In the wake of the recent financial crisis, the Dodd-Frank Wall Street Reform and Consumer Protection Act was signed into law in July 2010. The act addresses multiple themes that regulators believe will help regain and support stability in the financial marketplace by tackling systemic risk, reining in derivative products, improving consumer protection and increasing public company disclosures. The act affects all federal financial regulatory agencies and most facets of the financial services industry.

Some of the changes have an impact on oversight structures, reporting and trading operations and require that asset managers, brokers and custodians invest substantially in technology and counterparty oversight.

How it will work

In 2008, the G20 recommended legislation requiring buyers and sellers of over-the-counter (OTC) derivatives to clear their trades through a central counterparty (CCP). The U.S. implemented these recommendations via the Dodd-Frank Act, and Europeans followed suit with the European Market Infrastructure Regulation directive.

With no central securities regulator in Canada, each provincial regulator will likely adopt concepts similar to the U.S. regulatory reform at some point. However, there are no specific timelines as yet. And investors will feel the impact of regulatory changes, since many of the OTC derivatives in Canada are written by either U.S. or European counterparties. The Bank of Canada is also working with the six big banks to come up with a Canadian central counterparty solution.

Starting in 2012, standardized swap contracts written by U.S. or European counterparties will be cleared through a registered CCP such as the Chicago Mercantile Exchange. But not every CCP will handle every clearable contract type.

In order to clear OTC contracts via a CCP, institutional investors will need to appoint a futures commission merchant (FCM). CCPs will also require the FCM to contribute to a default fund within the CCP. This default fund will act as a layer of defence between the initial and variation margin paid to the CCP and the CCP’s capital in the event of FCM default.

How to prepare

Institutional investors should be aware of the consequences of these rules.

Fixed margining

Previously, bilateral collateral (between two parties) amounts were negotiated with your counterparty and reflected its view of institutional investor credit-worthiness. CCPs require consistent collateral requirements across all market participants, regardless of their credit-worthiness.

Initial margin requirement

All transactions will be subject to initial and variation margin, as collateral will be marked to market several times a day.

Collateral requirements

CCPs demand high-quality liquid initial margin. Variation margin will now need to be cash. Clients will need service providers to transform non-CCP deliverable securities into cash and eligible initial margin.

Common credit

Beneficial owners with good credit ratings, such as pension funds, enjoy favourable credit terms with counterparties. In a CCP transaction, all owners have the same credit conditions.

Trade portability

Many institutional investors are appointing more than one FCM to provide a backup in the event of clearing member default. But not all FCMs guarantee trade portability (moving contracts from one member to another).

In advance of mandatory clearing by the end of 2012, investors should be certain they understand their portfolio liquidity (to know whether they may need to appoint centralized collateral administrators for bilateral and clearable OTC contracts); their cash or high-grade collateral adequacy (which can be accomplished by appointing a collateral transformation or upgrade provider to review assets or create assets that reflect the new requirements); and, finally, their custodian’s capabilities.

This article was first published in Benefits Canada, March 14, 2012. 

IMPORTANT NOTICES

Proprietary and confidential
References to Mercer shall be construed to include Mercer LLC and/or its associated companies.
This contains confidential and proprietary information of Mercer and is intended for the exclusive use of the parties to whom it was provided by Mercer. Its content may not be modified, sold or otherwise provided, in whole or in part, to any other person or entity, without Mercer's prior written permission.
Opinions – not guarantees
The findings, ratings and/or opinions expressed herein are the intellectual property of Mercer and are subject to change without notice. They are not intended to convey any guarantees as to the future performance of the investment products, asset classes or capital markets discussed. Past performance does not guarantee future results. Mercer’s ratings do not constitute individualized investment advice.
Not investment advice
This does not contain investment advice relating to your particular circumstances. No investment decision should be made based on this information without first obtaining appropriate professional advice and considering your circumstances.