It's strange, but thinking about the global financial crisis, that scene from The Wizard of Oz where Toto pulls back the curtain and you see the man operating all those levers keeps springing to mind.
If the financial crisis pulled back the curtain on one thing, it was the inability of regulators to keep pace with blisteringly fast changes in financial market innovation. And the aftershocks have shaken world economies like some huge sonic boom.
The legacy of recession, high unemployment, currency crises and the lack of investment capital have set the set the stage for a whole new era of regulatory reform.
In a collective post-mortem in 2009, leaders of the G20 pledged “to turn the page” with a regulatory architecture designed to meet the needs of the 21st century global economy.
They settled on common themes, such as standardized contracts, central clearing and trade reporting for over-the-counter derivatives, which don't trade on an exchange. They also agreed to strengthen oversight of bank-like activity that falls outside the banking system, which captures transactions instruments such as securitizations.
The new framework was to be in effect by 2012. But issuing a coordinated global statement proved much easier than delivering a coordinated global response.
Almost seven years later, the phantoms of the crisis and the spectre of it happening again still haunt governments the world over.
Implementation across G20 countries is uneven as regulators struggle with the details of building the new post-crisis infrastructure in their local markets.
In Canada, the 13 provincial and territorial securities regulators working under the umbrella of the Canadian Securities Administrators (CSA) have been working to come up with regimes that will be compatible with one another, as well as with other jurisdictions around the world, to avoid arbitrage.
The CSA has introduced a flurry of proposed regulations and instruments, but with no coordinated timetable – and some variation in final rules – the provinces are out of synch.
The Bank of Canada, the Office of the Superintendent of Financial Institutions and the Department of Finance have also been working on the G20 commitments and, in what promises to add to the cotillion of confusion, the federal government announced in the last budget that it will be amending the Bank Act to create “explicit regulation-making authority” of over-the-counter derivatives activities by Canadian banks — by far the biggest players in the OTC derivatives markets.
“Many observers have asked how the provincial securities commissions realistically think they're going to become meaningful systemic watchdogs of financial markets in this area when so much of the activity is done by federally regulated institutions,” says Philip Henderson, co-head of the Structured Finance and Financial Products group at Stikeman Elliott LLP in Toronto.
“I think one of the big challenges we have in this country is how to make this work.”
No kidding.
When it comes to the world of over-the-counter derivatives and other complex financial instruments, here's something mind-boggling to some: There is disagreement over whether some instruments are even considered derivatives.
Many are structured more like bilateral contracts than securities, but in Canada regulators have taken the position that they may well be securities because of the way they're offered and distributed. That affects things such as disclosure.
Their classifications will likely change to derivatives under a new product determination rule already adopted by Ontario, Alberta and Manitoba. It's one of a few new measures that will drive up costs, Henderson says.
Like many practitioners in the field, he recognizes there were obviously problems but does not seem thrilled with all the specific solutions being introduced.
“When you sit back and look at the rules being promulgated – which obviously we're doing with clients a lot – you have to stand back a bit,” he says. “There's a lot of stuff here that leaves you scratching your head, wondering how it's ever going to be useful.
“It seemingly goes way beyond presumably what the G20 authors had in mind to protect against systemic risk.”
Henderson says most Canadian players are so small in the scheme of things that they don't see themselves as being in a position to create systemic disruption.
Asked whether they are actively pushing back against some of the proposed new measures – most of which have been out for comment – he says they are not, even though privately many feel that Canadian regulators are going too far.
While different clients have different concerns, he says, one area that seems to be causing many a lot of upset is foreign-exchange products and transactions.
“Some people in that product space are asking why Canada is going off in this direction; aren't we just implementing G20-type changes here? I think what's happening here is that many of the regulators drafting this stuff tend to be taking a bolder approach than they would have many years ago and saying: ‘If we're going to regulate derivatives, we'll actually regulate them.' So they are going well way beyond what G20 commitments intended.
“When you talk about what's come out of the financial crisis, my general view is that regulators have become emboldened by the financial crisis, in a sense. But the financial crisis was sufficiently devastating throughout the world that the naysayers when it comes to all this regulation don't really have a voice.”
