Table of contents

1.1 Introduction
1.2. Defining Derivatives

2. Official Derivatives Markets
2.1. Irish Regulation
2.1.1. IFOX
2.1.2. FINEX
2.2. European Union Regulation

3. Restrictions on Investment in Derivatives by Certain Entities
3.1. Banks
3.1.1. The Central Bank Acts
3.1.2. Capital Adequacy
3.1.3. Netting and the Basle Accord
3.2. Building Societies
3.3. Insurance companies
3.4. Collective investment undertakings
3.4.1. Authorisation of a fund
3.4.2. Capital protected futures and options fund
3.4.3. Leveraged futures and options funds
3.4.4. General restrictions on collective investment schemes
3.4.5. 'Professional investor funds'
3.5. Companies established in Dublin's International Financial Services Centre ("IFSC")
3.6. State entities
3.6.1. The Financial Transactions of Certain Companies and Other Bodies Act
3.6.2. Permitted derivatives transactions

4. Gaming and Lotteries legislation

5. Capacity of companies

1.1. Introduction

In light of the Barings collapse in February 1995, questions are being raised on a global basis on the regulatory regime applicable to derivative products. To date, Ireland has not enacted any comprehensive general financial regulatory regime within which derivatives business may fall to be regulated and no specific regulatory regime applies to derivatives. This position will change during 1995 with the transposition of the European Union Investment Services Directive into Irish law. The regulation of the financial services industry in Ireland is principally directed towards specific business activities. Banking business is regulated by the Central Bank; so too are a variety of other financial activities; insurance business is regulated by the Department of Enterprise and Employment. If a party to a derivatives transaction falls within a regulated category, the transaction may therefore be affected by the regulatory rules that apply to it.

1.2. Defining Derivatives

The term "derivatives" does not have a universal meaning and commentators and regulatory groups have each offered their own definitions. The International Swaps and Derivatives Association ("ISDA") has produced the following definition:

"Derivatives are bilateral contracts involving the exchange of cash flows and designed to shift risk between parties. When transactions mature, the amounts owed by each party to the other are determined by the prices of underlying commodities, securities or indices. Swaps, forwards, caps and floors are privately negotiated, customised transactions. Futures and warrants are standardised derivatives instruments traded on exchanges".

It is those derivative products that are encompassed by this definition that are the subject of this article.

2. Official Derivatives Markets

2.1. Irish Regulation

There are two official markets in Ireland for exchange traded derivatives:
  • (a) the Irish Futures and Options Exchange Limited ("IFOX"); and
  • (b) FINEX Europe (FINEX).
2.1.1. IFOX is an automated trading system dealing with a variety of Irish Pound interest rate instruments. The membership of IFOX includes most leading Irish financial and broking institutions.

The Irish Central Bank is responsible for the supervision of financial futures and options exchanges. The rules of any proposed exchange must, be approved by the Central Bank and such approval may, in certain circumstances, be revoked. Exchanges are subject to the prudential supervisory and reporting requirements and conditions imposed by the Central Bank. The real-time display of position information, deposit calculation and risk-management purposes, is also made available to the Central Bank so that it can implement its supervisory regime.

2.1.2. FINEX Europe ("FINEX"), a branch of a division of the New York Cotton Exchange, is an open-outcry trading facility located in Dublin's International Financial Services Centre in which cross-currency and dollar index contracts are traded. Conceived as a vehicle for the New York Cotton Exchange ("NYCE") to deliver financial futures contracts to the European time-zone, members are bound by the rules of NYCE. The Central Bank has established a mechanism for the suspension of members operating in FINEX and for approving exchange rules in conjunction with the Commodities and Futures Trading Commission ("CFTC"), the US regulatory body in respect of the futures and commodities market.

2.2. European Union Regulation

The Investment Services Directive, which is due to be implemented by 31 December 1995, applies to "investment firms" the "passport" concept applied by the Second EU Banking Directive to credit institutions. Investment firms, authorised to carry on investment business, which includes derivatives transactions other than commodity derivatives, in one member state will be authorised to conduct such business in any other member state without further authorisation. IFOX and any other exchanges that may be established in Ireland will be obliged to adopt non-discriminatory rules for membership by investment firms in other member states and will also have to comply with minimum standards established by the Directive in relation to matters such as transparency, reporting, access and their rules. The Directive does not apply to FINEX because it is not "established" in the EU, being a branch operation.

3. Restrictions on Investment in Derivatives by Certain Entities

Investment by certain entities in derivatives is subject to regulatory rules.

