Mutual Reliance Review System for Exemptive Relief Applications -- s. 19.1 of National Instrument 81-102 Mutual Funds -- exemption from section 2.7 (1)(a) of NI 81-102 to permit interest rate and credit derivative swaps and, for hedging purposes, currency swaps and forwards with a remaining term to maturity of greater than 3 years; exemption from section 2.8(1) of NI 81-102 to the extent that cash cover is required in respect of specified derivatives to permit the Funds to cover specified derivative positions with: certain bonds, debentures, notes or other evidences of indebtedness, floating rate notes and securities of money market funds.
Applicable Legislative Provisions
National Instrument 81-102 Mutual Funds, ss. 2.7(1)(a), 2.8(1), 19.1
September 25, 2007
IN THE MATTER OF
THE SECURITIES LEGISLATION OF
BRITISH COLUMBIA, ALBERTA, SASKATCHEWAN,
MANITOBA, ONTARIO, QUEBEC, NEW BRUNSWICK,
NOVA SCOTIA, PRINCE EDWARD ISLAND,
NEWFOUNDLAND AND LABRADOR,
NORTHWEST TERRITORIES, YUKON
IN THE MATTER OF
THE MUTUAL RELIANCE REVIEW SYSTEM
FOR EXEMPTIVE RELIEF APPLICATIONS
IN THE MATTER OF
MACKENZIE FINANCIAL CORPORATION
MRRS DECISION DOCUMENT
The local securities regulatory authority or regulator (the "Decision Maker") in each of the Jurisdictions has received an application (the "Application") from Mackenzie, on behalf of the funds that Mackenzie manages together with all future mutual funds managed by Mackenzie other than money market funds (collectively, the "Funds"), for a decision under the securities legislation of the Jurisdictions (the "Legislation") granting exemptions pursuant to section 19.1 of National Instrument 81-102 Mutual Funds (NI 81-102):
1. from the requirement in section 2.7(1)(a) of NI 81-102, insofar as it requires a swap or forward contract to have a remaining term to maturity of 3 years or less (or 5 years or less in certain circumstances), to permit the Funds to enter into interest rate swaps or credit default swaps or, if the transaction is for hedging purposes, currency forwards, in all cases with a remaining term to maturity of greater than 3 years; and
2. from the requirement in section 2.8(1) of NI 81-102, to the extent that cash cover is required in respect of specified derivatives, to permit the Funds to cover specified derivatives positions with:
(a) any bonds, debentures, notes or other evidences of indebtedness that are liquid (collectively, "Fixed Income Securities");
(b) floating rate evidences of indebtedness; or
(c) securities of money market funds managed by Mackenzie ("Mackenzie Money Market Funds")
(collectively, the "Requested Relief").
Under the Mutual Reliance Review System for Exemptive Relief Applications:
(a) the Ontario Securities Commission is the principal regulator for this Application, and
(b) this MRRS decision document evidences the decision of each Decision Maker.
Defined terms contained in National Instrument 14-101 Definitions have the same meaning in this decision unless they are defined in this decision.
This decision is based on the following facts represented by the Mackenzie and the Funds:
1. Mackenzie is a corporation amalgamated under the laws of Ontario and is registered as an advisor in the categories of investment counsel and portfolio manager in Ontario, Manitoba and Alberta. Mackenzie is also registered in Ontario as a dealer in the category of Limited Market Dealer, as well as registered under the Commodity Futures Act (Ontario) in the categories of Commodity Trading Counsel & Commodity Trading Manager. Mackenzie is or will be the manager of the Funds. Mackenzie's head office is in Toronto, Ontario.
2. The Funds are or will be mutual fund trusts or classes of corporations established under the laws of Ontario. The portfolio advisor is or will be either Mackenzie or another entity appointed by Mackenzie as portfolio advisor or portfolio sub-advisor. The Funds are or will be offered by prospectus in all the Jurisdictions. The Funds are or will be reporting issuers under the securities laws of some or all of the provinces and territories of Canada.
