National Policy 11-203 Process for Exemptive Relief Applications in Multiple Jurisdictions -- relief from certain specified derivatives and custodial requirements to permit mutual funds to enter into swap transactions that are cleared through a clearing corporation -- relief required because of U.S. and European requirements to clear over-the-counter derivatives including swaps -- decision treats cleared swaps similar to other cleared derivatives.
Applicable Legislative Provisions
National Instrument 81-102 Investment Funds, ss. 2.7(1) and (4), 6.1(1), 19.1.
January 29, 2016
IN THE MATTER OF THE SECURITIES LEGISLATION OF ONTARIO (the Jurisdiction) AND IN THE MATTER OF THE PROCESS FOR EXEMPTIVE RELIEF APPLICATIONS IN MULTIPLE JURISDICTIONS AND IN THE MATTER OF BMO ASSET MANAGEMENT INC. and BMO INVESTMENTS INC. (the Filers)
The principal regulator in the Jurisdiction has received an application from the Filers for a decision under the securities legislation of the Jurisdiction of the principal regulator (the Legislation), pursuant to section 19.1 of National Instrument 81-102 Investment Funds (NI 81-102), exempting all current and future mutual funds, including exchange-traded funds, managed by either one of the Filers (each, a BMO Fund) that enter into Swaps (as defined below):
(i) from the requirement in subsection 2.7(1) of NI 81-102 that a mutual fund must not purchase an option or a debt-like security or enter into a swap or a forward contract unless, at the time of the transaction, the option, debt-like security, swap or contract has a designated rating or the equivalent debt of the counterparty, or of a person or company that has fully and unconditionally guaranteed the obligations of the counterparty in respect of the option, debt-like security, swap or contract, has a designated rating;
(ii) from the limitation in subsection 2.7(4) of NI 81-102 that the mark-to-market value of the exposure of a mutual fund under its specified derivatives positions with any one counterparty other than an acceptable clearing corporation or a clearing corporation that settles transactions made on a futures exchange listed in Appendix A to NI 81-102 shall not exceed, for a period of 30 days or more, 10 percent of the net asset value of the mutual fund; and
(iii) from the requirement in subsection 6.1(1) of NI 81-102 to hold all portfolio assets of an investment fund under the custodianship of one custodian in order to permit each BMO Fund to deposit cash and other portfolio assets directly with a Futures Commission Merchant (as defined below) and indirectly with a Clearing Corporation (as defined below) as margin,
in each case, with respect to cleared Swaps (the Requested Relief).
Under the Process for Exemptive Relief Applications in Multiple Jurisdictions (for a passport application):
(a) the Ontario Securities Commission is the principal regulator for this application; and
(b) the Filer has provided notice that subsection 4.7(1) of Multilateral Instrument 11-102 Passport System (MI 11-102) is intended to be relied upon in each of the other provinces and territories of Canada (the Other Jurisdictions and collectively with Ontario, the Jurisdictions).
Terms defined in NI 81-102, National Instrument 14-101 Definitions, and MI 11-102 have the same meaning if used in this decision, unless otherwise defined. Capitalized terms used in this decision have the following meanings:
BMOAM means BMO Asset Management Inc.
BMOII means BMO Investments Inc.
