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 currency 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 and securities of money market funds; and exemption from sections 2.8(1)(d) and (f)(i) NI 81-102 to permit the Funds when they open or maintain a long position in a standardized future or forward contract or when they enter into or maintain an interest rate swap position and during the periods when the Funds are entitled to receive payments under the swap, to use as cover, an option to sell an equivalent quantity of the underlying interest of the standardized future, forward or swap.
Applicable Legislative Provisions
National Instrument 81-102 Mutual Funds, ss. 2.7(1)(a), 2.8(1), 2.8(1)(d), 2.8(1)(f)(i), 19.1.
November 15, 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, THE NORTHWEST
TERRITORIES, NUNAVUT AND YUKON
IN THE MATTER OF
THE MUTUAL RELIANCE REVIEW SYSTEM
FOR EXEMPTIVE RELIEF APPLICATIONS
IN THE MATTER OF
RBC ASSET MANAGEMENT INC.
THE FUNDS LISTED IN SCHEDULE A
MRRS DECISION DOCUMENT
The local securities regulatory authority or regulator (the "Decision Maker") in each of the Jurisdictions has received an application from the Filer 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") in respect of the mutual funds managed by the Filer in Schedule A together with all future funds managed by the Filer, other than money market funds (collectively, the "RBC Funds"):
(a) 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 RBC Funds to enter into interest rate swaps, credit default swaps or currency forwards, in all cases with a remaining term to maturity of greater than 3 years;
(b) 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 each of the RBC Funds to cover specified derivative positions with:
(i) any bonds, debentures, notes or other evidences of indebtedness that are liquid ("Fixed Income Securities") provided they have a remaining term to maturity of 365 days or less and have an approved credit rating;
(ii) floating rate evidences of indebtedness ("Floating Rate Securities"); or
(iii) securities of a money market mutual fund managed by the Filer to which NI 81-102 applies ("Money Market Funds"); and
(c) from the requirements in sections 2.8(1)(d) and (f)(i) of NI 81-102 to permit the RBC Funds when:
(i) they open or maintain a long position in a debt-like security that has a component that is a long position in a forward contract or in a standardized future or forward contract; or
(ii) they enter into or maintain a swap position and during the periods when the RBC Funds are entitled to receive payments under the swap;
to use as cover, a right or obligation to sell an equivalent quantity of the underlying interest of the standardized future, forward or swap (paragraphs (a), (b) and (c) will collectively be referred to as the "Requested Relief").
Under the Mutual Reliance Review System for Exemptive Relief Applications:
1. the Ontario Securities Commission is the principal regulator for this application; and
2. 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 Filer:
The RBC Funds
1. The Filer is a corporation governed by the Canada Business Corporations Act. The Filer is registered as an investment counsel and portfolio manager, or the equivalent, in each of the Jurisdictions and as a limited market dealer in Ontario and in Newfoundland and Labrador.
2. The RBC Funds are, or will be, mutual funds established under the laws of the Province of Ontario.
3. The RBC Funds are, or will be, reporting issuers in each of the provinces and territories of Canada. The existing RBC Funds are not, to the knowledge of the Filer, in default of any requirements of securities legislation in any of the Jurisdictions.
4. The Filer, or an affiliate of the Filer, is or will be the manager of the RBC Funds.
5. Many of the RBC Funds use specified derivatives as part of their investment strategies to gain or reduce exposure to securities and financial markets instead of investing in the securities directly. The RBC Funds may also use derivative instruments to: (i) reduce risk by protecting the RBC Funds against potential losses from changes in interest rates; (ii) to reduce the impact of currency fluctuations on the RBC Funds' portfolio holdings; and (iii) to provide protection for the RBC Funds' portfolios.
6. When specified derivatives are used for non-hedging purposes, the RBC Funds are subject to the cash cover requirements of NI 81-102.
Interest Rate Swaps, Credit Default Swaps and Currency Swaps/Forwards
7. Section 2.7(1)(a) of NI 81-102 prohibits mutual funds from entering into swaps or forward contracts 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. The RBC Funds seek the ability to enter into interest rate swaps, credit default swaps or, currency forwards, without a restriction as to the term of the swap or forward.