3. Nearly all of the Funds are or will be permitted to use derivative instruments (such as options, futures, forward contracts, swaps or customized derivatives). Any Fund that is not currently permitted to commence the use of derivatives will only do so in accordance with section 2.11 of NI 81-102.
4. The Funds that are or will be permitted to use derivatives can use derivatives to reduce risk by hedging against losses caused by changes in securities prices, interest rates, exchange rates and/or other risks. The Funds may also use specified derivatives for non-hedging purposes under their investment strategies in order to invest indirectly in securities or financial markets or to gain exposure to other currencies, provided the use of derivatives is consistent with the Fund's investment objectives. When specified derivatives are used for non-hedging purposes, the Funds are subject to the cash cover requirements of NI 81-102.
5. In all cases where the Funds may use derivatives, hedging of risks is permitted, including currency risks, whether the currency risk relates to income or equity securities or otherwise.
Interest Rate Swaps, Credit Default Swaps and Currency Forwards for Hedging Purposes
6. Section 2.7(1)(a) of NI 81-102 prohibits mutual funds from entering into certain over-the-counter derivatives transactions, with terms to maturity of greater than 3 years, or greater than 5 years if the contract provides the fund with a right to eliminate its exposure within 3 years. Mackenzie seeks the ability to enter into, on behalf of the Funds, interest rate swaps and credit default swaps or, if the transaction is for hedging purposes, currency forwards, without a restriction as to term of the swap or forward.
7. To a large extent, traditional mutual fund investing is about managing risks prudently to obtain commensurate returns. For fixed income investments, such risks include but are not limited to interest rate risk, credit risk and currency risk. These risks can be controlled or mitigated through the use of over-the-counter ("OTC") derivatives. Interest rate risk may be managed by interest rate swaps, credit risk is managed by credit default swaps and currency risk by currency forwards.
8. The term of a swap equals the maturity of its exposure, in contrast to other over-the-counter transactions, such as options and certain types of forwards, where the contract term and maturity of the underlying security are not related. As a result, there is no restriction under NI 81-102, for example, on a forward referencing an underlying interest having a term of 10 years or more, whereas there is a restriction if the derivative is in the form of a swap.
9. Credit default swaps ("CDS") have a similar risk profile to their reference entity (corporate or sovereign bonds), or in the case of an index of credit default swaps (such as CDX), to an average of all the reference entities in the CDX index. The term of a credit default swap imparts credit risk similar to that of a bond of the reference entity with the same term. The Funds may not be able to achieve the same sensitivity to the credit risk of a specific reference entity or their respective benchmarks by using credit default swaps with a maximum term of 3 years because the reference entity or relevant benchmark may have an average term that is longer. There is no term restriction in NI 81-102 when investing directly in the reference entities (corporate or sovereign bonds).
10. A currency forward used for hedging purposes may or may not have a contract term and maturity that equals the maturity of the underlying interest. For example, if a 10-year bond is denominated in U.S. dollars, under the current provisions of NI 81-102, the term of the currency forward can be at most 5 years whereas the term of the underlying interest is 10 years. Ideally to manage the currency risk, a fund must enter into two consecutive 5-year currency forwards. However, the pricing for the currency forward in respect of the second 5 year period is not known at the time the U.S. dollar bond is purchased but only 5 years hence. Consequently, the inability to enter into a 10-year currency forward transaction indirectly introduces currency risk when a hedged 10-year position was the desired outcome. Accordingly, whenever the term of the bond is longer than 5 years, the current provisions of NI 81-102 may unintentionally expose a fund to currency risk. This has become a very relevant issue given that there are no longer foreign investment restrictions under the Income Tax Act (Canada).
11. It is also not a market convention to have a transaction with a 5-year term (subject to a right to eliminate the exposure within 3 years) as required by NI 81-102 and, as a result, from time to time, this off-market feature may subject a fund to less efficient pricing.