BMO ETFs means all current and future exchange-traded funds managed by BMOAM and BMO ETF means any one of them
BMO Funds means, collectively, the BMO ETFs and the BMO Mutual Funds and BMO Fund means any one of them
BMO Mutual Funds means all current and future mutual funds managed by BMOII and BMO Mutual Fund means any one of them
CFTC means the U.S. Commodity Futures Trading Commission
Clearing Corporation means any clearing organization registered with the CFTC or central counterparty authorized by ESMA, as the case may be, that, in either case, is also permitted to operate in the Jurisdiction or the Other Jurisdiction, as the case may be, where the BMO Fund is located
Dodd-Frank means the Dodd-Frank Wall Street Reform and Consumer Protection Act
EMIR means the European Market Infrastructure Regulation
ESMA means the European Securities and Markets Authority
European Economic Area means all of the European Union countries and also Iceland, Liechtenstein and Norway
Futures Commission Merchant means any futures commission merchant that is registered with the CFTC and/or clearing member for purposes of EMIR, as applicable, and is a member of a Clearing Corporation
Investment Advisor means each of the Filers, each affiliate of the Filers and each third party portfolio manager retained from time to time by a Filer to manage or advise all or a portion of the investment portfolio of one or more BMO Funds
OTC means over-the-counter
Swaps means the swaps that are, or will become, subject to a clearing determination or a clearing obligation issued by the CFTC or ESMA, as the case may be, including fixed-to-floating interest rate swaps, basis swaps, forward rate agreements in U.S. dollars, the Euro, Pounds Sterling or the Japanese Yen, overnight index swaps in U.S. dollars, the Euro and Pounds Sterling and untranched credit default swaps on certain North American indices (CDX.NA.IG and CDX.NA.HY) and European indices (iTraxx Europe, iTraxx Europe Crossover and iTraxx Europe HiVol) at various tenors
U.S. Person has the meaning attributed thereto by the CFTC
This decision is based on the following facts represented by the Filers:
The Filers and the BMO Funds
1. BMOAM is, or will be, the investment fund manager of each BMO ETF. BMOAM is registered as an investment fund manager, a portfolio manager, an exempt market dealer and a commodity trading manager in the Province of Ontario. BMOAM is also registered as a portfolio manager and an exempt market dealer in each of the other Jurisdictions and as an investment fund manager in each of the Provinces of Quebec and Newfoundland and Labrador. The head office of BMOAM is in Toronto, Ontario.
2. BMOII is, or will be, the investment fund manager of each BMO Mutual Fund. BMOII is registered as an investment fund manager and a mutual fund dealer in the Provinces of Ontario, Newfoundland and Labrador and Quebec and a mutual fund dealer in each of the other Jurisdictions. The head office of BMOII is in Toronto, Ontario.
3. Either a Filer, an affiliate of the Filers or a third party portfolio manager is, or will be, the Investment Advisor of all or a portion of the investment portfolio of each BMO Fund.
4. Each BMO Fund is, or will be, a mutual fund created under the laws of the Province of Ontario and is, or will be, subject to the provisions of NI 81-102.
5. Neither the Filers nor the BMO Funds in existence as at the date hereof are in default of securities legislation in any Jurisdiction.
6. The securities of each BMO Fund are, or will be, qualified for distribution pursuant to a prospectus that was, or will be, prepared and filed in accordance with the securities legislation of the Jurisdictions. Accordingly, each BMO Fund is, or will be, a reporting issuer or the equivalent in each Jurisdiction.
7. The investment objective and investment strategies of each BMO Fund permit, or will permit, the BMO Fund to enter into derivative transactions, including Swaps. Each Investment Advisor for the BMO Funds in existence as at the date hereof considers Swaps to be an important investment tool that is available to it to properly manage such BMO Fund's portfolio.
8. Dodd-Frank requires that certain OTC derivatives be cleared through a Futures Commission Merchant at a clearing organization recognized by the CFTC. Generally, where one party to a Swap is a U.S. Person, that Swap must be cleared.
9. EMIR also requires that certain OTC derivatives be cleared through a central counterparty authorized to provide clearing services for purposes of EMIR. Generally, where one party to a Swap is a financial counterparty or a non-financial counterparty whose OTC derivative trading activity exceeds a certain threshold, in each case established in a state that is a participant in the European Economic Area, that Swap will be required to be cleared. The first clearing directive has been issued in respect of certain interest rate swaps and will be phased-in based on the category of both parties to the trade.
10. In order to benefit from both the pricing benefits and reduced trading costs that an Investment Advisor may be able to achieve through its trade execution practices for its advised investment funds and other accounts and from the reduced costs associated with cleared OTC derivatives as compared to other OTC trades, the Filers wish to have the BMO Funds enter into cleared Swaps.
