Following the near-collapse of the global financial services system in 2008, policy-makers around the world promised tougher rules for the largely unregulated derivatives markets. Almost 10 years later, that work remains ongoing, yet the financial services sector is pushing back on Canadian regulators’ latest effort.

In April, the Canadian Securities Administrators (CSA) published a proposed rule that would introduce a new regime of conduct rules for derivatives dealers and financial advisors, modelled on the existing rules for the securities industry. The proposal would introduce fair-dealing obligations, along with “know your client” suitability and disclosure requirements.

The CSA’s proposal includes an unusually long, 150-day comment period, which ended at the beginning of September. The investment industry’s feedback is negative for the most part.

The fundamental goal of the CSA’s proposed framework is to address weakness in the regulation of the over-the-counter (OTC) derivatives markets that were exposed during the financial crisis. These weaknesses were brought into sharper relief by a subsequent series of scandals in the global wholesale markets, including the manipulation of financial benchmarks (such as the London Interbank Offered Rate), and similar misconduct in the foreign-exchange markets.

In the wake of those events, there was little question that policy-makers must act to stamp out such fundamental misconduct, restore the integrity of markets and bolster financial stability. Yet, as is often the case, when common sense runs up against a complex, high-stakes world such as the global financial markets, reform is much more easily said than done.

Comments from the derivatives industry regarding the CSA’s proposal argue that the oversight regime would duplicate existing rules and do little to enhance investor protection or improve financial stability.

For example, the Investment Industry Association of Canada’s (IIAC) comment states the CSA’s proposed regime for derivatives dealers would largely replicate existing requirements that investment dealers face under both provincial securities rules and Investment Industry Regulatory Organization of Canada rules: “These proposed ‘duplicative’ rules, often similar but rarely identical, would not better protect the investing public.”

However, the added requirements would raise compliance costs, the IIAC comment maintains. And, given the IIAC’s position that these added costs wouldn’t produce any corresponding benefits for investors, the comment argues that investment dealers should be exempt from the proposed rule’s requirements.

The pushback on the proposal is even stronger from the Canadian Market Infrastructure Committee (CMIC) – a collection of major financial services institutions on both the buy side and the sell side, including the big banks and insurers, the major pension fund managers and several global investment firms and asset managers – that was formed in 2010 to provide feedback on proposed reforms related to the OTC derivatives market.

Significant overlap

Not only does the CMIC foresee significant overlap in the CSA’s proposals and various existing rules, the proposal argues that the regulators haven’t made a case for sweeping new conduct rules in the Canadian derivatives market.

“While other international jurisdictions have imposed business conduct rules for OTC derivatives, it’s the CMIC’s view that a robust public policy justification has not yet been presented that these separate rules are necessary in Canada,” that comment states.

The committee’s comment further notes there haven’t been any major episodes of misconduct by derivatives dealers in Canada nor have policy-makers in Canada pledged to address market conduct as part of their reform commitments to the G20.

Yet, not everyone is as sanguine about the prospects for misconduct in the Canadian derivatives markets.

According to the comment issued by the Canadian Advocacy Council for Canadian CFA Institute Societies: “The financial crisis of 2008 highlighted the intrinsic risk of some derivatives products and questionable business practices by dealers. In addition, recent benchmark manipulation scandals have highlighted unresolved issues. These factors, among others, should warrant the highest level of regulation/protection to investors and the highest level of accountability by registrants. Regulators should have as much flexibility (and enforcement power) as necessary to protect counterparties from issues such as price fixing, manipulation of benchmark rates [and] front-running of trades.”

Similarly, the Pension Investment Association of Canada’s (PIAC) comment states that securities regulators should “have the regulatory tools necessary to sanction dealers that engage in deceptive and manipulative trading practices or fraudulent activities.”

The PIAC’s comment also suggests firms be obliged to disclose conflicts of interest in connection with derivatives transactions. It adds that these provisions should require timely, specific disclosure rather than “catch-all” regulatory disclosure that’s provided to clients once a year or long after the time of the transaction.

Harmonizing rules

Regarding issues such as disclosure obligations, the CMIC comment maintains the CSA should fully harmonize its requirements with those of the U.S. Commodity Futures Trading Commission, as any CSA effort to impose different or additional requirements would be burdensome and costly for dealers.

Given the global nature of the derivatives markets, several comments insist that the Canadian rules should mimic the requirements of other jurisdictions closely; otherwise, regulators risk driving away foreign firms from Canadian markets altogether.

“Market participants are fatigued by the burden of regulatory compliance in multiple jurisdictions,” notes the CMIC’s comment. “Non-Canadian derivatives firms are increasingly weighing the burden of complying with Canadian-specific regulations in deciding to continue transacting with Canadian counterparties.”

To avoid driving away foreign firms from the Canadian market, the CMIC’s comment recommends the CSA adopt its proposed prohibition on “tied selling” or the imposition of complaint-handling standards, which don’t have equivalents in the U.S. or Europe.

Concerning the foreign- exchange (FX) market, the CMIC’s comment suggests the CSA be satisfied with the FX industry’s voluntary code of conduct, which was introduced earlier this year in response to a market-manipulation scandal in that corner of the derivatives market: “Any regulatory deviation from the FX code of conduct would result in market fragmentation.”

This challenge of developing local regulation that works within a global market is undoubtedly a major reason why almost 10 years have passed since the global financial crisis and much of the policy response remains a work in progress.

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