If business people who work in this area are unhappy with the recent barrage of rules and regulations, it may be because many feel that regulators are using an elephant gun to shoot a mouse — killing acceptable business risk while aiming for systemic risk.
Canada is not a player in the world derivatives market, accounting for only between 2 per cent and 3 per cent of global over-the-counter trades. It's true that with leverage you don't have to be huge to wreak havoc. But if you're looking for high-risk behaviour that sows the seeds of market disorder, Canadian derivatives practitioners say look somewhere else.
The vast majority of this country's derivatives transactions involve Canadian businesses hedging against US-dollar currency fluctuations, or turning floating interest-rate debt into a fixed rate, says Carol Pennycook, a partner at Davies Ward Phillips & Vineberg LLP in Toronto.
Yet they're being caught by measures aimed at their much-riskier cousins; the speculative derivatives, often synthetic, that were designed solely for the purpose of betting on one outcome over another.
“Some of the new measures go well beyond the type of transactions that gave rise to the financial crisis,” says Pennycook, who chaired a provincial advisory committee that delivered recommendations on the regulation of commodities and derivatives markets in Ontario right before the financial crisis hit.
“This is a bit typical. The pendulum often swings a little too far when legislation is trying to correct for a perceived harm or wrong. But it's affecting everyday conservative transactions done by Canadian companies trying to fix their cost of doing business.”
The lack of coordination between Canada and the US is adding to the problems because cross-border OTC derivatives transactions are far more common than those where both counterparties are Canadian, she says.
Cross-border transactions as well as Canadian banks, insurance companies and pension funds that do business in the US – which the vast majority do – are required to comply with US law in this area.
“It's becoming difficult for them to be comfortable that they're compliant because the law is evolving so quickly,” Pennycook points out.
Candace Pallone, counsel in the structured products group at McCarthy Tétrault LLP in Toronto, says she hopes Canadian regulators are mindful of the realities as they work on building the Canadian stretch of the new global derivatives infrastructure.
“The global nature of markets means that the majority of transactions entered into by Canadians are with foreign counterparties who have their own rules and regulations to comply with,” Pallone points out. “It's getting complex.”
Where regimes clash, she says, “someone's going to have to decide what's going to happen between the two competing jurisdictions.” That's not something theoretical for the future. She says it's already happening now.
Pension plans, for example, are getting caught between opposing policies. Under new European regulations, they are exempt from central clearing for a period of time. In Canada, “we only have draft rules that were recently published by CSA, but in our draft rules pension plans are not exempt from central clearing.
“So if you have a Canadian bank entering into a swap with a European pension plan, our draft rules say that trade should be cleared by a central counterparty. Their European rules say the pension plans are exempt.
“I actually don't know what the answer to that is. How does the Canadian bank comply with its rules when its counterparty would prefer not to because it's exempt under its own domestic rules? We have to resolve those types of issues.”
It's ironic that central clearing may be causing some issues because it is one plank in OTC derivatives reform that is causing no debate between provinces. The vast majority of OTC transactions are cleared outside the country.
Central counterparty clearing is key to the new post-crisis global architecture because it's a mechanism whose sole raison d'être is to mitigate risk.
The idea is that central counterparty clearing houses, referred to as CCPs, insert themselves into the middle of trades so that entitlements and obligations are offset.
The way it works is once two parties enter into a swap, each side of the transaction submits the trade to a CCP for clearing through its clearing member. The CCP becomes the buyer for every seller, and the seller for every buyer.
Each clearing house is a business that operates on a membership model. Members are required to post government securities or other liquid assets as collateral to cover their trading exposure, as well as additional lump sum deposits to help ensure that the CCP always has the assets to cover obligations.
Parties on both sides of the swap are required to do daily risk management and post collateral equal to the amount that would be required if the contract settled that day, as well as enough to cover off potential movements in value that could occur over a couple of days in times of market stress. Higher-risk transactions may require further top-ups to prevent surprises.
CCPs are run for profit, with income from memberships, transaction fees and interest from cash deposits.
“You might ask why the G20 wants this,” says Stephen Ashbourne, a Toronto partner at Blake, Cassels & Graydon LLP. “The financial crisis highlighted the contagion risk in the marketplace where if Bank A goes bankrupt and Bank B is owed a lot of money by Bank A, that can cripple Bank B and cause a chain reaction.