3.1. Banks

3.1.1. The Central Bank Acts ("CBA") contain extensive provisions for the licensing and supervision of banks by the Central Bank.

To carry on banking business, or hold itself out as a banker or as carrying on banking business, a company must have a banking licence granted by the Central Bank. During the currency of the licence, the Central Bank may exercise its powers under the CBA in relation to obtaining information, carrying out inspections and regulating activities of the licence holder. The Central Bank has published the standards and criteria against which it measures an application for a licence and conducts its ongoing reviews of a licensed bank's activities. These standards and requirements act as a framework within which the Central Bank can exercise its supervisory role.

The Central Bank adopts a flexible approach in relation to compliance with particular requirements or standards in each case and irrespective of these standards and requirements, the directors and the management of the licensed bank still have the responsibility to conduct the business in a prudent manner with full and primary regard for the safety of the depositors' funds.

3.1.2. Capital Adequacy

In July 1988 the Committee on Banking Regulations and Supervisory Practices (the "Basle Committee"), set a minimum standard of capital adequacy to be applied in each of the participating states (the "Basle Accord"). These practices have since been largely reflected in the EU Own Funds and Solvency Ratio Directives (although there are important differences stemming from the more detailed approach of the Directives).

In January 1990 the Central Bank adopted the capital criteria of the Basle Committee. In July 1991 the Central Bank issued a paper concerning implementation of the Directives. This confirmed that from 1 December 1993 the Central Bank's capital adequacy requirements would reflect fully the requirements of the Directives. In its guidelines the Central Bank provides that the licence holder must have a widely spread portfolio of risk assets with limits imposed on the level of risk assets employed in any one particular sector or connected sectors.

3.1.3. Netting and the Basle Accord

Netting in this context refers to the ability to set off a sum, or exposure, owing by a bank to its customer against a sum, or another exposure, owed by that customer to the bank, so as to produce a net sum. The question here is whether in measuring the risk assets/exposures of a bank, the effect of a netting arrangement concerning derivatives transactions may be taken into account to reduce the amount concerned, thereby reducing the amount of capital required to be maintained as a consequence of the transactions concerned.

The Basle Accord only permitted netting to be applied in determining the exposure against which capital is to be maintained where the netting is achieved by provisions providing for "netting by novation".

"Close-out netting", in contrast to netting by novation, takes place when specified events of default occur which give rise to the relevant transactions being accelerated.

The Basle Accord did not allow the different replacement costs for the various transactions to be set off against each other as the Committee was concerned that liquidators might separate the various transactions and cherrypick. Based on this, according to the Irish Central Bank's current capital adequacy requirements, exposures may be measured on a net basis only where netting by novation is provided for.

On 15 July 1994 the Basle Committee's Proposal on Netting (the "Proposal") was adopted as an amendment to the 1988 Basle Accord and this amendment has effect for Irish regulatory purposes. The proposal outlined circumstances in which exposures could be measured on a net basis where close-out netting, rather than netting by novation, was adopted. This requires certain legal opinions as to the efficacy of the arrangements to be obtained.

3.2. Building Societies

The Central Bank, under the Building Societies Act, 1989 (the "BSA"), administers the system of regulation and supervision of building societies. Like banks, building societies are subject to capital adequacy requirements. Additionally, however, specific provision is made concerning derivatives. Section 34 of the BSA permits Irish building societies to "effect contracts for the purpose of reducing the risk of loss arising from changes in interest rates, currency exchange rates or other factors of a similar nature affecting its business".

A building society may not therefore enter into derivatives transactions except for hedging purposes. In addition, Section 34(2) of the BSA provides that the Central Bank may specify requirements as to the type, and terms and conditions, of a contract that may be entered into by a building society under Section 34(1). Specifications have been laid down for individual building societies in this regard and any party dealing with an Irish building society counterparty to a derivatives transaction should obviously satisfy itself that these specifications are complied with in relation to any such transaction.

3.3. Insurance companies

The Insurance Acts 1909 to 1989 do not include any provision similar to Section 34 of the BSA and the power of an insurance company to enter into derivatives transactions will derive, like any other company, from the objects clause in its Memorandum of Association.

