1. Exchange-Traded Derivatives
2. Over-the-Counter Derivatives

The derivatives markets globally have been among the most dynamic of all financial markets for more than a generation. Derivatives are generally defined as instruments or contracts whose value depend on, or are derived from, something else, such as a commodity, reference rate, or index. Derivatives can be traded on stock exchanges, called exchange-traded derivatives, or over-the-counter, called over-the-counter (OTC) derivatives.⁴¹ Derivatives markets have shown exceptional growth and innovation. In 2008, OTC derivatives globally accounted for notional positions totalling in excess of US$680 trillion, representing much more than the underlying value of the corresponding assets.⁴²

Highly leveraged, lightly regulated entities (e.g., hedge funds), competing in largely unregulated OTC derivatives markets, are an important factor behind the current global financial crisis. This has underscored that the regulation of derivatives markets in many countries needs to be modernized to better address the new types of products, trading practices, and the interrelationship between the derivatives markets and the cash markets.

I. Exchange-Traded Derivatives 

Exchange-traded derivatives are traded through the Montreal Exchange in Montreal, ICE Futures Canada in Winnipeg, and the Natural Gas Exchange in Calgary. These exchanges act as intermediaries, servicing standardized exchange contracts with the intermediary being a counterparty to the contract. The exchanges also fulfill a regulatory role with respect to their markets.

Exchange-traded derivatives are regulated in Canada through securities regulatory authorities only in the provinces of British Columbia, Alberta, Manitoba, Ontario, and Quebec. Regulation in this area has suffered from a lack of attention and coordinated effort. Manitoba and Ontario have specific, though outdated, legislation focused on commodities and futures contracts; British Columbia and Alberta address exchange-traded derivatives through their securities acts; and Quebec has recently passed a new Derivatives Act and is working on a draft of the corresponding regulation. The inconsistency in treatment of exchange-traded derivatives arises from a historical difference of views as to whether or not derivatives are “securities” or should be treated as such. It is also compounded by the demands of a quickly evolving market for new derivative products. Consequently, Canada has three different regulatory approaches among five provinces.

We believe that there needs to be a strong interrelationship between the derivatives markets and the cash markets in securities legislation.

We conclude that the Canadian Securities Commission would bring significant improvement to the current fragmented approach to the derivatives market for exchange-traded contracts by providing a common regulatory base.

II. Over-the-Counter Derivatives

OTC derivatives markets are largely unregulated in Canada. Provincial authorities have however spent considerable time attempting to develop regulation in this area, including the new Quebec Derivatives Act. The various efforts to regulate have been met with significant opposition from a range of industry participants, arguing regulation would impede the growth of the Canadian market and make it potentially uncompetitive with the much larger derivatives market in the United States.

As noted in our introduction above, and explained in a commissioned research study that examines the recent non-bank ABCP crisis in Canada,⁴³ the approach of allowing market participants trading in OTC derivatives to regulate themselves has proven to be unsatisfactory. More broadly, the Panel is concerned that the lack of sound settlement, legal, and operational infrastructure in the OTC derivatives markets is a potential source of weakness for Canada’s financial system. While we advocate more regulatory oversight be applied to the OTC derivatives market, we are conscious that the United States and others are also considering regulatory responses. Until these are clearer, it would be premature for the Panel to recommend a regulatory approach that risks being out of step with much larger markets than our own. We are, however, of the view that the Canadian Securities Commission 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.

It is important to note that the regulation of the OTC derivatives markets is not a substitute for regulating the institutions that trade in them. Canada’s first line of regulation needs to be focused on these institutions, monitoring their risk and leverage.

Endnotes

⁴¹ A briefing note in Appendix 5 describes in greater detail the different approaches used by provincial securities regulators to regulate derivatives in Canada.

⁴² Bank for International Settlements. “OTC derivatives market activity in the first half of 2008.” Monetary and Economic Department (November 2008).

⁴³ Chant, John. “The ABCP Crisis in Canada: The Implications for the Regulation of Financial Markets.” Expert Panel on Securities Regulation (2009).