“The CCP is structured to mitigate risk by interrupting the chain reaction.”
In Canada, the Canadian Derivatives Clearing Corporation clears derivatives transactions traded on the Montreal Exchange and is also expanding into some OTC transactions.
But no home-grown CCP champion has emerged to claim the important areas such as currency and interest-rate swaps. Instead, Canadian institutions use a small number of global CCPs such as the Chicago Mercantile Exchange or London-based LCH. Clearnet LLC.
That makes it easier for regulators to track global movement but at the same time leaves the Bank of Canada with reduced regulatory oversight, which is supposed to protect the stability of local financial markets in times of crisis.
In 2011, Deputy Governor Timothy Lane said that the absence of a Canadian CCP was a glaring weakness in the country's regulatory framework, and the central bank spent more than a year studying whether to develop one or work with an offshore player to set one up.
Ashbourne says as far as he knows the idea has fallen off the map.
“I think our regulators would have liked it, that securities regulators would have felt more comfortable knowing that there were boots on the ground here. They would have had more ability to influence things.”
OTC derivatives aren't the only instruments to have emerged from the financial crisis with a bull's eye on their back. The regulation of securitizations has also been targeted for reform.
Traditional securitizations involve bundling receivables such as credit card balances, auto leases, consumer loans or mortgages into a basket, then issuing short-term notes against them.
The notes enjoyed top investment-grade ratings. They were considered very safe by many because they were backed by payments from diversified sources and the risk of default could be spread geographically, across tens of thousands of people and even across industries.
Securitization can be a very effective way for companies that couldn't otherwise tap debt market to access the capital they have tied up in high-quality receivables, and it also allows finance companies other than banks to compete with banks and offer alternative sources of funding.
But as markets became more sophisticated, bankers started putting together synthetic securitizations that copied the performance of one or more real baskets, and even baskets of baskets.
A unique arbitrage market developed in Canada where mostly foreign banks with large synthetic exposures would reduce their risk by selling it to Canadian asset-backed commercial paper issuers. The same bank would provide the liquidity back-stop, and the regulations at the time would deem the bank to have laid off the risk.
Commercial paper is exempt from prospectus-level disclosure provided it is highly rated by an accredited rating agency, so buyers often had only the most generic information about the assets in the basket.
Once synthetics started creeping in, you got the multiplication factor — much like looking into a three-way mirror where you see reflections yourself seeming to stretch into infinity. That meant that when one category of receivables like subprime mortgages got whacked, the impact echoed far beyond the original investors.
Many large Canadian investors were astonished to discover they were exposed to risky US sub-prime mortgages and synthetic baskets through supposedly safe securitizations. The sheer complexity and lack of detailed disclosure fuelled panic, and, as investors stopped rolling the notes over because they were afraid of default, it sparked Canada's asset-backed commercial paper crisis.
As part of the G20 commitments to stamping out systemic risk, the Canadian Securities Administrators put a proposed new national instrument out for comment earlier this year that focuses on increasing the amount of disclosure.
While noting that complex high-risk ABCP is no longer being issued in Canada, the regulators nonetheless designed a whole new framework for prospectus-exempt short-term securitized notes.
“It's six or seven years later and a lot of what's being proposed is closing the barn door after the horses are already out,” says James Rumball, a Toronto partner at Norton Rose Fulbright Canada LLP.
The marketplace has already made many of the recommended changes, Rumball says, such as requiring at least two ratings from different rating agencies and global-style liquidity. Synthetic assets are also effectively banned.
The proposed new Canadian instrument will require “near prospectus-level” disclosure requiring issuers to identify all significant parties, their underwriting guidelines, their asset-eligibility requirements and historical performance — and to provide monthly reports and change reports when something happens.
That will drive up the cost of doing a securitization, says Rumball. That has people concerned. Once transaction costs start to creep towards seven figures, it will begin to make it uneconomical to securitize smaller pools of assets in the tens of millions of dollars range, which makes up a large part of the Canadian securitization market.
“The changes may very well reduce the size of the market, which is already just a fraction of what it was. So ultimately it comes down to the question of whether these changes will improve securitization or hurt it, and how that will affect the economy.”
The increased cost is not the only worry, he says.