3.4. Collective investment undertakings

Since its creation in 1987, Dublin's International Financial Services Centre ("IFSC") has grown in significance as a base for collective investment undertakings (mutual funds). Ireland's collective investment undertakings, UCITS, non-UCITS and investment limited partnerships, are constituted as investment companies and unit trusts. A significant number of non-UCITS investment vehicles establishing in the IFSC are focused on derivative products. Regulatory control rests with the Central Bank by whom all collective investment undertakings must be authorised. Although the Central Bank may impose conditions specific to a particular fund, where warranted, it has published a series of notices governing the operation of authorised unit trusts, designated variable capital companies and investment limited partnerships. In its notices relating to futures and options funds published in July 1991 (Notices 20 and 21 respectively), the Central Bank has established general guidelines for (1) capital protected futures and options funds and (2) leveraged futures and options funds.

3.4.1. Authorisation of a fund

An application for authorisation is made to the Central Bank by the scheme or its manager. A detailed prospectus must be published which includes a clear statement in the prospectus of the risks attendant to investment in a fund of this nature.

Once a fund is authorised, it must comply with the Central Bank requirements relating to the submission of information including the submission of monthly returns. Progressively more detailed reports must also be submitted on a half-yearly and annual basis.

The Central Bank can impose supervisory and reporting requirements or conditions on futures and options funds from time to time. To date, these take the form of the published notices. The Central Bank also has extensive powers of inspection to ensure observance of these requirements.

3.4.2. Capital protected futures and options fund

The rules set out in Notice 20 apply in addition to the general rules applying to all collective investment vehicles to the extent that these are not disapplied by this notice. A capital protected futures and options fund is a scheme which has investment in futures and options as its primary object and which provides for the protection of capital invested in the fund over a certain period of time (not exceeding seven years).

The specific conditions applicable to a capital protected futures and options fund include:
  • The property of the fund may only consist of futures and options or other derivative instruments which are disclosed in the fund's prospectus and are approved by the Central Bank together with deposits and short-term securities.
  • Measures taken for the protection of capital are subject to the approval of the Central Bank.
  • No more than 5% of a fund's assets may be invested in the securities of companies (other than banks) which have shareholders' funds of less than IR£1 billion or its foreign currency equivalent.
  • Any futures and options which form part of the fund's assets must be traded on an organised exchange. Off-exchange options are only permitted where the counterparty has own funds in excess of IR£100 million or its foreign currency equivalent.
  • There are restrictions on the percentage of net assets that may be represented by the margin or premium for a single futures or options contract or a single commodity or financial instrument.
  • Borrowing by the fund is not permitted.
  • The Central Bank must be satisfied that the directors of the management company/investment advisory company have specific experience in this area of investment. The prospectus prepared for investors must contain the full description of the risks involved in this type of fund.

3.4.3. Leveraged futures and options funds

A leveraged futures and options fund is a collective investment scheme which has as its primary object, investment in futures and options but which does not provide for the protection of capital invested in the fund. Such a fund is subject to the general rules set out above in relation to capital protected futures and options funds other than those relating to capital protection measures. However, as set out in Notice 21, there are the following additional requirements:
  • The property of the scheme must include liquid assets which have a total minimum value at all times equal to the amount of the sum of all margins deposited and all premiums paid in respect of transactions which have not been closed out.
  • The scheme must have a minimum subscription requirement of IR£10,000 or its equivalent in foreign currency.
  • Given that the level of risk is higher than that for a capital protected futures and options fund, the prospectus must contain a full description of the risks involved together with a prominent risk warning.

3.4.4. General restrictions on collective investment schemes

General restrictions applicable to collective investment schemes which raise funds from the public continue to apply to futures and options funds, whether capital protected or leveraged, to the extent to which these do not contradict the specific provisions relating to such funds. These restrictions also apply to investment limited partnerships which may raise funds on a private or public basis.

3.4.5. 'Professional investor funds'

Specialist schemes, including futures and options funds, marketing solely to professional investors may qualify for a derogation from the investment and borrowing restrictions generally applicable to collective investment schemes. To qualify for the derogation, a collective investment scheme must have a minimum subscription requirement of IR£200,000 or its equivalent in other currencies, and the scheme's prospectus must indicate that the Central Bank's investment and borrowing restrictions do not apply to the particular scheme.

3.5. Companies established in Dublin's International Financial Services Centre ("IFSC")

The Central Bank Act, 1989 confers general powers of supervision on the Central Bank with regard to companies carrying on activities in the IFSC that are certified for the 10% corporation tax rate. These companies are subject to the supervisory and reporting requirements relating to their businesses that the Central Bank considers prudent to impose from time to time in the interest of the proper and orderly regulation of the company concerned or for the development of the IFSC as an international financial centre.

