Sounding out the market: OSFI publishes draft Guideline B-7 Derivatives Sound Practices for Comment 

publication 

October 2014

Derivatives Bulletin
Shahen A. Mirakian, Prithviraj Shankar, Student-at-Law
On January 24, 2013, the Office of the Superintendent of Financial Institutions ("OSFI") issued a letter highlighting OSFI's progress in implementing the G-20 reforms for over-the-counter ("OTC") derivatives markets.1 This letter stated that OSFI intended to revise the Derivatives Best Practice Guideline (B-7) (the "1995 Guideline") before the end of 2013 to reflect the commitments made by the Canadian government to the G-20 regarding issues such as central clearing principles and counterparty risk management.2

Although 2013 ended without any revisions to the 1995 Guideline, on October 1, 2014 OSFI published a revised draft guideline for comment reflecting Canada's G-20 commitments and setting out OSFI's approach to regulating the OTC derivatives activities of Canadian federally regulated financial institutions ("FRFIs").3 The draft guideline is titled "Guideline B-7 Derivatives Sound Practices" (the "Proposed Guideline") to underscore that the practices set out in the draft guideline are OSFI's expectations rather than the highest possible standard for a FRFI engaged in derivatives activities.

The title is not the only difference between the 1995 Guideline and the Proposed Guideline. The Proposed Guideline builds upon the principles articulated in the 1995 Guideline along with the general framework for OTC derivatives regulation articulated in the discussion paper published by the Canadian OTC Derivatives Working Group (of which OSFI is a member) published in October 2010 titled Reform of Over-the-Counter (OTC) Derivatives Markets in Canada ("OTCD WG Paper").4

In addition to dealing with capital standards and standardization of OTC derivatives, the OTCD WG Paper recommended that regulators take steps to force Canadian financial institutions to move towards centrally clearing OTC derivatives transactions and adopting stricter counterparty risk management standards for bilateral transactions (including setting minimum margin requirements). The OTCD WG Paper also recommended that regulators require the reporting of OTC derivatives transactions to trade repositories and encourage the movement of OTC derivatives onto electronic trading platforms.

Most of these recommendations are adopted by the Proposed Guideline. The major exception is that OSFI has not included any discussion of minimum initial and variation margin requirements in the Proposed Guideline saying that it will do so at a future date when an international framework for bilateral OTC derivative transaction margining has been adopted.

Central Clearing

In addition to the basic principles on settlement risk adopted from the 1995 Guideline, the Proposed Guideline provides guidance for FRFIs who are adopting central clearing. As the Proposed Guideline notes, OSFI implemented capital incentives for central clearing of derivatives on January 1, 2013 in the Capital Adequacy Requirements (CAR) Guideline.5 In response to these guidelines many FRFIs have been moving transactions on to central counterparties ("CCPs").

The Proposed Guideline recommends that FRFIs establish risk ratings and credit limits for CCPS consistent with their particular risk appetite and policies. The Proposed Guideline also states that all central clearing of standardized derivatives by FRFIs should be done using global CCPs which are regulated in a jurisdiction which applies rules consistent with the international standards for CCPs and recognized by Canadian authorities (such CCPs are termed "Qualified Central Counterparties" or "QCCPs"). If no Canadian-recognized QCCPs are available, then FRFIs should use QCCPs recognized in a foreign jurisdiction. Intra-group transactions between a FRFI and its affiliates are not required to be centrally cleared provided a risk management framework is available to monitor the risks involved with such transactions.

Trade Reporting

OSFI expects that FRFIs will comply with the requirements set out by the provincial securities regulator in their principal place of business for derivatives reporting. OSFI says that it will monitor the compliance of FRFIs with this requirement and FRFIs should include an assessment of their compliance with trade reporting requirements in their annual compliance reports to OSFI. The Proposed Guideline also states that not only should FRFIs obtain global Legal Entity Identifiers ("LEIs"),6 but they should also encourage their clients and counterparties to do so as well. This is in keeping with the views of provincial securities regulators that LEIs are a fundamental element of trade reporting.

Risk Management

The Proposed Guideline advocates an integrated approach to the management of risks associated with derivatives. The Proposed Guideline recommends that FRFIs integrate derivative risks into their overall risk management framework through the adoption of policies and guidelines. The Proposed Guideline suggests, for example, that the risk arising from the uncertainty of valuing derivatives with complex payoffs should be handled with robust control processes and documented procedures and that the Board of Directors and senior management should play an active role in managing this risk. The Proposed Guideline divides the discussion of risk into (1) market risk, (2) credit risk, (3) liquidity risk, and (4) operational risk.

1.    Market Risk

The Proposed Guideline defines market risk as "the risk of losses arising from fluctuations in the market value of the underlying reference asset". Examples of market risks include the risks arising from a change in interest rates, credit spreads, equity prices, etc. The Proposed Guideline recommends that in tackling this risk, that based on their risk appetite framework, FRFIs must identify the drivers of this risk, estimate the extent of exposure to such risks, and importantly set limits on the exposure to such risk.