There is concern over the effect of disclosing the names of significant parties such as the securitization's originator, which is the business – usually a financial institution – that makes the loans to the consumers and securitizes them.
Up until now, originators have been permitted to keep their identities anonymous from investors.
The trouble with dropping the veil, says Rumball, is that securitized debt will become lumped together with corporate debt from the same originator. That could put institutional investors offside their own internal caps that dictate how much investment they can concentrate in any one particular company.
Investors may also start to differentiate pricing between different issuers, leaving what was once a stable form of funding volatile and unpredictable.
Rumball believes the knockout blow for securitizations in Canada may turn out to be changes to withholding tax rules made several years ago that make it easier for Canadian originators to securitize outside the country.
Given rising costs and the loss of anonymity, those large enough to access capital markets in New York or London may just skip Canada altogether, he says.
“Securitization has shrunk so much in this country. It's really starting to rebound in the United States and Europe — but it hasn't here.
“Policymakers will need to weigh these concerns carefully or there may not be a domestic market for these.”
One of the more interesting revelations to emerge from the financial collapse was that not just retail investors who got caught up in the collapse of the US sub-prime market and subsequent ABCP freeze. It turns out many, if not most, institutional investors were buying sophisticated instruments with little or no understanding of the actual assets that underpinned them.
So as Canadian regulators try to shine the light into the dark corners of high-risk transactions through greater disclosure, many are looking at enlisting a conscript army — the financial advisors and dealers who provide investing advice.
Some of the proposed changes being considered would lift the impetus from investors to understand what they're purchasing and transfer it to the shoulders of those doing the selling.
The CSA and several provinces are in consultations over the appropriateness of introducing a statutory fiduciary duty to act in the best interests of clients.
Carol Pennycook does not believe adding a new level of statutory liability will have the effect regulators are hoping for. She says investors already have all the protections they need, and it's more a matter of enforcing the existing regime that imposes a duty on advisors and dealers to act “fairly, honestly and in good faith” towards their clients, and to understand their risk-tolerance profile through the “know-your-client” rules.
“With sophisticated commercial parties, I get concerned that the rules not be too paternalistic and try to protect people from themselves and making bad decisions, because I just don't think that works.”
With changes coming thick and fast, high-frequency trading has also been placed under intense scrutiny, with regulators using the new generation of infrastructure to tackle issues associated with trades done in nanoseconds.
Many high-frequency traders use dealing and arbitrage strategies to offer liquidity or to move liquidity among markets. The speed at which they buy and sell – driven by software strategies – can affect the stability of equity markets by greatly magnifying volatility.
That was made clear in the so-called flash crash of May 2011, in which the S&P 500 index rose and fell 6 per cent in 20 minutes, with dozens of stocks and exchange traded funds swinging to extreme prices.
The provinces and territories have been working together for the past two years to design a framework to curb potential systemic risk, says Félix Touzin, an associate at Davis LLP in Montreal.
In March, they adopted a national instrument deigned to make market manipulation more difficult.
“Market participants such as dealers have duties as gatekeepers and what this does is institute a number of controls, such as so-called circuit-breakers, or pre-trade risk controls, for dealers who provide direct electronic access to markets to some of their clients,” says Touzin.
“And the same goes for credit risks. This new framework says a dealer that provides direct electronic access is responsible for a client access later not honouring their trade. So they have to ensure the client has sufficient collateral pre-trade, which requires dealers to have risk-management and supervision controls, which will limit their financial exposure.
“The regulators are always looking to make sure markets function efficiently and that a risk of contagion is not there.”
Touzin interned at the Montréal Exchange, where he gained experience working with financial derivatives, and at the Autorité des marchés financiers, where he helped work on the Canadian reform initiatives related to the mandatory clearing of OTC derivatives.
When asked how well he sees Canada's securities regulators working together in this area in the wake of the financial collapse, he replies by saying he has the impression regulators around the world are co-operating more closely than before.
“At the same time, what they can achieve globally is limited. Each and every marketplace is different and needs different approaches.”
In other words, the world may need some kind of Wizard of Oz to pull it off. The man behind the curtain can only do so much.
Sandra Rubin is a Toronto-based writer and strategic consultant.
