Improving market governance of the New Zealand Emissions Trading Scheme

• Option one: Crimes Act 1961 (status quo). There are key protections under the Crimes Act and penalties apply for crimes, but the Act has limited insider trading provisions and no laws against market manipulation in the NZU market.
• Option two: Financial Markets Conduct Act with suitable modifications. This would prohibit insider trading and market manipulation in relation to trading of NZUs. An optional centralised exchange has been agreed to, in principle, and the Government is considering options to procure and fund an NZU exchange. Market operators would be required to hold a licence and comply with obligations.
• Option three: Crimes Act and market manipulation prohibitions. This would use key protections in the Crimes Act while prohibiting market manipulation with similar FMC Act provisions. This option would not require a licensed market operator, meaning the operator would not be required to monitor for insider trading or market manipulation.
• We recommend progressing with option two: FMC Act with suitable modifications.

• Option two has a new regulatory burden for any person providing a facility that meets the definition of financial product market, including ongoing financial and resource impacts of applying for and complying with licence terms and obligations. This may affect existing facilities that allow or facilitate NZUs to be bought or sold if it meets the definition of financial product market.
• Option two may have flow-on costs for users trading on those facilities, in the form of fees to use the market along with the burden of complying with market rules.
• Both options two and three could promote confidence and integrity in NZU trading, as market manipulation and insider trading are prohibited, using similar frameworks as other financial product markets. However, the degree of surveillance and regulation varies between the options.
• Option two increases oversight of facilities where NZUs are traded.
• Option one falls short of preventing insider trading and market manipulation in a growing market.

We aim to ensure that the NZU market trades with integrity, functions efficiently, promotes confidence and addresses the risks of misconduct.

A fair, efficient, transparent NZU market requires all NZU market users to have the same material information relating to NZUs. If some people have material information before others and are allowed to take advantage of this through trading, it undermines the fairness of the NZU market.

Additional objectives of this topic include:

• greater activity oversight by a regulator on NZU trading facilities or exchanges
• that market access, including the cost of trading on the NZU market, is proportionate and not a barrier to using those markets, and that those markets operate efficiently
• that proposed rules do not unnecessarily limit trading – recognising that some people are required to trade NZUs to meet surrender obligations.

Stakeholders recommended that the Government should consider treating NZUs as a ‘financial product’, because the FMC Act is well placed to protect users from the market risks.

Stakeholders supported appointing an appropriately skilled regulator to improve the NZU market. Submitters stated a market regulator would improve the integrity of the NZU market and promote confidence that NZU market users are behaving ethically.

Option one: Crimes Act 1961 (status quo)

This option would maintain current provisions and laws. Under the status quo, there are limited insider trading provisions and no specific laws against market manipulation in NZU markets.

The current key protections are outlined below.

Officials:

• are bound by employment contracts, employers’ policies and the Public Service Commission Standards of Integrity and Conduct [New Zealand Public Service website], which are all governed by the Employment Relations Act 2000 [New Zealand Legislation website]
• commit an offence if they corruptly use or disclose any information, acquired in their official capacity, to obtain an advantage or pecuniary gain for themselves or any other person under section 105A [New Zealand Legislation website] of the Crimes Act. This is subject to a maximum term of seven years’ imprisonment but no civil penalties.

All other persons, otherwise:

• are bound by the terms of service of particular trading platforms (eg, terms of use) which can include contractual provisions about conduct expectations (limited to that platform)
• commit an offence under section 105B [New Zealand Legislation website] of the Crimes Act if they use or disclose personal information (ie, about a natural person only) that comes into their possession as a result of an offence under section 105A, knowing that the information is in contravention of that provision, and use/disclose the information to obtain an advantage or pecuniary gain. This is subject to a maximum term of seven years’ imprisonment but no civil penalties
• are not subject to any statutory restrictions on the use of non-public material information about NZUs.

Under this option:

• insider trading and market manipulation would continue to be addressed under the existing law
• there is no proposal to license market operators, and persons that facilitate (directly or indirectly) acquisitions and disposals of NZUs are not required to monitor for suspected insider trading or market manipulation
• any misconduct complaints relating to the corrupt use of official information remain a matter for the police. Any complaints about conduct on market platforms remain the responsibility of the market operator as a matter of contract.