2.    Credit Risk

The Proposed Guideline states that a risk of default by a counterparty (i.e. credit risk) can be mitigated by using timely reporting measures based on established policies and procedures. Credit risk management must be delinked from those units involved with trading functions that create the risk. The ideal requirements for a credit risk management framework include approving counterparty credit exposure measurement standards, and assigning and approving internal credit risk ratings.

3.    Liquidity Risk

Liquidity risk is basically the risk arising from the uncertainty that a derivatives position can be offset or eliminated at the market price due to a lack of market liquidity. A FRFI in establishing its market risk exposure limits and policies should consider what the appropriate holding periods should be for positions, especially those which are in historically illiquid markets or have few hedging alternatives. FRFIs should also consider the risks arising from having to meet margin requirements for QCCPs in illiquid margin conditions. Liquidity risk management strategy should focus on active management of collateral positions and preparing for unexpected situations where additional collateral may be required (for instance, a decline in credit rating).

4.    Operational Risk

Operational risk is the risk arising from people, inadequate controls or processes or from external events (it is a catch-all category for the risks which are not described in the other sections). Operational risks include legal risk, regulatory compliance risk and business continuity risk.

To mitigate the legal risk, a FRFI must determine the authority of a counterparty to enter into derivatives transactions and ensure that all material terms, rights and obligations are in writing especially in scenarios where there is no central clearing of contracts. A FRFI should also satisfy itself that the transaction documentation is adequate especially regarding the timing of the termination of outstanding transactions, and the settlement amount calculations upon the termination of such transactions.

In mitigating regulatory compliance risk a FRFI should maintain knowledge of regulatory requirements of all jurisdictions which may apply to its derivatives activities. Among other things, a failure to follow these requirements can lead to a loss of reputation.

The Proposed Guideline recommends that FRFIs should have business resiliency and continuity plans to limit losses if a severe business disruption occurs. Business impact analysis, recovery strategies and testing are some strategies that help develop a business resiliency and continuity framework. An assessment of possible business disruptions from a financial, operational and reputational perspective must be considered in developing resiliency and continuity plans.

System Infrastructure Considerations

The Proposed Guideline states that FRFIs should ensure that their systems infrastructure meets current and long term needs by supporting the size and complexity of the derivatives market. The features of a good system are:

• Ensuring that data is disseminated quickly, accurately and efficiently throughout the FRFI, and allowing for effective monitoring and control of risks from trade execution to settlement.

  • Allowing for portfolio compression to reduce the risk, cost, and inefficiency of maintaining redundant transactions.

  • Allowing for portfolio reconciliation of uncleared derivatives and the efficient resolution of any disputes or discrepancies in a timely manner.

  • Supporting the trading of OTC derivatives through organised platforms (such as electronic trading venues and exchanges).

Application

Similar to the 1995 Guideline, the Proposed Guideline applies to all Canadian federally-regulated financial institutions (banks, foreign bank branches, federally-regulated trust and loan companies, co-operative credit associations, life insurance companies, and property and casualty insurance companies). The application to the Canadian branches of foreign bank branches is particularly important because regulating branch operations of foreign banks has been a topic of substantial discussion during meetings of regulators from various jurisdictions and there is not yet any resolution on exactly which regime will apply to such branches.

Comments

OSFI encourages market participants and the public to submit comment letters addressing any issues or raised by the Proposed Guideline. Comments must be submitted by November 14, 2014.

We invite market participants to discuss any comments and questions with us. We are available to assist those wishing to submit comments to OSFI regarding the Proposed Guideline.

by Shahen Mirakian and Prithviraj Shankar, Student-at-Law

1 Office of the Superintendent of Financial Institutions ("OSFI"), "G-20 Commitments for OTC Derivative Market Reform", Letter dated January, 2013.

2 OSFI, "Derivatives Best Practices", Guideline dated May 1995.

3 OSFI, "Derivatives Sound Practices", Draft Guideline No B7 effective date November 2014.

4 OTC Derivatives Working Group, "Reform of Over-the-Counter (OTC) Derivatives Markets in Canada: Discussion Paper from the Canadian OTC Derivatives Working Group", Discussion Paper dated October 26, 2010; Please see our bulletin, Shahen Mirakian & Maria Sagan, change is near but unclear: Canadian regulators publish initial proposals on OTC derivatives (2010).

5 OSFI, "Capital Adequacy Requirements (CAR) Guideline", Guideline Impact Analysis Statement December 2012.

6 Global Legal Entity Identifiers are unique 20 character identifiers issued by Local Operating Units (such as GMEI in North America) that can be obtained by legal entities and are used to identify entities in derivatives trade reporting.

a cautionary note

The foregoing provides only an overview and does not constitute legal advice. Readers are cautioned against making any decisions based on this material alone. Rather, specific legal advice should be obtained.

© McMillan LLP 2014