Derivatives Sound Practices – Letter (2015)

Suggest deleting the word “market” in the first sentence of this section to appropriately expand the use of derivatives beyond only market risk.

OSFI agrees and the change had been made.

Greater clarity was requested with respect to OSFI’s expectations in the context of the phrase “FRFIs should clearly define the nature and types of incidents with respect to its derivatives activities that would constitute issues requiring escalation to senior management and/or the Board.”

This was revised for greater consistency with other OSFI guidance as follows “Effective control, monitoring and reporting systems and procedures should be in place to ensure on-going operational compliance with the Risk Appetite Framework.”

Any approach to calculate such adjustments should take into account the materiality of such risks. Dealers and active position takers may need more sophisticated models than end-users.

OSFI acknowledges that end-users may generally need less sophisticated models and FRFIs should consider what valuation adjustments are “relevant”.

It is unclear what “exceptions to non-standard International Swaps and Derivatives Association (ISDA) terms” would be as all ISDA Master Agreements contain individually negotiated terms. Amend the sixth bullet to specify the approval requirement is for approval of non-standard credit-related ISDA terms, as ISDA master agreements often include non-standard non-credit terms that should be approved by the appropriate independent control.

This has been revised to “non-standard credit-related ISDA terms”. The intention is to ensure that amendments to any of the standard ISDA terms are approved by the independent risk function.

Provide clarity on the statement “For end-users, these functions may be embedded into an enterprise-wide credit risk management framework” as a FRFI may be both an end-user and a dealer.

OSFI’s expects that the credit risk management function should have analytical capabilities commensurate with the complexity and sophistication of the FRFI’s derivatives activities. FRFIs that act as both end-users and dealers would be held to higher standards than those that use derivatives exclusively as end-users.

Reference to wrong way risk could raise inconsistencies with capital and the internal model method (IMM). Meeting capital requirements guidelines by means of the IMM for EAD should be deemed to satisfy best practice requirements.

Not all FRFIs use the IMM, and the internal credit risk management systems in place should be appropriate for the FRFI commensurate with the nature, size and complexity of its activities.

The requirement to obtain enforceability opinions, which are usually obtained via membership in ISDA, should not be applicable to end-users as many are not currently ISDA members.

The expectation is that FRFIs used netting agreements “where practicable”. The requirement for an enforceability opinion is consistent with the netting requirements for capital purposes.

Greater clarity was requested with respect to netting and margining expectations for limited end-users.

OSFI believes netting and margining are good practices for controlling exposure and risk management purposes, and should be done by FRFIs where practicable. OSFI is planning the application to FRFIs of an international policy framework establishing initial and variation margin requirements for non-centrally cleared derivatives at a future date to be communicated in 2015. The introduction of new OSFI guidance will follow the normal consultation process.

Amend the first sentence to “where practicable and appropriate , new standardized derivatives transactions in which it is transacting where the clearing of such products is offered by a CCP or a QCCP” as there may be cases where central clearing may be practicable but not appropriate from a risk management perspective.

The term “where practicable” allows a FRFI to exercise reasonable judgment, but OSFI expects that all central clearing by FRFIs should be done through a QCCP. OSFI has incorporated “ new standardized derivatives transactions ” into the sentence.  

Amend the sentence re: indirect clearing to “For FRFIs that do not qualify for direct membership, or choose not to become direct members for business and/or credit reasons , indirect clearing may be available as an alternative means of accessing central clearing.

OSFI expects that FRFIs centrally clear where practicable but is not prescribing the manner in which this should be accomplished. The sentence has been revised to read “for FRFIs that are not direct clearing members...”

Greater clarity was requested with respect to the use of central clearing entities by limited end-users.