Option two: FMC Act with suitable modifications

Appendix B of this discussion document provides the option and risk analysis tables for topic 1.

Option one (the status quo) provides limited protection from insider trading and market manipulation and does not meet the objectives set out. Maintaining this option when the NZU market is increasing in value could create opportunities for bad actors to take advantage of a poorly regulated market.

Option two (FMC Act with suitable modifications) provides the highest integrity of all the options by applying trusted and tested financial market tools. Those that operate and use markets for trading NZUs will likely be subject to additional costs, however the costs associated with implementing this option are mitigated by removing some unnecessary obligations, while still providing the greatest amount of protection to market users. The established rules in the FMC Act are consistent and proportionate to other financial markets and carve-outs have been proposed to allow for the unique nature of the NZU market. Feedback on this document will also be considered to assess whether other modifications are necessary.

This option increases market efficiency by creating clear rules against insider trading and market manipulation and establishing a regulator to investigate any potential misconduct. When compared to the status quo, option two meets the objectives of integrity, efficiency, fairness and promoting confidence in the NZU market.

In terms of risk mitigation, option two also provides the best overall coverage. In particular, the FMC Act has specific provisions to address insider trading and market manipulation in financial markets. Option two will also minimise a lack of transparency, and credit and counterparty risks, through market rules for licensed market operators. The market operators are required to operate their platforms in a fair, orderly and transparent manner. The market rules often contain provisions to resolve events of transaction defaults among platform users.

Option three (Crimes Act and market manipulation prohibitions) is an improvement when compared to the status quo but falls short on catching misconduct. This option does not require licensed markets and therefore lacks a market operator to conduct frontline monitoring surveillance.

Option three relies on formal complaints being lodged to the regulator about possible misconduct instead of maintaining active surveillance on the market. The lack of information collected from a frontline market operator could also be difficult when investigating a complaint. Further, this option does not align with domestic financial markets or international carbon market standards.

While option three is better than the status quo, it provides a lower level of protection against poor transparency in secondary markets and market manipulation. Our analysis also suggests it performs no better than the status quo in addressing credit and counterparty risk and insider trading.

Considering the analyses above, our current view is that option two (FMC Act with suitable modifications) is best suited to address the risks of insider trading and market manipulation while meeting the criteria set out for market governance.

The proposed option aligns with the objective for topic 1, in that it satisfies the criteria much better than option one (status quo) and option three (Crimes Act and market manipulation prohibitions), in terms of integrity, consistency and proportionality, and clarity and transparency.

The proposals outlined in option two increases market confidence by requiring a licensed market operator to survey for misconduct and a regulator to investigate irregular trades. This option meets the criteria and objectives that increase market efficiency.

A person could not trade NZUs if they have material non-public information about government policy

The FMC Act insider trading provision prohibits a person from buying or selling financial products that are ‘quoted’ (ie, listed for trading) on a licensed market if they hold material non-public information, being information that:

• is not generally available to the market
• a reasonable person would expect to have a material effect on the price of the financial product on the licensed market if the information was generally available.

This includes provisions for an information insider (Person A) of a listed issuer to not directly or indirectly disclose inside information to another person (Person B) if Person A knows or ought reasonably to know or believes that Person B will, or is likely to:

• trade quoted financial products (ie, NZUs) of the listed issuer
• advise or encourage another person (Person C) to trade or hold those products.

Table 9 provides a summary of this proposed prohibition.

Table 9: Proposal to prohibit insider trading for quoted financial products and NZUs

However, there could be scenarios where, for example, a person who receives inside information may need to trade to meet a legal obligation that may require forms of exclusions or exemptions.

In these circumstances, we consider a likely source of a person becoming an NZU information insider is through targeted consultation. In this instance, it may be appropriate for the Government to first consider its approach to consultation, and whether it may have a negative impact on one or more persons with legal surrender obligations.