8. Fixed income investments have risks which 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 can be managed by credit default swaps and currency risk by currency swaps or forwards.
9. The term of a swap equals the maturity of its exposure, in contrast to other over-the-counter transactions, such as options and certain other 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 with an underlying interest having a term of 10 years whereas there is a restriction if the derivative is in the form of a swap.
10. Credit default swaps have a similar risk profile to their reference entity (corporate or sovereign bonds or asset backed securities) or, in the case of an index of credit default swaps (such as CDX), to an average of all the reference entities in the index or, in the case of a basket of reference entities, to an average of all the reference entities in the basket. 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 RBC Funds may not be able to achieve the same sensitivity to credit risk as their respective benchmarks by using credit default swaps with a maximum term of 3 years because the relevant benchmark may have an average term that is longer. It should also be noted that the most liquid terms for single name credit default swaps and/or indices are 5 years and 10 years. There is no term restriction in NI 81-102 when investing directly in the reference entities.
11. 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, a fund may be exposed to currency risk. This constraint has become very relevant given that there are no longer foreign investment restrictions under the Income Tax Act (Canada). It should also be noted that it is not market convention to have a transaction with a 5 year term (subject to a right to eliminate the exposure within 3 years) and, as a result, from time to time, this off-market feature may subject a fund to less efficient pricing.
12. Currency forwards may be used for non-hedging purposes as part of the overall investment strategy of RBC Funds which invest in foreign securities. A portfolio manager may take a view that a currency will underperform or overperform another currency over a period of time (including a period of time longer than 3 years). The portfolio manager may use currency forwards to take on currency exposure on a short or long term basis (including longer than 3 years). Unless disclosed as a principal investment strategy of a fund, a fund's exposure to non-hedging currency transactions will vary from time to time, however, such exposure will not exceed 7.5% of the assets of a fund.
13. When using currency forwards for non-hedging purposes the RBC Funds will hold cash cover that is not less than, on a daily mark-to-market basis, the underlying market exposure of the currency forward.
14. At the time of the next prospectus renewal, the RBC funds will expand the prospectus disclosure relating to the use of derivatives for non-hedging purposes in order to more fully explain that they may be used to gain exposure to other currencies. Risk disclosure will also be expanded.
15. The interest rate swap market, credit default swap market and currency swap and forward markets are very large and liquid.
16. 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. $230 trillion as of December 31, 2006. In Canada, there were over U.S. $1.7 trillion of interest rate swaps outstanding as of December 31, 2005, greater than the sum of all outstanding federal and provincial debt.
17. Credit default swaps, on average, are highly liquid instruments. Single name credit default swaps have become as liquid and in most cases more liquid than the cash bonds of their reference entities, while credit default swaps 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. $29 trillion as of December 31, 2006. The International Swap and Derivatives Association's 2006 year-end market survey estimated the notional amount outstanding to be U.S. $35 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.
18. 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 trillion as at December 31, 2006. For comparative purposes, the S&P 500 had an estimated market capitalization of U.S. $13.77 trillion on June 20, 2007. 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 totalled U.S. $1,152 billion during such period. For comparative purposes, the dollar volume traded during May 2007 was in the case of the New York Stock Exchange approximately U.S. $83.7 billion and in the case of the Toronto Stock Exchange approximately CAD $7 billion. Daily trading is many times larger for currencies and currency forwards than for well-known equity exchanges.
19. Because swaps 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 swaps or forwards by simply entering into an opposing swap or forward with an acceptable counterparty at market value. In this way, the original economic position of the initial swap or forward is offset. Parties may also agree to terminate the agreement at a fair market price prior to the maturity date of the agreement.
20. Credit risk exposure to a counterparty on an interest rate swap transaction or currency forward transaction is generally a small fraction of the underlying notional exposure, equal to the cumulative price change since the inception of the swap or forward. Even that small risk will be mitigated because the counterparty will be required to have an approved credit rating prescribed by NI 81-102.