OSFI acknowledges that central clearing may not currently be practicable for all FRFIs in all circumstances. The requirement for central clearing is “where practicable” which allows a FRFI to exercise reasonable judgment with respect to the scope and timing of the move to central clearing of standardized OTC derivatives, consistent with the G-20 commitment. OSFI believe that appropriate incentives are in place to promote central clearing by FRFIs. OSFI is monitoring the development of mandatory central clearing rules by other regulators, and future revisions to OSFI guidance will be considered to ensure there are comparable requirements across jurisdictions in order to provide a level playing field for all counterparties.

Delete the word “actively” from the requirement to manage its collateral positions.

This term is consistent with other OSFI guidance and is appropriate in this context.

Risk related to derivatives should be considered in a FRFI’s “significant business units”.

The sentence has been revised to read “If derivatives products, activities, processes or systems are material to the FRFI, the inherent operational risk should be identified, assessed and understood…” The concept of materiality should provide sufficient flexibility, and the proposed exemption may be inconsistent with other OSFI guidance.

Requiring all material terms to be agreed in writing prior to executing a non-centrally cleared derivative would in some cases be a significant change from current practices and would place FRFIs at a competitive disadvantage relative to non-FRFIs and foreign market participants.

OSFI believes that FRFIs should seek to agree in writing to all material terms prior to or at the time of execution of a non-centrally cleared derivative, as this is a good practice which promotes legal certainty. OSFI understands that a similar requirement for other market participants (non-FRFIs) may be considered in the future as part of an international policy framework.

The effects of price changes on the close-out value of the portfolio as well as changes in assumptions about the adjustments to the close-out price may not be an applicable or appropriate consideration for FRFIs using derivatives to hedge complex structured liabilities.

OSFI acknowledges that stress testing scenarios should be appropriate for the FRFI based on the nature, size and complexity of its involvement in derivatives, and has incorporated “if appropriate” in this sentence.

Please provide greater clarity on existing and/or future guidelines addressing the following requirements: explicit stress testing of wrong way risk; potential enhancements in capturing liquidity constraints (“prolonged inactivity”); evaluation of the effect of price changes on the close-out cost of the derivatives portfolio; and, evaluation of the breakdown in historically stable correlation relationships.

A reference to OSFI Guideline E-18 Stress Testing has been added. Future updates to OSFI guidance will be made as required.

It may not be feasible for end-users to engage in portfolio compression.

OSFI acknowledges that portfolio compression may not always be feasible for end-users with low volumes or primarily directional trades, and has reflected this in the wording. The requirement is to periodically assess the potential for portfolio compression and, where appropriate , engage in portfolio compression.

This section should acknowledge that a FRFI cannot compel counterparties to reconcile, and should clarify that this requirement only applies to un-cleared derivatives.

OSFI acknowledges this, and would note that the requirement is for FRFIs to “ seek to periodically engage in portfolio reconciliation of uncleared derivatives”.

The words “or cause to be reported” suggest that an end-user is responsible for ensuring dealer counterparties report trades.

The provincial data reporting requirements that OSFI directs FRFIs to follow address the reporting hierarchy. In order to avoid duplication or inconsistency, OSFI has removed “or cause to be reported”.

FRFIs should report derivatives transactions following the derivatives data reporting requirements that have been adopted in the province in which the head office and/or the principal place of business of the FRFI is located.

The suggested wording has been incorporated into the guideline.

Please clarify that FRFIs are not to breach any foreign privacy and data protection laws in order to comply with this section.

OSFI understands that certain FRFIs have obtained relief from provincial and foreign derivatives data reporting requirements related to foreign privacy and data protection laws, and therefore does not believe that changes to the section are required.

Greater clarity was requested with respect to the annual compliance report requirement.

A reference to OSFI Guideline E-13, which addresses reporting by the chief compliance officer (CCO), was added. OSFI expects that this will include an assessment of compliance with the local reporting requirements. The wording has been revised and this requirement has been limited to dealers.

Greater clarity was requested with respect to expectations for reporting to TRs by limited end-users.

The provincial data reporting requirements apply to all FRFIs pursuant to Guideline B-7. The timing and content of the reporting obligation for different market participants are specified in the local reporting requirements.