Second, matters may also be manageable by clearly stating that the terms of the targeted consultation may involve the recipients becoming NZU information insiders and are thereby prohibited from trading for a defined period. We may also consider whether future exclusions and/or modifications may be appropriate if this approach is insufficient.

Government information as material information

In relation to NZUs, we propose a much narrower and more tailored definition of material information for prohibitions on insider trading, which would apply where a person holds material non-public information about government policy only.* As part of this discussion document, we are seeking your feedback on:

• what information should be considered government policy – for example, decisions approved by Cabinet or policy under active consideration
• what stakeholders expect from the Government in terms of disclosures and publishing of information.

Our objective is to provide sufficient transparency and to not impede the Government’s ability to consult on and test proposals with the marketplace.

However, the definition of ‘information insider’ is broad enough to capture third parties if they hold material information relating to the government that they ought to reasonably know is material information and generally not available to the market.  

*See below in relation to proposals to apply the prohibition to both licensed markets and beyond. 

Market manipulation is where someone misleads (or attempts to mislead) the market through false or misleading information or statements, or by giving a false appearance of trading activity, supply, demand, or the value of financial products.

The FMC Act includes provisions for two types of market manipulation in relation to financial products traded on licensed markets:

• Information-based manipulation (section 262): This is where someone says something – or otherwise shares information – that they know (or should know) contains information that is false or materially misleading, and which is likely to: 
• induce a person to trade in financial products
• impact the price for trading those products
• impact the way a person exercises any voting rights associated with a financial product.
• Transaction-based manipulation (section 265): This is where someone does something, or chooses not to do something, that the person knows or ought to reasonably know will (or could) give a false or misleading impression about the extent of trading activity of a financial product or about its popularity, availability, price or value.

Market manipulation could include a person placing, or giving the impression that they will place, orders on a licensed financial product market to buy a product when they do not actually want or intend to buy it. This would give a false impression of demand for the product.

As with insider trading, in the most serious cases, market manipulation may amount to a criminal offence and be punishable with up to five years’ imprisonment, and a maximum fine of $500,000 for individuals or $2.5 million for companies.

To promote integrity in NZU markets, we propose that similar market manipulation prohibitions and offences that apply in financial markets could apply to NZUs.

There are two functions in detecting insider trading and market manipulation.

• Monitoring and surveillance, which take place on the market frontline. If misconduct is detected by the licensed market operator, it would be forwarded for investigation.
• Investigation and enforcement, by which misconduct would be sent for investigation and, if considered to have a good basis, there is potential for enforcement via regulatory action or formal proceedings.

Frontline monitoring and surveillance

In other financial product markets, a licensed market operator receives both on- and off-market trading information about products quoted on its market and is responsible for the frontline monitoring of insider trading and market manipulation.

We propose that in the NZU secondary market there is a frontline monitor for insider trading and market manipulation who can gather information, from both over-the-counter trades and trades that could occur on the proposed optional centralised exchange discussed below.

Regulatory responsibility for investigation and enforcement could sit with the FMA

We propose that, in the event misconduct is detected, it will be forwarded to the FMA as the potential regulator of the NZU market, for investigation and possibly enforcement.

In financial product markets, insider trading and market manipulation are prohibited in relation to products ‘quoted’ on licensed market (ie, products listed on the NZX).

Example

If Company X’s shares are listed for trading on the NZX, insider trading and market manipulation are prohibited in relation to trading of Company X’s shares – both trading through the NZX exchange or off the exchange (noting that off-exchange transactions are reported to the exchange operator).

Insider trading and market manipulation are not prohibited in the trading of financial products that are not listed on licensed markets. The limitation to quoted financial products aligns with the responsibility of licensed market operators to monitor for insider trading and market manipulation in relation to trading in products quoted on their market.

Given there is only one product being discussed (NZUs), if NZUs are traded (quoted) on one licensed market, applying the FMC Act rules would mean insider trading and market manipulation would be prohibited for all forms of secondary trading of NZUs, whether over the counter or through other platforms that may not meet the definition of being a financial product market.

