One of the compelling arguments for a national regulator is that having such a body would make it easier to deal with the increasingly international nature of securities regulation. A prime example is the push for regulatory reform in the over-the-counter derivatives market.

In early November, the Cana-dian Securities Admin-istrators published a consultation paper setting out its views on the reforms required in the regulation of the OTC derivatives market in the wake of the global financial crisis. As the CSA paper notes, the OTC derivatives market was not a primary cause of the crisis, but it was certainly an aggravating factor — for both regulators and market players.

When major Wall Street firms such as Bear Stearns Cos. Inc., Lehman Brothers Holdings Inc. and insurance giant (and major player in the derivatives market) American International Group Inc. were teetering on the brink of failure, other market players had a hard time figuring out their own exposures to those firms. More problematic was the latter group’s difficulty in understanding the exposure of other firms to these troubled companies, which caused credit markets to grind to a halt as firms throughout the financial services system were simply unable to assess one another’s creditworthiness.

Regulators didn’t have a much better understanding of what was going on, either, notes the CSA paper: “The complexity of OTC derivatives contracts was compounded by the lack of transparency within the OTC derivatives markets, making it challenging for regulators to identify risk before and during the crisis.”

This situation contributed to firms being considered “too interconnected to fail” and led policy-makers to bail out leading financial services companies in order to keep the whole financial system from collapsing.

Reform of the OTC derivatives markets has become a major agenda item for policy-makers, central bankers and regulators around the world. Through the G20, these three groups have committed to improving transparency and oversight of the OTC derivatives market — including requiring standardized contracts to trade on exchanges or electronic platforms by the end of 2012. As a member of the G20, Canada has signed up for these commitments, and now domestic regulators have to do the necessary spadework to make it happen.

Implementation is particularly complicated in Canada, where regulation of the derivatives market is highly fragmented, with provinces taking divergent approaches and some not regulating it at all. Historically, the provinces have taken different stances on fundamental questions — such as whether derivatives should be considered securities and thereby regulated under securities legislation, or whether they should have their own separate legislation. And, within the derivatives space, approaches to exchange-traded contracts and OTC contracts differ.

In recent years, some provinces have been working to overhaul their derivatives regulations, but those efforts are now being overtaken by the new G20 commitments. Quebec has passed modernized derivatives legislation, but it is not yet in force. Ontario recently undertook a review of its Commodity Fu-tures Act, which has recommended fundamental reform of that legislation, but that report has not been acted upon.@page_break@The report by the so-called “ex-pert panel” on the creation of a national securities regulator, published in January 2009, also calls for reform of derivatives market regulation. That report notes that provincial authorities have spent considerable time trying to overhaul regulation in this area, only to face strong opposition from the industry, which has argued that regulation could make the Canadian market uncompetitive and impede its growth. The report concludes, however: “The approach of allowing market participants trading in OTC derivatives to regulate themselves has proven to be unsatisfactory.”

The panel’s report also notes that the lack of “sound settlement, legal and operational infrastructure” in the OTC markets could be a potential source of weakness for Canada’s financial system.

The CSA report agrees that there is a need for more regulation in the OTC derivatives area. The report says that while Canadian firms account for a relatively small slice of the international OTC derivatives market and were not heavily involved in the sort of trading (in credit-default swaps) that was such a problem during the financial crisis: “…the recent financial turmoil has highlighted the risks of permitting OTC derivatives trading to continue unfettered and without some regulatory oversight.”

In addition, the CSA report notes, the adoption of new rules by other jurisdictions could affect Canadian firms that aim to trade with players in those markets. Canadian firms could be required to meet any new requirements: “Regulatory inaction is not an option, given the commitments Canada has made as part of the G20.”

Even without those commitments, the CSA report suggests, there are compelling reasons to introduce regulation in the OTC derivatives market in Canada: “If other countries adopt stringent regulations, and Canada does not act, it may gain a reputation as a haven, resulting in regulatory arbitrage and a flight of risky trading to Canada.”

That could lead to trouble for Canadian firms trying to participate in international markets.

While it seems accepted that new derivatives regulation is needed, divergent provincial approaches makes that easier said than done. Ideally, it might be best to leave the development of a single approach to derivatives regulation to a national regulator — if we could be sure a national regulator would be created.

The expert panel’s report concludes that a national regulator “would be in a much better position than the current provincial securities regulators to participate in international discussions and to direct the development of corresponding regulation in Canada.”

That report’s recommended approach is for exchange-traded derivatives to be captured by securities legislation, and that the new national regulator be prepared to deal with developing OTC market regulation. The report refrains from recommending a specific approach to OTC markets, citing the ongoing reforms in larger markets such as the U.S. and Europe.

When the draft legislation to enable the creation of a national regulator was released earlier this year, the Department of Finance stated that the new body will have the authority to regulate exchange-traded and OTC derivatives. The new regulator’s initial rules will be based largely on the existing rules, but the derivatives sector is one in which entirely new rules are likely to be crafted.

In the meantime, however, the CSA must now take on this tricky task, one that is going to entail legislative changes in each province. The CSA paper points out that for each of the areas in which it is proposing reform: “Clear jurisdictional authority in each province, as well as specific rule-making powers, need to be set out in provincial securities and derivatives legislation.” IE