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Canada’s securities regulators prepare new rules for derivative sales

STOCK IMAGE - NOT ASSIGNED - Toronto, Ontario - June 2, 2014 -- BAY STREET -- A Bay street sign is seen in the financial district in Toronto, Monday June 2, 2014 (Mark Blinch for the Globe and Mail)

Mark Blinch/The Globe and Mail

Canada's securities commissions are introducing new rules to govern the sale of derivatives such as interest-rate swaps as part of a global effort to bring more oversight to a murky and largely unregulated segment of the financial industry.

The Canadian Securities Administrators, an umbrella group for Canada's provincial and territorial securities commissions, unveiled proposed new rules Tuesday to govern sales of derivatives, modelling them on existing rules for the sales of other securities such as stocks.

The rules will apply to over-the-counter (OTC) derivatives, which are products that do not trade on a securities exchange and encompass the most commonly used derivatives in Canada. They include currency and interest-rate derivatives, which are bought not just by sophisticated institutional investors, but also by individuals and small companies seeking to hedge themselves from the risks of rate swings.

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"The main goal is to protect investors against market abuse," said Kevin Fine, director of the derivatives branch at the Ontario Securities Commission.

Under the new rules, firms selling OTC derivatives will have to gather information on clients to meet "know-your-derivatives party" obligations – and ensure the products are suitable for the buyer and meet their investment needs. Sellers will be subject to rules about fair dealing and pricing and conflicts of interest.

Similarly to other securities rules, some buyers of derivatives – including large institutional investors – can be designated as sophisticated purchasers, which reduces some of the obligations on firms selling the products.

In practical terms, the new rules will not create an entirely new regime for retail investors because financial advisers who are licensed by the industry's self-regulatory body, the Investment Industry Regulatory Organization of Canada (IIROC), already had to follow IIROC conduct standards when selling derivatives to retail clients, so many similar standards already apply. Most major financial institutions also have controls and supervision on sales of all securities to clients, which would typically also cover derivatives sales.

However, the new rules will create new standards to protect institutional buyers, and will particularly fill a gap for those firms that specialize in derivatives products and are not subject to other securities oversight.

They also contain a feature that is not present in standard securities conduct rules that will hold managers directly liable for wrongdoing by the traders they supervise. Britain introduced the standard in its derivatives regulations, Mr. Fine said, and Canadian regulators decided to include it as well to ensure senior managers have a strong incentive to watch what their staff are doing.

The regime was designed to match similar rules introduced in other major countries, which pledged to crack down together on unregulated derivatives trading in the wake of the 2008 financial crisis, Mr. Fine said.

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"We are a little bit behind in terms of international jurisdictions having these types of business conduct rules for their derivatives dealers, so it's an important milestone for us in the regulation of these products in Canada, bringing us up to these international standards," he said.

The regulations are part of a broader package of derivatives reforms being rolled out as part of Canada's global commitments.

Securities commissions, for example, introduced a system in 2014 requiring firms to privately report all derivatives trades to regulators, then introduced public trade reporting in the most popular derivatives as of January this year. As of this week, firms are also required to transact trades in the most liquid OTC derivatives through a clearing house rather than clearing them internally, which reduces systemic risks in case of financial problems at a company that is a party to trades.

Regulators are also working on a new system to register many participants in the derivatives market, including derivatives dealers, and are expected to publish those proposed rules this summer.

The business conduct rules unveiled Tuesday are open for public comment for 150 days until Sept. 1, which is a lengthy period. Mr. Fine said the time frame is so long because regulators hope to publish the registration rules in the interim so that investors and industry participants can provide feedback on both together.

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About the Author
Real Estate Reporter

Janet McFarland is the real estate reporter for The Globe and Mail’s Report on Business, with a focus on residential real estate trends. She joined Report on Business in 1995, and has specialized in reporting on corporate governance, executive compensation, pension policy, business law, securities regulation and enforcement of white-collar crime. More

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