We will further consider the impact of the possible shape of the secondary market for the insider trading and market manipulation provisions and monitoring of those provisions.

We are considering addressing governance of trading risks with an optional centralised exchange, given that the optional centralised exchange would be designed to preserve the option of treating NZUs as a financial product.

As part of this engagement, we seek your feedback on applying particular FMC Act definitions and obligations for licensed markets to the potential NZU market centralised exchange.

The Government intends to run a procurement process for the supply of market services for a trading platform to buy and sell NZUs, alongside the development of the NZ ETS market governance reform package. This would be subject to the terms and conditions of any RFI and RFP, the nature and extent of interest, and any offers received.

The objectives of progressing this non-legislative tool now are to improve the liquidity and functioning of the NZU market, and to increase transparency, monitoring and oversight of the NZU market.

It is currently intended that the market operator(s) on this platform would be subject to the same regulatory requirements that are proposed in this engagement document, including being required to hold a market operator licence to operate that licensed market.

Under the FMC Act, a financial product market is a facility where financial products are bought or sold, or where offers or invitations to buy or sell financial products are made. Financial product market operators are required to hold a licence issued by the Minister of Commerce and Consumer Affairs for each market that they operate.

Section 314 and section 316 set out the considerations for the Minister and the FMA before a licence may be granted. These include meeting general obligations that a market operator must ensure that licensed markets operate in a fair, orderly and transparent way, and must have arrangements in place for:

• handling conflicts between the operator’s commercial interests and fair, orderly and transparent licensed markets
• making market disclosures available
• monitoring conduct on licensed markets
• enforcing market rules.

Those requirements also include having adequate arrangements to monitor for potential insider trading and market manipulation for trading on that licensed market. Market operators are also required to notify the FMA of certain events, such as when disciplinary action is taken for breaches of market rules (eg, by market participants).

We propose that similar licensing requirements could apply to any facility for trading of NZUs that meets the definition of a financial product market (a licensed NZU exchange).

This proposal would maintain the existing exclusions from the definition of financial product market under section 309(2) of the FMC Act. For example, a person making or accepting offers to acquire or dispose of NZUs on the sole behalf of one party to the transaction would be excluded from the definition of a licensed NZU exchange.

Licensing of NZU trading facilities that meet the definition of a financial product market would provide greater oversight of some trading activity on secondary markets generally, as well as maintaining mechanisms for detecting insider trading and market manipulation on licensed NZU exchanges.

Some adjustments to the existing obligations of licensed market operators would be required, to reflect that there are no ‘issuers’ of financial products for the operator to oversee, as the Government would be the issuer in this market (and potentially in others).

This proposal would have a large impact on market operators because:

• market operators may incur material compliance costs to put in place processes, systems, and rules (to the extent those are not in place or below the required standard)
• those who trade on a licensed NZU exchange incur costs complying with those rules (eg, becoming an authorised broker – to the extent that is applicable).

The licensing process can take an extended period – potentially upwards of six months – which businesses would need to factor in as part of any transitional period if this proposal is implemented.

A licensed market operator would need to pay licensing fees (based on the FMA’s hourly rate) and annual FMA levies. Any brokers authorised to trade on the market would also need to pay annual FMA levies.* Levy amounts would need to be determined at a later stage. There may be a need to introduce a separate FMA levy for any NZU exchange market operator if the nature of the obligations and regulation differ sufficiently from general market operators (this is currently uncertain).

The licence fee and levy structure are still being considered, as levies for existing markets may differ from a new market. However, these costs (or a portion of them) are likely to be passed on to participants – for example, in the form of transaction fees.

The following proposals are made in relation to the primary NZU auction market:

• It is expected that the auction market operator would not need to be licensed as a financial product market operator. A person accepting offers to acquire NZUs on behalf of one party to the transaction only (the Crown) would be excluded from the definition of a licensed financial product market operator.
• We propose that the insider trading prohibition does not apply to transactions on the primary auction market. This is consistent with the treatment of most financial products under the FMC Act,* as the Government aims to make all material information available before the auction.

*See reg 114A of the Financial Markets Conduct Regulations 2014 [New Zealand Legislation website].