12. The interest rate swap market, credit default swap markets and currency forward markets are very large and liquid.
13. The interest rate swap market is generally as liquid as government bonds and more liquid than corporate bonds. The Bank for International Settlements reported that the notional amount of interest rate swaps outstanding was U.S. $172.8 trillion as of December 31, 2005 (U.S. $207.3 trillion as of June 30, 2006). In Canada, there were over U.S. $1.5 trillion of interest rate swaps outstanding as of December 31, 2005, greater than the sum of all outstanding federal and provincial debt.
14. Credit default swaps, on average, are highly liquid instruments. Single name CDS are slightly less liquid than the bonds of their reference entities, while CDS on CDX are generally more liquid, than corporate or emerging market bonds. The Bank for International Settlements reported that the notional amount of credit default swaps outstanding was U.S. $20.3 trillion as of June 30, 2006. The International Swap and Derivatives Association's 2006 mid-year market survey estimated the notional amount outstanding to be U.S. $26.0 trillion. Using either source, the credit default swap market has surpassed the size of the equity derivatives markets, and is one of the fastest growing financial markets.
15. With respect to foreign exchange, the Bank for International Settlements reported that the notional amount of outright forwards and foreign exchange swaps outstanding was U.S. $19.4 trillion as at June 30, 2006. For comparative purposes, the S & P 500 had an approximate market capitalization of U.S. $11.7 trillion on such date. The Bank for International Settlements also reported that the average daily turnover of OTC foreign exchange was U.S. $1,292 billion during April, 2004. The average daily turnover of outright forwards and foreign exchange swaps totaled U.S. $1,152 billion during such period. For comparative purposes, the daily trading during May 2007 was in the case of the New York Stock Exchange approximately U.S. $82.2 billion and in the case of the Toronto Stock Exchange approximately CAD $7.1 billion. Daily trading is many times larger for currencies and currency forwards than for well-known equity exchanges.
16. Because swap and forward contracts are private agreements between two counterparties, a secondary market for the agreements would be a cumbersome process whereby one counterparty would have to find a new counterparty willing to take over its contract at a fair market price, get the original counterparty to approve the new counterparty, and exchange a whole new set of documents. To avoid that process, market participants can unwind their positions in interest rate swaps and currency forwards by simply entering into an opposing swap with an acceptable counterparty at market value. In this way, the original economic position of the initial swap or forward is offset. In the case of CDS, Mackenzie would trade with the original counterparty, which has the effect of cancelling the CDS at current prices, or trade with another counterparty by assigning the swap to the other counterparty. Should one of the two remaining parties in the contract default, there would be no recourse back to the Funds.
17. Credit risk exposure to a counterparty on an interest rate swap transaction is generally a small fraction of the underlying notional exposure, equal to the cumulative price change since the inception of the swap. Even that small risk will be mitigated because the counterparty will be required to have an approved credit rating prescribed by NI 81-102.
18. Potential credit exposure to a counterparty on a credit default swap on a CDX is equal to the notional exposure to any issuer in the index who has defaulted, or in the case of a single name CDS, equal to the full notional exposure. The Bank for International Settlements reported that, as at June 30, 2006, that the "gross market value" of credit default swaps was approximately 1.4% of the notional amount. The Bank for International Settlements states that "gross market value" is defined as the sums of all absolute values of all open contracts with either a positive or negative replacement value evaluated at prevailing market prices. This essentially is a proxy for the sum of all counterparty exposures. Such approach is a conservative measurement since the figure is compiled without netting of positions between counterparties, which in practice would be common. As is the case with interest rate swaps, this exposure is mitigated because the counterparty will be required to have an approved credit rating prescribed by NI 81-102 and exposure to any individual counterparty is limited by NI 81-102.
19. Like interest rate swaps and credit default swaps, credit risk exposure to a counterparty is only a small fraction of the underlying notional exposure of a currency forward. The Bank for International Settlements reported that, as at June 30, 2006, the "gross market value" of outright forwards and foreign exchange swaps was approximately 2.2% of the notional amount.
20. By permitting the Funds to enter into swaps beyond 3-year terms, it increases the possibility for the Funds to increase returns due to the fact that the opportunity set is expanded and to target exposures that might not otherwise be available in the cash bond markets or could not be achieved as efficiently as in the cash bond markets. Further, the use of swaps and forwards beyond 3-year terms enables the Funds to effect hedging transactions that are more efficient and tailored that help mitigate underlying investment risks.
