It is safe to say that in the events of 2007-2008 the term “derivative” took a severe reputational beating in Canadian and international capital markets. Commencing with the August 2007 meltdown in the Canadian asset-backed commercial paper market, and following through to massive net asset value (NAV) contractions in many hedge funds using alternate strategies including derivatives, once popular derivatives became the “security that must not be named”. Former champions of derivatives as both good for the markets and good for investors turned reverently towards Omaha and contemplated Warren Buffet’s famous admonition that “derivatives are financial weapons of mass destruction”.
Against this background, it is interesting to observe some “green shoots” with a distinctly derivative flavour that are emerging. In particular, contracts for differences which had started to be available through internet trading in the past several years have now been officially acknowledged by both the Ontario Securities Commission and the Autorité des marchés Financiers in Québec. These instruments permit short-term speculation or hedging on the movements of common shares and other securities without ownership of the underlying security. In a simple CFD, an investor makes a payment to open his position and then is entitled to receive a payment at the end of the contract closing his position. Depending on how the reference investment has fared in the contract period, the payment received on closing the position will be higher or lower than the payment made by the investor on the opening. Akin to the now perhaps unfairly discredited credit default swap, a CFD can be established by any two parties and is similarly unconnected with the “actual” risk of holding the reference investment directly. Another similarity to credit default swaps is that CFDs typically use a high level of leverage – sometimes up to 98% of the nominal amount of the trade.
CFDs therefore definitely appear to be derivatives and thus their distribution raises all the same issues that obtain for other derivatives. In particular, the following issues present themselves:
- adequate risk disclosure to the investor;
- counterparty disclosure including credit worthiness with respect to closing payments;
- the economic impact (“daisy-chain risk”) of creating expanded exposure in the marketplace based on price volatility of the underlying asset;
- liquidity of the instruments;
- whether the regulatory approach should be one of disclosure or in fact regulation of the types of CFDs that may be offered.
Looking around the world, there have been extensive studies in the United Kingdom, the US and Australia of the role of CFDs, and the appropriate regulatory approach. There is little consistency in the different approaches. In the United Kingdom, after extensive consultation, the Financial Services Authority implemented a general disclosure regime of CFD positions with heavy focus on market transparency and the daisy-chain risk of large “secret” positions in the underlying security. In the United States, the availability of CFDs has been severely restricted by over-the-counter financial instrument rules. In Australia, CFDs are both exchange-traded and available over-the-counter.
After the events of 2007 and 2008, there has been a general slowdown in regulatory activity in the derivatives area in Canada. In June 2007, the Investment Dealers Association of Canada published a regulatory analysis of CFDs and the CSA has stated on a number of occasions that it continues to review the area with the objective of bringing forth a coordinated regime for the distribution and trading of derivatives across Canada. In this context, the staff notice, issued in October 2009 by the OSC, seemed somewhat anomalous in that it was dealing with a subject that was part of derivatives but in an interim and limited fashion only. In the staff notice, it is stated affirmatively that CFDs are “securities”, “derivatives” and “investment contracts”. Based on those assertions, the OSC has laid claim to full jurisdiction over the distribution of CFDs even though the IDA Report of June 2007 states “there is some uncertainty as to whether OTC derivative contracts such as CFDs are, or should be, considered to be securities”. The logic of the staff notice is clear, however, when one considers that the OSC simultaneously granted regulatory relief to offer CFDs without a prospectus to CMC Markets Canada. This relief to CMC Markets, a world leader in CFD trading, paralleled similar relief granted by the AMF under the regulatory framework established by the new Québec Derivatives Act. An interesting feature of the Ontario exemption order is that it contains an earlier of four years or introduction of a new rule sunset provision. While the sunset provision implies that work continues on a comprehensive OTC derivatives trading policy for Canada, the four-year expiry provision suggests that we cannot expect to see that rule very soon and so we must infer that progress made to date within the CSA on such a policy is limited.
What we can also infer from this initiative by CMC Markets and the relief granted to it by both the OSC and the AMF is that derivative activity has begun to resurge albeit quietly and we may expect this process to continue. Further, the reputational damage done to the word “derivative” may ultimately be repaired though it is certainly too early to predict when.