The Commonwealth Treasury


PROPOSED LEGISLATIVE FRAMEWORK

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CHAPTER 1: UNIFORM REGULATION OF FINANCIAL PRODUCTS

1.1 KEY POINTS

— Deposit-taking products;
— Risk insurance products (including general insurance);
— Credit arrangements that fall outside the scope of the Uniform Consumer Credit Code;
— Means of payment services such as smart cards and e cash; and
— Foreign exchange.
— A broad functional definition of financial product which will capture new products without the need for legislative amendment; and
— The ability to exempt products via regulation or an ASIC exemption power.

1.2 CONCEPT OF FINANCIAL PRODUCT

A key element of the reforms is the range of financial products or services that will fall within the new regulatory framework. The Financial System Inquiry (FSI) took a broad approach to the function of the financial system, seeing it as involving all mechanisms for the exchange of financial promises. The role of the financial system is to identify, allocate and price the risk that a financial promise may not be met.

CLERP 6 noted that the definition of a financial product would need to be broad and all-encompassing, but did not attempt to define the scope exclusively. The paper listed a range of existing products that should fall squarely within the new regulatory framework, that is, securities, futures and other derivatives, foreign exchange, superannuation, general and life insurance and deposit accounts. It acknowledged, however, that any definition would need to be broad enough to cover developments and innovations in the financial markets and also proposed a mechanism to extend or restrict the application of the definition.

Submissions received on the CLERP 6 paper were generally supportive of the FSI proposal for functional regulation in the financial system and for the inclusion of the products identified by CLERP 6 in a single licensing, conduct and disclosure regime. A number of submissions noted that the wider the definition of financial product, the more difficult it might be to apply uniform principles to what could be a diverse range of products. They suggested that the regime would need to include mechanisms to enable uniform principles to be applied in specific ways to particular products.

Scope of the new regulatory framework

A number of submissions suggested that the scope of the new regulatory framework should be extended beyond the range of products mentioned in CLERP 6 to:
Other submissions were of the view that the scope of the framework should be narrowed to exclude:
A summary of views and the proposed application of the new regulatory framework to these products is at Appendix B.

1.3 DEFINITION OF FINANCIAL PRODUCT

There will be a four-part definition of financial product comprising a:
  1. Broad functional definition outlining the key features of all financial products;
  2. List of products that are specifically included;
  3. List of products that are specifically excluded; and
  4. Regulation-making power to include and exclude products.

Functional definition

The overarching definition of financial product will focus on the key attributes of, and functions performed by, financial products. A financial product will be defined as:
A facility or arrangement through which a person does one or more of the following:
— Makes a financial investment;
— Manages a financial risk;
— Obtains credit; or
— Obtains or receives a means of payment.
The facility or arrangement may be provided by means of a contract or agreement or a number of contracts or agreements.

An arrangement that combines one or more of these elements will be captured by the definition of financial product.

This broad conceptual definition will capture the wide range of financial products referred to in both the FSI Report and CLERP 6. It will also ensure that innovations in financial products come within the new regulatory framework as they develop, without the need to amend the Law. To ensure flexibility a number of mechanisms are proposed to allow products to be taken outside the scope of the definition:

Financial investment

The concept of making a financial investment will have two key elements:
This would encompass:
It would not encompass arrangements such as investing directly in bullion as these arrangements do not involve investing with another person.

Financial risk management

A facility or arrangement will be taken to involve managing a financial risk if it enables a person to:
The concept of financial risk management would encompass arrangements under which:
Specifically it would include:
It will not encompass other arrangements for risk management that are not linked to the financial consequences of particular events happening. For example, an arrangement under which a security firm is employed would not fall within the definition, as this is an arrangement for managing the risk that thefts will occur, not the economic consequences if thefts do occur.

Credit

A person will be taken to obtain credit if they:
This would encompass such arrangements as:
While one-off credit arrangements will fall within the definition of financial product, the licensing and conduct and disclosure provisions will not apply to such arrangements unless the service provider is in the business of providing, or advising on, credit. This concept is discussed further in Chapter 2.
Credit covered by the Uniform Consumer Credit Code will be specifically excluded in the third limb of the definition.

Means of payment

A person will be taken to obtain or receive a means of payment if they:
This would encompass arrangements such as:
However, the arrangements for ultimate settlement of payment instruments will not be captured within the definition of financial product - they are regulated by the Payments System Board.

Notes and coins, other than foreign currency, will be specifically excluded.

Specific inclusions

Without limiting the generality of the functional definition, specific items will be included within the definition of financial product. These definitions will be relevant to applying targeted regulation to particular types of financial products where necessary. The following products will be specifically included:
A discussion of these inclusions is at Appendix A. The implications of including particular products within the new regulatory framework is at Appendix B.

Specific exclusions

Certain facilities and arrangements that would otherwise fall within the broad functional definition of financial product will be specifically excluded. The following items will be excluded from the definition either because other regulatory regimes apply to them or because it would not be appropriate for the new regulatory framework to apply to them:
A discussion of these exclusions and other proposed exclusions is at Appendix C.

Regulation making power

A regulation making power will be available to include emerging facilities and arrangements as well as to exclude products where necessary.

1.4 ROLE OF THE REGULATOR

ASIC will be given an exemption power in relation to the definition of financial product. This power will enable ASIC to exempt a product or class of products from the new regulatory framework.
A number of submissions suggested that ASIC should be given a broad power to include and exclude products to ensure that the regulatory framework applies flexibly to meet developments in financial markets. Other submissions were concerned that ASIC not be given too much discretion as this would create uncertainty and could be seen as an inappropriate delegation of legislative power.
The functional definition of financial product will be sufficiently broad to address the concerns that the new regulatory framework will not be able to keep up with developments in the financial markets. Any additions to the coverage of the regulatory framework should be subject to Parliamentary scrutiny either through regulations or by amendments to the legislation. This will also provide greater certainty for the financial markets as to the scope of the regulatory framework.