21. Mackenzie has and/or will have the right to terminate the swap or forward early if a counterparty's credit rating drops below the credit ratings established by NI 81-102. In the case of an NI 81-102 fund, Mackenzie will do so in accordance with the requirements of section 2.7 of NI 81-102 and the definition of approved credit rating in NI 81-102.
22. The purpose of the cash cover requirement in NI 81-102 is to prohibit a mutual fund from leveraging its assets when using certain specified derivatives and to ensure that the mutual fund is in a position to meet its obligations on the settlement date. This is evident from the definition of "cash cover", which is defined as certain specific portfolio assets of the mutual fund that have not been allocated for specific purposes and that are available to satisfy all or part of the obligations arising from a position in specified derivatives held by the mutual fund. Currently, the definition of "cash cover" includes six different categories of securities, including certain evidences of indebtedness (cash equivalents and commercial paper) that generally have a remaining term to maturity of 365 days or less and that have an approved credit rating or are issued or guaranteed by an entity with an approved credit rating (collectively, "short-term debt").
23. In addition to the securities currently included in the definition of cash cover, the Funds would also like to invest in Fixed Income Securities, floating rate evidences of indebtedness and/or securities of the Mackenzie Money Market Funds for purposes of satisfying their cash cover requirements.
Fixed Income Securities
24. While the money market instruments that are currently permitted as cash cover are highly liquid, these instruments typically generate very low yields relative to longer dated instruments and similar risk alternatives.
25. The definition of cash cover in NI 81-102 addresses regulatory concerns of interest rate risk and credit risk by limiting the terms of the instruments and requiring the instruments to have an approved credit rating. By permitting the Funds to use for cash cover purposes Fixed Income Securities with a remaining term to maturity of 365 days or less and an approved credit rating, the regulatory concerns are met, since the term and credit rating will be the same as other instruments currently permitted to be used as cash cover.
Floating Rate Evidences of Indebtedness
26. Floating rate evidences of indebtedness, also known as floating rate notes ("FRNs"), are debt securities issued by the federal or provincial governments, the Crown or other corporations and other entities with floating interest rates that reset periodically, usually every 30 to 90 days.
27. Although the term to maturity of FRNs can be more than 365 days, the Funds propose to limit their investment in FRNs used for cash cover purposes to those that have interest rates that reset at least every 185 days.
28. Allowing the Funds to use FRNs for cash cover purposes could increase the rate of return earned by each of the Fund's investors without reducing the credit quality of the instruments held as cash cover. It is submitted that the frequent interest rate resets mitigate the risk of investing in FRNs as cash cover. For the purposes of money market funds under NI 81-102 meeting the 90 days dollar-weighted average term to maturity, the term of a floating rate evidence of indebtedness is the period remaining to the date of the next rate setting. If a FRN resets every 365 days, then the interest rate risk of the FRN is about the same as a fixed rate instrument with a term to maturity of 365 days.
29. Financial instruments that meet the current cash cover requirements have low credit risk. The current cash cover requirements provide that evidences of indebtedness of issuers, other than government agencies, must have approved credit ratings. As a result, if the issuer of FRNs is an entity other than a government agency, the FRNs used by the Funds for cash cover purposes will have an approved credit rating as required by NI 81-102.
30. Given the frequent interest rate resets, the nature of the issuer and the adequate liquidity of FRNs, the risk profile and the other characteristics of FRNs are similar to those of short-term debt, which constitute cash cover under NI 81-102.
Mackenzie Money Market Funds
31. Under NI 81-102, in order to qualify as money market funds, the Mackenzie Money Market Funds are restricted to investments that are, essentially, considered to be cash cover. These investments include floating rate evidences of indebtedness if their principal amounts continue to have a market value of approximately par at the time of each change in the rate to be paid to their holders.
