OTC Derivatives Regulation: End Users Mark Time

Canadian initiatives to regulate over-the-counter (OTC) derivatives—customized contracts whose values or obligations are based on the performance of an underlying asset, index, rate or other variable—gathered momentum in the past year, but progress has been slow and uncertain.

Financial institutions and sophisticated buy-side market participants that invest globally, such as Canada’s major pension funds, have been tracking the more advanced American and European OTC derivatives regulatory developments and are preparing for regulation in Canada. Many commercial (non-financial) end users whose operations are primarily Canadian and who use derivatives mainly to hedge interest rate, currency and commodity risks, have felt the effects of U.S. OTC derivatives legislation and are standing by for Canadian regulation to be implemented. But so far, they have little incentive to commit significant management time and financial resources to getting up to speed on legislative initiatives and preparing for compliance.

Derivatives and their Role in the Financial Crisis

Derivatives are unquestionably a useful and efficient way for commercial entities and financial institutions to hedge or mitigate interest rate, currency, credit and other risks. However, derivatives can also be used to engage in excessive speculation, particularly since they allow investors to make highly leveraged bets on existing risks or to gain exposure to risks created solely for speculative purposes. While governments, regulatory agencies and market participants still debate the reasons for the 2008 financial crisis, the use of OTC derivatives, if not a cause, was at least an aggravating factor. Among OTC derivatives, the credit default swap—an insurance-like contract that allows parties to isolate the risk of certain credit events (such as a company defaulting on a loan obligation or becoming bankrupt) and to buy or sell protection against those events occurring—is singled out for its role in some of the worst excesses of the financial crisis. Complex financial instruments linked through credit default swaps to the performance of risky subprime mortgages contributed to the collapse, fire sale or bailout of several large financial institutions.

Canada, which weathered the global financial crisis relatively well, was forced to deal with its own homegrown crisis when investors, spooked by rising subprime defaults, balked at investing in highly rated non-bank-sponsored asset-backed commercial paper (ABCP). Issuers of non-bank ABCP, who were relying on investment in new paper to repay paper coming due, were unable to retire outstanding ABCP. The use of credit default swaps added to these woes. Non-bank ABCP issuers entered into credit default swaps to sell long-term credit protection to international banks on portfolios of debt, asset-backed securities and other derivatives in order to generate a significant part of the yield on non-bank ABCP. When credit spreads (a measure of relative credit risk) increased and the credit protection became more valuable to the banks, the terms of the credit default swaps required ABCP issuers to provide more collateral to support their obligations, collateral they didn’t have. For more than a year, the $32-billion non-bank ABCP market in Canada remained in a holding pattern while issuers, large investors, dealers and their advisers mapped out and implemented a plan to restructure the frozen paper.

The Road to Regulation

After several high-profile failures linked to the use of OTC derivatives, governments identified four main areas of risk associated with their unregulated use:

• systemic risk: the risk that the failure of one or more important counterparties could have knock-on effects on a larger number of interconnected financial markets participants, thereby putting global financial markets in jeopardy
• counterparty (credit) risk: the risk of a counterparty being unable to fulfill its obligations, which contributes to systemic risk if the counterparty has substantial positions in derivatives
• lack of transparency: lack of information about the OTC derivatives activities and financial position of banks, dealers and other large financial markets participants
• conflicts of interest: the skewing, often through misaligned incentives, of interests of institutions such as mortgage lenders, brokers and credit rating agencies in favour of certain stakeholders to the detriment of others

To address these risks, G-20 governments committed to principles requiring OTC derivatives to be:

• traded on exchanges or electronic trading platforms where appropriate;
• cleared through central counterparties (CCPs), which would require derivatives users to provide collateral to support their obligations;
• reported to trade repositories (TRs)—centralized storehouses of OTC derivatives data; and
• subject to higher capital and minimum margining requirements if not centrally cleared.

In the United States, the main vehicle for regulatory reform of OTC derivatives is the 2010 Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank). This voluminous piece of legislation, checking in at over 800 pages, comprehensively overhauls U.S. financial regulation, including the regulation of OTC derivatives activities. Implementing Dodd-Frank is a massive undertaking requiring the passage of almost 400 rules. Not surprisingly, it has not proceeded as quickly or as smoothly as initially intended. However, although not all rules are final (and some are not even available in draft form), many important provisions are operative, so Canadian companies that do business with U.S. counterparties are already feeling Dodd-Frank’s effects.

Canadian commercial end users are only beginning to consider how new legislation will apply to and affect their derivatives activities.