21. Potential credit exposure to a counterparty on a credit default swap on a credit default index is equal to the pro rated notional exposure to any issuer in the index who has defaulted or, in the case of a single name credit default swap, equal to the full notional exposure. 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.
22. By permitting the RBC Funds to enter into swaps and forwards beyond 3 year terms, it increases the possibility for the RBC Funds to (i) increase returns due to the fact that the opportunity set is expanded, and (ii) 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 RBC Funds to effect hedging transactions that help mitigate underlying investment risks associated with investing in fixed income investments.
23. The RBC Funds have the right to terminate swaps and forwards early if a counterparty's credit rating drops below the credit ratings required by NI 81-102, and the RBC Funds will do so in accordance with the terms of section 2.7(4) of NI 81-102.
Using Fixed Income Securities, Floating Rate Securities and Money Market Funds as Cash Cover
24. 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").
25. In addition to the securities currently included in the definition of cash cover, the RBC Funds would also like to invest in Fixed Income Securities, Floating Rate Securities and/or the Money Market Funds for purposes of satisfying their cash cover requirements.
Fixed Income Securities
26. 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.
27. Other fixed income instruments with maturities less than 365 days and approved credit ratings are also liquid but provide the potential for higher yields.
28. The definition of cash cover 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 RBC 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 Securities
29. Floating Rate Securities 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.
30. Although the term to maturity of Floating Rate Securities can be more than 365 days, the RBC Funds propose to limit their investment in Floating Rate Securities used for cash cover purposes to those that have interest rates that reset at least every 185 days.
31. Allowing the RBC Funds to use Floating Rate Securities for cash cover purposes could increase the rate of return earned by each of the RBC 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 Floating Rate Securities 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 Floating Rate Security resets every 365 days, then the interest rate of the Floating Rate Security is about the same as a fixed rate instrument with a term to maturity of 365 days.
32. 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 Floating Rate Securities is an entity other than a government agency, the Floating Rate Securities used by the RBC Funds for cash cover purposes will have an approved credit rating as required by NI 81-102.
33. Given the frequent interest rate resets, the nature of the issuer and the adequate liquidity of Floating Rate Securities, the risk profile and the other characteristics of Floating Rate Securities are similar to those of short-term debt, which constitute cash cover under NI 81-102.
Money Market Funds
34. Under NI 81-102, in order to qualify as money market funds, the issuers of Money Market Funds are restricted to investments that are, for the most part, considered to be cash cover.
35. If the direct investments of the Money Market Funds would constitute cash cover under NI 81-102, then indirectly holding these investments through an investment in the Money Market Funds should also satisfy the cash cover requirements of NI 81-102.
Using Put Options as Cover for Long Positions in Futures, Forwards and Swaps
36. Sections 2.8(1)(d) and 2.8(1)(f)(i) of NI 81-102 do not permit covering the position in long positions in futures and forwards and positions in swaps for a period when a Fund is entitled to receive payments under the swap, in whole or in part with a right or obligation to sell an equivalent quantity of the underlying interest of the future, forward or swap. Accordingly, those sections of NI 81-102 do not permit the use of put options or short future, forward or swap positions to cover long future, forward or swap positions.
37. Regulatory regimes in other countries recognize the hedging properties of options for all categories of derivatives, including long positions evidenced by standardized futures or forwards or in respect of swaps where a fund is entitled to receive payments from the counterparty, provided they are covered by an amount equal to the difference between the market price of a holding and the strike price of the option that was bought or sold to hedge it. NI 81-102 effectively imposes the requirement to overcollateralize, since the maximum liability to the fund under the scenario described is equal to the difference between the market value of the long and the exercise price of the option. Overcollateralization imposes a cost on a mutual fund.
38. Section 2.8(1)(c) of NI 81-102 permits a mutual fund to write a put option and cover it with buying a put option on an equivalent quantity of the underlying interest of the written put option. This position has similar risks as a long position in a future, forward or swap and the RBC Funds should be permitted to cover a long position in a future, forward or swap with a put option or short future, forward or swap position.
