BMO Asset Management Inc., 2014 CanLII 2132

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

January 23, 2014

(the Jurisdiction)

AND

(the Filer)

Background

The principal regulator in the Jurisdiction has received an application from the Filer for a decision under the securities legislation of the Jurisdiction of the principal regulator (the Legislation), pursuant to section 19.1 of National Instrument 81-102 Mutual Funds (NI 81-102), exempting BMO Floating Rate High Yield ETF (the Proposed BMO Fund) and all current and future mutual funds, including exchange-traded funds, managed by the Filer that enter into Swaps (as defined below) in the future (each, a Future BMO Fund and, together with the Proposed BMO Fund, each, a BMO Fund and, collectively, the BMO Funds):

(i) from 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;

(ii) from 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 clears and 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

(iii) from 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 BMO Fund to deposit cash and other 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 cleared Swaps (the Requested Relief).

Under the Process for Exemptive Relief Applications in Multiple Jurisdictions (for a passport application):

(a) the Ontario Securities Commission is the principal regulator for this application; and

(b) the Filer has provided notice that subsection 4.7(1) of Multilateral Instrument 11-102 Passport System (MI 11-102) is intended to be relied upon in each of the other provinces and territories of Canada (the Other Jurisdictions).

Interpretation

Terms defined in NI 81-102, National Instrument 14-101 Definitions, and MI 11-102 have the same meaning if used in this decision, unless otherwise defined. Capitalized terms used in this decision have the following meanings:

“CFTC” means the U.S. Commodity Futures Trading Commission

“Clearing Corporation” means any of the Chicago Mercantile Exchange Inc., ICE Clear Credit LLC and LCH.Clearnet Limited and any other clearing organization that is permitted to operate in the Jurisdiction or the Other Jurisdiction, as the case may be, where the BMO Fund is located

“Dodd-Frank” means the Dodd-Frank Wall Street Reform and Consumer Protection Act

“Futures Commission Merchant” means any futures commission merchant that is registered with the CFTC and is a member of a Clearing Corporation

“OTC” means over-the-counter

“Portfolio Manager” means each of the Filer, each affiliate of the Filer and each third party portfolio manager retained from time to time by the Filer to manage all or a portion of the investment portfolio of one or more BMO Funds

“Swaps” means the swaps that are, or will become, 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

“U.S. Person” has the meaning attributed thereto by the CFTC

Representations

This decision is based on the following facts represented by the Filer:

The Filer will be the investment fund manager of each BMO Fund. The Filer is registered as an investment fund manager, a portfolio manager, an exempt market dealer and a commodity trading manager in the Province of Ontario. The Filer is also registered as a portfolio manager and an exempt market dealer in each of the Other Jurisdictions and as an investment fund manager in each of the Provinces of Quebec and Newfoundland and Labrador. The head office of the Filer is in Toronto, Ontario.
Either the Filer, an affiliate of the Filer or a third party portfolio manager will be the portfolio manager of all or a portion of the investment portfolio of each BMO Fund.
Each BMO Fund will be a mutual fund created under the laws of the Province of Ontario and will be subject to the provisions of NI 81-102.
The Filer is not, and the BMO Funds will not be, in default of securities legislation in the Jurisdiction or any Other Jurisdiction.
The securities of each BMO Fund will be qualified for distribution pursuant to a prospectus that will be prepared and filed in accordance with the securities legislation of the Jurisdiction and the Other Jurisdictions. Accordingly, each BMO Fund will be a reporting issuer or the equivalent in the Jurisdiction and each Other Jurisdiction.
The investment objective and investment strategies of each BMO Fund will permit the BMO Fund to enter into derivative transactions, including Swaps. The Portfolio Manager for the Proposed BMO Fund considers Swaps to be an important investment tool that is available to it to properly manage the Proposed BMO Fund’s portfolio. Prior to the launch of the Proposed BMO Fund, the Portfolio Manager for the Proposed BMO Fund intends to put in place the arrangements required to permit the Proposed BMO Fund to enter into Swaps.
Dodd-Frank requires that certain OTC derivatives be cleared through a Futures Commission Merchant at a clearing organization recognized by the CFTC. Generally, where one party to a Swap is a U.S. Person and the other party to the Swap is a mutual fund, such as a BMO Fund, that Swap, absent an available exception, has been required to be cleared since June 10, 2013. With respect to entities such as the BMO Funds, the compliance date for the clearing of iTraxx CDS indices was July 25, 2013.
Once the Proposed BMO Fund is launched, it may enter into derivatives on an OTC basis with Canadian, U.S. and other international counterparties. These OTC derivatives are entered into in compliance with the derivative provisions of NI 81-102.
In order to benefit from both the pricing benefits and reduced trading costs that the Portfolio Manager may be able to achieve through its trade execution practices for its advised investment funds and other accounts and from the reduced costs associated with cleared OTC derivatives as compared to other OTC trades, the Filer wishes to have the BMO Funds have the ability to enter into cleared Swaps.
In the absence of the Requested Relief, each Portfolio Manager will need to structure the Swaps entered into by the BMO 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 BMO Funds and their investors for a number of reasons, as set out below.
The Filer strongly believes that it is in the best interests of the BMO Funds and their investors to be able to execute OTC derivatives with U.S. Persons, including U.S. swap dealers.
In its role as a fiduciary for the BMO Funds, the Filer has determined that central clearing represents the best choice for the investors in the BMO Funds to mitigate the legal, operational and back office risks faced by investors in the global swap markets.
A Portfolio Manager may use the same trade execution practices for all of its advised investment funds and other accounts, including the BMO Funds. An example of these trade execution practices is block trading, where a large number of securities are purchased or sold or large derivative trades are entered into on behalf of a number of investment funds and other accounts advised by one Portfolio Manager. These practices include the use of cleared Swaps if such trades are executed with a U.S. swap dealer. If the BMO Funds are unable to employ these trade execution practices, then each affected Portfolio Manager will have to create separate trade execution practices only for the BMO Funds and will have to execute trades for the BMO Funds on a separate basis. This will increase the operational risk for the BMO Funds, as separate execution procedures will need to be established and followed only for the BMO Funds. In addition, the BMO Funds will no longer be able to enjoy the possible price benefits and reduction in trading costs that a Portfolio Manager may be able to achieve through a common practice for its advised funds and other accounts. 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.
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 BMO Funds. The Filer respectfully submits that the BMO Funds should be encouraged to comply with the robust clearing requirements established by the CFTC by granting them the Requested Relief.
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.
For the reasons provided above, the Filer submits 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 SRO that is a participating member of CIPF; and

(ii) the amount of margin deposited 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 BMO 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 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 BMO 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.

“Darren McKall”

Manager, Investment Funds

Ontario Securities Commission