Legislative changes are being suggested as a way of countering problems that “several” banks operating in New Zealand may face as a result of new overseas rules covering margin requirements on over-the-counter derivatives.
The Reserve Bank of New Zealand and the Ministry of Business, Innovation and Employment have started a public consultation, with submissions to be in by August 24.
The RBNZ and MBIE say New Zealand has no margin requirements in over-the-counter derivatives, but several banks registered to operate in New Zealand will likely have to comply with margin rules being implemented in foreign jurisdictions. ‘Margin’ is collateral exchanged by derivative market participants in order to protect against the risk posed by credit exposures and to reduce the risks of financial market contagion if a derivative contract counter-party defaults.
They say some features in New Zealand laws that cover statutory management and creditor priorities could impede the prompt and free availability of margin provided by New Zealand banks, potentially impairing banks’ access to derivative products and markets they use for funding and hedging. “Addressing the issue can help to protect and promote the soundness, efficiency and global integration of New Zealand’s financial sector,” the RBNZ and MBIE said.
The consultation document issued by RBNZ and MBIE says that the two have recently become aware of certain features in New Zealand law that may pose barriers to our banks’ ability to provide margin in compliance with foreign margin rules and to the satisfaction of their international counterparties.
“The issues particularly relate to legal uncertainties around enforceability in insolvency, given moratoria on creditors’ claims and preference provisions that may impact creditors’ access to assets and prevent margin provided under New Zealand law from being promptly available and bankruptcy remote.”
The document says potential issues for New Zealand banks directly captured by Australian margin requirements were first identified in mid-2016. In response, the Reserve Bank worked through the identified issues with industry stakeholders and Australian regulators to reach a mutually-acceptable interim outcome without the need for legislative change.
“In late 2016, however, further concerns were raised that the same issues may arise for New Zealand banks indirectly captured by foreign margin requirements. The Reserve Bank in coordination with the MBIE (together, “the Agencies” responsible for administering the relevant legislation) and Treasury have considered these concerns via engagement with affected local banks and their foreign counterparties, relevant foreign regulators, and industry experts.
“This engagement has indicated that, under existing laws, there may be barriers to New Zealand banks’ ability to comply with the new margin rules to the satisfaction of their foreign counterparties. This could impede banks’ access to key international counterparties and financial markets, undermining existing operating and funding models. In particular, the viability of offshore funding programmes, which currently account for around 15% of the banking sector’s non-equity funding, could be partly threatened.”
The document says an inability to achieve clear compliance with the new margin rules could have important ramifications for New Zealand businesses, including:
►Reduced access to offshore derivatives products and counterparties. Access to foreign swap dealers in key derivative markets like the US and Europe may be impeded.
►Increased country- and counterparty-concentration risks due to the limited number of viable counterparties in non-cleared derivatives products.
►Increased OTC derivative trading costs from reduced competition in New Zealand participants’ dealer panels.
►Increased hedging complexities and costs, potentially leading to a rise in unhedged exposures for New Zealand participants.
“New Zealand banks’ funding models rely on access to global capital and derivatives markets. Approximately 30% of their debt funding is sourced from wholesale markets, around 60% of which is raised offshore, almost entirely in foreign currency: our banking sector currently has around NZ$50 billion of non-NZD offshore funding outstanding.
Exchange rate risk
“This foreign currency funding exposes banks to exchange rate risk which is typically hedged via cross-currency basis swaps – an OTC derivative which cannot currently be centrally cleared. If New Zealand banks’ access to these swaps is impeded under the new margin rules, foreign currency risks may no longer be able to be effectively and efficiently hedged,” the document says.
“More generally, if New Zealand banks cannot trade with a broad array of international counterparties, and cannot freely access (at competitive rates) liquidity pools in key foreign markets, this may result in higher costs of funding and a loss of cross-border competitiveness at individual institutions, increasing the domestic cost of credit. New Zealand’s integration and competitiveness within the global financial system may also be damaged, impacting the efficiency and soundness of the New Zealand financial sector as a whole.”
The document gives two options – retain the status quo, or option ‘B’, make legislative change. It favours ‘B’.
The document says that If legislative change is made to address potential impediments to compliance with foreign margin rules, RBNZ and MBIE believe it would be most appropriately done through targeted legislative amendments, ensuring all issues are addressed in an effective, timely, and proportionate manner whilst mitigating the risk of unintended consequences from legislative change (including adverse impacts on the rights of creditors, or on the integrity of the law relating to insolvency and the enforcement of security interests).
Some of the banks though have apparently suggested a standalone ‘Netting Act’ that incorporates the various necessary provisions. The RBNZ and MBIE don’t agree with that approach.
Through the consultation process RBNZ and MBIE seek to confirm the specific legal provisions that may prevent New Zealand banks from posting derivatives margin in compliance with the requirements and practices of potential foreign counterparties.
The key areas of New Zealand law that the two agencies have identified as posing a barrier to compliance and which might need to be amended are:
- Statutory moratoria on the enforcement of security interests as per the CIMA, the Companies Act and the RBNZ Act;
- Priority of preferential creditors over secured creditors under schedule 7 of the Companies Act when cash is posted as margin; and
- Priority rules under the PPSA overriding the rights of secured creditors in certain situations.
“In each of these cases, the basic approach we propose under this option is to adopt is an exception from current rules covering lawfully granted security interests over initial margin that is posted by one party to an OTC derivative to another.
The document says, subject to drafting, this exclusion could apply where:
► The regulatory requirements in New Zealand or any other jurisdiction require the margin to be posted;
► The OTC derivative is subject to a netting agreement that is enforceable under New Zealand law;
► The security interest is evidenced in writing;
►The security interest is over financial property; and
► If the defaulting party was insolvent at the time when the security interest over the collateral was created, the party seeking to enforce the security interest was not aware of that fact.
“We stress that the exact drafting of this exclusion would be subject to further work. Respondents are invited to comment on whether there might be preferable ways of approaching the legislative amendments. The form of any chosen legislative response may differ, drawing on the outcomes of this consultation and subject to the legislative design process.”