If the financial crisis pulled back the curtain on one thing, it was the inability of regulators to keep pace with blisteringly fast changes in financial market innovation. And the aftershocks have shaken world economies like some huge sonic boom.
The legacy of recession, high unemployment, currency crises and the lack of investment capital have set the set the stage for a whole new era of regulatory reform.
In a collective post-mortem in 2009, leaders of the G20 pledged “to turn the page” with a regulatory architecture designed to meet the needs of the 21st century global economy.
They settled on common themes, such as standardized contracts, central clearing and trade reporting for over-the-counter derivatives, which don't trade on an exchange. They also agreed to strengthen oversight of bank-like activity that falls outside the banking system, which captures transactions instruments such as securitizations.
The new framework was to be in effect by 2012. But issuing a coordinated global statement proved much easier than delivering a coordinated global response.
Almost seven years later, the phantoms of the crisis and the spectre of it happening again still haunt governments the world over.
Implementation across G20 countries is uneven as regulators struggle with the details of building the new post-crisis infrastructure in their local markets.
In Canada, the 13 provincial and territorial securities regulators working under the umbrella of the Canadian Securities Administrators (CSA) have been working to come up with regimes that will be compatible with one another, as well as with other jurisdictions around the world, to avoid arbitrage.
The CSA has introduced a flurry of proposed regulations and instruments, but with no coordinated timetable – and some variation in final rules – the provinces are out of synch.
The Bank of Canada, the Office of the Superintendent of Financial Institutions and the Department of Finance have also been working on the G20 commitments and, in what promises to add to the cotillion of confusion, the federal government announced in the last budget that it will be amending the Bank Act to create “explicit regulation-making authority” of over-the-counter derivatives activities by Canadian banks — by far the biggest players in the OTC derivatives markets.
“Many observers have asked how the provincial securities commissions realistically think they're going to become meaningful systemic watchdogs of financial markets in this area when so much of the activity is done by federally regulated institutions,” says Philip Henderson, co-head of the Structured Finance and Financial Products group at Stikeman Elliott LLP in Toronto.
“I think one of the big challenges we have in this country is how to make this work.”
No kidding.
When it comes to the world of over-the-counter derivatives and other complex financial instruments, here's something mind-boggling to some: There is disagreement over whether some instruments are even considered derivatives.
Many are structured more like bilateral contracts than securities, but in Canada regulators have taken the position that they may well be securities because of the way they're offered and distributed. That affects things such as disclosure.
Their classifications will likely change to derivatives under a new product determination rule already adopted by Ontario, Alberta and Manitoba. It's one of a few new measures that will drive up costs, Henderson says.
Like many practitioners in the field, he recognizes there were obviously problems but does not seem thrilled with all the specific solutions being introduced.
“When you sit back and look at the rules being promulgated – which obviously we're doing with clients a lot – you have to stand back a bit,” he says. “There's a lot of stuff here that leaves you scratching your head, wondering how it's ever going to be useful.
“It seemingly goes way beyond presumably what the G20 authors had in mind to protect against systemic risk.”
Henderson says most Canadian players are so small in the scheme of things that they don't see themselves as being in a position to create systemic disruption.
Asked whether they are actively pushing back against some of the proposed new measures – most of which have been out for comment – he says they are not, even though privately many feel that Canadian regulators are going too far.
While different clients have different concerns, he says, one area that seems to be causing many a lot of upset is foreign-exchange products and transactions.
“Some people in that product space are asking why Canada is going off in this direction; aren't we just implementing G20-type changes here? I think what's happening here is that many of the regulators drafting this stuff tend to be taking a bolder approach than they would have many years ago and saying: ‘If we're going to regulate derivatives, we'll actually regulate them.' So they are going well way beyond what G20 commitments intended.
“When you talk about what's come out of the financial crisis, my general view is that regulators have become emboldened by the financial crisis, in a sense. But the financial crisis was sufficiently devastating throughout the world that the naysayers when it comes to all this regulation don't really have a voice.”
If business people who work in this area are unhappy with the recent barrage of rules and regulations, it may be because many feel that regulators are using an elephant gun to shoot a mouse — killing acceptable business risk while aiming for systemic risk.
