As previously reported, staff of the Ontario Securities Commission (OSC) has issued welcome guidance in the absence of clearly articulated restrictions on the re-hypothecation of collateral supporting specified derivatives transactions in portfolios of prospectus-qualified investment funds. The guidance, however, also serves to highlight some of the challenges faced by portfolio managers, their counterparties and legal advisers when it comes to managing these derivatives portfolios on a basis that is both compliant with the very technical rulebook governing transactions in “specified derivatives” under National Instrument 81-102 Investment Funds (81-102) and consistent with standard market terms and practices in the broader OTC derivatives industry.
OTC derivatives markets reform is gradually taking shape in the major global derivatives markets. As the contours of this new regulatory order begin to settle in the United States and Europe, the Canadian Securities Administrators (CSA) and federal regulators continue to piece together a made-in-Canada framework of rules that will mandate, among other changes, derivatives trade data reporting, central counterparty clearing, registration, trading and custody of OTC derivatives and enhanced custody and collateral requirements for non-cleared derivatives. Here, as in other markets, these new ground rules are being specifically developed to address systemic, counterparty, liquidity, credit and other key risks in the Canadian and cross-border OTC derivatives market and to make that market more transparent, liquid and safe
Against this backdrop, the investment funds branches of the CSA are also working to develop a framework of new rules that would govern prospectus-qualified alternative investment funds. As the regulatory foundation underlying OTC derivative transactions firms up, the opportunity seems particularly ripe for the CSA to repeal the prescriptive, complex and operationally challenging rulebook for “specified derivatives" in favour of a more principles-based prudent portfolio manager standard for the management of the derivatives portfolios of regulated investment funds or, failing that, an updated set of investment restrictions which, with respect to OTC derivatives at least, more closely reflects industry terminology and current market practices.
In its April 2014 edition of the Investment Funds Practitioner, the Investment Funds and Structured Products Branch of the OSC states its view that the collateral deposited by an 81-102 regulated investment fund with a counterparty to support a “specified derivatives” transaction may not be re-hypothecated by the counterparty.
The guidance states that 81-102 provides a limited "carve-out" from the broader custody rules prescribed by 81-102 for the safekeeping of mutual fund assets. Under this limited carve-out, assets of the mutual fund may be deposited with a counterparty for the sole purpose of effecting a specified derivatives transaction. In staff’s view, “the counterparty stands in the place of the custodian to safeguard the portfolio assets deposited with it”.
Although re-hypothecation would reduce transaction costs to the fund, it would, in staff’s view, subject the collateral to “risks inconsistent with the core restrictions” in 81-102 because the collateral carve-out permits “all or substantially all of a fund’s assets to be deposited with a counterparty". As a practical matter, however, an 81-102 investment fund may not, absent specific discretionary relief, have mark-to-market exposure to a single counterparty greater than 10% of the net asset value of the fund. It is unlikely therefore that all or substantially all of its assets would be pledged as collateral in favour of a single counterparty. Staff’s risk assessment on this count might therefore be somewhat overstated.
Other collateral guidance
Staff’s views on re-hypothecation comes with further guidance to the effect that “[g]iven this interpretation, we remind fund managers of their responsibility to ensure that any agreement documenting the OTC derivatives transaction (such as the ISDA or other agreement) prohibits the counterparty from using the collateral for any purpose other than the purpose for which it was originally pledged to the counterparty, namely, the completion of the "particular specified derivatives transaction". Further, our view is that a fund manager must ensure that any documentation evidencing the terms of a specified derivatives transaction: (i) adequately protects the investment fund's portfolio assets from counterparty credit risk, (ii) limits the purpose for which collateral has been deposited by the investment fund to that of the completion of the derivatives transaction consistent with NI 81-102, and (iii) limits the ability of the counterparty to deal with portfolio assets deposited by the investment fund as collateral, in a manner that is consistent with the ability of the fund's custodian to deal with the fund's assets under custody."
Managers of 81-102 governed portfolios may want to revisit their supporting documentation and collateral arrangements in light of this guidance.
The guidance on collateral for specified derivatives is welcome but certain longstanding conceptual difficulties with the specified derivatives restrictions remain. These restrictions have been the subject of detailed commentary by market participants (see, for example, the October 17, 2002 and December 19, 2008 comment letters by ISDA). Certain of these difficulties continue to raise a number of technical compliance issues which complicate the negotiation of standard OTC derivatives arrangements on behalf of an 81-102 regulated mutual fund. The CSA’s current initiative in developing a regulatory framework for prospectus-qualified alternative investment funds may be an opportune time to rethink the specified derivatives rulebook in the context of current OTC derivatives rulemaking initiatives in Canada, similar regulatory initiatives in the United States (see, for example, Use of Derivatives by Investment Companies under the Investment Company Act of 1940, Release No. IC-29776 (Aug. 31,2011), 76 Fed. Reg. 55237 (Sept. 7, 2011)) and elsewhere and current market practice. Making these rules more simple to interpret and apply may be a win-win for all industry stakeholders.