Regulatory Impact Statement (RIS) for the Financial Market Infrastructure (FMI) Bill

1 Agency disclosure statement

This Regulatory Impact Statement (RIS) has been prepared by the Reserve Bank of New Zealand (the ‘RBNZ’). It provides an analysis of outstanding policy issues relating to the Financial Market Infrastructure (FMI) Bill.

The analysis supplements a comprehensive RIS that assessed options for an enhanced oversight framework for FMIs (a copy of this comprehensive RIS is available at: https://www.rbnz.govt.nz/-/media/ReserveBank/Files/regulation-and-supervision/financial-market-infrastructure-oversight/regulatory%20developments/FMIs-regulatory-impact-statement.pdf?la=en ) There has been no formal consultation on the policy issues discussed in this RIS, as they were judged to either;

• relate to a highly specific and technical matter;
• align with other existing RBNZ regulatory frameworks; or
• are likely to be unobjectionable to stakeholders.

The detail of the FMI Bill will also be consulted on shortly through the release of an exposure draft of the Bill.

The nature of this analysis is entirely qualitative. The options under analysis in this RIS make any quantitative cost-benefit analysis difficult and potentially misleading.

Geoff Bascand
Deputy Governor and Head of Financial Stability
Reserve Bank of New Zealand

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2 Executive summary

FMIs are multilateral networks or systems that provide trading, clearing, settlement and reporting services in relation to payments, securities, derivatives and other financial transactions. FMIs reduce the cost and risk market participants bear by providing centralised settlement, clearing, and recording of transactions. Well-operated FMIs promote greater financial stability.

FMIs are susceptible to several market failures which may cause them to be less efficient, sound, innovative, or transparent. These market failures include:

• Negative network externalities;
• Coordination difficulties;
• High concentration of market power and quasi-monopoly behaviour;

The above market failures have been found to exist in some overseas jurisdictions and may exist (now or in the future) in New Zealand as well. There are prima facie grounds for regulatory intervention when it can mitigate risk and produce a net benefit to society. In the case of FMIs, the risks from potential market failures have been identified and Cabinet has decided that the existing regime does not mitigate these risks effectively. This current lack of an effective regulatory regime led to the development of the FMI Bill, which establishes a new regulatory regime for FMIs, and aligns with international best practice and recommendations made by the International Monetary Fund in its 2016 Financial Sector Assessment Programme Review of New Zealand.

The key features of the regime established by the FMI Bill are:

• The Reserve Bank and the FMA (joint regulators) would have information gathering powers for all FMIs, in order to monitor the broader sector and identify potential systemic risks;
• An FMI that is identified as being significant could be required to be designated under a revised designation regime;
• Joint regulators would have enhanced regulatory oversight powers for designated FMIs, including powers to set regulatory requirements, oversee FMIs’ rules, investigative and enforcement powers, and crisis management powers;
• Where relevant, designated FMI’s would be able to access the legal protections around settlement finality and netting that currently exist under the Part 5C of the Reserve Bank of New Zealand Act 1989 (RBNZ Act).

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3 Status quo and problem definition

Financial Market Infrastructures are multilateral networks or systems that provide trading, clearing, settlement and reporting services in relation to payments, securities, derivatives and other financial transactions. FMIs centralise clearing and settlements as well as the recording of transactions which lowers both the costs and risk participants in financial markets have to bear. Some FMIs, by virtue of their size and the nature of the services they provide, are essential to the stability of the financial system. These are referred to as Systemically Important Financial Market Infrastructures (SIFMIs).

The sound and efficient operation of SIFMIs is a precondition for financial stability. However, FMIs can be subject to a number of market failures that stop them operating as soundly and efficiently as possible, as well as stifling innovation and transparency. These market failures include:

• Negative network externalities.
• Coordination difficulties.
• High concentration of market power and quasi-monopoly.

A detailed analysis of these market failures can be found in the comprehensive RIS. The regulatory regime in its current form is not suited to mitigate the risks arising from these market failures. This insufficiency led to the development of the FMI Bill.

3.1 Agreed regulatory arrangements

The FMI Bill establishes an enhanced regulatory oversight regime for FMIs. The key features of this new regime are:

• The Reserve Bank and the Financial Markets Authority (FMA) would have information gathering powers for all FMIs, in order to monitor the broader sector and identify potential systemic risks
• An FMI that is identified as being significant could be required to be designated under a revised designation regime;

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3.2 Phase 2

Concurrent to the drafting of the FMI Bill is the review of the Reserve Bank Act 1989 (the ‘Act’). This review is currently in its second phase (phase 2) which includes the review of the statutory functions and powers of the RBNZ. The FMI Bill is expected to be enacted before the completion of phase 2. With regards to the policy choices assessed in this RIS, where phase 2 are looking at similar issues there may be some benefit in adopting interim approaches until the conclusions of phase 2 are clear. This would allow alignment between the banking and FMI regimes in the long term.

