Headnote National Policy 11-203 Process for Exemptive Relief Applications in Multiple Jurisdictions – relief from certain specified derivatives and custodial requirements to permit mutual funds to enter into swap transactions that are cleared through a clearing corporation – relief required because of new U.S. requirements to clear over-the-counter derivatives including swaps - decision treats cleared swaps similar to other cleared derivatives – National Instrument 81-102 Mutual Funds
Applicable Legislative Provisions
National Instrument 81-102 Mutual Funds, ss. 2.7(1) and (4), 6.8(1), 19.1
December 16, 2013
IN THE MATTER OF THE SECURITIES LEGISLATION OF ONTARIO
(the Jurisdiction)
and
IN THE MATTER OF
THE PROCESS FOR EXEMPTIVE RELIEF APPLICATIONS IN MULTIPLE JURISDICTIONS
and
IN THE MATTER OF 1832 Asset Management L.P. (1832)
DECISION
Background
The principal regulator in the Jurisdiction has received an application (the Application) from 1832 (the Filer), pursuant to section 19.1 of National Instrument 81-102 – Mutual Funds (NI 81-102), on behalf of existing and future mutual funds that are subject to NI 81-102, that are permitted to enter into Swaps (as defined below) and for which the Filer or an affiliate of the Filer acts as manager or portfolio advisor or both (each, a Fund), for an exemption from:
(a) the requirement in subsection 2.7(1) of NI 81-102 that a mutual fund must not purchase an option or a debt-like security or enter into a swap or a forward contract unless, at the time of the transaction, the option, debt-like security, swap or contract has a designated rating or the equivalent debt of the counterparty, or of a person or company that has fully and unconditionally guaranteed the obligations of the counterparty in respect of the option, debt-like security, swap or contract, has a designated rating;
(b) the limitation in subsection 2.7(4) of NI 81-102 that the mark-to-market value of the exposure of a mutual fund under its specified derivatives positions with any one counterparty other than an acceptable clearing corporation or a clearing corporation that settles transactions made on a futures exchange listed in Appendix A to NI 81-102 shall not exceed, for a period of 30 days or more, 10 percent of the net asset value of the mutual fund; and
(c) the requirement in subsection 6.1(1) of NI 81-102 to hold all portfolio assets of a mutual fund under the custodianship of one custodian in order to permit each of the Funds to deposit cash and portfolio assets directly with a Futures Commission Merchant (as defined below) and indirectly with a Clearing Corporation (as defined below) as margin.
in each case, with respect to Swaps (the Requested Relief), on the terms and conditions provided for in this decision.
Under the Process for Exemptive Relief Applications in Multiple Jurisdictions:
(a) the Ontario Securities Commission is the principal regulator for this Application, and
(b) the Filer has provided notice that subsections 4.7(1) and 4.7(2) of Multilateral Instrument 11-102 – Passport System are intended to be relied upon in each of the provinces and territories of Canada (together with the Jurisdiction, the Jurisdictions).
Interpretation
Terms defined in National Instrument 14-101 – Definitions, the Securities Act (Ontario) and NI 81-102 have the same meaning if used in this decision, unless otherwise defined. In addition, the following capitalized have the following meanings herein:
“CFTC” means the U.S. Commodity Futures Trading Commission;
“Clearing Corporation” means any of the Chicago Mercantile Exchange Inc., ICE Clear Credit LLC, LCH.Clearnet Limited and any other clearing organization that is permitted to operate in the Jurisdiction;
“Dodd-Frank Act” means the Dodd-Frank Wall Street Reform and Consumer Protect Act;
“Futures Commission Merchant” means a futures commission merchant that is registered with the CFTC and is a member of a Clearing Corporation;
“OTC” means over-the-counter; and
“Swaps” means swaps that are subject to a clearing determination issued by the CFTC, including fixed-to-floating interest rate swaps, basis swaps, forward rate agreements in U.S. dollars, the Euro, Pounds Sterling or the Japanese Yen, overnight index swaps in U.S. dollars, the Euro and Pounds Sterling and untranched credit default swaps on certain North American indices (CDX.NA.IG and CDX.NA.HY) and European indices (iTraxx Europe, iTraxx Europe Crossover and iTraxx Europe hiVol) at various tenors.
Representations
This decision is based on the following facts represented by the Filer:
(a) 1832 is a limited partnership established under the laws of Ontario with its head office in Toronto, Ontario. 1832 is registered as: (i) a portfolio manager in all of the provinces of Canada and in the Yukon; (ii) an exempt market dealer in all of the provinces of Canada (except Prince Edward Island and Saskatchewan); (iii) an investment fund manager in Ontario, Québec and Newfoundland and Labrador; and (iv) a commodity trading manager in Ontario.
(b) The Filer, or an affiliate of the Filer, is or will be the manager and/or portfolio advisor of the Funds. In addition, from time to time, third parties who are registered as portfolio managers may act as portfolio advisors to a Fund.
(c) Each of the Funds is or will be an open-ended mutual fund trust, limited partnership or corporation established under the laws of the Province of Ontario or the laws of Canada and is or will be subject to the provisions of NI 81-102.
(d) The securities of each of the Funds are or will be qualified for distribution in the Jurisdictions pursuant to simplified prospectuses and annual information forms prepared and filed in accordance with the securities legislation of the Jurisdictions. Accordingly, each Fund is or will be a reporting issuer or the equivalent in each Jurisdiction.
