Technical Amendments
25. Emissions units are a relatively new product in our markets. NZX asserts that in order to trade emissions units and emissions units futures products on an exchange, and to clear and settle those transactions adequately, the treatment of emissions units under our securities legislation needs to be clarified. However, the Australian Securities Exchange submitted that there is nothing within the existing regulatory framework to prohibit or restrict firms in New Zealand or elsewhere from providing over the counter and exchange infrastructure to support the New Zealand Emissions Trading Scheme.
26. The New Zealand government is committed to taking action on climate change. This commitment goes further than the Kyoto Protocol and the New Zealand Emissions Trading Scheme in that the government regards the voluntary carbon market as complementary to the regulated market, useful for meeting consumer demand for action on climate change, and a valuable testing ground for new emissions reduction measures.
27. The Settlement Systems, Futures, and Emissions Units Bill therefore goes beyond what is simply necessary for the trading of emission units under the New Zealand Emissions Trading Scheme. The policy objective is to clarify the regulatory treatment of emissions units to support the development of the market for emissions units. This applies to both units issued under binding regulations, such as the New Zealand Emissions Trading Scheme, and units issued in the voluntary market.
28. Cabinet has agreed to technical amendments to clarify the regulatory treatment of emissions units (CBC Min (07) 22/11). It is important to note that none of these technical amendments are necessary for the operation of the New Zealand Emissions Trading Scheme. On 15 October 2007, Cabinet agreed:
- that it is not appropriate to limit the scope of emissions units that may be cleared and settled through a regulated clearing and settlement system (CBC Min (07) 22/11). As such, Cabinet's decisions should apply equally to emissions units issued under a binding emissions trading scheme, such as the Kyoto Protocol or the proposed New Zealand Emissions Trading Scheme, or by voluntary emissions units providers;
- to provide that an emissions unit is not a security (CBC Min (07) 22/11). This is given effect by amending the Securities Act 1978 to ensure that the issuance of emissions units will not need to meet the requirements of the regulatory regime for offers of securities, or the relevant provisions of the Securities Markets Act unless they are part of an investment scheme;
- to extend the priority provided by section 97 of the Personal Property Securities Act in respect of shares and other securities to emissions units (CBC Min (07) 22/11). Under the Personal Property Securities Act, emissions units will be defined as investment securities. Without this amendment, the benefits of anonymous exchange trading would be lost since a purchaser would need to check the Personal Property Securities Register to ascertain whether anyone else had a registered security interest over the specific emissions units they were seeking to purchase. NZX maintains that it is not possible to trade emissions units on an exchange without this amendment;
- to make clear that "futures contract" extends to a futures contract for emissions units (CBC Min (07) 22/11). This decision is given effect by amending the Securities Markets Act 1988 to include emissions units in the definition of commodity, providing certainty that futures contracts in emissions units are regulated by the Securities Markets Act.
- to provide that registration of an emissions unit on a register is prima facie evidence of title (CBC Min (07) 22/11) i.e. registration is evidence of title to an emissions unit unless evidence is produced to the contrary. During consultation, submitters criticised this technical amendment. Submitters suggested that the government should either regulate the quality of voluntary emissions unit registers, which are recognised by this provision, or that it should restrict the technical amendments to units issued by the government on its emissions unit register.
The legislation that establishes the government register for emissions units already provides that entry on the government register is prima facie evidence of title. Unfortunately, it is not currently possible to provide an acceptable definition for 'register of emissions units' in the voluntary carbon market because the market is still developing and consistent standards and practices have not yet evolved. NZX considered that they would be able to operate without this technical amendment. I therefore recommend that this technical amendment should not be given effect through the Settlement Systems, Futures, and Emissions Units Bill, and that the Cabinet decision should be rescinded.
- to confirm the ability to register an electronic transfer of securities and emissions units traded through a registered clearing and settlement system. (CBC Min (07) 22/11). When finalising this technical amendments for introduction, it became apparent that this provision was applied too narrowly to securities and emissions units, since designation is equally available to any settlement system for any products. Rather than limit the amendments to those products that NZX is seeking to clear and settle, I recommend that this provision be extended to cover any product transferred through a designated settlement system.
New Zealand's Approach to Clearing and Settlement
29. Settlement systems contribute to a well functioning capital market, capital market development, and world class infrastructure objectives. The inter-agency Financial Markets Saving and Investment work programme has also identified efficient clearing and settlement infrastructure as a necessary element for a well performing financial system in the medium to long term. To date there has not been a coordinated review of the settlement system infrastructure that underpins New Zealand's financial system.