3.3 Outstanding Issues

When the overall regulatory regime reflected in the FMI Bill was agreed, a number of details were left for further consideration. During the drafting of the Bill a small number of additional policy issues have also arisen. These matters are the subject of this RIS.

Because this RIS is assessing some design features of an entirely new regime there is no existing status quo. With regards to the policy options in this RIS, choosing the status quo is therefore not possible. The specific issues this RIS deals with are as follows.

3.3.1 The Choice of regulatory instrument

The first issue is whether conditions or standards should be the legal instrument in the proposed Bill for imposing regulatory requirements on designated FMIs. The key distinction between these two instruments is that conditions are more administrative in nature (like traditional conditions of licences) whereas standards are more legislative in nature (e.g. akin to regulations). Conditions would allow for greater flexibility in application but they are not necessarily subject to the parliamentary disallowance procedure which applies to standards. The choice of legal instrument also needs to reflect the breadth of the power being delegated to joint regulators.

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3.4 Crisis Management

The remaining issues relate to the same broad problem: that the current legislation lacks any real crisis management powers in respect of FMIs. In the event of the disruption or failure of an FMI, participants of the FMI may be put at risk. Both the interconnectedness of FMIs with the rest of the financial system and the services they provide make their operation essential for financial stability.

The lack of crisis management powers under the current regime means there is scope for substantial risks to financial stability from the disruption or failure of an FMI. The following policy options offer choices designed to mitigate this risk by providing effective crisis management provisions.

3.4.1 Ministerial consent for directions

Under the proposed Bill, joint regulators have the authority to issue directions to designated FMIs if certain thresholds are met. It has yet to be determined whether Ministerial consent should be required for the issuance of directions.

Directions are one of the more intrusive regulatory tools. In the recent New Zealand FSAP, the IMF recommended that certain directions not require ministerial consent, however there may be concerns over the potential lack of appropriate checks and balances such as Ministerial consent.

With regards to the Reserve Bank’s other supervisory duties, whether directions require Ministerial consent depends on the type of entity in question. Specifically, when directing Non-Bank Deposit Takers (NBDTs) and insurers, Ministerial consent is not required, however when directing banks it is.

In a crisis situation, swift regulatory response (in hours, or at most in a few days) is vital. It is possible that the requirement for Ministerial consent may cause a material decrease in the joint regulators’ swiftness of response. Hence there is a balance to be struck between the oversight provided by Ministerial consent and the potential reduction in swiftness of response.

3.4.2 Statutory Management

Statutory management involves the appointment of a third party (the statutory manager) to manage a designated FMI. Phase 2 is looking at potential issues with the statutory management regime in the RBNZ Act that may also be relevant to the proposed statutory management regime for FMIs. These include whether resolution objectives and the roles of relevant parties in a crisis are sufficiently clear.

The proposed FMI Bill charges the statutory manager of an FMI operator with ensuring the continuation of core services to ensure the FMI can function. To this end, the Bill currently includes an FMI-specific statutory management regime that contains provisions tailored towards achieving this objective. The policy choice here is whether these provisions remain in the proposed Bill.

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3.4.3 Stays on termination rights

Currently the FMI Bill does not include provisions for a stay (suspension) on contractual termination rights. The policy choice here is whether a provision for stays on termination rights should be included in the proposed Bill.

An FMI would have to be in a crisis state for joint regulators to exercise their resolution powers. If an FMI found itself in such a condition, third parties that provide vital services may have grounds to exercise their contractual termination rights, as may counterparties to derivative contracts. Exercise of termination rights and the withdrawal of core services or the disorderly close out of financial contracts may mean that the continuity of essential services provided by the FMI cannot be assured. This could have significant systemic implications for financial stability.

One of the key objectives of the regime is the maintenance of financial stability. The Bill’s lack of provisions to stay termination rights reduces the ability of the regime to achieve this objective. From the perspective of a third party however, a stay on termination rights may be undesirable. The ability for a failing FMI operator to honour their debts may be substantially reduced. As such, third parties may wish to terminate contracts to reduce the amount of risk they are exposed to. Stays on termination rights may therefore harm third parties.

This policy choice presents a trade-off between both the rights of third parties and the joint regulators ability to maintain financial stability.

