Securities regulation has grown into an unwieldy monster over the years as reams of rules were created to keep pace with the industry’s constant evolution. Now, Canadian regulators are zeroing in on the booming derivatives sector, hoping to build a dream regime that may act as an example for the rest of the securities markets.

In late May, the Autorité des marchés financiers published a concept paper that proposes a new regulatory regime for the derivatives market in Quebec. It imagines a system which, given its druthers, the industry might prefer for the securities markets as a whole: flexible and principles-based, with oversight focused on transactions involving retail investors yet aloof from trades between sophisticated market players.

The proposal sees a new Derivatives Act crafted around core principles rather than prescriptive rules. “Regulation based on core principles would allow for rapid adaptation to changing business structures, the introduction of new products and market developments. It would also reduce the regulatory burden without affecting the quality of supervision,” the paper says. Regulators would be left to “focus on policy development, inspections and investigations.”

The push for a new regulatory regime comes amid continued strong growth in the derivatives sector worldwide. The latest data from the Bank for International Settlements show that derivatives trading is on fire. Trading in interest rate, equity index and currency contracts increased by about 25% in the first quarter of 2006 to US$429 trillion.

The Canadian market is enjoying even stronger growth. The Montreal Exchange reported a 44% increase in trading volume in its first quarter of this fiscal year, driven by strong gains in trading interest rate products and a 34% increase in equity options trading.

This robust growth in trading, plus the pressure for consolidation in the exchange business, is focusing attention on the derivatives area as the world’s leading equity markets target derivatives as a key growth opportunity. The trends are driving regulators’ interest as well.

“We want Quebec to be equipped with modern and flexible regulatory instruments that are in step with developments in the sector and take into account market realities in Canada and throughout North America,” AMF president and CEO Jean St-Gelais said in releasing the paper.

The AMF suggests the kind of model it is proposing “would allow this expanding market to continue developing efficiently, without the traditional constraints that hamper growth and are poorly suited to the reality of such a market.”

Under its proposed regime, market players such as exchanges and clearing agencies would be recognized by the regulator, then those players would largely be responsible for overseeing the firms trading under their auspices. Those agencies would develop rules on proficiency, solvency and other registration requirements. They would also be able to “self-certify” their rules rather than waiting for approval from the securities commission to make a rule change.

The paper proposes a broad definition of derivatives, which would give the AMF jurisdiction over all types of existing and future derivatives contracts. Over-the-counter products traded between sophisticated parties would be exempt, however. “The AMF would intervene only when these products are offered to retail investors, or in the case of fraud or market manipulation,” the paper notes.

Many of the same concepts probably would be welcomed by the securities industry for the overall markets, not just for derivatives. When the B.C. Securities Commission looked at its regulatory regime from the ground up and proposed a shift to a more principles-based model, many of its ideas won broad support from the industry. Concerns about lack of harmonization with the rest of the country dogged the BCSC model, but many of its basic ideas were praised.

In this case, harmonization is also an issue. The AMF’s concept proposal is out for comment until July 25. Since it was released, the Ontario Commodity Futures Act advisory committee, a committee appointed last year by Minister of Government Services Gerry Phillips, came out with its own paper addressing many of the same issues and soliciting comment on the regulation of derivatives trading in Ontario. Comments on this interim report are requested by July 14. The final report is expected to be filed by Sept. 30.

In the interim Ontario report, the committee recommends that the existing legislation be repealed and replaced. It doesn’t expect this recommendation to be controversial, the report says: “The more difficult issues are whether the new legislation should be separate legislation or a scheme of regulation integrated into the [Ontario Securities Act], and what the broad content of that legislation should be.” The details, in other words, are critical.

@page_break@On the basic issues, the Ontario committee echoes the AMF. It recommends that the new regime be set out in new legislation or a separate section of the Securities Act rather than bundling it into the existing securities laws or using rules, as Ontario Securities Commission staff have recommended. The committee recommends that the regulatory framework be principles-based, not rule-heavy.

“Ontario should work with Quebec and other Canadian jurisdictions to endeavour to define a set of common core principles,” the interim committee report states. “In doing so, it should consider core principles which have been adopted in other jurisdictions, such as the U.S.”

The AMF paper notes that complete uniformity among provinces isn’t necessary, particularly as Quebec is currently the only jurisdiction with a derivatives exchange. It does, however, recommend striving for harmonization.

These efforts to harmonize and pursue a principles-based system are meeting with initial praise. In response to the publication of the AMF paper, the ME indicated that it is pleased with the proposal and its commitment to harmonize the proposed rules with the other provinces and with international principles.

It remains to be seen if the regulators can put together a relatively progressive regime, a step that would stand in contrast to recent regulatory history. The AMF acknowledges that introducing a new approach to regulation can “give rise to uncertainty” but, it says: “We believe that the regulation of this industry segment justifies as much imagination in the development of new legislative and regulatory tools as is displayed by the market.”

Indeed, a modern and flexible regulatory regime would surely be welcomed by the rest of the securities industry players well beyond the derivatives business. Undertaking such a wholesale shift, however, from one type of regulatory system to a fundamentally different model — such as moving from a rule-heavy system to a lighter, principles-based regime — typically demands some sort of “big bang.” It is not something that can be done incrementally, which is how most regulatory reform happens nowadays.

In British Columbia, the catalyst for its proposed move to a more principles-based regime was a province-wide effort to reduce its regulatory burden. In Britain, new securities legislation was adopted as part of a fundamental public policy shift that saw the government scrap self-regulation and merge all its regulatory authorities into a single body. As a result, it was able to build a system that largely aims to leave market discipline to police the wholesale side of the business, while focusing regulatory attention on protecting retail financial clients and correcting market failures.

Now, recognition of the apparent need for modern regulation in the derivatives business is allowing a similar sort of rethinking about the best way to oversee that aspect of the markets. Whether the same type of reform could happen in the mainstream securities world seems like a very long shot. As the B.C. experience shows, it’s hard to make dramatic reforms in the current fragmented system.

Under a single regulator, major reform may well be easier, and the prospect of a single regulator is still the subject of much discussion. Ontario is still committed to the idea, and the Purdy Crawford panel is championing the cause. So is the new federal finance minister, Jim Flaherty.

The sort of provincially led model that’s now being touted, however, seems an unlikely vehicle for dramatic reform. If it were to succeed, it would probably mean creating a body that remains beholden to numerous provincial masters. Either way, conditions don’t yet appear ripe for a full-fledged overhaul.

In the meanwhile, regulators will have to content themselves with the project of building a more compelling system in the derivatives area. If it works, perhaps it will eventually inspire even greater reform. IE