(e) The investment objective and investment strategies of each Fund permit or will permit the Fund to enter into derivative transactions, including Swaps. The portfolio management team of each of the existing Funds consider Swaps to be an important investment tool that is available to it to properly manage the Fund’s portfolio. Over the last five calendar years, the existing Funds have entered into credit default swaps on single names and indices that had an aggregate absolute notional value of approximately $645.5 million.
(f) Neither 1832 nor any Fund is currently in default of securities legislation in any of the Jurisdictions.
(g) The Dodd-Frank Act requires that certain OTC Swaps be cleared through Futures Commission Merchants at a Clearing Corporation. Generally, where one party to a Swap is a “U.S. person” (within the meaning attributed to such term by the CFTC) and the other party to the Swap is a mutual fund, such as a Fund, that Swap must be cleared, absent an available exception.
(h) Currently, certain Funds enter into Swaps on an OTC basis with a number of Canadian and non-U.S. international counterparties. These OTC Swaps are entered into in compliance with the derivative provisions of NI 81-102. At the earliest opportunity, the Funds would like to be in a position to enter into Swaps with U.S. counter-parties, which would be subject to the Dodd-Frank Act. These Swaps will not be permitted without the Requested Relief.
(i) In order to benefit from both the pricing benefits and reduced trading costs that the Filer is often able to achieve through its trade execution practices for its managed investment funds and from the reduced costs associated with cleared OTC derivatives as compared to other OTC trades, the Filer wishes to enter into cleared Swaps on behalf of the Funds.
(j) In the absence of the Requested Relief, the Filer may need to structure certain Swaps entered into by the Funds so as to avoid the clearing requirements of the CFTC. The Filer respectfully submits that this would not be in the best interests of the Funds and their investors for a number of reasons, as set out below.
(k) The filer strongly believes that it is in the best interests of the Funds and their investors to execute OTC derivatives with U.S. persons, including U.S. swap dealers.
(l) In its role as a fiduciary for the Funds, the Filer has determined that central clearing represents the best choice for the investors in the Funds to mitigate the legal, operational and back office risks faced by investors in the global swap markets.
(m) The Filer currently uses the same trade execution practices for all of its managed funds, including the Funds. An example of these trade execution practices is block trading, where large number of securities are purchased or sold or large derivative trades are entered into on behalf of a number of investment funds advised by the Filer. The Filer wishes to include in such practices the use of cleared Swaps where such trades are executed with a U.S. swap dealer. If the Funds are unable to employ these trade execution practices, then the Filer will have to execute trades for the Funds on a separate basis. This will increase the operational risk for the Funds, as separate execution procedures will need to be established and followed only for the Funds. In addition, the Funds would not be able to enjoy the possible price benefits and reduction in trading costs that the Filer may be able to achieve through a common practice for its family of investment funds. In the Filer’s opinion, best execution and maximum certainty can best be achieved through common trade execution practices, which, in the case of OTC derivatives, involve the execution of Swaps on a cleared basis.
(n) As a member of the G20 and a participant in the September 2009 commitment of G20 nations to improve transparency and mitigate risk in derivatives markets, Canada has expressly recognized the systemic benefits that clearing OTC derivatives offers to market participants, such as the Funds. The Filer respectfully submits that the Funds should be encouraged to comply with the robust clearing requirements established by the CFTC by granting them the Requested Relief.
(o) The Requested Relief is analogous to the treatment currently afforded under NI 81-102 to other types of derivatives that are cleared, such as clearing corporation options, options on futures and standardized futures. This demonstrates that, from a policy perspective, the Requested Relief is consistent with the views of the Canadian securities authorities in respect of cleared derivative trades.
(p) For the reasons provided above, the Filer believes that it would not be prejudicial to the public interest to grant the Requested Relief.
Decision
The principal regulator is satisfied that the decision meets the test set out in the Legislation for the principal regulator to make the decision.
The decision of the principal regulator under the Legislation is that the Requested Relief is granted provided that, in respect of the deposit of cash and portfolio assets as margin:
(a) in Canada,
i. the Futures Commission Merchant is a member of a self-regulatory organization that is a participating member of CIPF; and
ii. the amount of margin deposited by a Fund and maintained with the Futures Commission Merchant does not, when aggregated with the amount of margin already held by the Futures Commission Merchant, exceed 10 percent of the net asset value of the Fund as at the time of deposit; and
(b) outside of Canada,
i. the Futures Commission Merchant is a member of a Clearing Corporation and, as a result, is subject to a regulatory audit;
ii. the Futures Commission Merchant has a net worth, determined from its most recent audited financial statements that have been made public or from other publicly available financial information, in excess of the equivalent of $50 million; and
iii. the amount of margin deposited by a Fund and maintained with the Futures Commission Merchant does not, when aggregated with the amount of margin already held by the Futures Commission Merchant, exceed 10 percent of the net asset value of the Fund as at the time of deposit.
This decision will terminate on the earlier of (i) the coming into force of any revisions to the provisions of NI 81-102 that address the clearing of OTC derivatives, and (ii) two years from the date of this decision.
Signed
Vera Nunes
Manager, Investment Funds
Ontario Securities Commission