3.4.4 Creditor Hierarchy

The FMI Bill includes provisions for the statutory manager to act in a manner not consistent with the interests or hierarchy of creditors for the purpose of maintaining financial stability. The policy choice presented here is whether this provision should remain in the proposed Bill.

The operator of an FMI acts as the intermediary for all transactions that occur through the network, so their ability to honour the claims of participants is essential for continuation of services. In the event that an FMI operator is liquidated, honouring the claims of creditors in accordance with the hierarchy may leave insufficient funds to honour the claims of participants, thereby preventing the continuation of core services.

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3.4.5 The role of Ministers and Government to give general policy directions

Currently the FMI Bill includes provisions for the Minister of Finance to direct the Reserve Bank to have regard to a government policy. However, during the drafting of this Bill, the question has been raised whether the FMA should also be subject to Ministerial consent when exercising the powers under the proposed Bill.

The FMA are an Independent Crown Entity which means they would not usually be subject to these types of direction. The Reserve Bank on the other has a unique legal status as a stand-alone agency with governance and accountability partly based on those applying to Autonomous Crown Entities (which are subject to these types of direction).

Because the powers in the proposed Bill will be exercised jointly, the RBNZ being subject to Ministerial direction while the FMA is not may generate some ambiguity around the effect such a direction would have.

It should be noted that this form of direction is not intended to reduce the operational independence of the joint regulators. These directions only require the regulator to have regard to a government policy, and cannot be used to bring about a specific outcome in relation to a specific person or entity.

4 Objectives

The RBNZ’s primary objectives are to:

• Promote the maintenance of a sound and efficient financial system; and
• Avoid significant damage to the financial system that could result from the failure of an FMI or the participant of an FMI.

The FMA’s primary objectives are to:

• Promote the confident and informed participation of businesses, investors and consumers in the financial market; and

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5 Consultation

The Reserve Bank first consulted on the new regulatory framework for FMIs in 2013. The Reserve Bank received sixteen submissions to the public consultation paper. Most submitters agreed that current oversight powers were light handed and there was a case for stronger powers. There was also strong support for most of the proposed powers, especially crisis management powers. This first consultation was followed up by continuing engagement between the Reserve Bank and a wide range of interested parties.

In April to December 2015, the Reserve Bank held a second round of consultation on revised proposals to strengthen its statutory powers for the oversight of FMIs. By this stage, the Reserve Bank considered an alternative option of modifying the existing Designation Regime would be preferable, rather than having separate overlapping regimes for access to legal protection around settlement finality and netting, and for regulatory oversight. This change was in part a response to the Reserve Bank’s initial consultation with interested parties. The other reason for a change in view was to avoid the complexity of running two regimes. Nineteen submissions were received to the second public consultation document.

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6 Options and impact analysis

In this section we identify options for each of the issues outlined in the above subsections, provide analysis and make recommendations.

6.1 The choice of regulatory instrument

The choice of potential legal instruments are: standards, or conditions.

Options	Costs	Benefits
Option one: standards as the legal instrument	There are additional administrative steps involved in the Parliamentary Disallowance procedure which will impose a greater time cost on the joint regulators. In the first weeks of a standard’s introduction it is subject to disallowance. Theoretically, this introduces some regulatory uncertainty. In reality this cost is not expected to be material.	It is arguable that standards are subject to more democratic oversight because they may be disallowed by Parliament. The Parliamentary Disallowance procedure provides an additional check on regulators.
Option two: conditions as the legal instrument	Using conditions as the legal instrument may be viewed as placing too much power in the hands of the regulator.	Conditions provide regulatory certainty. Conditions allow for greater regulatory flexibility for the joint regulators.

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6.2 Ministerial consent for directions

The two options available are: Ministerial consent is required for issuing directions; or Ministerial consent is not required for directions.

Options	Costs	Benefits
Option one: Issuance of directions requires Ministerial consent on an interim basis	Applying for Ministerial consent imposes an additional time cost on the joint regulators.	In theory, this allows ministers to judge whether or not the direction is appropriate. The

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6.3 Statutory Management

The two options available here are: retain the existing provisions establishing an FMI-specific statutory management regime; or remove these provisions and revert to the statutory management regime under the Corporations (Investigation and Management) Act 1989 (CIMA).

