Securities regulators in Ontario and Quebec have spent the past couple of years retooling their oversight of derivatives trading. But with these markets now affected by unprecedented turmoil in the financial markets, reforming their regulation has become a global priority.

Long before the current financial market mayhem developed, Canadian regulators were working to modernize their derivatives regulation.

There are parallel efforts underway in both Ontario and Quebec, but Quebec’s efforts are more advanced. The Autorité des marchés financiers has crafted a whole new principles-based model for derivatives market oversight. In June, the province’s national assembly passed legislation to implement that new model.

Ontario is further behind. The province has commissioned a review of the sector’s legislation, the Commodity Futures Act. The results of that review, which recommended a new regulatory framework, were delivered to the legislature in early 2007 and were referred to the standing committee on finance and economic affairs in April of that year; however, the committee has yet to review the report and make any recommendations to the government.

Carol Pennycook, a partner with Davies Ward Phillips & Vineberg LLP in Toronto and chairwoman of the CFA review committee, suggests that the report is likely to be moved forward soon at the committee level. However, she adds, new regulation is unlikely to be introduced with global reforms also under consideration.

“One of our committee’s strongest recommendations was that Ontario recognize the global nature of commodities and derivatives trading,” Pennycook says, “and ensure that any new legislation was compatible with the global marketplace.”

Indeed, there is no shortage of international attention being directed at the derivatives markets. Throughout the summer, spiking oil prices brought cries of market manipulation and allegations that speculators were driving the action — the latter claim that was dismissed by regulators in the U.S. who studied the issue.

Since then, oil prices may have eased significantly, but attention has instead swung to the credit derivatives market. The huge growth in credit-default swaps, and the resulting increase in the importance of this segment to overall global financial markets, is only now being recognized as the credit cycle has taken an abrupt turn and defaults are rising.

Moreover, the fact that huge financial institutions — once thought to be unassailably stable and secure — have collapsed with staggering speed has intensified fears about their role as counterparties in these markets.

According to Christopher Cox, chairman of the U.S. Securities and Exchange Commission, the US$85-billion bailout of insurance giant American International Group Inc. was motivated largely by the firm having written US$440 billion in CDSes, and so the government feared the systemic implications of allowing it to fail.

Similarly, the decision to allow New York-based brokerage firm Lehman Brothers Holdings Inc. to fail has been criticized for inciting fear in the market about other firms’ exposures to Lehman, including its CDS positions, aggravating suspicion about the health of all other counterparties.

Additionally, the decline in the fortunes of numerous financial services firms may have been hastened by widening CDS spreads, which communicated the progressive loss of confidence in those firms as market counterparties.

Not only is the CDS segment of the market proving to be systemically significant, but it has also become very big, very quickly.

Although the failure of AIG may have posed a large risk in itself, it is small in comparison to the overall size of the CDS market, which the International Swaps and Derivatives Association reported to be more than US$62 trillion in notional value at the end of 2007 (declining to slightly less than $55 trillion by mid-2008).

The CDS market’s growth has also been very rapid. The ISDA began to survey the market in 2001, at which point the notional value of the market was less than US$1 trillion.

That this huge market functions with little or no oversight, and that it is now being recognized to pose a significant risk to overall financial market stability, is driving calls for increased regulation.

The New York-based research firm CreditSights Inc. suggests that regulatory concerns fall into three basic categories: lack of transparency, counterparty risk and market risk.

Lack of transparency means that neither investors nor regulators can get a clear picture of which credits are systemically significant, nor can they accurately assess the ability of various counterparties to hold up their end of any given deal. There’s also the risk that this uncertainty spills over into other venues, such as equities markets.

@page_break@The result is significant systemic risk, which “is particularly serious in the current stressful economic environment, contributing to a gravitational pull that stands to drag everyone down,” says Cox.

As a result, Cox has called on Congress to come up with legislation that would demand more transparency from the CDS market and give regulators oversight power. He suggests that the legislation could require traders to report their trades publicly, and it could also push the use of exchanges and central counterparties rather than leaving the business to operate over the counter.