1.5 REGULATION OF WHOLESALE FINANCIAL PRODUCTS

The new regulatory framework will apply to all financial products, whether they are made available to retail clients [2] or not. Products that are only made available to wholesale clients will be brought within the regime:
The FSI Report considered that, in the interests of competitive neutrality, there should be no regulatory prohibition on retail consumers accessing wholesale transactions or markets. Specifically, the FSI recommended that prohibitions on retail consumers participating in over-the-counter derivative (OTC) markets should be discontinued. [3]

At the same time, however, it was recognised that consumer protection requirements should not impinge unduly on the operation of wholesale markets. It was proposed that the regulatory framework establish a clear definition of retail clients who would be entitled to disclosure and other specific consumer protection measures. However, these consumer protection measures should not apply in relation to wholesale participants.

CLERP 6 also proposed that wholesale intermediaries be licensed, but that they should not be subject to the full range of conduct and disclosure obligations in relation to their transactions with wholesale clients. It indicated that retail clients should be permitted to participate in OTC derivatives markets.
While financial service providers who provide services to wholesale clients will be required to obtain a licence, a number of features of the regulatory framework will ensure that undue burdens are not imposed in relation to their dealings with wholesale clients:
— Professional indemnity insurance or fidelity fund arrangements;
— Complaints handling mechanisms;

Retail clients’ access to wholesale financial products - opting to be treated as wholesale

CLERP 6 noted that it was difficult to draw a dividing line between wholesale and retail clients and proposed that flexibility be achieved by allowing retail clients to ‘opt up ’ to be treated as wholesale clients and wholesale clients to opt down to be treated as retail.

While submissions were generally supportive of the proposal to allow wholesale clients to opt down, there was some concern about allowing retail clients to opt up.
The purpose of enabling retail clients to opt to be treated as wholesale clients is to allow retail clients:
— The ability to access wholesale markets is particularly relevant in relation to OTC markets. A number of retail clients have shown an interest in participating in OTC commodity markets. For example, wool growers have expressed an interest in entering markets which provide more accurate hedging of risk through individually tailored contracts; and
Without a facility which allows a retail client to opt to be wholesale, it is possible that wholesale markets would continue to limit retail access. Wholesale participants may not be prepared to provide the types of protections required for retail participation. The opting up mechanism is considered necessary to provide retail participants effective access to wholesale markets.

Concern has been expressed about the potential abuse of a facility allowing retail clients to opt to be treated as wholesale, thereby foregoing the protections afforded to retail clients. It is argued that service providers may induce retail clients to opt up to wholesale so that the service provider will be relieved of the need to provide the client with financial service product disclosure as well as the obligation to comply with various conduct of business rules such as the suitability requirements. It has also been argued that market forces and competitive pressures will ultimately result in retail clients having access to products which are normally only available to wholesale clients.

While these points are valid, the philosophy underlying the reform of the financial system is to reduce regulatory barriers to participation in the financial sector while at the same time ensuring consumers receive sufficient disclosure of information to enable them to make informed decisions.

In addition, ASIC has now acquired wide-ranging consumer protection powers in the financial service sector relating to unconscionable conduct, and misleading and deceptive conduct and representations. [4]

In light of the philosophy underlying the FSI and CLERP reforms, and ASIC’s enhanced consumer protection powers, any barriers to retail consumers accessing wholesale markets seem unwarranted.

Retail clients [5] will, therefore, be allowed to opt to be treated as wholesale clients and to participate in wholesale markets. It is intended that the availability of the opting mechanism should only be used in limited circumstances to provide flexibility and enable persons who are regular market participants and do not fall within the definition of wholesale client the ability to determine the protections which they consider necessary. The mechanism is not intended to allow, for example, employers offering superannuation to employees pursuant to choice of funds the option of asking employees to opt out of receiving disclosure documents for their superannuation.

Additional safeguards will be introduced in the form of warnings about the consequences of opting and an offence of unconscionably inducing a retail client to opt up to the wholesale category.

Mechanism for opting

A financial service provider, product issuer or financial market operator will be prohibited from treating a retail client as a wholesale client unless the client has signed a written declaration opting to be treated as wholesale.

Wholesale clients opting to be treated as retail will similarly be required to sign a written declaration. Only a limited range of wholesale clients will be allowed to opt to be treated as retail.

Duration of opting

A client may opt to be treated as either retail or wholesale in relation to an individual transaction or financial product; transactions relating to a class of financial products; or in relation to all transactions. The written declaration signed by the client should indicate the duration of the election.

Protections for retail clients

A prohibition on unconscionably inducing retail clients to opt up to the category of wholesale will be introduced into the Law.
In addition, where a retail client opts to be treated as wholesale, the written declaration signed by the client must include a warning about the consequences of opting to be treated as wholesale and the client must acknowledge in the written declaration that they have received the warning. The warning must indicate that by opting to be treated as wholesale, the retail client will lose the benefit of service provider and product disclosure, as well as the benefit of the various conduct of business obligations (such as the suitability requirement).

[2]. See Dictionary for definition of ‘retail client ’.
[3]. FSI Report, Recommendation 20. Note that ‘OTC market ’ may not necessarily be a financial product market -– see Chapter 6.
[4]. Australian Securities and Investments Commission Act 1989 , Division 2 Part 2.
[5]. Note that retail client in this context also includes retail participant – see footnote 81.