The proposed condition aims to address the FMA’s concern that retail investors risk incurring significant losses as a result of CFDs with high leverage. The FMA is also consulting on a revision to standard condition 12 of DI licences which requires DIs to assess the suitability of a derivative for a retail investor before the investor enters into the derivative.
CFDs
CFDs are derivative contracts that allow an investor to speculate in the change in value of an underlying asset, (e.g. foreign exchange rates, equities, commodities or crypto-assets) on a leveraged basis. DIs allow investors to leverage their exposure to financial products by depositing capital (margin), which acts as a deposit towards a larger financial exposure. The amount of that potential exposure is determined by the leverage ratio permitted by the DI.
Leverage limits
There are currently no limits on the amount of leverage in respect of OTC derivatives such as CFDs. The FMA reports that some DIs have issued derivatives with leverage as high as 500:1. In the FMA’s view, the consequences of such an arrangement without full appreciation of the associated risks may be significant, and, in the context of a small market like New Zealand, are exacerbated by a lack of liquidity leading to potential further volatility.
The FMA’s proposal, which would bring New Zealand into line with the approach to regulation taken in comparable jurisdictions, follows a 2020 risk assessment by the FMA, which found there was a “medium-high” risk that “[r]etail customers may be getting poor outcomes from margin trading” including in relation to DIs offering a large amount of leverage.1 Accordingly, the proposed new condition would impose leverage limits on all OTC derivatives issued to retail investors as follows:
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- 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); and
- 5:1 for equity securities or other underlying assets.
The levels of the proposed limits are identical to those imposed by the Australian Securities and Markets Authority (ASIC) in 2021 via a Product Intervention Order, which has since been renewed (in 2022) until 2027. Similar regulations also exist in the UK under the Financial Conduct Authority’s Conduct of Business (Contracts for Difference) Instrument 2019, which provides margin requirements for CFDs, which are categorised as “restricted speculative investments”.
Potential outcomes of the proposal
The Australian model provides a useful illustration of the potential benefits of setting leverage limits, given its close similarity to the proposed new condition in New Zealand. When renewing its leverage limits in 2022, ASIC recorded that it had observed, during the first six months of operation of the limits, a 91% reduction in aggregate net losses by retail client accounts. Further, enforcement of the new limits, has led to more than AU$17.4 million being paid out to retail investors in compensation.
While consistent with approaches overseas, by these proposals, the FMA may be starting to move away from disclosure as its primary focus for regulation of products such as CFDs, instead intervening in the actual substance of the products themselves.
The consultation paper recognises that there may be different approaches taken to limiting leverage, and accordingly provides a number of consultation questions relating to the potential outcomes of its proposal.
Next steps
Submissions on the FMA’s consultation paper, which may be made by reference to the consultation questions contained in the paper, close on 7 August 2024. The consultation questions relate to issues including the scope of regulation to all types of derivatives, the proposed margins, the potential implementation costs for DIs, and the cost/benefit impact of the proposed limits on investors and providers.
If you have any questions about the matters raised in this article, please get in touch with the contacts listed or your usual Bell Gully adviser.
{1] Derivatives Issuer Sector Risk Assessment (SRA) at page 4. See https://www.fma.govt.nz/assets/Reports/Derivatives-issuer-sector-risk-assessment-v2.pdf.