Derivative Policies and Risk Management
39. The Filer is responsible for managing the risks associated with the use of derivatives. The Filer has written guidelines that set out the objectives and goals for derivatives trading, which are established and reviewed annually by the board of directors of the Filer.
40. In addition, the Filer has written control policies and procedures in place that set out the risk management procedures applicable to derivatives trading. These policies and procedures set out specific procedures for the authorization, documentation, reporting, monitoring and review of derivative strategies ensuring that these functions are performed by individuals independent of those who trade.
41. Limits and controls on derivatives trading are part of the Filer's compliance regime. All derivatives transactions are reviewed by a specially trained team that ensures that the derivative positions of the funds are within the existing control policies and procedures.
42. The derivative contracts entered into on behalf of the RBC Funds must be in accordance with the investment objectives and strategies of each of the RBC Funds.
43. The prospectus and annual information form of the RBC Funds discloses the internal controls and risk management processes of the Filer regarding the use of derivatives and, upon renewal, will include disclosure of the nature of the Requested Relief being sought in respect of the RBC Funds.
44. Without the Requested Relief the RBC Funds will not have the flexibility to enhance yield and to manage more effectively their exposure under specified derivatives.
Each of the Decision Makers is satisfied that the test contained in the Legislation that provides the Decision Makers 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:
1. 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;
2. the Floating Rate Securities meet the following requirements:
(a) the floating interest rates of the Floating Rate Securities reset no later than every 185 days;
(b) the Floating Rate Securities 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 Floating Rate Securities are issued by a person or company other than a government or "permitted supranational agency" as defined in NI 81-102, the Floating Rate Securities must have an "approved credit rating" as defined in NI 81-102;
(d) if the Floating Rate Securities are issued by a government or permitted supranational agency, the Floating Rate Securities 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 Floating Rate Securities have an "approved credit rating" as defined in NI 81-102; and
(e) the Floating Rate Securities meet the definition of "conventional floating rate debt instrument" in section 1.1 of NI 81-102;
3. a RBC Fund shall not open or maintain a long position in a debt-like security that has a component that is a long position in a forward contract, or in a standardized future or forward contract unless the RBC Fund holds
(a) cash cover in an amount that, together with margin on account for the specified derivative and the market value of the specified derivative, is not less than, on a daily mark-to-market basis, the underlying market exposure of the specified derivative;
(b) a right or obligation to sell an equivalent quantity of the underlying interest of the future or forward contract, and cash cover that together with margin on account for the position, is not less than the amount, if any, by which the strike price of the future or forward contract exceeds the strike price of the right or obligation to sell the underlying interest; or
(c) a combination of the positions referred to in subparagraphs (a) and (b) that is sufficient, without recourse to other assets of the RBC Fund, to enable the RBC Fund to acquire the underlying interest of the future or forward contract;
4. a RBC Fund shall not enter into or maintain a swap position unless for periods when the RBC Fund would be entitled to receive fixed payments under the swap, the RBC Fund holds
(a) cash cover in an amount that, together with margin on account for the swap and the market value of the swap, is not less than, on a daily mark-to-market basis, the underlying market exposure of the swap;
(b) a right or obligation to enter into an offsetting swap on an equivalent quantity and with an equivalent term and cash cover that together with margin on account for the position is not less than the aggregate amount, if any, of the obligations of the RBC Fund under the swap less the obligations of the RBC Fund under such offsetting swap; or
(c) a combination of the positions referred to in clauses (a) and (b) that is sufficient, without recourse to other assets of the RBC Fund, to enable the RBC Fund to satisfy its obligations under the swap.
5. at the time of the next renewal and all subsequent renewals of the prospectus and annual information form the RBC Fund shall:
(a) disclose the nature and terms of this relief in the annual information form of the RBC Fund with a cross reference thereto in the prospectus of the RBC Fund; and
(b) shall include a summary of the nature and terms of this relief in the prospectus of the RBC Fund under the Investment Strategies section or in the introduction to Part B of the prospectus with a cross reference thereto under the Investment Strategies section for the RBC Fund.