11. In the absence of the Requested Relief, each Investment Advisor will need to structure the Swaps entered into by the BMO Funds so as to avoid the clearing requirements of the CFTC and under EMIR, as applicable. The Filers respectfully submit that this would not be in the best interests of the BMO Funds and their investors for a number of reasons, as set out below.
12. The Filers strongly believe that it is in the best interests of the BMO Funds and their investors to be able to execute OTC derivatives with global counterparties, including U.S. and European swap dealers.
13. Each of the Filers, in its role as a fiduciary for the BMO Funds, has determined that central clearing represents the best choice for the investors in the BMO Funds to mitigate the legal, operational and back office risks faced by investors in the global swap markets.
14. Each Investment Advisor may use the same trade execution practices for all of its advised funds and other accounts, including the BMO Funds. An example of these trade execution practices is block trading, where large number of securities are purchased or sold or large derivative trades are entered into on behalf of a number of investment funds and other accounts advised by one Investment Advisor. These practices include the use of cleared Swaps. If the BMO Funds are unable to employ these trade execution practices, then each affected Investment Advisor will have to create separate trade execution practices only for the BMO Funds and will have to execute trades for the BMO Funds on a separate basis. This will increase the operational risk for the BMO Funds, as separate execution procedures will need to be established and followed only for the BMO Funds. In addition, the BMO Funds will no longer be able to enjoy the possible price benefits and reduction in trading costs that an Investment Advisor may be able to achieve through a common practice for its advised funds and other accounts. In the Filers' opinion, best execution and maximum certainty can best be achieved through common trade execution practices, which, in the case of OTC derivatives, involve the execution of Swaps on a cleared basis.
15. As a member of the G20 and a participant in the September 2009 commitment of G20 nations to improve transparency and mitigate risk in derivatives markets, Canada has expressly recognized the systemic benefits that clearing OTC derivatives offers to market participants, such as the BMO Funds. The Filers respectfully submit that the BMO Funds should be encouraged to comply with the robust clearing requirements established by the CFTC and under EMIR by granting them the Requested Relief.
16. The Requested Relief is analogous to the treatment currently afforded under NI 81-102 to other types of derivatives that are cleared, such as clearing corporation options, options on futures and standardized futures. This demonstrates that, from a policy perspective, the Requested Relief is consistent with the views of the Canadian securities authorities in respect of cleared derivative trades.
17. For the reasons provided above, the Filers submit that it would not be prejudicial to the public interest to grant the Requested Relief.
The principal regulator is satisfied that the decision meets the test set out in the Legislation for the principal regulator to make the decision.
The decision of the principal regulator under the Legislation is that the Requested Relief is granted provided that when any rules applicable to customer clearing of OTC derivatives enter into force, the Clearing Corporation is permitted to offer customer clearing of OTC derivatives in the Jurisdiction or the Other Jurisdiction, as the case may be, where the BMO Fund is located and provided further that, in respect of the deposit of cash and other portfolio assets as margin:
(a) in Canada,
(i) the Futures Commission Merchant is a member of a SRO that is a participating member of CIPF; and
(ii) the amount of margin deposited and maintained with the Futures Commission Merchant does not, when aggregated with the amount of margin already held by the Futures Commission Merchant, exceed 10 percent of the net asset value of the BMO Fund as at the time of deposit; and
(b) outside of Canada,
(i) the Futures Commission Merchant is a member of a Clearing Corporation and, as a result, is subject to a regulatory audit;
(ii) the Futures Commission Merchant has a net worth, determined from its most recent audited financial statements that have been made public or from other publicly available financial information, in excess of the equivalent of $50 million; and
(iii) the amount of margin deposited and maintained with the Futures Commission Merchant does not, when aggregated with the amount of margin already held by the Futures Commission Merchant, exceed 10 percent of the net asset value of the BMO Fund as at the time of deposit.
This decision will terminate on the coming into force of any revisions to the provisions of NI 81-102 that address the clearing of OTC derivatives.