Options	Costs	Benefits
Option one: leave the FMI-specific Statutory Management provision in the Bill	Statutory management is very intrusive. The costs of this power would include any losses or expenses in excess of those were the power not exercised. The costs of this power depend on the particular FMI and the situation it is in. Statutory management creates scope for moral hazard. Phase 2 is looking at whether the statutory management regime for banks (on which the regime in the FMI Bill is based) provides sufficient clarity about roles and objectives. If	The imposition of statutory management provides an important final measure in a crisis situation. Statutory management may prevent further deterioration of an FMI. It may be beneficial to select this option on an interim basis to better enable changes made in response to the outcomes of phase 2. The FMI specific regime allows for a number of FMI-specific provisions which include:

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6.4 Stays on termination rights

There are two options here: leave provisions for stays on contractual termination rights out of the FMI Bill; or include provisions for contractual termination rights in the FMI Bill.

Options	Costs	Benefits
Option one: leave provisions for joint regulators to stay contractual termination rights in the proposed Bill	The power to stay termination rights introduces uncertainty over the contractual rights of third parties. This may reduce the willingness of third parties to enter into contracts, which	This reduces the risk of an FMI ceasing to provide core services due to a lack of third party support, or to the exercise of close out rights by counterparties to derivatives

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6.5 Creditor Hierarchy

With regards to this issue there are two policy choices: leave the provisions that allow the manager to act in a manner contrary to preserving the position or hierarchy of creditors in the proposed Bill; or remove these provisions.

Option	Costs	Benefits
Option one: leave the provisions that allow the statutory manager to act in a manner contrary to preserving the position or hierarchy of creditors in the proposed Bill.	This creates a new risk for creditors which theoretically may raise costs for FMIs. The current FMI-specific statutory management regime may require more specific objectives. This power may therefore not be subject to the appropriate checks and balances. This does not align with the “No Creditor Worse Off” (NCWO) principle in the resolution of systemically important financial institutions.	This option would be in line with that of the Reserve Bank Act 1989. Aligning with the current regime on an interim basis will make future adjustment easier upon the completion of phase 2. This option allows for statutory managers to take a wider range of actions to promote financial stability. The potential for the subordination of creditor rights increases the incentive for third parties to monitor the risk of FMIs. This may increase market discipline.
Option two: remove the provisions that allow the statutory managers to act in a manner contrary to preserving the position or hierarchy of creditors from the proposed Bill.	This reduces the range of tools open to the statutory manager. This may reduce their ability to ensure continuity of core services.	This option protects creditor’s rights.

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6.6 The role of Ministers and Government to give general policy directions

The options here are to have the power for Ministers to direct regulators to have regard to a government policy apply only to the Reserve Bank, or to both the Reserve Bank and FMA.

Option	Costs	Benefits
Option one: Ministers power to direct the regulators to have regard to a government policy only applies to the Reserve Bank	This generates a degree of legal uncertainty. If one of the regulators is subject to constraints on the powers they exercise jointly there will be	Consistency with other FMA legislation.

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7 Conclusion and recommendations

There are a number of potential market failures that FMIs in New Zealand are susceptible to. These market failures raise systemic risk. The FMI Bill is being developed to address the systematic risk created by FMIs.

A RIS that deals with the overall framework in the FMI Bill has already been published. This RIS has addressed all of the outstanding issues.

The interim arrangements recommended in this RIS all align with the RBNZ Act and should be updated as necessary to reflect the outcome of phase 2. These interim arrangements are:

• Ministerial consent is required for joint operators to issue directions to the operators of designated FMIs;
• The proposed statutory management regime should be retained;

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8 Implementation

The implementation of the FMI Bill as a whole is addressed in the comprehensive RIS. The Bill will incorporate the recommendations in this RIS.

9 Monitoring, evaluation and review

Once the FMI Bill is enacted the new regime would be monitored by seeking informal feedback from industry in our regular engagements. Both the Reserve Bank and FMA regularly review the legislative regimes they operate. An example is the 2013 review of the Non-bank Deposit Takers legislation (introduced originally as an amendment to the Act). We anticipate the regime proposed here will be reviewed when any revisions to the FMI Bill required as a result of phase 2 are considered.

A review of the proposed FMI regime would be run in an open and transparent manner and will actively seek input from industry, stakeholders and interested government departments and agencies. This input will be solicited when the scope of the review is determined, when options for any changes are being considered, and before any proposed amendments are finalised. The review would set out to identify whether the regime is meeting its objectives as envisaged and what changes (if any) may be required to ensure it remains fit for purpose. To aid the review the Reserve Bank is likely to keep an internal register of any problems with the new regime that are identified after the legislation first takes effect. Because it is envisaged that supervisors from the Reserve Bank and FMA will have extensive interaction with industry under the regime (as they do so currently) it is highly likely that most, if not all, potential problems will be picked up.

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