32. If the direct investments of the Mackenzie Money Market Funds would constitute cash cover under NI 81-102 (assuming that the relief allowing FRNs as cash cover is granted), then it is submitted that indirectly holding these investments through an investment in the securities of Mackenzie Money Market Funds should also satisfy the cash cover requirements of NI 81-102.
Derivative Policies and Risk Management
33. Mackenzie has adopted various written policies and internal procedures to supervise the use of derivatives as investments with its fund portfolios. All policies and procedures comply with the derivative rules set out in NI 81-102.
34. These policies and procedures are reviewed at least annually by senior management of Mackenzie. The designated Senior Vice-President, Investments of Mackenzie is responsible for oversight of all derivatives strategies used by the Funds. In addition, compliance personnel employed by both the portfolio advisors/sub-advisors and Mackenzie review the use of derivatives as part of their ongoing review of Fund activity. Compliance personnel are not members of the investment and trading group and report to a different functional area.
35. Limits and controls on the use of derivatives are part of Mackenzie's compliance regime and include reviews by compliance analysts who ensure that the derivative positions of the Funds are within applicable policies. As the use of the derivatives by the Funds is limited, Mackenzie does not currently conduct simulations to test the portfolio under stress conditions.
36. The derivative contracts entered into by Mackenzie, a portfolio advisor or portfolio sub-advisor on behalf of the Funds must be in accordance with the investment objectives and strategies of each of the Funds. Mackenzie, the portfolio advisors and portfolio sub-advisors of the Funds are also required to adhere to NI 81-102. Mackenzie sets and reviews the investment policies of the Funds, which also allows the trading in derivatives.
37. The annual information forms of the Funds disclose the internal controls and risk management processes of Mackenzie regarding the use of derivatives and, upon renewal of the prospectus and annual information forms of the Funds, will include disclosure of the nature of the exemptions granted in respect of the Funds.
38. Without these exemptions regarding the cash cover requirements of NI 81-102, the Funds will not have the flexibility to potentially enhance yield and to more effectively manage their exposure under specified derivatives.
39. The use of derivatives by investors and portfolio managers has increased substantially during the last 20 to 30 years. Mackenzie is seeking an exemption to permit the Funds to engage in strategies consistent and/or familiar with industry practice.
40. Mackenzie believes that the Requested Relief will be in the best interests of the Funds as they save costs, potentially enhance performance of the Funds or reduce risks and do not leave the Funds exposed to any material incremental risk beyond the risk that the portfolio manager is targeting and are or will be consistent with the investment objectives and strategies of the respective Funds. Mackenzie further believes the Requested Relief is not contrary to the public interest.
Each of the Decision Makers is satisfied that the test contained in the Legislation that provides the Decision Maker with the jurisdiction to make the decision has been met.
The decision of the Decision Makers under the Legislation is that the Requested Relief is granted provided that:
(i) the Fixed Income Securities have a remaining term to maturity of 365 days or less and have an "approved credit rating" as defined in NI 81-102;
(ii) the FRNs meet the following requirements:
(a) the floating interest rates of the FRNs reset no later than every 185 days;
(b) the FRNs are floating rate evidences of indebtedness with the principal amounts of the obligations that will continue to have a market value of approximately par at the time of each change in the rate to be paid to the holders of the evidences of indebtedness;
(c) if the FRNs are issued by a person or company other than a government or permitted supranational agency, the FRNs must have an approved credit rating;
(d) if the FRNs are issued by a government or permitted supranational agency, the FRNs have their principal and interest fully and unconditionally guaranteed by:
(I) the government of Canada or the government of a jurisdiction in Canada; or
(II) the government of the United States of America, the government of one of the states of the United States of America, the government of another sovereign state or a "permitted supranational agency" as defined in NI 81-102, if, in each case, the FRN has an "approved credit rating" as defined in NI 81-102; and
(e) the FRNs meet the definition of "conventional floating rate debt instrument" in section 1.1 of NI 81-102;
(iii) at the time of the next renewal of the prospectus and annual information form of the Funds, each of the Funds relying upon this relief shall disclose the nature of this relief in each Fund's prospectus and the nature and terms of the relief in each Fund's annual information form.