Rapid growth and seem-ingly unlimited potential are making the derivatives market an intensely contested battlefield in the major markets. In Canada, the rules of engagement are still being established in the two biggest theatres of war, Ontario and Quebec.

Overlooked by regulators and legislators for years, the derivatives market now is getting plenty of attention, and the push to overhaul its regulation is chugging along.

In late March, Gerry Phillips, Ontario’s minister of government services, tabled the final report of a committee chaired by Carol Pennycook, partner with Toronto-based law firm Davies Ward Phillips & Vineberg LLP. It had been given the task of reviewing the regulatory regime for Ontario’s derivatives market. The report, which calls for new legislation to oversee the burgeoning market segment, must now be referred to a legislative committee for further consultation before legislation can be drafted.

Meanwhile, in Quebec, the Au-torité des marchés financiers has been going through a similar exercise. Last May, it published a concept paper that spelled out a proposed new regulatory framework for the regulation of derivatives in the province. Earlier this year, the AMF published a summary of the comments it has received on the proposal, along with its responses to many of the comments. Daniel Laurion, AMF executive director, special projects, says that the AMF expects to have a first draft of its new act and regulations published in French by the end of June.

Additionally, the recent federal budget proposes measures to aid the development of the derivatives market. It promises amendments to bankruptcy legislation that should give players in the market more certainty that they will be able to collect on collateral pledged to cover derivatives transactions in the event that a counterparty goes bust. The authorities in the U.S. and Europe have already made similar changes to their bankruptcy laws, and the federal Finance Department aims to follow suit to ensure that Canadian laws keep pace.

All of this is coming at a time when the derivatives market continues to grow impressively, in both the over-the-counter and the exchange-traded varieties. The latest data from the International Swaps and Derivatives Association show the outstanding notional amount of OTC derivatives was US$327.4 trillion at the end of 2006, and data from the Bank of International Settlements show there was another $71 trillion outstanding in exchange-traded derivatives.

Moreover, total turnover in exchange-traded options was up about 35% during the year, and futures trading was up 25%. The growing volumes are inspiring intense competition among the exchanges that trade such sorts of contracts.

In Canada, Montreal Exchange Inc. has effectively had a monopoly on exchange-traded derivatives since 1999, when a stock market reorganization took place. That comes to an end in less than two years, and TSX Group Inc. of Toronto recently announced its intention to launch a new market of its own once the handcuffs come off. In March 2009, it plans to introduce the DEX, in partnership with U.S.-based International Securities Exchange Holdings Inc.

Of course, Canada is far from the only battleground. In the U.S., a three-way takeover fight is underway among some of the biggest derivatives markets after Intercontinental Exchange Inc. moved to disrupt a proposed merger between the Chicago Mercantile Exchange and the Chicago Board of Trade. The ICE seeks a deal of its own with the CBOT.

Getting more deeply into derivatives is also on the minds of the two big U.S. stock exchange rivals, Nasdaq Inc. and NYSE Group Inc. , which see derivatives as a growth opportunity that’s developing faster than the traditional equities trading business.

The organizational jousting reflects expectations for continued derivatives growth. The boom seems likely because the supply of products is limited only by human ingenuity; plus, the increasing need for risk-management instruments among companies, institutional investors and others promises to keep driving demand.

The Canadian market appears to have plenty of room to grow as well. Currently, the exchange-traded derivatives market is far smaller than the size of our capital markets suggests it should be. Analysts offer a variety of reasons, including that a lot of the larger players prefer to trade over-the-counter and retail participation is very low compared with other jurisdictions.

Additionally, the regulatory regimes in Canada have not kept up with developments in the global markets. Modernizing the regulatory regime, while hardly a silver bullet for the growing pains of the Canadian market, should help the situation by making oversight more flexible and efficient. It would shore up investor confidence, encourage competition in the sector and facilitate cross-border access and trading. It is also long overdue.