In all cases, the Central Bank is concerned, to ensure that the owners and managers of the company are fit and proper persons and that it is adequately capitalised in the light of the risks inherent in its business. Where retail investment business is concerned, the Central Bank looks primarily to the conduct of business practices and expertise, whilst in other cases the primary emphasis is on capital adequacy and risk management policies. Because of the wide range of participants and so as to maintain the maximum degree of flexibility, the Central Bank does not publish supervision standards. The Bank is, however, committed to an even-handed approach.

In regard to IFSC businesses to which the Investment Services Directive will apply when transposed, the Central Bank already treats the requirements of that Directive as applicable.

3.6. State entities

3.6.1. The Financial Transactions of Certain Companies and Other Bodies Act, 1992 (the "FTCCA"), which came into force on 17 June 1992, must be taken into consideration when entering into derivatives transactions with entities in the Irish commercial state-sponsored sector. The FTCCA applies to all persons, other than two state banks, whose power to borrow money is subject to the consent of the Minister for Finance of Ireland. It also applies to any subsidiary or holding company of such a person and to any other subsidiary of such a holding company.

3.6.2. Permitted derivatives transactions
Section 2(1)(a) of the FTCCA confers power on these bodies to enter into contracts "whose purpose or one of whose purposes is:
  • (i) to eliminate or reduce the risk of loss arising from changes in interest rates, currency exchange rates, commodity prices or from other factors of a similar nature affecting the person's business,
  • (ii) to eliminate or reduce the cost of borrowing or the cost of other transactions carried out in the course of that business, or
  • (iii) to increase the return on an investment including a loan".
The FTCCA allows the Minister for Finance of Ireland to specify the types of contracts that a particular commercial state enterprise entity can enter into and the conditions that must be met in each case. The Department of Finance has written to entities affected by the legislation setting out specifications on a case by case basis. No contract of the kind referred to above may be entered into by such a body unless in doing so these specifications are observed.

4. Gaming and Lotteries legislation

As in many other countries, under Irish law, a contract by way of gaming or wagering is unenforceable. This is provided for in Section 36 of the Gaming and Lotteries Act, 1956 (the "GLA"). Section 98 of the Central Bank Act, 1989 provides, for the avoidance of doubt, that contracts or options traded on an exchange supervised by the Irish Central Bank under the CBA shall not be void or unenforceable by virtue of the GLA. With that exception, a derivative transaction is unenforceable in Ireland if it amounts to a wagering contract.

There is no equivalent in Irish law of the English section 63 of the Financial Services Act 1986 (as a result of which no contract entered into by either party by way of business, where its making or performance is an investment dealing under that Act, is void or unenforceable by reason of the English Gaming Acts, 1845 and 1892).

The question of what constitutes a "wagering contract" is, therefore, of significance in the context of derivatives transactions. Derivatives transactions are of a kind that are capable of constituting a wagering contract but whether they do or not depends on the interests of the parties and their purpose in entering into the particular contract.

The English case law in this area would be of persuasive authority in Ireland. It appears from that case law that as long as at least one of the parties is entering into the contract for a commercial purpose, the contract will not be invalidated by virtue of the GLA.

5. Capacity of companies

Capacity is an issue that needs to be considered in relation to all Irish corporate parties to such transactions. An Irish company is restricted in the activities it may engage in by the provisions of its memorandum of association. Before the 1991 House of Lords decision in Hazell -v- The Council of the London Borough of Hammersmith and Fulham and Ors, which held that debt management was not an implied function of a local authority's power to borrow, it had generally been assumed that the necessary powers could be implied as incidental to the pursuit of the activities that were expressly authorised, especially where the transaction was concluded as part of a bona fide hedging strategy, rather than for speculative purposes. Although the matter has not been addressed by an Irish court and the decision of the House of Lords is of persuasive authority only, it does raise questions about the validity of this assumption and, as a result, many Irish corporates have amended their memoranda of association to clarify their capacity to enter into derivatives transactions.

It is generally necessary to ensure that an Irish corporate counterparty has an express provision in its memorandum of association entitling it to enter into the relevant type of derivatives transaction.

In the light of the legal uncertainties, the safest course to follow is to ensure that the Irish counterparty's capacity derives, not from a power, but from an object. If this is so, the purpose of the transaction becomes irrelevant as far as capacity is concerned; where there is doubt as to whether the relevant Irish counterparty's capacity derives from an object, a suitably worded object should be added, by amendment to the memorandum of association.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.