The impact of the financial crisis that started in late 2007 was felt worldwide. Massive government interventions were put in place, from Asia, Europe and Canada and the U.S. We all agree that it is very important for the financial industry to re-establish credibility among investors as soon as possible. As investment and financial industry practitioners, we are committed to the process of continuously assessing new products and refining our management strategies to meet the financial needs of our retail and institutional clients. It is therefore timely for us to review the changing landscape regarding derivatives.

Derivative usage is wide spread, supporting many economic activities, from international trade to risk management in the agricultural and natural resource sectors. At year-end 2009, the outstanding notional amount of derivatives globally amounted to US$427 trillion¹ (out of which $30 trillion were credit default swaps). This compares with US$58 trillion at the end of 1999, a phenomenal growth in usage over ten years.

On 21 July 2010 the Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank Act”) was signed into law by President Obama. This marked the beginning of the implementation of a new era that may yet transform the U.S. financial regulatory system.

There are significant benefits to investors for having derivative trades and settlement moved to exchange trading and central clearinghouses.

The scope of the Dodd-Frank Act² impacts all U.S. federal financial regulatory agencies and defines a new regulatory environment for derivatives. International regulators, outside the United States, are working under the coordination of Group of 20 Leaders. Two key proposals of the Dodd-Frank Act are as follows:

• The Act mandates a regulated, centralized clearing and trading environment for swaps, which were previously traded over the counter
  • Limited exemption is granted on the clearing requirement for the following circumstances: one of the counter-parties is not a financial entity, and the swap is used for hedging of business risks, and that party notifies the regulator on the use of this non-cleared swap contract
• The Commodity Futures Trading Commission will be responsible for the regulation of most types of swaps. The Securities and Exchange Commission will regulate security-based swaps (defined as narrow-based security index or a single security or loan). There will be a registration requirement for swap dealers and major participants, who will be required to meet certain capital and margin standards

The Lincoln Provision of the Act also outlines the requirements of regulated depositary institutions to move non-permitted derivative activities to non-bank affiliates with new capital and support standards. (Permitted swap activities under the Act include interest rate and currency swaps, cleared credit derivatives on investment grade securities and hedging activities).

There are significant benefits to investors for having derivative trades and settlement moved to exchange trading and central clearinghouses. These include improved access, increased transparency and liquidity, faster execution and lowered costs from automation. More importantly – as we learnt from the recent crisis – investors will benefit as well from regulators overseeing counter-party risk.

However, there are potential challenges to the regulators and solutions may not be simple due to the size and customization of the OTC instruments. Key issues may include:

1. achieving standardization of OTC derivative contracts, including pre-trade and post-trade price transparency, and setting capital and collateral requirements, and
2. technology related matters including electronic access, the linkages between international service providers and the need for 24/7 visibility.

Fortunately in Canada we already have well established derivative trading and clearing structures. The TMX Group³ operations at the Montreal Exchange have had a long history of specialization in financial derivatives trading management and are supported by the AA-rated Canadian Derivatives Clearing Corporation. The ability to leverage on our existing infrastructure and expertise, together with our established strong regulatory oversight, leave Canadians well prepared to meet the new global operating requirements for derivatives.

¹ International Swaps and Derivatives Association, Inc (“ISDA”) 2009-year end survey results.
² “The Dodd-Frank Act, Commentary & Insights”, Sadden, Arps, Slate, Meagher & Flom LLP & Affiliates, July 12, 2010
³ ‘Transparency, market integrity and risk management: The role of the regulated exchange”, TMX, Sept 2010