Securities Law & Instruments


Headnote

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 as contemplated under U.S. and European requirements – decision treats cleared swaps similar to other cleared derivatives.

Applicable Legislative Provisions

National Instrument 81-102 Investment Funds, ss. 2.7(1), (4) and 6.1(1), 19.1.

August 19, 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
1832 ASSET MANAGEMENT L.P.
(the Filer or Manager)

DECISION

Background

The principal regulator in the Jurisdiction has received an application from the Filer 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 existing and future mutual funds managed by the Filer that enter into Swaps (as defined below) (each, a Fund) from:

(a)           the following requirements to permit each Fund to enter into cleared Swaps as further described below:

(i)            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)           the requirement 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 clears and 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

(b)           the requirement in subsection 6.1(1) of NI 81-102 that all portfolio assets of an investment fund be held under the custodianship of one custodian to permit each Fund to deposit cash and other portfolio assets as margin directly with a Futures Commission Merchant (as defined below) and indirectly with a Clearing Corporation (as defined below) in connection with entering into the cleared Swaps, as further described below

(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 section 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 (each, an Other Jurisdiction, and together with the Jurisdiction, the Jurisdictions).

Interpretation

Unless otherwise defined herein, terms defined in National Instrument 14-101 Definitions, MI 11-102 and NI 81-102 have the same meaning in this decision. In addition, the following terms used in this decision have the following meanings:

Act means the Securities Act (Ontario) as may be amended from time to time

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 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 the Filer, each affiliate of the Filer and each third party portfolio manager retained from time to time by the Filer to manage all or a portion of the investment portfolio of one or more 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

Representations

This decision is based on the following facts represented by the Filer:

The Manager

1.             The Manager is an Ontario limited partnership, which is wholly-owned indirectly by The Bank of Nova Scotia. The general partner of the Manager is 1832 Asset Management G.P. Inc., an Ontario corporation wholly-owned directly by The Bank of Nova Scotia, with its head office in Ontario.

2.             The Manager is registered as: (i) a portfolio manager in all of the provinces of Canada and in Northwest Territories and Yukon; (ii) an exempt market dealer in all of the provinces of Canada (except Prince Edward Island and Saskatchewan); (iii) an investment fund manager in Ontario, Quebec, Newfoundland and Labrador and Northwest Territories; and (iv) a commodity trading manager in Ontario.

3.             The Manager is the investment fund manager of each existing Fund and will be the investment fund manager of each future Fund. An Investment Advisor is the portfolio manager of each existing Fund and will be the portfolio manager of each future Fund.

4.             The Manager is not in default of securities legislation in any of the Jurisdictions.

The Funds

5.             Each existing Fund is, and each future Fund will be, an open-ended mutual fund organized as a trust, limited partnership or class of shares of a mutual fund corporation, in each case established under the laws of the Province of Ontario or the laws of Canada.

6.             Each existing Fund is, and each future Fund will be, a “reporting issuer” (as defined in the Act) in one or more of the Jurisdictions. The securities of each existing Fund are, and of each future Fund will be, qualified for distribution in one or more of the Jurisdictions pursuant to a simplified prospectus and annual information form filed in accordance with the securities legislation of each of the relevant Jurisdictions. Each existing Fund is, and each future Fund will be, subject to the provisions of NI 81-102.

7.             No existing Fund is in default of securities legislation in any of the Jurisdictions.

The Previous Relief

8.             The Funds were granted similar relief in a decision of the principal regulator dated December 16, 2013 (the Previous Relief).

9.             The Previous Relief contained a provision terminating the Previous Relief on the earlier of (i) the coming into force of any revisions to the provisions of NI 81-102 that address the clearing of OTC derivatives, and (ii) two years from the date of the Previous Relief (the Termination Date).

10.          The Funds have not relied on the Previous Relief since the Termination Date.

Cleared Swaps

11.          The investment objective and investment strategies of each existing Fund permit, and of each future Fund will permit, the Fund to enter into derivative transactions, including Swaps. Each Investment Advisor for the 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 Fund’s portfolio.

12.          Dodd-Frank requires that certain OTC derivatives be cleared through a Futures Commission Merchant at a clearing organization, as recognized by the CFTC. Generally, where one party to a Swap is a U.S. Person, that Swap must be cleared.

13.          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.

14.          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 Filer wishes to have the Funds enter into cleared Swaps.

15.          In the absence of the Requested Relief, each Investment Advisor will need to structure the Swaps entered into by the Funds so as to avoid the clearing requirements of the CFTC and under EMIR, as applicable. The Filer respectfully submits that this would not be in the best interests of the Funds and their investors for a number of reasons, as set out below.

16.          The Filer strongly believes that it is in the best interests of the Funds and their investors to be able to execute OTC derivatives with global counterparties, including U.S. and European swap dealers.

17.          The Filer, in its role as a fiduciary for the Funds, has determined that central clearing represents the best choice for the investors in the Funds to mitigate the legal, operational and back office risks faced by investors in the global swap markets.

18.          Each Investment Advisor may use the same trade execution practices for all of its advised investment funds and other accounts, including the Funds. An example of these trade execution practices is block trading, where large numbers 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 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 Funds and will have to execute trades for the Funds on a separate basis. This will increase the operational risk for the Funds, as separate execution procedures will need to be established and followed only for the Funds. In addition, the 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 investment funds and other accounts. In the Filer’s 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.

19.          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 Funds. The Filer respectfully submits that the Funds should be encouraged to comply with the robust clearing requirements established by the CFTC and under EMIR by granting them the Requested Relief.

20.          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.

21.          For the reasons provided above, the Filer submits that it would not be prejudicial to the public interest to grant the Requested Relief.

Decision

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 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 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 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.

“Darren McKall”
Manager, Investment Funds and Structured Products Branch
Ontario Securities Commission