On October 1, 2014, the Office of the Superintendent of Financial Institutions (OSFI) released draft Guideline B-7 Derivatives Sound Practices (Guideline). The Guideline, a copy of which can be found [here], applies to federally-regulated financial institutions (FRFIs). OSFI first set out its expectations for FRFIs regarding their derivative activities in the guideline that it published in May 1995. The current updates to the Guideline are intended to enforce reforms for the over-the-counter (OTC) derivatives market introduced by G-20 leaders.
SCOPE OF APPLICABILITY
Effective November 1, 2014, the Guideline will apply to all FRFIs and their subsidiaries, as well as the Canadian branch operations of foreign institutions. FRFIs include banks, bank holding companies, federally regulated trust and loan companies, co-operative associations and federally regulated insurers. FRFIs may use derivatives as end-users, active position-takers and dealers. Depending on the categorization of an individual FRFI, there are different guiding principles that apply. The Guideline considers a FRFI as: i) an end-user when it uses derivatives to take positions as part of its proprietary trading or for hedging; and ii) a dealer when it quotes bids and offers and commits capital to meet customers’ demands for derivatives.
RISK MANAGEMENT FOR DERIVATIVES
The Guideline reflects sound practices that FRFIs should adopt with respect to the risk management of derivatives activities, some of which are highlighted below:
- a FRFI’s derivatives activities should be consistent with its Risk Appetite Framework1 and be subject to risk limits approved by its board of directors
- a FRFI should clearly define the nature and types of incidents that would require escalation to senior management or to its board of directors
- a FRFI should have a strong governance process concerning the valuation of derivatives, including control processes and document procedures
- the sophistication of a FRFI’s approach to risk measurement and stress testing should match its activity in the derivatives market and the complexity of its positions
- the assumptions and parameters of a FRFI’s measurement of market risk should be frequently reviewed against actual experience and updated market information
- FRFIs should take all relevant valuation adjustments into account when pricing derivatives
- enterprise-wide credit risk management function of FRFIs should be independent of individuals and units that conduct trades and create risk exposure, with clear authority and responsibilities as outlined in the Guideline
- FRFIs should apply binding limits regarding counterparty exposures for derivatives trading and settlement
- internal credit risk ratings and counterparty credit limits should be established for central counterparties on a risk-adjusted basis
- all central clearing of standardized derivatives by FRFIs should be done through qualifying central counterparties (QCCPs), including recognized global QCCPs
- bi-lateral and multi-lateral netting agreements with counterparties should be put in place in order to reduce counterparty credit risk exposure
- reasonable steps should be taken by FRFIs dealing in derivatives to identify and address potential material conflicts of interest
- FRFIs should maintain systems infrastructure that meets the size and complexity of its derivatives activities and
- FRFIs should periodically engage in portfolio compression, as well as in portfolio reconciliation of uncleared derivatives with counterparties with whom the FRFI has a material number of derivatives outstanding in order to resolve any discrepancies.
The Guideline provides an updated internal measurement model that should be used by dealers and active position-takers to identify and aggregate risk. Furthermore, a FRFI is required to fully support its risk exposures in its derivatives activities by having sufficient capital. A FRFI should engage in a capital adequacy analysis, which should address its potential for material loss resulting from derivatives-related risks.
REPORTING TO TRADE REPOSITORIES
The Guideline requires each FRFI to report, or cause to be reported, derivatives transactions to a recognized trade repository (TR) in accordance with provincial securities regulation. OSFI will monitor a FRFI’s compliance with these local reporting requirements and each FRFI should include an assessment of such compliance in its annual compliance report to the OSFI.
OSFI recognizes that global aggregation of TR data is a complex issue and continues to follow international developments regarding the access to data by authorities. Meanwhile, a FRFI should use its best efforts to enable OSFI to access derivatives data reported to a TR.
The Guideline should be read in conjunction with other relevant OSFI guidance, which are referred to in the Guideline.