We are aware that there are several operators who provide different types of facilities or services that enable parties to make direct or indirect offers to buy or sell NZUs.

Under this proposal, these facilities or services (to the extent they would meet the definition of financial product market and do not fall under the existing exclusions) would be required to either change the way those services are provided or to seek a market operator licence.

We note that, because the Government is the issuer of NZUs, those operators would need to have an agreement to quote NZUs on any market, as well as needing to obtain a licence.

Information disclosure requirements would not apply, but the Government would observe best practice in relation to release of material information

When financial products are issued for the first time, the issuer is required to provide a Product Disclosure Statement that sets out material information about the product, in accordance with detailed requirements in legislation.* If the product is listed for trading on a market platform, then ‘continuous disclosure’ provisions apply, which require the issuer to release material information to the public, as and when such information comes to light.

These disclosure requirements promote transparency and reduce the risk of insider trading, as they limit the ability of a person to trade on non-public information.

We do not propose to introduce legislated disclosure requirements in relation to NZU markets, as the Government is the only ‘issuer’ of NZUs. The Government is, however, committed to best practice in releasing material information before auctions as and when information arises, including observing the principles of the relevant Cabinet circular (eg, around releasing information outside of trading hours).**

While we propose regulating some aspects of NZU markets by applying the same obligations as in financial markets, we do not propose applying other obligations that apply in financial markets in relation to:

• requiring Product Disclosure Statements (Part 3 of the FMC Act [New Zealand Legislation website])
• governance relating to debt securities and managed investment schemes (Part 4 of the FMC Act [New Zealand Legislation website])
• obligations of FMC reporting entities (Part 7 of the FMC Act [New Zealand Legislation website]) for NZU financial advice providers (although we expect any licensed market operator would be an FMC reporting entity and need to comply with the additional associated financial reporting requirements)
• regulation of discretionary investment management services (subpart 6 of Part 6 of the FMC Act [New Zealand Legislation website]).

Market operators are required to have systems and processes to allow the market to operate in a fair, orderly and transparent manner, including arrangements to clear and settle transactions.

Submitters on the July 2021 consultation provided feedback that, under the current NZ ETS settings, credit and counterparty risks were seen as negligible. Although some participants had been required to adapt their procedures to manage those risks, it had not limited their ability to participate in the NZ ETS. Submitters also suggested that an in-built escrow arrangement within the NZETR may help to mitigate counterparty risk.*

Most submitters also favoured voluntary exchange-based trading while leaving space for over-the-counter (OTC) markets to continue to operate.

*An escrow is a contractual arrangement in which a third party receives and disburses money or property for the primary transacting parties, with the disbursement dependent on conditions agreed to by the transacting parties.

The current market governance proposal is to introduce licensing for NZU market operators. It has been considered desirable to develop a centralised clearing and settlement arrangement to handle the transfer of payments and NZUs in a similar manner as financial markets.

The objectives for doing so would be to mitigate credit and counterparty risks, and to improve oversight of price, volumes and trading activity on the secondary market.

The form and structure of any clearing and settlement system will depend on the future state of the secondary market structure. For example, it may look like in-house clearing and settlement systems and processes operated separately by one or more small NZU markets for persons that participate in trading on each particular market (eg, auction houses or small exchanges, where the secondary market has low levels of trading activity and/or liquidity).

In its most sophisticated form, the clearing and settlement system may involve:

• a general centralised clearing (with or without a central counterparty).
• a ‘NZU securities’ depository function (among other things).

Collectively, these functions:

• support the management of counterparty risks
• allow multilateral netting of trades
• provide custodial holdings, recording of beneficial and security interests, and transaction settling.

This system may be accessible for all NZU transactions (whether they take place on-market or over the counter).

We seek your feedback on the extent to which you consider it necessary or desirable to facilitate particular forms of clearing and settlement systems and arrangements. This will help us determine what (if any) changes should be made to the systems-level regulatory settings in the context of the NZU market, and consideration of the costs and benefits of requiring NZU financial product markets to be licensed.