Canada may have suffered only a mild version of the financial crisis, but the episode awoke Canadian policy-makers to the dangers of complex products and the threat of systemic risk. The latest result of this awakening is an effort to recast the exempt market and steer small investors clear of such convoluted investments.

There has been plenty of talk about how tougher regulation in Canada had prevented a serious financial crisis when much of the rest of the developed world was suffering one. But Canada’s smoother ride was mostly because of our banking regulations, which had kept Canadian banks’ capital positions healthier, limited their leverage and prevented some of the riskier lending practices that had developed in the U.S.

Our securities regulation, on the other hand, was exposed as being deficient in the collapse of the non-bank asset-backed commercial paper market in Canada in late 2007. (Although, to be fair, a weakness in bank regulation played a part in that as well.) The failure of the ABCP market revealed that numerous retail investors had been sold complex securities that neither they nor their brokers really understood.

This failure in the ABCP market led to some hefty enforcement settlements with several firms, and regulators are now moving to change some rules. In early April, the Canadian Securities Administrators proposed new rules for securitized products — including asset-backed securities, collateralized debt obligations, collateralized mortgage and bond obligations (a.k.a. CMBs) and assorted variations on these vehicles — in response to some of the regulatory weaknesses that had been exposed by the market’s failure.

The CSA’s proposed new rules aim to enhance disclosure requirements and improve the transparency of securitized products so that investors can better understand what they’re buying and dealers have a better sense of what they’re selling. And, at the same time, the CSA is seeking to shrink the pool of possible investors for these products — concluding, essentially, that securitized products are just too complicated for most investors.

Indeed, one of the central lessons to come out of the financial crisis was that particularly Byzantine securities can be a dangerous conduit for transmitting risk throughout the financial system because they obscure the size and location of inherent risks.

According to the CSA’s notice introducing its proposed rules: “[I]f not properly regulated, the securitization markets can be a source of systemic risk. The collapse of subprime securitizations in the U.S. had major spillover effects into other markets and into the wider U.S. and global economy, and was a major contributing factor to the financial crisis.”

The notion that securities regulators should be keeping an eye out for systemic risk is a relatively new concept born out of the financial crisis. In the past, it was thought that this issue was largely the purview of prudential regulators.

However, in the wake of the financial crisis, securities regulators have been alerted to their role in mitigating systemic risk. Last summer, the umbrella group of global regulators, the International Organization of Securities Commissions, called on regulators worldwide to increase their focus on systemic risk issues.

In Canada, the obligation on regulators to watch for, and react to, emerging systemic risks has also become a key justification for the proposed national securities regulator. Proponents of a national regime argue that the provinces aren’t up to the task of dealing with systemic risks, thereby making a new national authority necessary.

In the meantime, the CSA is embarking on its initiative to deal with securitized products (in part, because these products represent a possible source of systemic risk) by demanding increased transparency from issuers and restricting access to them for many investors.

In particular, the CSA aims to narrow the number of investors who can buy securitized products in the exempt market “to a smaller, more sophisticated group” in an effort to keep these products from being sold to unsuitable investors. Effectively, the proposed rules will create a new regulatory regime for the distribution of securitized products on an exempt basis, which, the CSA says, represents “a significant departure” from the current regulatory regime in the exempt market.

The proposed rules would create a new category of “eligible securitized product investors” that mimics the definition of the “permitted client” under the registration reform rules; this category includes such clearly sophisticated investors as banks and pension funds along with governments and individuals with at least $5 million in financial assets, or net assets of at least $25 million, among others.@page_break@Only these “highly sophisticated” investors would be able to buy securitized products in the exempt market. Ordinary retail investors and others who don’t meet the criteria would be able to buy securitized products only via prospectus. (Regulators are also reviewing the retail investor exemption qualifications in general, but have yet to decide whether changes are necessary).

The CSA appears to be cautious about making such a fundamental change to the exempt market and if this is the right way to go. One alternative, the CSA notice suggests, would be to allow all investors to continue to have access to these products but only through a registered dealer that would be obliged to ensure suitability.

However, dealer suitability checks weren’t enough to prevent the ABCP debacle in the first place. In fact, in the wake of the that market’s seize-up, the In-vest–ment Industry Regulatory Organization of Canada’s review had determined that a primary reason retail investors found themselves holding these frozen securities was that dealers weren’t living up to their suitability obligations when selling them. IIROC’s review found that dealers didn’t consider suitability issues when they sold ABCP to retail clients because the dealers viewed these products as just another virtually risk-free money market instrument.

IIROC’s review concluded that complex structured products, such as ABCP and principal-protected notes, “may not be fully understood” by both retail inves-tors and the advisors that were recommending them. And the review suggested that the existence of less risky, less complicated or less expensive products that offer the same types of benefits to investors as these costlier, more complicated structured products had given rise to “concerns about suitability and potential conflicts of interest.”

So, although some segments of the securities industry may resist this effort to wall off certain investors from specific products, history suggests that investors can hardly take comfort in dealer suitability obligations to keep them safe where particularly complex products are concerned.

Moreover, it’s not clear how much the securitized product market will suffer if small retail investors are excluded. Despite the ABCP debacle, these products are bought primarily by institutional investors anyway. And the Canadian securitization market has already shrunk dramatically from its peak in mid-2007, when outstanding issues totalled slightly less than $180 billion. (Today, according to data from Toronto-based DBRS Ltd. , the market is just $95.3 billion.)

In addition to the CSA’s proposed restrictions on who can buy securitized products, the regulator is seeking to enhance the transparency provided by the issuers of these products, both when they’re first distributed and on an ongoing basis. This would require issuers to report on the underlying asset pool’s performance, along with timely disclosure of significant events, annual reports from servicers and disclosure of any significant instance of non-compliance with servicing standards. In addition, non-reporting issuers that distribute securitized products in the exempt market will also be subject to certain initial and ongoing disclosure requirements.

The CSA says these new disclosure requirements have been designed to be consistent with international developments, such as IOSCO’s disclosure principles, and the U.S. Securities and Exchange Commission’s proposed new disclosure rules. But the CSA does not go as far as the SEC, which is seeking to require these products be structured so that issuers have “skin in the game” — that is, that issuers retain at least 5% of the credit risk of any asset included in an asset-backed security. The goal is to do a better job of aligning the interests of the original asset owner and the securitizer with investors.

Notes a recent report from New York-based research firm CreditSights Inc.: “In both Europe and the U.S., structured finance has uniformly been identified as a material cause of the financial crisis, and a 5% risk retention mandate is viewed as the cornerstone to the solution.”

For now, the CSA isn’t proposing such a measure but is seeking comment on this and other regulatory proposals from the SEC concerning securitization. It remains to be seen whether the CSA feels compelled to follow suit. IE