30. Consultation on an exposure draft Emissions Units, Settlement Systems, and Futures Bill revealed significant concerns about the provision of settlement services and how these systems are expected to develop in future. These concerns warrant further analysis of our settlement services in terms of competition, structure, ownership, and governance of our settlement services. It is important to consider the perspectives of all stakeholders, both onshore and offshore, and their expectations of further government consultation on these issues.
31. There are currently two domestic providers of securities settlement services in New Zealand and one designated payment system. The Reserve Bank's "Austraclear" settlement system processes an average total value of daily transactions of NZ$6 billion compared to NZX's "Faster" settlement system which processes approximately NZ$115 million. The New Zealand Central Securities Depository, which is part of Austraclear, holds about NZ$92.5 billion of securities. CLS Bank International, based in New York, is a designated payment system and settles foreign exchange transactions including New Zealand dollars at a gross daily average of NZ$67 billion. The diagram in the appendix shows the current configuration of systems and where they fit within New Zealand's financial market infrastructure.
32. The Reserve Bank of New Zealand became the default provider of security settlement services in a New Zealand market that could not reach consensus on a service owned and operated by participants. To date, the dominance of Austraclear in the market has not been a concern because it is government owned and operated. Government ownership has also inspired confidence in the stability and financial backing of the system. The downside of government ownership is that Austraclear might not provide the competitive pressures on other service providers that a privately owned system might.
33. Each securities settlement system primarily services a particular market segment or product, although there is overlap between them. The Austraclear system primarily services the over the counter market and is also the conduit for a significant proportion of trades originating from NZX. NZX primarily services users of its exchange. Each system requires reinvestment from time to time, a decision made by the system provider, typically based on user and technological resiliency requirements. Austraclear's development is informed by its industry users' group and Austraclear's services were upgraded in the last few years. NZX has also recently decided to upgrade its services. It is expected that both the Reserve Bank of New Zealand and NZX will seek designation for their systems following the passage of the Settlement Systems, Futures, and Emissions Units Bill.
34. Consultation with the finance sector on legislation to provide for the designation of settlement systems revealed concerns about the implications of NZX's upgraded services for the rest of the market, given the perceived potential for NZX to attain a more dominant position in the provision of clearing and settlement services through aggressive expansion of its services and direct competition with existing service providers. Some members of the financial sector have expressed dissatisfaction with NZX's consultation over the upgrade in its settlement services and the costs involved for them in complying with this upgrade. Others have said that the model of settlement and clearing proposed by NZX is not well suited to certain exchange participants. In addition, one submitter expressed concern about NZX's vertically integrated position as provider of trading, clearing, settlement and some registry services and encouraged the government to examine the costs and benefits of NZX's decision to move away from real time gross settlement of transactions.
35. NZX is developing a clearing and settlement system with a central counterparty. This model of clearing and settlement is well suited to managing the risks of a party to a transaction defaulting on their obligations in a futures market or on an exchange where the parties to a transaction are anonymous. The default risk is managed in over the counter transactions because the contracting parties are known to each other and any risk can be priced into the transaction. Officials understand that some participants in the exchange perceive settlement risk for New Zealand exchange transactions can currently be effectively managed without a central counterparty due to the limited number of exchange participants. Based on the limited information available, it appears that potential clearing participants in NZX's upgraded clearing and settlement system expect to spend approximately $0.5-$1 million to upgrade their interface with NZX. In addition, these parties will need to provide capital backing for their participation with NZX's central counterparty. A rough estimate of the capital required is in the range of $1-$5 million.
36. Competition authorities in other jurisdictions have been concerned by a potential or actual concentration of market power in the provision of settlement services. There are a number of possible market configurations; including a regulated vertical monopoly provider of financial services, competing and complementary settlement systems, or the separation of settlement and trading system providers. There are advantages and disadvantages to each approach. In New Zealand's case, there may be benefit in sourcing settlement services offshore. From a policy point of view, the key element is whether participants have reasonable access to services, not necessarily who provides them.
37. I therefore announced my intention to undertake consultation on New Zealand's approach to clearing and settlement, following introduction of the Settlement Systems, Futures, and Emissions Units Bill and in parallel to the passage of the Bill through Parliament. This approach requires substantive analysis of New Zealand's financial infrastructure needs and consultation with market participants.
