In response to perceived concerns about the lack of understanding of the risks associated with investments in derivatives, the Financial Services Commission of Ontario (FSCO) has developed guidelines for pension plans investing in derivatives and similar financial instruments. Currently in draft form, FSCO’s Investment Guidance Note on Prudent Investment Practices for Derivatives is posted for public comment until November 24, 2014.

FSCO’s Note is framed as a set of expectations of those investing in derivatives and is intended to serve as a starting point for plan administrators. It contemplates a system for internal oversight of derivatives practices that is extremely broad in scope and will increase the costs to pension plans that invest directly in derivatives or that invest in pooled funds that use derivatives. The suggestion in the Note is that prudence might require more, but not less, rigorous practices.

FSCO’s Note sets out explicit expectations for documentation, risk mitigation and risk monitoring as follows:

  • Documentation is expected to include more robust authorization regarding derivatives investment and collateral use in the Statement of Investment Policies and Procedures (SIPP) and to include risk monitoring practices (RMP) policies or guidelines relating to derivatives investments.
  • Risk mitigation strategies for over-the-counter (OTC) derivatives should include an evaluation of pricing and other terms and conditions to ensure they are appropriate, and standardized netting agreements. Administrators should also consider appropriate collateral requirements for all derivatives, impose “specific and unambiguous” quantitative limits on a fund’s exposure to derivatives (including “soft limits, where positions must be analyzed, and hard limits, where positions must be liquidated”), and ensure compensation for staff involved in derivatives activities is set to avoid undue risk-taking.
  • Risk monitoring for derivatives is expected to be more precise and frequent than for other investments, including monitoring of market risk, liquidity risk, counterparty risk, basis risk and operations and systems risk. Scenario analysis and stress testing are expected to be carried out.

A notable aspect of FSCO’s expectations regarding risk management and monitoring is the setting of a 10% limit on exposure to derivatives transactions with the same counterparty or associated counterparties. This is similar to the 10% diversification rule for investments under Schedule III to the Pension Benefits Standards Regulations, 1985, which is adopted in Ontario. FSCO’s expectation is that prudence may require a limit lower than 10% to be set. Such a rule would require new levels of monitoring of OTC derivative and repo contracts to ensure that they do not exceed this limit (or such other lower limit as is set by the administrator).

It is also worth noting that FSCO sets out its expectation that administrators will implement appropriate risk management practices and procedures for pooled fund and master trust investments that engage in derivatives transactions. While FSCO recognizes that it may not be possible for a plan administrator to ensure that a pooled fund that is open for investment to unrelated entities meets the standards set out in its Note, FSCO nonetheless sets out due diligence requirements with respect to pooled fund investments that may involve derivatives, including reviewing the pooled fund constituent documents and considering whether the operation of the pooled fund meets the standards set out in FSCO’s Guidance Note.

Based on our experience, FSCO would welcome comments from the industry. If you have concerns about the new guidelines, you should take advantage of the opportunity to provide FSCO with your comments.