Of course, the concerns about the operation of derivatives markets goes well beyond the U.S. In early October, the technical committee of the International Organization of Securities Commissions also announced the creation of a task force to examine the evolution of commodities futures markets and whether regulation is keeping pace amid increased globalization, product innovation, technical development and greater investor participation.

IOSCO says that the decision to establish a task force comes in response to national regulators’ concerns about the growth of, and increased volatility in, these markets.

According to IOSCO communications officer David Cliffe, the task force, which is to be led by the U.S. Commodities and Futures Trading Commission and Britain’s Finan-cial Services Authority, is still being formed, but it is expected to report at the technical committee’s next meeting, slated for February.

It remains to be seen how the existing Canadian efforts may be influenced by these emerging global initiatives. In addition, the Council of Ministers, which oversees provincial securities regulators, has asked the Canadian Securities Administrators to review derivatives legislation in Canada and to develop recommendations for harmonized legislation.

The Ontario Ministry of Finance says it is monitoring developments in the financial markets, and that this will be incorporated into any policy coming out of the review of derivatives legislation it had commissioned.

“We expect that the government’s response to the CFA advisory committee report will be informed by recommendations being developed by governments, central banks and regulators in Canada and internationally to respond to the current financial market turmoil,” says ministry media relations officer Scott Blodgett.

Meanwhile, in Quebec, things seem to be moving ahead. The AMF recently released draft regulations for comment that would implement its new legislation. That period for comment from interested parties closed on Nov. 3.

Michael Bantey, a partner with Blake Cassels & Graydon LLP in Montreal, says that he is a bit surprised that the AMF is putting forward regulations. However, he points out that these are just a draft at this point, and that they don’t cover certain issues that will surely require clarification — so they are likely not the AMF’s final word on derivatives regulation.

Moreover, neither effort in Canada contemplates much oversight of the OTC markets, focusing instead on the exchange-traded component.

Both provinces have concluded that retail investors may need protection in the OTC market, but that institutional investors generally do not.

Yet, it’s in the institutional OTC market that the systemic problems have emerged in the CDS segment, and where major reforms are being pushed forward in the U.S.

Concern about the lack of transparency in the OTC derivatives market have been around for some time, but only recently has this lack of transparency been treated with a sense of urgency, now that the effects of CDS market opacity have become obvious. For several years, the Federal Reserve Bank of New York has been working with market players to improve the operation of the credit-derivatives market. But the focus was on enhancing efficiency, rather than on preserving system stability, by reducing the backlog in trade confirmations, improving controls and settlement procedures.

Now the focus has shifted more toward systemic stability. In the summer, the New York Fed hosted a meeting with major market players at which they agreed to develop a central counterparty for CDSes, among other changes designed to improve market operations.

In mid-October, the New York Fed held a meeting with four potential candidates for the role of the central counterparty (Eurex, NYSE Euronext, CME Group/Citadel, and Intercontinental Exchange/The Clearing Corp.).

According to Moody’s Investors Service Inc., the adoption of a central counterparty could “substantially reduce, although not completely eliminate” counterparty and other risks, along with limiting leverage and excessive credit exposure.

Another solution would be to push more trades onto exchanges, where they can be standardized and more closely scrutinized by both regulators and investors.

CreditSights reports that efforts to drive OTC trading onto exchanges have been tried before but have never caught on, largely due to dealer resistance.

“Part of the reason why the prior efforts never reached critical mass for liquidity is because they were largely ignored by the dealer community, and thus, in turn, the buy-side community,” it notes.

Now, both exchange and central counterparty solutions are under consideration.

“We would hope that the market gets both types of facilities set up — a central clearing facility and an exchange for certain products,” says CreditSights. “Either way, we believe that increased market clarity is on its way — either via centralized clearinghouses or increased regulatory reporting requirements.”

Nevertheless, it doesn’t believe that the OTC market will disappear.

As these solutions begin to take shape, they will surely have implications for the Canadian markets, either because of increased exchange trading or by bringing pressure for greater oversight of OTC markets.

There’s no question that the massive derivatives markets aren’t going away, but they’re sure to look much different coming out of this market turmoil from how they looked going in. IE