investor's interests to those of the licensed DI.

Proposed variation to Standard Condition 12: Suitability

Standard Condition 12 requires licensed DIs to take all reasonable steps to determine whether a retail investor seeking to enter into a derivative has the ability to understand the particular type of derivative and risk involved.

The FMA says its monitoring identified instances of non-compliance and ineffective procedures so is concerned licensed DIs may not be taking the required reasonable steps to determine suitability.

The FMA therefore proposes to revise the condition to help ensure that DIs ask retail investors for relevant information needed to assess whether the derivative is suitable, and to prevent DIs from entering into a derivative despite assessing a product to not be suitable or not receiving adequate information to conduct a suitability assessment.

The main changes proposed to the condition are to:

• Clarify that the suitability assessment must be conducted each time a retail investor enters into a derivative of a particular type for the first time (rather than each time a derivative is entered into).
• Clarify that the assessment is aimed at assessing whether the investor actually understands the particular type of derivative and its risks (rather than whether the investor has the capacity to understand those things).
• Prohibit the licensed DI from entering into a derivative with the investor where the investor provides insufficient information to make the suitability assessment (rather than allowing the transaction to proceed subject to warning the investor).

Looking at other jurisdictions

The FMA sees merit in imposing leverage limits as a way of mitigating the risk of investor harm. It points out that leverage limits are commonly used overseas to control this risk and there is evidence to support the protective effect of these measures. For example, the consultation notes:

• UK: the Financial Conduct Authority (FCA) has set margin requirements for "restricted speculative investments¹".
• Australia: the Australian Securities and Investments Commissions (ASIC) has sets leverage limits for CFDs at 30:1.
• Europe: the European Securities and Markets Authority (ESMA) has set leverage limits, margin-closeout rules and negative balance protections on a per account basis for CFDs.
• USA: CFDs are banned, and there are limits on FOREX Dealer Members' leverage.

What next?

After reviewing the submissions, the FMA will finalise the standard conditions and publish them on the FMA website. One of the questions in the consultation is whether a six-month implementation period should follow the publication of the finalised conditions, allowing licensed DIs to establish the new processes, procedures and controls that may be required to comply.

¹ These include CFDs, spread betting, rolling spot FOREX contracts and restricted options.