@page_break@The review carried out in Ontario represents the first time legislation has been comprehensively examined since it was introduced in 1978. The committee found the existing Commodity Futures Act so woefully out of date as to be beyond salvation. Instead, the committee proposes that new legislation must be developed to govern the area, and its recommendations sketch out how it believes that legislation should look.

It proposes a largely principles-based model for the regulation of exchange-traded derivatives, set out in separate legislation rather than folded into existing securities legislation, as occurs in some other provinces. The AMF concept paper proposes a similar approach.

The prospect of a principles-based system is appealing to many market players and to regulators, which see it as an opportunity to get away from the rigid rules-based world of securities regulation. Some worry, however, that an excessively principles-based regime could create too much uncertainty. Firms don’t want to be bound by rules, but they do want to know when they are likely to be found offside with something.

A principles-based regulatory regime would be so different from the existing regime of securities legislation that the committee reviewing the commodities act has concluded that it requires its own legislation.

Some in the industry see the step as unnecessary fragmentation of financial market regulation, preferring that derivatives legislation be bundled with existing securities laws.

The act review committee, however, says that integrating derivatives regulation into the existing securities legislation would be tricky, and would probably delay the introduction of sorely needed reforms.

“It would be difficult to implement a core principles model of regulation into the largely rules-based regulatory scheme of the [Securities Act] unless it was also being amended to move to a core principles-based model of regulation,” the committee report states.

Given that such a reform of securities legislation is unlikely — at least, in the near future — the committee recommends pushing ahead with a separate act despite some possible risks. Such drawbacks include: the fragmentation of regulation; that the preservation of two separate regimes adds uncertainty; it may cost more to administer; and it could cause growing divergence between the regulatory regimes for securities and derivatives over time.

The proposed approach for derivatives is somewhat different from the one used in some other provinces, where derivatives are captured under securities laws but largely exempt from regulatory requirements. Nevertheless, the report from Ontario’s committee notes that “compatibility” with the regimes in other jurisdictions is desirable, rather than harmonization.

Indeed, it suggests that ensuring compatibility with the relatively new regulatory regime for derivatives in the U.S. is at least as important as it is among provinces.

Although both Ontario’s review committee and the AMF indicate that developing compatible regimes is important, the one area they disagree on is how to deal with the OTC market. Both agree that there really isn’t a role for regulators in the institutional end of the OTC market, but that there should be one when it comes to retail investors. Yet they differ about how to get there.

The AMF maintains that it should claim jurisdiction over the entire OTC market, providing exemptions for the sophisticated investors. Ontario’s review committee proposes an opposite approach — that regulators should seek to claim jurisdiction over only retail investor involvement in the OTC market. Additionally, the committee stresses that the priority should be to develop the new, modern legislation for the exchange-traded portion of the market. In the meantime, it recommends that the government provide guidance to the Ontario Securities Commissionas to the regulation of derivatives in the retail OTC market.

Comments submitted on the AMF proposal suggest that many in the derivatives industry prefer Ontario’s approach. In its response, however, the AMF maintains that “protecting small investors and detecting instances of manipulation require a certain degree of authority to intervene in these markets.” That said, the AMF says that there should be a harmonized solution to the issue for both Ontario and Quebec, suggesting that it may be open to adopting Ontario’s proposed approach.

Along with the basic structure of the new regime, the content is equally critical.

The Ontario committee recommends that a principles-based regulatory regime apply to exchanges, clearing houses, self-regulators and market players. It says exchanges and clearing houses should be subject to the “recognition or exemption” approach to approving their market participation, and they should also be able to self-certify their rules, subject to oversight from the OSC. SROs should have to be recognized by the OSC, and the committee says that self-certification should be also considered for them.

One area that the committee doesn’t really deal with is updating registration requirements for dealers. It notes that the current regime is outdated and increasingly diverging from the securities world, but it suggests the matter should be addressed once the Canadian Securities Administrators’ registration reform project is complete.

Notably, reform of dealer registration requirements is one development that analysts suggest could serve as a real catalyst for growth of the exchange-traded derivatives market by inviting much greater retail participation. IE