Canada is not a player in the world derivatives market, accounting for only between 2 per cent and 3 per cent of global over-the-counter trades. It's true that with leverage you don't have to be huge to wreak havoc. But if you're looking for high-risk behaviour that sows the seeds of market disorder, Canadian derivatives practitioners say look somewhere else.
The vast majority of this country's derivatives transactions involve Canadian businesses hedging against US-dollar currency fluctuations, or turning floating interest-rate debt into a fixed rate, says Carol Pennycook, a partner at Davies Ward Phillips & Vineberg LLP in Toronto.
Yet they're being caught by measures aimed at their much-riskier cousins; the speculative derivatives, often synthetic, that were designed solely for the purpose of betting on one outcome over another.
“Some of the new measures go well beyond the type of transactions that gave rise to the financial crisis,” says Pennycook, who chaired a provincial advisory committee that delivered recommendations on the regulation of commodities and derivatives markets in Ontario right before the financial crisis hit.
“This is a bit typical. The pendulum often swings a little too far when legislation is trying to correct for a perceived harm or wrong. But it's affecting everyday conservative transactions done by Canadian companies trying to fix their cost of doing business.”
The lack of coordination between Canada and the US is adding to the problems because cross-border OTC derivatives transactions are far more common than those where both counterparties are Canadian, she says.
Cross-border transactions as well as Canadian banks, insurance companies and pension funds that do business in the US – which the vast majority do – are required to comply with US law in this area.
“It's becoming difficult for them to be comfortable that they're compliant because the law is evolving so quickly,” Pennycook points out.
Candace Pallone, counsel in the structured products group at McCarthy Tétrault LLP in Toronto, says she hopes Canadian regulators are mindful of the realities as they work on building the Canadian stretch of the new global derivatives infrastructure.
“The global nature of markets means that the majority of transactions entered into by Canadians are with foreign counterparties who have their own rules and regulations to comply with,” Pallone points out. “It's getting complex.”
Where regimes clash, she says, “someone's going to have to decide what's going to happen between the two competing jurisdictions.” That's not something theoretical for the future. She says it's already happening now.
Pension plans, for example, are getting caught between opposing policies. Under new European regulations, they are exempt from central clearing for a period of time. In Canada, “we only have draft rules that were recently published by CSA, but in our draft rules pension plans are not exempt from central clearing.
“So if you have a Canadian bank entering into a swap with a European pension plan, our draft rules say that trade should be cleared by a central counterparty. Their European rules say the pension plans are exempt.
“I actually don't know what the answer to that is. How does the Canadian bank comply with its rules when its counterparty would prefer not to because it's exempt under its own domestic rules? We have to resolve those types of issues.”
It's ironic that central clearing may be causing some issues because it is one plank in OTC derivatives reform that is causing no debate between provinces. The vast majority of OTC transactions are cleared outside the country.
Central counterparty clearing is key to the new post-crisis global architecture because it's a mechanism whose sole raison d'être is to mitigate risk.
The idea is that central counterparty clearing houses, referred to as CCPs, insert themselves into the middle of trades so that entitlements and obligations are offset.
The way it works is once two parties enter into a swap, each side of the transaction submits the trade to a CCP for clearing through its clearing member. The CCP becomes the buyer for every seller, and the seller for every buyer.
Each clearing house is a business that operates on a membership model. Members are required to post government securities or other liquid assets as collateral to cover their trading exposure, as well as additional lump sum deposits to help ensure that the CCP always has the assets to cover obligations.
Parties on both sides of the swap are required to do daily risk management and post collateral equal to the amount that would be required if the contract settled that day, as well as enough to cover off potential movements in value that could occur over a couple of days in times of market stress. Higher-risk transactions may require further top-ups to prevent surprises.
CCPs are run for profit, with income from memberships, transaction fees and interest from cash deposits.
“You might ask why the G20 wants this,” says Stephen Ashbourne, a Toronto partner at Blake, Cassels & Graydon LLP. “The financial crisis highlighted the contagion risk in the marketplace where if Bank A goes bankrupt and Bank B is owed a lot of money by Bank A, that can cripple Bank B and cause a chain reaction.
“The CCP is structured to mitigate risk by interrupting the chain reaction.”
In Canada, the Canadian Derivatives Clearing Corporation clears derivatives transactions traded on the Montreal Exchange and is also expanding into some OTC transactions.
