National Policy 11-203 Process for Exemptive Relief Applications in Multiple Jurisdictions -- exemption from section 2.7(1)(a) of NI 81-102 to permit credit default swaps with a remaining term to maturity of greater than 3 years.
Applicable Legislative Provisions
National Instrument 81-102 Mutual Funds, ss. 2.7(1)(a), 19.1.
September 10, 2010
IN THE MATTER OF
THE SECURITIES LEGISLATION OF
QUÉBEC AND ONTARIO
IN THE MATTER OF
THE PROCESS FOR EXEMPTIVE RELIEF
APPLICATIONS IN MULTIPLE JURISDICTIONS
IN THE MATTER OF
NATIONAL BANK SECURITIES INC.
The securities regulatory authority or regulator in each of the Jurisdictions (the Decision Maker) has received an application from the Filer for a decision under the securities legislation of the Jurisdictions (the Legislation) providing an exemption, pursuant to section 19.1 of National Instrument 81-102 -- Mutual Funds (NI 81-102), from section 2.7(1)(a) of NI 81-102 to permit the investment funds of which the Filer is the investment fund manager, other than any investment fund that describes itself as a "money market fund", that are subject to NI 81-102 (Existing Funds) and investment funds of which the Filer or an affiliate of the Filer is the investment fund manager, other than any investment fund that describes itself as a "money market fund", to be established hereafter that are also subject to NI 81-102 (Future Funds, together with the Existing Funds, the Funds) to enter into credit default swaps without any restriction as to the remaining term to maturity of the swap (the Exemption Sought).
Under the Process for Exemptive Relief Applications in Multiple Jurisdictions (for a dual application):
(a) the Autorité des marchés financiers is the principal regulator for this application;
(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 British Columbia, Alberta, Saskatchewan, Manitoba, New Brunswick, Nova Scotia, Price Edward Island, Newfoundland and Labrador, Yukon, Nunavut and Northwest Territories; and
(c) the decision is the decision of the principal regulator and evidences the decision of the securities regulatory authority or regulator in Ontario.
Terms defined in NI 81-102, MI 11-102 and National Instrument 14-101 -- Definitions have the same meanings if used in this decision. Certain other defined terms have the meanings given to them above or below.
The decision is based on the following facts represented by the Filer:
1. The Filer is a corporation incorporated under the laws of Canada and is registered in all of the provinces and territories of Canada as a dealer in the category of mutual fund dealer.
2. The Filer and the Existing Funds are not in default of securities legislation in any jurisdiction of Canada.
3. Natcan Investment Management Inc. (Natcan) is a corporation incorporated under the laws of Quebec and is registered in: (a) Quebec as an adviser in the categories of portfolio manager and derivatives portfolio manager; (b) Ontario as an adviser in the category of portfolio manager, as a dealer in the category of exempt market dealer, and under the Commodity Futures Act (Ontario) as a commodity trading manager; (c) Newfoundland and Labrador as an adviser in the category of portfolio manager and as a dealer in the category of exempt market dealer; and (d) Alberta, British Columbia, Manitoba, New Brunswick, Northwest Territories, Nova Scotia and Saskatchewan as an adviser in the category of portfolio manager. Natcan acts as the portfolio manager for the Funds.
4. Each of the Funds, other than the National Bank Protected Canadian Bond Fund, the National Bank Protected Retirement Balanced Fund, the National Bank Protected Growth Balanced Fund, the National Bank Protected Canadian Equity Fund and the National Bank Protected Global Fund (collectively, the Protected Funds) is, or will be, a reporting issuer and qualified for distribution in each of the provinces and territories of Canada pursuant to a simplified prospectus and annual information form prepared and filed in accordance with securities legislation. The Protected Funds are reporting issuers that are required to file an annual information form pursuant to section 9.2 of National Instrument 81-106 -- Investment Fund Continuous Disclosure but are not currently qualified for distribution.
5. Any of the Funds may use specified derivatives that comply with their investment objectives as part of their investment strategies to offset or reduce a risk associated with the portfolio investments of the Fund. Portfolio managers may seek to improve the portfolio's rate of return by using derivatives and accepting a lower, more predictable rate of return through hedging transactions, rather than a higher but less predictable potential rate of return.
Portfolio managers may use derivatives to reduce the risk of currency fluctuations, stock market volatility and interest rate fluctuations. In some cases, portfolio managers may use derivatives instead of direct investments. This reduces transaction costs and can improve liquidity and increase the flexibility of a portfolio.
Portfolio managers may also use derivatives for non-hedging purposes. Derivatives can help mutual funds increase the speed and flexibility with which they trade.
6. Section 2.7(1)(a) of NI 81-102 prohibits mutual funds from entering into swaps 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 Funds seek the ability to enter into credit default swaps without a restriction as to the term of the swap.
7. 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 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.
8. The term of a swap equals the maturity of its exposure, in contrast to other over-the-counter derivatives, such as options and certain types of forwards, where the contract term and maturity of the underlying security are not related.
9. 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 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 and/or index credit default swaps are 5 years and 10 years. There is no term restriction in NI 81-102 when investing directly in the reference entities.
10. It is not market convention to have a credit default swap transaction with a 5-year term (subject to a right to eliminate the exposure within 3 years) and, as a result, such an off-market feature may subject a Fund to less efficient pricing.
11. The credit default swap market is very large. 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. $32.7 trillion as of December 31, 2009. The International Swap and Derivatives Association's 2009 year-end market survey estimated the notional amount outstanding to be U.S. $30.4 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.
12. Because swaps are private agreements between two counterparties, a secondary market for these 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 credit default swaps 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 is offset. Parties may also agree to terminate the agreement at a fair market price prior to the maturity date of the agreement.
13. 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 which has defaulted or, in the case of a single name credit default swap, equal to the full notional exposure. This exposure is mitigated because the counterparty or a guarantor 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.
14. By permitting the Funds to enter into credit default swaps beyond 3 years terms, it increases the possibility for the 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 credit default swaps beyond 3 year terms enables the Funds to effect hedging transactions that help mitigate underlying investment risks associated with investing in fixed income investments. It also allows the Funds to respond more rapidly to changes in the corporate market.
15. The Funds have the right to terminate swaps early if a counterparty's credit rating drops below the credit ratings required by NI 81-102, and the Funds will do so in accordance with the terms of section 2.7(2) of NI 81-102.
16. Natcan is responsible for managing the risks associated with the use of derivatives. Natcan has written guidelines that set out the objectives and goals for derivatives trading.
17. In addition, Natcan 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.
18. Limits and controls on derivatives trading are part of Natcan'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.
19. The derivative transactions entered into on behalf of a Fund must be in accordance with the investment strategies of the Fund
20. The prospectus and annual information form of the Funds discloses the internal controls and risk management processes of the Filer and Natcan regarding the use of derivatives and, upon renewal, will include disclosure of the nature of the Exemption Sought until such time as the amendment to section 2.7(1) of NI 81-102 (which has been proposed in a Notice of Proposed Amendments to NI 81-102 dated June 25, 2010 and is consistent with the Exemption Sought) is in effect.
21. Without the Exemption Sought, the Funds will not have the flexibility to enhance yield and to manage more effectively their exposure and credit risk under specified derivatives.
Each of the Decision Makers is satisfied that the decision meets the test set out in the Legislation for the Decision Maker to make the decision.
The decision of the Decision Makers under the Legislation is that the Exemption Sought is granted.