On October 1st, the Office of the Superintendent of Financial Institutions (OSFI) issued an updated guideline setting out its expectations with respect to the derivatives activities of federally regulated financial institutions. The Guideline entitled Guideline B-7 – Derivatives Sound Practices, comes into effect on November 1st.
Following the financial crisis of 2008, the G20 countries agreed to reform the over the counter (OTC) derivatives market to mitigate the high levels of systemic risk posed by these bilateral transactions. The G20 agreements focused on increasing transparency for OTC derivatives trading by requiring that standardized OTC derivatives be traded on exchanges and electronic trading platforms and reported to trade repositories. While the regulation of exchanges and trading platforms for OTC derivatives is under provincial jurisdiction, according to the Canadian Bankers Association, Canada’s five largest banks are the counterparties to over 95 per cent of OTC derivatives transactions that take place in Canada. Therefore, the OSFI Guideline will play a major role in shaping the market for OTC derivatives in Canada.
Central Clearing and Adherence to Provincial Laws
Given Canada’s G20 commitments, and the significant involvement of the large banks in the derivatives market, the Guideline directly addresses the trading of OTC derivatives through exchanges and electronic platforms and the reporting of trades to trade repositories. The Guideline states that institutions must centrally clear standardized derivatives where the clearing of such products is offered by a Qualified Central Counter Party (QCCP). Under the Guideline, a QCCP is a Central Counter Party (CCP) that is based, and prudentially supervised, in a jurisdiction where the relevant regulator/overseer has established, and publicly indicated that it applies to the CCP on an on-going basis, domestic rules and regulations that are consistent with the CPSS-IOSCO Principles for Financial Market Infrastructures.
The Guideline also requires that an institution report, or cause to be reported, derivatives transactions to a recognized trade repository, following the derivatives data reporting requirements that have been adopted in the province in which the principal place of business of the institution is located. OSFI intends to monitor compliance with this requirement and institutions are required to include in their annual compliance reports to OSFI an assessment of compliance with the local reporting requirements. Institutions are also expected to obtain their own Legal Entity Identifier (LEI) and to encourage their clients and counterparties to derivatives transactions to obtain a LEI.
The new Guideline also addresses OSFI’s expectations for risk management processes related to derivatives activities. First, the Guideline clarifies that an institution must address its derivatives activities as part of its overall risk management program and Risk Appetite Framework. Risk limits must be approved by the board and a clearly defined escalation procedure must be put in place to raise issues to senior management and the board. The Guideline also sets out specific expectations with respect to the management of market risk, credit risk, liquidity risk and operational risk.
Although specific capital requirements have been established for derivatives activities under the industry specific capital guidelines, OSFI has reminded all institutions that they must also account for their derivatives activities as part of their Internal Capital Adequacy Assessment Process or Own Risk Solvency Assessment. Further, each institution’s stress testing program must consider the potential for material loss arising from derivatives activities.
A link to the Guideline is available here.