But no home-grown CCP champion has emerged to claim the important areas such as currency and interest-rate swaps. Instead, Canadian institutions use a small number of global CCPs such as the Chicago Mercantile Exchange or London-based LCH. Clearnet LLC.
That makes it easier for regulators to track global movement but at the same time leaves the Bank of Canada with reduced regulatory oversight, which is supposed to protect the stability of local financial markets in times of crisis.
In 2011, Deputy Governor Timothy Lane said that the absence of a Canadian CCP was a glaring weakness in the country's regulatory framework, and the central bank spent more than a year studying whether to develop one or work with an offshore player to set one up.
Ashbourne says as far as he knows the idea has fallen off the map.
“I think our regulators would have liked it, that securities regulators would have felt more comfortable knowing that there were boots on the ground here. They would have had more ability to influence things.”
OTC derivatives aren't the only instruments to have emerged from the financial crisis with a bull's eye on their back. The regulation of securitizations has also been targeted for reform.
Traditional securitizations involve bundling receivables such as credit card balances, auto leases, consumer loans or mortgages into a basket, then issuing short-term notes against them.
The notes enjoyed top investment-grade ratings. They were considered very safe by many because they were backed by payments from diversified sources and the risk of default could be spread geographically, across tens of thousands of people and even across industries.
Securitization can be a very effective way for companies that couldn't otherwise tap debt market to access the capital they have tied up in high-quality receivables, and it also allows finance companies other than banks to compete with banks and offer alternative sources of funding.
But as markets became more sophisticated, bankers started putting together synthetic securitizations that copied the performance of one or more real baskets, and even baskets of baskets.
A unique arbitrage market developed in Canada where mostly foreign banks with large synthetic exposures would reduce their risk by selling it to Canadian asset-backed commercial paper issuers. The same bank would provide the liquidity back-stop, and the regulations at the time would deem the bank to have laid off the risk.
Commercial paper is exempt from prospectus-level disclosure provided it is highly rated by an accredited rating agency, so buyers often had only the most generic information about the assets in the basket.
Once synthetics started creeping in, you got the multiplication factor — much like looking into a three-way mirror where you see reflections yourself seeming to stretch into infinity. That meant that when one category of receivables like subprime mortgages got whacked, the impact echoed far beyond the original investors.
Many large Canadian investors were astonished to discover they were exposed to risky US sub-prime mortgages and synthetic baskets through supposedly safe securitizations. The sheer complexity and lack of detailed disclosure fuelled panic, and, as investors stopped rolling the notes over because they were afraid of default, it sparked Canada's asset-backed commercial paper crisis.
As part of the G20 commitments to stamping out systemic risk, the Canadian Securities Administrators put a proposed new national instrument out for comment earlier this year that focuses on increasing the amount of disclosure.
While noting that complex high-risk ABCP is no longer being issued in Canada, the regulators nonetheless designed a whole new framework for prospectus-exempt short-term securitized notes.
“It's six or seven years later and a lot of what's being proposed is closing the barn door after the horses are already out,” says James Rumball, a Toronto partner at Norton Rose Fulbright Canada LLP.
The marketplace has already made many of the recommended changes, Rumball says, such as requiring at least two ratings from different rating agencies and global-style liquidity. Synthetic assets are also effectively banned.
The proposed new Canadian instrument will require “near prospectus-level” disclosure requiring issuers to identify all significant parties, their underwriting guidelines, their asset-eligibility requirements and historical performance — and to provide monthly reports and change reports when something happens.
That will drive up the cost of doing a securitization, says Rumball. That has people concerned. Once transaction costs start to creep towards seven figures, it will begin to make it uneconomical to securitize smaller pools of assets in the tens of millions of dollars range, which makes up a large part of the Canadian securitization market.
“The changes may very well reduce the size of the market, which is already just a fraction of what it was. So ultimately it comes down to the question of whether these changes will improve securitization or hurt it, and how that will affect the economy.”
The increased cost is not the only worry, he says.
There is concern over the effect of disclosing the names of significant parties such as the securitization's originator, which is the business – usually a financial institution – that makes the loans to the consumers and securitizes them.
Up until now, originators have been permitted to keep their identities anonymous from investors.
