Guidance the Financial Markets Authority (FMA) has provided on New Zealand's wholesale interest rates market is being hailed as an approach other jurisdictions would do well to follow.
The FMA yesterday published a guidance note for market participants on the Bank Bill Benchmark Rate (BKBM) and closing rates, plus a resource sheet explaining how BKBM and closing rates operate and are regulated in NZ. The guidance note comes a month after FMA CEO Rob Everett disclosed it was coming, saying the FMA had been asked by the industry to look at the wholesale interest rate market with "anxiety within the banking sector" about the BKBM.
In its guidance note the FMA points out one of its strategic priorities is capital market growth and integrity, noting it wants to establish conduct expectations in wholesale markets that support growth and integrity. Only six banks participate in trading that sets the BKBM which are ANZ, ASB, BNZ, Westpac, Kiwibank and Citibank.
"Over recent years many banks have stopped participating in the calculation of certain benchmarks. This may be largely due to a perceived increase in regulatory risk. When fewer banks participate in setting a benchmark there are increased risks the benchmark will not be robust. These issues are particularly acute in New Zealand as we have a small financial market and a small number of banks," the FMA says.
"One reason for clarifying our expectations around BKBM and closing rate trading conduct is to help reduce regulatory uncertainty. This guidance aims to encourage other institutional participants to return to trading in bank bills markets. We are willing to engage with any such participants to ensure they are clear about our role and expectations."
As the FMA puts it; "BKBM is the main interest rate benchmark in New Zealand. It is designed to reflect the supply and demand for bank bills and is used by market participants to calculate the
amounts payable under various financial instruments. It is also used in calculating the value of many financial instruments."
"Closing rates are the end of day rates or prices for various traded securities, including interest rate swaps, foreign exchange (FX) rates, corporate bonds and government bonds. Closing rates are particularly important to the funds management industry, including KiwiSaver funds, which rely on closing rates to assess the value of their portfolios."
A 'pragmatic, practical, sensible guidance note that stands out globally'
Paul Atmore, CEO of the New Zealand Financial Markets Association which is NZ's professional body for wholesale banking and financial markets and has worked on the guidance note with the FMA, says the NZFMA is very supportive of and pleased with the initiative shown by the FMA in terms of clarifying conduct expectations around rate setting processes and other rates such as swaps and overnight index swaps.
"When you look at what's been happening around the world, and dare I say it you look at the Australian environment with ASIC and the banks over there, I think what we've got from the FMA is a very pragmatic, practical, sensible guidance note which I think stands out globally as a document that could be used elsewhere to provide that confident participation in other regulatory environments," Atmore told interest.co.nz.
"So we're very proud of the fact that the banks have worked closely with the FMA to come up with what we all believe is a very good document, and focuses on that legitimate purpose and provides a lot of clarity around it. We think that's excellent for the market."
Atmore says it's possible international banks will re-engage with the NZ wholesale interest rate market off the back of the FMA guidance. But he points out some banks that pulled out did so due to policy decisions handed down from their head offices.
"With the guidance note that has come out from the conduct regulator there could be a strong argument provided by the local branches of those international banks that there's good reason to come back into those [rate setting] processes if it meant that they could participate in instruments that made sense for them to do so," says Atmore.
"Do I think we'll see a rush of banks coming back into supporting BKBM and the closing rates? I think the short answer's no. But in time I think the confidence will increase and improve . And time's a great healer. There's still a lot of banks smarting from global regulatory reprimands around LIBOR, EURIBOR and TIBOR. That has left a distaste in the mouth and largely through their own faults in some cases."
Banks returning to the market would mean increased liquidity, and thus increased robustness in the determination of the benchmark and closing interest rates, Atmore adds.
He says the likes of Deutsche Bank and JP Morgan used to participate while Citibank chooses not to be involved in any part of the process that determines the establishment of BKBM even though it remains an active participant in the bank bill market.
Banks 'pleased the FMA has confirmed there are no systemic conduct issues'
The New Zealand Bankers’ Association (NZBA) also welcomed the FMA's guidance. NZBA chief executive Karen Scott-Howman says it provides further clarity for banks that rely on the BKBM rate.
“We’re particularly pleased that the FMA has confirmed there are no systemic conduct issues around the use of the benchmark. That provides an assurance that banks can use the rate with confidence," Scott-Howman says.
“The New Zealand banking industry has not suffered the kind of conduct and reputational issues that other countries have. For example, BKBM is based on actual trade, unlike LIBOR which was able to be manipulated. The FMA’s findings will support our international reputation, and that’s good for New Zealand," Scott-Howman adds.
The FMA's guidance notes that NZ law supports the fundamental principle that banks may trade to hedge their risk as long as their purpose is to hedge and not to influence the rate set. The regulator notes its recent court victory over former Milford Asset Management fund manager Mark Warminger has provided clarification. This judgment shows a central element of trade-based market manipulation is that trades have, or are likely to have, the effect of misleading the market, the FMA says.
"The market is entitled to assume that any trading activity is for a legitimate purpose. Trades without a legitimate purpose are likely to be illegal. Although this [Warminger] judgment applies to market manipulation of listed securities under section 265 of the Financial Markets Conduct Act, similar reasoning would apply to trading in unlisted financial products such as bank bills," the FMA says.
Spot checks pledged
The FMA also sets out that if the main purpose of trading is to move an observed rate or price, this would be an illegitimate purpose and illegal. This trading would be illegal even if the trader has nothing to gain from moving the rate or price, the FMA says. According to the regulator legitimate purposes for trading in the bank bills market include price or volume discovery, obtaining funding, managing a cash position by investing in bank bills, and hedging interest rate risk.
"To distinguish between acceptable and illegal trading one must look at whether there was a legitimate commercial purpose for the trading," the FMA says.
'We may carry out spot checks on order and trading data and ask how market participants are comfortable that higher risk trading is legitimate. We may request records of any trading activity in bank bills or closing rate markets, whether inside or outside the relevant rate-set trading windows, and records of the bank's relevant exposure to those rate sets at those times. Records of orders and any supporting information of the legitimate purpose of any higher risk trading should be kept for at least seven years," the regulator adds.
The FMA has also set out six high-level principles it expects banks and other market participants to meet. These are;
1. Ensure their hedging activity is solely aimed at risk mitigation and is never performed for the purpose of influencing or manipulating a rate set or price.
2. Ensure conflicts of interest are managed in a way that promotes the fair treatment of customers and other market participants.
3. Ensure that customers are aware of the key mechanics of any trading activity that leads to potential conflicts of interest.
4. Influence the culture of trading staff to minimise the risk they might trade for any non-legitimate purpose.
5. Provide adequate and up-to-date training to all relevant staff on acceptable trading practices and the participant’s relevant controls.
6. Take a risk-based approach to: a. Recording any evidence that might reasonably be expected to show the purpose behind trading activity; and b. Reviewing trading data and contextual evidence to ensure that trading activity has a legitimate purpose.
In a press release the FMA notes significant publicity around misconduct relating to various global benchmarks such as LIBOR and EURIBOR over recent years.
"In 2014, the FMA analysed a sample of trading and other data relating to BKBM between 2013 and 2014. The FMA has conducted further targeted enquiries into specific conduct since then, but have found no evidence of systemic trading in bank bills that was not for legitimate purposes. However the FMA will continue to engage with banks and overseas regulators on this topic," the FMA says.
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