On Oct. 1, the Office of the Superintendent of Financial Institutions altered the trajectory of over-the-counter (OTC) derivatives reform in Canada. With the release of its much-anticipated and now-renamed Guideline B-7 Derivatives Sound Practices, OSFI has veered away from proposals issued in stages by the Canadian Securities Administrators (CSA) over the past four years, but has added an essential piece to the up to now incomplete provincial response to the G-20 leaders who, in 2010, committed to reform OTC derivatives markets.
Although short of asserting complete federal jurisdiction over derivatives as a matter of international trade and commerce and control of systemic risk in the economy, the Guideline is the clearest indication to date that the federal government has staked out a dominant role for itself in this area.
The Guideline applies to all federally-regulated financial institutions (FRFIs) and their consolidated subsidiaries. Clearly OSFI does not intend to play a secondary role in overseeing FRFIs’ derivatives-related activities. As noted in the introductory letter to the Guideline “[t]he Canadian derivatives market is dominated by FRFIs including the five largest banks for which derivatives activities represent a core business overseen by OSFI as part of its prudential mandate.” By including securities dealers and other bank subsidiaries under federal derivatives regulation OSFI has left only commercial end-users under provincial jurisdiction, rendering the provincial rules essentially redundant since activities of end-users’ counterparties will fall under the federal rules, 99 times out of 100.
Guideline B-7 differs markedly from the CSA proposals on OTC derivatives reform, being geared towards the actual risks (market, credit, liquidity and operational) assumed by market participants, and including proposals to measure, monitor and reduce those risks. The Guideline acknowledges and reflects the international and global nature of derivatives activities, and guides FRFIs and their subsidiaries participating in and contributing to international reform efforts. By both including and omitting, OSFI lays out what is important and what is not from a Canadian regulatory and risk management perspective. In contrast, CSA reform proposals simply imported, on a province-by-province basis, virtually all OTC derivatives reforms in the U.S. Dodd-Frank Wall Street Reform and Consumer Protection Act (the Dodd-Frank Act) and its European Union counterpart, EU Regulation No.648/2012 (EMIR), and regulated those matters at the provincial and territorial level in the same way they are regulated internationally by the U.S. and European regulators. It is apparent that OSFI has consulted with (and listened to) its regulatory constituency, and has striven to develop a set of principles-based guidelines that recognize the sufficiency and paramountcy of international rules as a code of conduct for Canadian financial institutions.
It is far from clear how the provincial OTC derivatives regime will apply to FRFIs and their subsidiaries in light of the OSFI Guideline. In the most recent omnibus budget implementation bill, the federal government gave itself the explicit power to regulate derivatives activities of banks under the Bank Act, but it has not yet done so. The explanatory letter accompanying the Guideline states “In the Guideline, reference may be made to rules promulgated by other regulators, including provincial securities regulators, which will be considered to be applicable to FRFIs by virtue of this Guideline. OSFI will monitor FRFIs compliance with these requirements, and will continue to review the appropriateness of their application to FRFIs.” Read: for now certain provincial rules will overlay the OSFI Guideline, but the federal government reserves the right to withdraw FRFIs and their subsidiaries from the provincial rules. In any case, OSFI will monitor FRFIs’ compliance with provincial rules incorporated by reference into the federal regime. A small but significant note in the Guideline says that the province where an FRFI has its principal place of business will be the province whose rules apply to the derivatives activities of that FRFI. In contrast, the provincial rules now assume jurisdiction if an institution meets any one of three criteria: having its principal place of business, or its head office, in the province, or being incorporated under the laws of that province, a scenario that could see three jurisdictions claiming primary regulator status. The OSFI Guideline provides a reprieve for FRFIs and their subsidiaries from this bit of inter-provincial regulatory turf squabble, one that was needed because three of the five largest banks would have potentially been caught in a jurisdictional tug-of-war.
Areas to anticipate ongoing federal attention include:
- Electronic Trading: A push toward standardizing OTC derivatives and moving trading to organized platforms. (The CSA had promised to publish a consultation paper on this subject in the summer of 2014, but has not yet done so.)
- Reportable Data to Trade Repositories: OSFI adopts the provincial regimes by reference but publishes a much shorter list of data it considers important compared to what is currently included in the provincial rules (which in their original form went beyond what was required under the Dodd-Frank Act and EMIR, but have since been amended to harmonize with the international requirements).
- Exchange-Traded Derivatives: The Guideline, like the Dodd-Frank Act and EMIR, applies to exchange-traded derivatives activities in many respects, and not just OTC derivatives. The CSA proposed reforms only apply to OTC derivatives.
- Margining: Margin and capital requirements for counterparties figure prominently in the Guideline, whereas the CSA has not yet set out its position for margining or indicated a date when the CSA proposal on margin and capital would be issued.
- Market Conduct: Here OSFI and provincial proposals are possibly headed for collision, with the Guideline taking a very principles-based approach and the provincial proposals being very prescriptive.
On the surface, the Canadian framework for OTC derivatives reform appears as fragmented as ever. But perhaps, given the scope of the territory staked out by OSFI in its new Guideline, and the looming threat of actual federal regulations, the system will become less fragmented, and more harmonized. The reality is that most, if not all, of the derivatives activity in the system will be governed by revised Guideline B-7, eventual federal regulations, and/or international rules. Stay tuned.