In Canada, the pace of regulation has been slow. Quebec was first out of the gate when its Derivatives Act came into force in 2009. Late in 2010, Ontario amended its Securities Act to put in place a framework for the Ontario Securities Commission (OSC) to regulate derivatives trading activities, derivatives trade repositories and clearing agencies, derivatives-related insider trading and tipping, and derivatives dealers and advisers. Most of the operative provisions are not yet in effect. Several other provinces have passed similar amendments to their securities legislation.

Of the rules intended to give substance to Ontario’s regulatory framework, only two have been approved to date, both relating to derivatives reporting. One rule determines which derivatives transactions must be reported. The other rule provides for the regulation of TRs and mandates the reporting of derivatives data to TRs for transactions entered into by local counterparties organized or based in Ontario (or affiliates whose liabilities they are responsible for or derivatives dealers and other registrants under Ontario’s Securities Act).

Under the reporting rule, reporting responsibility falls to counterparties that are either clearing agencies or derivatives dealers or, if neither counterparty is a clearing agency or derivatives dealer (if, for example, the trade is between two commercial end users), each local counterparty. Data to be reported include unique counterparty, transaction and product identifiers, detailed information about the terms of the transaction, any subsequent changes to previously reported data, and industry-standard valuation data.

Originally, derivatives dealers were to report new derivatives transactions beginning on July 2, 2014. In April 2014, citing the unreadiness of any TR to be designated to accept trade reporting, the OSC delayed the effective dates for reporting new transactions until October 31, 2014 for clearing agencies and derivatives dealers, and until June 30, 2015 for other parties (transactions in effect before those dates have later reporting dates). Since derivatives data that are not accepted by a designated TR must be reported to the OSC, the OSC’s decision to wait for TRs to come online is understandable.

Canadian securities regulators have also published draft model rules covering mandatory clearing of derivatives through CCPs (with exemptions for derivatives used by non-financial entities to hedge or mitigate commercial risk and for certain intra-group transactions) and the treatment and transfer of customer collateral and positions. Some provinces may adopt final clearing rules by the end of 2014.

But much remains to be done. After trade reporting rules are fully in effect and clearing rules are finalized and implemented, regulators must still publish and finalize rules to deal with the registration of derivatives dealers, advisers and other market participants, exchange trading and collateral requirements.

Effect of Regulation on Commercial End Users

Canadian commercial end users are only beginning to consider how new legislation will apply to and affect their derivatives activities. Although experience in the U.S. may be instructive, many important consequences of OTC derivatives legislation will only be apparent once a fully constructed legislative regime is in place. Canadian OTC derivatives regulation for commercial end users will likely result in:

• more monitoring, oversight and board involvement in derivatives activities as end users implement derivatives trading policies to ensure regulatory compliance and to take advantage of any applicable exemptions from derivatives regulations
• increased costs of legal and operational compliance, including any additional capital and compliance costs passed on by dealers to their end user clients and any direct costs incurred by end users for record-keeping, reporting and clearing as well as for obtaining legal and accounting advice
• increased collateral requirements since both cleared and uncleared derivatives will require counterparties to post margin or collateral. The effects of collateral requirements may be felt more acutely by large creditworthy end users that so far may have provided little or no credit support to derivatives counterparties
• more basis risk (mismatch between the risk being hedged and the protection provided by derivatives) as end users trade the more precise hedge of a tailor-made, uncleared derivative that requires more collateral for the imperfect hedge of a ready-made cleared derivative requiring less collateral. Eventually, a sufficiently broad suite of exchange-traded and cleared products may be available to allow end users to cover common commercial risks through one or more exchange-traded derivatives without assuming excessive basis risk
• reduced use of derivatives by end users who consider compliance with derivatives rules to be too onerous, complicated or costly and therefore seek alternative hedging solutions or even choose to self-insure risks they might otherwise have hedged
• required compliance with the rules of more than one jurisdiction. OTC derivatives legislation from province to province should be fairly uniform but may not be identical. So even purely domestic contracts will require counterparties to be alert to possible differences. Additional compliance burdens may be imposed on Canadian end users who have, or whose counterparties have, a connection to a jurisdiction outside Canada. Canadian end users have received requests from U.S. dealer counterparties to sign up to protocols drafted by the International Swaps and Derivatives Association to assist U.S. derivatives dealers and other large market participants in complying with their Dodd-Frank obligations. End users must therefore understand and assess the obligations imposed on them by these protocols or similar protocols designed for other jurisdictions. The application of highly technical foreign rules to cross-border derivatives transactions and the different approaches taken by different jurisdictions will add to the complexity.

Financial institutions and other sophisticated market participants and their advisers will continue to prepare for Canadian OTC derivatives regulation by taking stock of their derivatives activities, participating in industry groups, and commenting on draft legislation published by securities regulators. However, the slow pace of regulatory reform has not inspired commercial end users to prepare for regulation that—for now—seems distant.