38. The objective of the review will be to undertake analysis and consultation to inform recommendations for New Zealand's clearing and settlement infrastructure with regard to the following criteria: at a minimum, New Zealand's clearing and settlement system infrastructure should deliver reliable clearing and settlement services to the financial sector at a reasonable cost; New Zealand's infrastructure should be responsive to the demands of users of clearing and settlement services and, as appropriate, the structure should address any public interest concerns; and finally, New Zealand's clearing and settlement infrastructure should support innovation of products and services in the financial sector.
39. Examples of the types of questions that the review of settlement and clearing services should consider include:
- Scope
- Which systems and which transactions are within the scope of the review e.g. over the counter transaction derivatives settlement systems?
- How do clearing and settlement systems fit within New Zealand's financial system e.g. which transactions and products require clearing and settlement services?
Background
- To what degree does our existing settlement systems infrastructure meet our policy objectives and relevant international standards?
- What are the characteristics of the existing market e.g. to what extent are there economies of scale/scope or network effects and are there any barriers to entry?
Competition
- Are there potential barriers to competition - for example, does the settlement system infrastructure in New Zealand exhibit the characteristics of a network?
- What are the merits of a monopoly structure to exploit any economies of scale and scope within the system and to ensure efficient service delivery?
- To what degree can competition be provided by offshore service providers and what is the ability of offshore providers to meet demand for services in New Zealand
Ownership
- What is the nature of ownership and governance that will ensure that users needs are considered and that the system is stable (reliable)?
- Does New Zealand ownership of clearing and settlement matter in terms of financial system development?
Innovation
- Are there any barriers to innovation in the provision of clearing and settlement systems?
- What clearing and settlement structure will support innovation in other parts of the financial system?
Policy responses
- What are other countries' approaches to the provision of clearing and settlement services and to what extent are these applicable to New Zealand?
- Is regulation needed to ensure that any public interest concerns are addressed, including whether there should be some sort of regulatory oversight of pricing and other significant decision making by settlement systems?
40. Members of the financial sector have already exhibited a great deal of enthusiasm to become involved as a result of my announcement that the government would undertake further consultation on the structure of clearing and settlement in New Zealand. It is therefore recommended that the scope and content of the review should be signalled early to financial sector participants by releasing this Cabinet paper and a press statement announcing Cabinet's agreement to this approach.
41. However, it should be noted that in the past, members of New Zealand's financial sector have found it difficult to agree upon an industry-led approach to clearing and settlement (for example, the industry initiated review in 2004). While there are some historical tensions in this area, we should seek to draw on the goodwill of those industry organisations who have already expressed an interest in contributing to this process.
42. The Ministry of Economic Development is already working closely with Treasury, the Reserve Bank of New Zealand, and the Securities Commission. Officials also expect to consult with international experts and officials from other jurisdictions. For example, officials have already spoken with a representative of the Reserve Bank of Australia, on secondment from the Bank of England, to discuss their recent "Review of Settlement Practices for Australian Equities".
43. The programme of work on New Zealand's clearing and settlement infrastructure is scheduled to take place following the introduction of the Settlement Systems, Futures, and Emissions Units Bill into Parliament; to be completed while the Bill progresses through Parliamentary processes and before the amendments pass into statute. It is estimated that this process will take up to nine months from introduction, taking into account the 2008 general election and full select committee process for the Settlement Systems, Futures, and Emissions Units Bill itself. It is therefore recommended that I report back to Cabinet in March 2009 with recommendations arising from a policy review of New Zealand's approach to clearing and settlement. It is not yet clear whether this process will result in any recommendations for the Settlement Systems Bill.
44. The timetable for the parallel policy process poses no risks for New Zealand's financial system. However, NZX might be concerned because they have spent $5-$7million1 on the new system they are developing before the government had considered the policy proposals and give final approvals for changes to the regulatory environment for settlement systems.
45. At the end of 2007 Cabinet directed Ministry of Economic Development officials to undertake scoping and report back to the Minister of Commerce on further work required in the 2008/9 year in relation to whether the new regime should remain opt-in or become mandatory for trading in emissions units and whether the regime should be opened to clearing and settlement in relation to products other than securities and emissions units (POL (07) 382). This review is no longer relevant in the context of a broader policy review of New Zealand's approach to clearing and settlement.
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