The trouble with dropping the veil, says Rumball, is that securitized debt will become lumped together with corporate debt from the same originator. That could put institutional investors offside their own internal caps that dictate how much investment they can concentrate in any one particular company.
Investors may also start to differentiate pricing between different issuers, leaving what was once a stable form of funding volatile and unpredictable.
Rumball believes the knockout blow for securitizations in Canada may turn out to be changes to withholding tax rules made several years ago that make it easier for Canadian originators to securitize outside the country.
Given rising costs and the loss of anonymity, those large enough to access capital markets in New York or London may just skip Canada altogether, he says.
“Securitization has shrunk so much in this country. It's really starting to rebound in the United States and Europe — but it hasn't here.
“Policymakers will need to weigh these concerns carefully or there may not be a domestic market for these.”
One of the more interesting revelations to emerge from the financial collapse was that not just retail investors who got caught up in the collapse of the US sub-prime market and subsequent ABCP freeze. It turns out many, if not most, institutional investors were buying sophisticated instruments with little or no understanding of the actual assets that underpinned them.
So as Canadian regulators try to shine the light into the dark corners of high-risk transactions through greater disclosure, many are looking at enlisting a conscript army — the financial advisors and dealers who provide investing advice.
Some of the proposed changes being considered would lift the impetus from investors to understand what they're purchasing and transfer it to the shoulders of those doing the selling.
The CSA and several provinces are in consultations over the appropriateness of introducing a statutory fiduciary duty to act in the best interests of clients.
Carol Pennycook does not believe adding a new level of statutory liability will have the effect regulators are hoping for. She says investors already have all the protections they need, and it's more a matter of enforcing the existing regime that imposes a duty on advisors and dealers to act “fairly, honestly and in good faith” towards their clients, and to understand their risk-tolerance profile through the “know-your-client” rules.
“With sophisticated commercial parties, I get concerned that the rules not be too paternalistic and try to protect people from themselves and making bad decisions, because I just don't think that works.”
With changes coming thick and fast, high-frequency trading has also been placed under intense scrutiny, with regulators using the new generation of infrastructure to tackle issues associated with trades done in nanoseconds.
Many high-frequency traders use dealing and arbitrage strategies to offer liquidity or to move liquidity among markets. The speed at which they buy and sell – driven by software strategies – can affect the stability of equity markets by greatly magnifying volatility.
That was made clear in the so-called flash crash of May 2011, in which the S&P 500 index rose and fell 6 per cent in 20 minutes, with dozens of stocks and exchange traded funds swinging to extreme prices.
The provinces and territories have been working together for the past two years to design a framework to curb potential systemic risk, says Félix Touzin, an associate at Davis LLP in Montreal.
In March, they adopted a national instrument deigned to make market manipulation more difficult.
“Market participants such as dealers have duties as gatekeepers and what this does is institute a number of controls, such as so-called circuit-breakers, or pre-trade risk controls, for dealers who provide direct electronic access to markets to some of their clients,” says Touzin.
“And the same goes for credit risks. This new framework says a dealer that provides direct electronic access is responsible for a client access later not honouring their trade. So they have to ensure the client has sufficient collateral pre-trade, which requires dealers to have risk-management and supervision controls, which will limit their financial exposure.
“The regulators are always looking to make sure markets function efficiently and that a risk of contagion is not there.”
Touzin interned at the Montréal Exchange, where he gained experience working with financial derivatives, and at the Autorité des marchés financiers, where he helped work on the Canadian reform initiatives related to the mandatory clearing of OTC derivatives.
When asked how well he sees Canada's securities regulators working together in this area in the wake of the financial collapse, he replies by saying he has the impression regulators around the world are co-operating more closely than before.
“At the same time, what they can achieve globally is limited. Each and every marketplace is different and needs different approaches.”
In other words, the world may need some kind of Wizard of Oz to pull it off. The man behind the curtain can only do so much.
Sandra Rubin is a Toronto-based writer and strategic consultant.
Lawyer(s)
Firm(s)
Davies Ward Phillips & Vineberg LLP
Stikeman Elliott LLP
McCarthy Tétrault LLP
Blake, Cassels & Graydon LLP
Norton Rose Fulbright Canada LLP
DLA Piper (Canada) LLP